International support is needed to reverse the vicious circle of climate vulnerability and higher cost of capital in developing countries

The financial sector is increasingly awakening to the challenges posed to our economies by climate change. Since Bank of England governor Mark Carney made his famous speech on the ‘Tragedy of the horizon’ in September 2015, climate change has moved from being a backroom issue for a few concerned ethical investors to become a boardroom issue for finance executives and high-level finance officials. 

Propelled by international initiatives such as the UN Inquiry into the Design of a Sustainable Financial System, the G20 Sustainable Finance Study Group and the Financial Stability Board’s Task Force on Climate-related Financial Disclosures, financial institutions and authorities are progressively exploring how environmental risk analysis can be incorporated in financial decision-making and regulation. Likewise, credit rating agencies have started to incorporate climate risks into their rating methodologies, although they do not expect these risks to materialise in the current five-year sovereign horizon.

Integrating climate risk into financial decision-making is critical to addressing financial stability risks associated with climate change. It is also crucial for pricing the true cost of carbon-intensive investments and fostering sustainable investment and development. However, it should be acknowledged that properly accounting for the risks and costs posed by climate change will have unintended, negative consequences for those who are particularly vulnerable to climate change and lack the means to invest in resilience.

In recently published research commissioned by UN Environment, we set out to undertake 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. In other words, for every $10 climate-vulnerable developing countries spend on interest payments, they pay another dollar because they are climate vulnerable.

In absolute terms, this translated into more than $40bn (€30.4bn) 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 $62bn in higher interest payments across the public and private sectors. We expect these additional costs to balloon to between $146bn and $168bn over the next decade.

Obviously, such forecasts provide only a rough estimate of the additional cost facing climate-vulnerable developing countries. 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.

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.

Vicious circle

An important corollary of our finding is that a higher cost of debt makes investments in climate adaptation more difficult. There is a risk that climate-vulnerable developing countries enter a vicious circle: greater climate vulnerability raises the cost of debt, limiting the fiscal room for investment in climate adaptation, which in turn makes these countries even more vulnerable, with further adverse effects on the cost of capital. As financial markets increasingly price climate risks, the risk premia of vulnerable countries, already high, are likely to rise further.

The increase in the costs of debt servicing associated with climate vulnerability is an issue of concern beyond economics and finance. It touches upon a country’s capacity to fund education, health, infrastructure, and to enable basic standards of living. Because poorer countries tend to have relatively weak sovereign ratings and higher borrowing rates, they are particularly sensitive to new financial risks. Greater overall debt burdens could prevent poor countries from funding the investments required to protect their citizens and economies from the physical manifestations of climate change, at a time when those investments are most needed.

Better to be prepared

But our research also reveals a bright spot. We find that investing in social preparedness for 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 rates for adaptation projects are too high, and the returns on such projects are commensurately greater. Helping people address climate risk is a good investment.

We need international cooperation and adequate investment in climate resilience 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 senior lecturer/associate professor in Economics at SOAS, University of London. He is also a senior research fellow at the German Development Institute, honorary professor of economics at the University of Leipzig, a member of the advisory council of the Asian Development Bank Institute in Tokyo, chairman of the Japan Economy Network, and co-editor-in-chief of the Asia Europe Journal. Bob Buhr is a research fellow at the Centre for Climate Finance and Investment at Imperial College Business School.