Asymmetric sovereign risk: Implications for climate change preparation

Abstract

Climate change adaptation efforts heavily depend on a country’s fiscal capacity and the costs associated with implementing adaptation policies. The high levels of debt currently accumulated by developing countries, which disproportionately bear the brunt of climate change, raise significant concerns. We investigate whether these asymmetric economic conditions are reflected in how sovereign spreads react to climate change risks across different countries. Our study introduces a panel quantile model with fixed effects from statistical medicine and leverages recent advances in machine learning to address selection bias often encountered when constructing a balanced panel of spreads across countries for varying maturities. Our findings indicate that sovereign risk and, consequently, funding costs for governments exhibit significantly asymmetric reactions to their determinants across the conditional distribution of credit spreads. Countries with elevated risk levels are disproportionately impacted by climate change vulnerability compared to their lower-risk counterparts, particularly in the short term. Notably, investing in climate change preparedness proves effective in mitigating vulnerability, especially regarding sovereign risk for countries with low spreads and long-term debt. However, for those with high spreads and short-term debt, additional measures are essential, as climate change readiness alone is often insufficient to offset vulnerability effects. Our results contribute to the understanding of the ecological transition and the fiscal risks faced by developing countries.