Abstract
Both the physical and transition-related impacts of climate change pose substantial macroeconomic risks. Yet, markets still lack credible estimates of how climate change will affect debt sustainability, sovereign creditworthiness and the public finances of major economies. We present a taxonomy for tracing the physical and transition impacts of climate change through to impacts on sovereign risk. We then apply the taxonomy to the UK’s potential transition to net zero. Meeting internationally agreed climate targets will require an unprecedented structural transformation of the global economy over the next two or three decades. The changing landscape of risks warrants new risk management and hedging strategies to contain climate risk and minimise the impact of asset stranding and asset devaluation. Yet, conditional on action being taken early, the opportunities from managing a net zero transition would substantially outweigh the costs.
Highlights
Advancements in recent decades in climate science and economic modelling, juxtaposed against the real-time observation of the dire consequences of extreme weather events, have revealed important lessons about the macroeconomic consequences of climate change
Whilst climate-economic models have described in ever greater detail the potential costs of the physical impacts of climate change, we highlight the importance of understanding the transition impacts and how they affect fiscal sustainability
Bastien-Olvera and Moore (2020) construct a GreenDICE model to simultaneously model these linkages, showing that they have long-lasting implications for human welfare, carbon prices and the optimum investment strategy for addressing climate change. They find that the macroeconomic consequences of emissions are even greater when climate-induced natural capital loss is included and because early investments in biodiversity and ecosystems can partially offset the costs of climate change, they are important components of any climate strategy (Agarwala and Coyle, 2020)
Summary
Advancements in recent decades in climate science and economic modelling, juxtaposed against the real-time observation of the dire consequences of extreme weather events, have revealed important lessons about the macroeconomic consequences of climate change. Whilst climate-economic models have described in ever greater detail the potential costs of the physical impacts of climate change, we highlight the importance of understanding the transition impacts and how they affect fiscal sustainability. Our contribution to this special issue is timely, not just with respect to COP26 in Glasgow, Scotland, and in the midst of unprecedented fiscal disruption in response to the Covid-19 pandemic. Concern over debt-rollover, fiscal space and the ability to respond to future shocks are paramount in policy circles These discussions must include an understanding of how climate change—and our responses to it—will affect the public finances and sovereign debt markets. The topics discussed here are of interest to policy-makers and investors concerned with financial system stability, institutional investors and pension managers, and the flow of accurate information through markets—a necessary condition for the efficient management of risk
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