Climate-vulnerable developing countries face rising cost of debt

Integrating climate risk into financial decision-making is key to addressing financial stability risks associated with climate change. It is also critical for pricing the correct cost of carbon-intensive investments and fostering sustainable investment and development. Yet, properly accounting for the risks and costs posed by climate change will have unintended, adverse consequences for those who are particularly vulnerable to climate change and lack the resources to invest in resilience.

In recent research undertaken jointly by Imperial Business School and SOAS University of London that was commissioned by UN Environment, we conducted the first systematic analysis of the relationship between climate vulnerability, sovereign credit profiles and the cost of debt. Our empirical work indicates that interest rates on debt of climate vulnerable developing countries are already higher than they would otherwise be, due to climate vulnerability. We estimate that exposure to climate risks has increased the cost of debt for these countries by 117 basis points, on average. This means that for every ten dollars climate vulnerable developing countries spend on interest payments, they have to pay another dollar because they are climate vulnerable.

In absolute terms, this translated into more than USD 40 billion in additional interest payments for 40 climate vulnerable countries over the past 10 years on government debt alone. Incorporating higher sovereign borrowing rates into the cost of private external debt we estimate that climate risks have cost debt-issuing vulnerable developing countries over USD 62 billion in higher interest payments across the public and private sectors. We expect these additional costs to expand to between USD 146 – 168 billion over the next decade.

Clearly, such forecasts provide only a rough. If anything, our estimates are conservative. The underlying model incorporates only a subset of climate vulnerabilities, which itself is a subset of the wider range of climate risks. It is implicitly biased downwards by its backward-looking nature and the exclusion of indirect effects on the economy, higher project hurdle rates and the fact that access to financial markets by these countries is already limited.

Vulnerable countries pay twice

A higher cost of sovereign debt has a broad impact on an economy as it also raises the cost of capital that the private sector has to pay. The worsening of both public and private financing costs will hold back crucial investments and the development prospects of societies that are already punished by climate change. The cruel irony is that countries that have not contributed to climate change effectively end up paying twice: for the physical damage their economies face and through higher costs of capital. Climate-vulnerable countries face the unenviable task of managing the increased financial costs of climate change as the physical impacts of climate risks themselves accelerate.

But our research also reveals a bright spot. We find that investing in social preparedness to climate change partially offsets the effects of climate vulnerability. This highlights the crucial importance of investments that enhance the adaption capacity and resilience of climate vulnerable countries. Such investments will not only help vulnerable countries to better deal with climate risks, they will also help to bring down the cost of their borrowing. So far markets are placing the wrong value on efforts that mitigate climate risks. Such a market failure implies that the hurdle rate for adaption projects are too high, and the returns on such projects are commensurately greater. Helping people address climate risk is a good investment.

International cooperation and adequate investment in climate resilience is needed to mitigate the increased capital costs facing climate vulnerable developing countries. International support for increased investments in climate adaptation measures and mechanisms to transfer financial risks can help these countries to enter a virtuous circle: Greater investments in adaptation will reduce both vulnerability and the cost of debt, providing these countries with extra room to scale up investments to tackle the climate challenge. Without international support, the likely outcomes are increased vulnerability, rising cost of capital and deferred development.

Ulrich Volz is Head of the Department of Economics and Reader in Economics at SOAS University of London.

Bob Buhr is a Research Fellow at the Centre for Climate Finance and Investment at Imperial College Business School.

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