Climate Change Transition Risk on Sovereign Bond Markets

Abstract

We challenge the narrative that climate change transition risk is not being priced into sovereign bond markets. As measured by carbon dioxide emissions, natural resources rents and renewable energy consumption, climate change transition risk is factored into sovereign bond yields (and spreads) by investors. Using a sample of data from 23 advanced and 16 developing markets from 2000-2019, we show that countries with lower carbon emissions incur a lower risk premium on sovereign borrowing costs. Moreover, advanced countries willing to reduce their earnings from natural resources rents and, to some extent, increase renewable energy consumption are associated with lower sovereign borrowing costs. In contrast, developing countries with a strong dependence on natural resources or restricted renewable energy consumption incur lower sovereign borrowing costs. Thus, advanced economies that perform poorly in managing their climate transition may encounter increased sovereign borrowing costs, liquidity constraints, reduced capacity to effectively manage climate transition and the inability to finance economic recovery from severe climate shocks or natural disasters. The necessity to support developing countries to meet climate change targets also emerges. Given the threat climate change poses to the global economy and the fact that transition risk is materialized much faster than physical risk, we advocate an increase in the significance of climate transition risk factors as determinants of sovereign bond markets.

Keywords: climate change, transition risk, sovereign yields, carbon dioxide, natural resources rents, renewables, GDP

JEL Classification: F34, G15, H63, Q20, Q51