The baseline is wrong: How debt sustainability analyses used in the EU ignore climate change

The European Union has reformed its fiscal rules in late 2024, making debt sustainability analysis (DSAs) the central steering tool for European fiscal policy. DSAs will be used to project debt-to-GDP ratios and derive fiscal policy requirements. In this paper, we show that DSAs currently largely ignore economic impacts resulting from climate damages, as well as from the climate policies needed to satisfy the emissions constraint set by European climate targets. Both will likely reduce economic growth and worsen fiscal indicators, according to relevant literature. We further discuss how the growth impact of climate policy depends on the mix of policy instruments. In the presence of market failures beyond the carbon externality and uncoordinated global climate action, a balanced policy approach including public investment will likely lead to better economic outcomes than an approach based purely on carbon pricing. We show how DSAs can account for the impacts of climate damages and for policies in alignment with the current fiscal constraints (a new baseline). Illustrated by indicative simulations, we show that a more balanced climate policy approach could improve growth and possibly even fiscal indicators vis-à-vis this new baseline. We conclude that DSA methodology should be reformed to account for European climate targets and highlight some research gaps and modelling inconsistencies that need to be addressed to do so.