Climate-Linked Bonds

Research Highlights

• In this paper, we introduce a novel financial instrument, climate-linked bonds, whose payoffs are adjusted based on climate-related variables (e.g., temperature, climate emissions, water levels, etc.), enabling investors to hedge against long-term climate risks.
• We argue that climate-linked bonds issued by governments or supranational organizations are critical for transitioning to a net-zero economy, signaling governments’ commitment to climate action, aligning financial incentives with climate policies, and fostering robust early-stage measures against climate risks.
• In a stylized model of supply and demand for climate hedging, we establish the factors that drive the pricing of these bonds in equilibrium and estimate that, on average, around three percent of outstanding government debt in large economies could be converted into climate-linked bonds.
• These instruments have the potential to reduce the information, incentive, and insurance gaps in climate risk, thus aiding the management of climate risks while aligning public and private sector interests.
• Central banks can support the market for climate-linked bonds by incorporating these instruments into their monetary policy frameworks, thereby promoting sustainable finance practices.