Climate change poses a significant risk to financial stability by impacting sovereign credit risk. Quantifying the exact impact is difficult as climate risk encompasses different components– transition risk and physical risk – with some of these, as well as the policies to address them, playing out over a long time horizon. In this paper, we use a large panel of 52 developed and developing economies over two decades to empirically investigate the extent to which climate risks influence sovereign yields. The results of a panel regression analysis show that transition risk is associated with higher sovereign yields, with the effect more pronounced for developing economies and for high-emitting countries after the Paris agreement. In contrast, high-temperature anomalies do not appear to be priced-in sovereign borrowing costs. At the same time, countries with high levels of debt tend to record higher sovereign yields as acute physical risk increases. In the medium term, using local projections, we find that sovereign yields respond significantly but also differently to different types of disaster caused by climate change. We also explore the nonlinear effects of weather-related natural disasters on sovereign yields and find a striking contrast in the impact of climate shocks on sovereign borrowing costs according to income level and fiscal space when the shock hits.
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