European Central Bank publishes research modelling climate-linked sovereign bonds and estimating around 3% of major economies’ government debt could be converted

The European Central Bank has published a Working Paper examining climate-linked bonds issued by governments and supranational organisations, where coupons or principal adjust to realised climate variables such as average temperature or greenhouse gas emissions. The paper develops an asset pricing and risk-sharing framework and argues that market pricing of these instruments could reveal market-implied climate expectations and a climate risk premium, while providing investors with a long-term hedge against physical climate risk. It estimates that around three percent of outstanding government debt in major economies could be converted into climate-linked bonds. The paper sets out how climate-linked bonds could align sovereign financing costs with climate outcomes, potentially lowering debt-service costs when climate metrics improve while increasing them when they deteriorate. It outlines potential benefits for investors including simplified long-horizon hedging relative to dynamic strategies, diversification due to lower correlation with the business cycle, and a mechanism to help narrow the climate insurance protection gap by making part of the government backstop explicit. It also discusses a possible role for central banks in supporting market development and liquidity by holding such instruments on their balance sheets, and highlights design and implementation considerations including metric selection and standardisation, maturity structure and liquidity, basis risk, transparency and governance, and the need for international coordination to mitigate free-riding.