On the intersection of climate change and sovereign debt

Climate change and government debt: A review

Caterina Seghini, in this literature review, explores the complex relationships between climate change and sovereign debt sustainability. The review highlights that while policy discussions have recognized the impact of climate change on government finances, academic studies on this topic are still limited. Most existing papers focus on empirically estimating the impact of climate events on sovereign risk and financing conditions. In particular, Seghini finds that:

• Climate vulnerability notably increases borrowing costs, especially in high-risk economies.
• Climate-induced sovereign credit rating downgrades are predicted as early as 2030 under various warming scenarios.
• Failing to mitigate emissions globally leads to reduced fiscal space and heightened debt sustainability challenges.
• Coordinated global action towards a green transition can stabilize and potentially improve fiscal limits in the medium-long term, despite initial economic impacts.
• Expenditure-based measures can threaten public debt sustainability and economic stability, especially in high-debt countries and in the presence of spillover mechanisms from public to private financing conditions.

Conclusion

The review underscores the urgent need for integrated fiscal and environmental strategies in modeling frameworks to address the dual challenges of climate change and sovereign debt sustainability. It emphasizes the importance of considering climate risks and mitigation costs in assessing long-term public debt dynamics and economic stability.

Climate and sovereign debt sustainability: A literature review
Author: Caterina Seghini
From: Banque de France

Rethinking climate fiscal policy

Caselli et al., in this IMF working paper, examine the potential impacts and challenges of implementing “green fiscal rules” designed to protect climate-related spending. The authors use simulations to analyze the effects of green fiscal rules on debt dynamics for a typical emerging market (EM) economy. The methodology involves:

1. Estimating a debt limit and fiscal buffers needed to maintain debt sustainability.
2. Projecting climate-related spending needs based on IMF estimates.
3. Simulating debt trajectories under different green fiscal rule scenarios.

Their findings include:

Challenges with Green Fiscal Rules

1. Unsustainable Debt Dynamics: If countries rely mainly on spending measures (e.g. investment, subsidies) to address climate change, green rules that exempt such spending from fiscal limits can lead to unsustainable debt levels.
2. Overly Tight Non-Green Budgets: To maintain debt sustainability while exempting green spending, countries would need to run very large surpluses in their non-green budgets, which may be politically unfeasible.
3. Credibility Issues: The large trade-offs involved in implementing green rules could undermine their credibility and effectiveness in promoting fiscal discipline.

Simulation Results

1. Under a scenario with no fiscal rule and 2% of GDP annual green spending, debt would surge to almost 140% of GDP by 2050 for a typical EM.
2. With a green rule exempting 2% of GDP in mitigation spending from a 3% deficit ceiling, debt would still reach over 100% of GDP by 2050.
3. To preserve debt sustainability with 2% annual green spending, a country would need to maintain a 2.5% of GDP primary surplus in its non-green budget.

Proposed Alternative

The authors suggest developing “green medium-term fiscal frameworks” (MTFFs) as a more comprehensive approach to incorporate climate considerations into fiscal policy while maintaining sustainability. This would involve:

1. Integrating climate risks and policies into budget planning.
2. Optimizing the mix of green fiscal policy tools, including carbon pricing.
3. Prioritizing high-impact green spending within overall fiscal constraints.

Green Fiscal Rules? Challenges and Policy Alternatives
Authors: Francesca Caselli, Andresa Lagerborg, Paulo Medas
From: IMF