Assessing Climate Change Impact on Sovereign Bonds

Abstract

The authors propose an approach to assess climate change’s impact on sovereign bonds by considering forward-looking climate forecasts and their economic impact and using those as overlays in a pricing model for sovereign bonds. The authors use outputs from climate models reviewed by the Intergovernmental Panel for Climate Change and published literature on the economic impact of rising temperatures, change in tropical cyclone activity, and coastal flooding caused by sea level rise. The authors improve on existing sovereign pricing models by considering sovereign segmentation into developed markets, emerging markets issuing bonds in local currency, and emerging markets issuing bonds in a hard currency. By passing climate change’s economic impacts through the pricing model, the authors can assess the relative pricing impact for each security. The authors also provide country-level climate risk scores and change in risk-neutral probability of default for each issuer. This is novel research and is likely to be improved over time as more practitioners start considering climate risks as financial risks.