The impact of climate risk on fiscal space is a critical issue that affects countries globally. Recent literature highlights how climate risk can reduce fiscal space and hinder the financing of green transition projects, especially in emerging markets. While the literature acknowledges these challenges, it has not delved into the role of financial development and political stability in influencing the climate risk premium.
In a recent collaborative study, researchers investigated the relationship between climate risk, fiscal space, financial development, and political stability. By analyzing data from 199 economies over the years 1990-2022, the study revealed several key insights:
- Climate risks adversely affect fiscal space, especially in economies most vulnerable to climate change.
- Political stability and financial development can mitigate the impact of climate risk on fiscal space.
- Nonlinearities exist in the climate risk-fiscal space nexus, with the greatest impact observed in economies with constrained fiscal space.
Figure 1 depicts a heat map showing countries with low vulnerability scores, indicating a higher resilience to climate risks. Interestingly, some less economically developed countries display low vulnerability scores due to factors like infrastructure quality and energy autonomy. Conversely, Figure 2 illustrates countries with high vulnerability scores, mostly located in sub-Saharan Africa and South Asia, which tend to be at lower stages of development and have underdeveloped financial markets.
Further analysis in Figures 3 and 4 reveals that countries highly exposed to climate change experience significant impacts on sovereign bond yields and ratings. Financial institution development plays a crucial role in mitigating these impacts, as seen in the results presented in Figures 5 and 6. Countries with mature financial institutions are less affected by climate vulnerability shocks, highlighting the importance of sound financial systems.
Moreover, the study examined the influence of political stability on the climate risk premium. Results in Figure 7 and Figure 8 indicate that countries with stable political systems are less affected by climate risk, except in cases of religious tensions. Understanding these dynamics can help policymakers navigate funding challenges associated with the ecological transition.
In conclusion, the study underscores the interconnected nature of climate risk, financial development, political stability, and fiscal space. By addressing these factors collectively, countries can better prepare for climate challenges and ensure sustainable development in the years to come.
