No. 2026-03 - The Adaptation Imperative: Climate Change and Sovereign Credit Risk

Abstract:

This paper examines how climate change affects sovereign credit ratings and borrowing costs under the latest IPCC climate scenarios. We integrate country-specific income-loss estimates from Mohaddes and Raissi (2025) into the IMF’s Q-CRAFT macro-fiscal framework and apply a Random Forest emulator to predict rating trajectories. We also use the CDS-spread mapping from Aizenman et al. (2013) to translate these rating changes into borrowing-cost effects. Results show negligible rating impacts under the Paris aligned scenario but significant downgrades (up to 2.8 notches) and increases in borrowing costs (30 basis points) under high-emission, slow-adaptation pathways by 2100 for the G20 countries. Monte Carlo simulations highlight substantial tail risks and cross-country heterogeneity, with tail outcomes producing downgrades of up to six notches by century end. We further extend the analysis to unrated economies and incorporate acute physical risks from climate-related natural disasters, using DIGNAD to estimate their cumulative GDP effects over 30 years and feeding these into the Q-CRAFT and the Random Forest emulator to project ratings. Disaster exposure can induce 1–3 notch downgrades by 2050 for highly vulnerable emerging economies.