Highlights

Just under two-thirds of Debt Sustainability Analyses (DSAs) mentioned climate change or natural disasters as relevant to debt stress over the long term. This share is expected to increase with the introduction of Country Climate and Development Reports as a new core diagnostic, integrating climate change and development considerations.

The implications of climate change and natural disasters on debt sustainability were discussed in DSAs for almost all Small Island Developing States, a group particularly vulnerable to climate change.

Just under two-thirds of the most recent DSAs discussed climate change, as did four of nine case studies. Of 18 Small Island Developing States, 13 included climate change or natural disasters in their baseline assumptions and 15 incorporated climate change or natural disasters in tailored tests.

Climate shocks are increasingly affecting global growth, and the frequency and intensity of climate shocks are expected to increase, including in the form of acute events (such as wildfires, storms, and floods) and chronic ones (such as drought, rising temperatures, and rising sea levels). Climate shocks reduce macroeconomic performance (due to slowed growth from disruption to business activities) and the fiscal costs associated with recovery and reconstruction. Vulnerability to climate change can also increase the cost of government borrowing. Recent IMF analysis suggests that an increase of 10 percentage points in climate change vulnerability is associated with an increase of over 150 basis points in long-term government bond spreads for emerging markets and developing economies (Cevik and Jalles 2021). For these and other reasons, it is imperative that the impact of climate change be taken into account in DSAs.

The impact of climate change on long-term growth and debt prospects was discussed in DSAs for four of nine case studies—Bhutan, the Comoros, Dominica, and Papua New Guinea—to varying degrees, including all cases where the impact of climate change on debt vulnerabilities is particularly prominent.

• Climate change was discussed throughout Dominica’s DSA (IMF 2022b), after back-to-back natural disasters in 2015 and 2017, which put public debt on an upward trajectory. The country is establishing resilience funds, and the DSA includes a “catastrophic climate event” scenario, which assumes the reoccurrence of a Category 5 hurricane that impacts real GDP, exports, and revenues similar to those after Hurricane Maria, and a considerable increase in expenditure in rehabilitation, albeit with a slower pace of recovery to account for more binding financing constraints.
• The Comoros’s DSA included discussion of 2019 Cyclone Kenneth and how potential growth was revised down to reflect the impact of natural disasters that are increasingly frequent because of climate change; it also discussed incorporating a tailored test (IMF 2021f).

Bhutan’s and Papua New Guinea’s DSAs had fewer mentions of climate change. Bhutan’s DSA simply mentioned how the country could be vulnerable to climate-related shocks, considering how climate-induced changes to glacier-fed rivers and adverse weather patterns could reduce hydropower generation and exports (IMF 2022a). It did not include climate change in the baseline or a natural disaster tailored test. Similarly, for Papua New Guinea, the DSA mentioned how the country is vulnerable to natural disasters (flooding, landslides, and earthquakes) and the impact of climate change through droughts and sea-level rises (IMF 2022d). It also did not include climate change in baseline projections or a natural disaster tailored test.

Small Island Developing States (SIDS)1 are considered to be among the most vulnerable to climate change. SIDS typically have less diversified economies and are more reliant on industries that are susceptible to climate change. Climate risks for SIDS include a rise in sea levels, an increase in tropical and extratropical cyclones, rising air and sea surface temperatures, and changing rainfall patterns (CDKN 2014). Higher exposure to disasters translates to lower GDP per capita, higher poverty, and a more volatile stream of fiscal revenue (IMF 2016). On average, the annual cost of disasters for SIDS is 2 percent of GDP, over four times higher than for larger countries. The cost of rising sea levels as a percentage of GDP is highest for SIDS in the Pacific.2 The expectation was that if climate change was rigorously incorporated into DSAs, it would most likely show up for this group of countries.

Climate change and natural disasters were incorporated into DSAs for all but 1 of 18 SIDS. This compares favorably with the DSAs for all countries, where only 61 percent mentioned climate change or natural disasters, and for case study countries, where 4 of 9 countries discussed climate change. Of the most recent DSAs for 18 SIDS, 17 mentioned climate change or natural disasters in their analysis; only Cabo Verde (September 2020) did not. Of the 18 countries, 13 included climate change and natural disasters in their baseline assumptions,3 and 15 incorporated climate change and natural disasters in tailored tests.4 Most DSAs, including Haiti (April 2020), Kiribati (January 2019), Samoa (March 2021), Tonga (February 2021), Tuvalu (August 2021), and Vanuatu (September 2021), assumed that there would be no major climate events or disasters in the medium term and included them in the baseline scenario for the long term, given the likelihood over the long term for disasters, recovery and reconstruction needs, and resilience-building demands. Of the 18 countries with this analysis, 4—Haiti, the Federated States of Micronesia, Samoa, and Tuvalu—used an extended projection period of 20 years, rather than the standard 10 years.

For the most part, DSAs for SIDS include a robust analysis on the impact of climate change on debt sustainability (box 5.1). However, the most recent DSAs for some SIDS include only minimal discussion of climate change. For example, in the DSA for Maldives, climate change and natural disasters receive only a brief mention; the DSA states that the natural disaster tailored test is relevant to Maldives and that the country is susceptible to rising sea levels (IMF 2020b).

According to the LIC-DSF guidelines, small states vulnerable to natural disasters and LICs that meet frequency criteria (of two disasters every three years) and economic loss criteria (above 5 percent of GDP per year)5 require a natural disaster tailored shock test. If assumptions about the impact of natural disasters are already embedded in the baseline scenario, DSA users should adjust the default shock parameters. For example, the Solomon Islands is automatically subject to the standard natural disaster shock, and the parameter setting is customized based on national data on natural disasters from the Emergency Events Database. In the DSA for the Federated States of Micronesia, the increasing severity of natural disasters was cited as the reason for a tailored stress test. The DSA noted that the country is highly vulnerable to natural disaster shocks, which would raise the present value of the external debt-to-GDP ratio above the threshold five years earlier than in the baseline and lead to an “explosive debt path” (IMF 2021a, 6).

DSAs for some SIDS treat financing for climate adaptation as both a source of fiscal stress and a necessity to maintain debt sustainability in the long term. In the medium term, the fiscal resources required to finance rehabilitation from recent shocks and resilient infrastructure for the future are projected to widen deficits. However, generally, DSAs suggest that this is a good use of resources, given it will reduce costly damages later. Some illustrative examples are presented below:

• In Vanuatu, the baseline primary deficit is expected to deteriorate as a result of increasing infrastructure spending associated with Tropical Cyclone Harold. However, the DSA results also indicate that building fiscal buffers and enhancing resilience from natural disasters are a precondition for debt sustainability (IMF 2021g).
• In Grenada, long-term growth forecasts incorporate the negative impacts of climate change and the positive impact of adaptation, specifically implementation of the national Disaster Resilience Strategy (IMF 2022c).
• In Tuvalu, a cyclone similar to Tropical Cyclone Pam (in 2015) was projected to hit the island in 2022 and cause damage amounting to 30 percent of GDP. Recovery and rehabilitation programs are projected to take five years and widen the fiscal deficit to 11 percent of GDP in 2031 (compared with a 6 percent of GDP baseline) and add approximately 1 percent to the deficit in 2032–36, but they are imperative for strengthening longer-term resilience (IMF 2021e).

The World Bank has recently introduced Country Climate and Development Reports (CCDRs) as a core diagnostic integrating climate change and development considerations. They were designed to help countries prioritize the most impactful actions that can reduce greenhouse gas emissions and boost adaptation, while delivering on broader development goals. CCDRs build on data and rigorous research and identify pathways to reduce greenhouse gas emissions and climate vulnerabilities, including the costs, challenges, benefits, and opportunities from doing so. They articulate priority actions to support a low-carbon, resilient transition. The first CCDR was published in June 2022, and they are expected to be rolled out to all World Bank countries within four years.

As part of the analysis underlying CCDRs, the World Bank’s macroeconomic and fiscal model (MFMod) has incorporated a forecasting instrument that can simulate a range of climate and policy scenarios. Models cover greenhouse gas emissions from five sources and economic damages from climate change derived from the literature. Such damage includes physical damage from extreme weather events and the impacts of higher temperatures and increased rain variability on economic activity (for example, effects on competitiveness of sectors such as tourism, reduced labor and agricultural productivity, and declines in health and labor supply; World Bank 2022). MFMod also incorporates co-benefits from mitigation. These cobenefits include reduced pollution, which results in improved health outcomes, lower health spending, and increased labor productivity and supply, as well as interactions with other country-level externalities, such as those coming from excess informality or the elimination of tax distortions. The standard model includes a basic adaptation module that can be supplemented with country-specific data and estimates. MFMod is particularly beneficial for exploring economic dynamics after economic shocks (for example, natural disasters or material price changes; World Bank 2022).