Look up and ahead: How climate scenarios affect European sovereign credit risk

Abstract

We provide empirical evidence on the potential evolution of future climate-related impacts on sovereign credit risk in Europe, measured through sovereign Credit Default Swap (CDS) spreads and risk-neutral implied probabilities of default. We analyze the interaction between countries’ climate risk exposure and their fiscal and financial fundamentals using a panel model estimated with annual data for 24 European countries over the period 2010–2022. The estimated model is then used to project sovereign credit risk up to 2050 under the supervisory climate scenarios developed by the Network for Greening the Financial System (NGFS). Results reveal both temporal and structural dimensions of climate-related sovereign risk. In the short term, adjustments to GDP and fiscal policy induced by climate transition risk increase sovereign risk. Over the long run, however, an orderly transition toward the Net Zero 2050 target leads to lower sovereign credit risk than a delayed or less ambitious transition in greenhouse gas emissions reduction. The increase in sovereign risk is particularly pronounced in economies with carbon-intensive production. Our findings underscore the importance of timely and credible climate policy in enhancing sovereign debt sustainability in Europe amid growing climate change impacts.