Are sovereign debts sustainable under energy transition?

We document the effects of transitioning the economy’s energy sectors towards low-carbon sources on sovereign debt sustainability by integrating climate change assessment models into stochastic debt sustainability analysis. Using projections from the Network for Greening the Financial System (NGFS), we evaluate orderly and disorderly transition pathways aligned with the Paris Agreement. The model accounts for both the transition risk premium affecting debt financing costs and the transition impacts on economic growth affecting the debt-to-GDP ratio. We find significant increases in sovereign debt across 16 countries worldwide, beginning in the late 2030s. To offset these debt increases, annual fiscal adjustments up to 0.9% of GDP would be necessary, with substantial cross-country differences. Stabilizing the elevated debt levels resulting from energy transition would require total fiscal adjustments averaging 1.5%–1.7% of GDP, depending on climate projections. Transitions with stringency set at about two-thirds of the NGFS’s can be financed sustainably. Green growth, spurred by the transition, of about 0.6% could offset the debt impact. We further show that transition risks incentivize debt management toward longer maturities. Accounting for the debt fundamentals across the full economy, we corroborate the findings for the energy sector and show that recycling carbon tax revenues toward debt repayment could improve debt sustainability under certain conditions.