The frequency and intensify of shocks hitting the global economy has risen over the past two decades. Governments have repeatedly stepped in to act as ‘insurers of last resort’. With every successful intervention, the expectation grows that government will once again step in when the next extraneous shock hits. This generates moral hazard. Climate change is a major contingent liability risk, with both ex-ante known and unknown fiscal costs.
All else equal, climate change has a negative effect on sovereign balance sheets. There is a consensus amongst scientists that global warming will lead to more frequent and intense adverse weather events (climate physical risk). Many developing countries will bear the brunt of these costs. But developed markets are exposed too. Southern Europe is a case in point. Reinforcing feedback effects exacerbate the risks. Rising public sector debt burdens in turn reduce the ability of governments to invest, to hit net zero targets.
A negative term premium is hard to substantiate in the current scenario of rising climate risk. Some dispute the models used to estimate the term premia. But the slope of the yield curve tells a similar story: if the risks associated with climate change are increasing, investors should demand a premium for holding longer-duration government debt. Governments will be asked to bear the costs of climate change.
