Climate Defaults and Financial Adaptation

Abstract

We analyze the relationship between climate-related disasters and sovereign debt crises using a model with capital accumulation, sovereign default, and disaster risk. We find that disaster risk and default risk together lead to slow post-disaster recovery and heightened borrowing costs. Calibrating the model to Mexico, we find that the increase in cyclone risk due to climate change leads to a welfare loss equivalent to a permanent 1% consumption drop. However, financial adaptation via catastrophe bonds and disaster insurance can reduce these losses by about 25%. Our study highlights the importance of financial frictions in analyzing climate change impacts.

Chapter 19 : Economics. Fifth National Climate Assessment

“…For example, declines in property values due to climate change could adversely affect mortgage markets and financial institutions' balance sheets, potentially leading to financial distress, especially if climate risks are imperfectly priced or if they are concentrated in government-sponsored enterprises. 202,206,207,208,209,210 While more research is needed to understand these systemic effects, some underlying risks can be managed. For example, the risk of future asset price corrections, driven by misalignment between current prices and the expected effects of climate change, 57,101,102,103,109,211 can be reduced through communication and disclosure of climate risks to market actors.…”