Climate-related disasters can push up the cost of debt

19 February 2026

By Sofia Anyfantaki, Marianna Blix Grimaldi, Carlos Madeira, Simona Malovana and Georgios Papadopoulos

Climate change poses risks to public finances through various channels: adaptation and mitigation measures may demand higher public spending, governments may have to divert resources from productive investments to new climate change-mitigating technologies, and the effects of climate change may weigh on prices of sovereign bonds. The cost of emergency assistance and post-disaster reconstruction can have a direct fiscal impact, while indirect effects may include lower tax revenues caused by production disruptions or additional spending on food and energy support schemes as a result of changes in commodity prices. These mechanisms can interact with sovereign debt dynamics in complex ways.

How we measure the climate risk effect on bond yields

In this blog post, we provide new evidence on how climate risk affects the market prices of sovereign bonds. To do so, we use a detailed climate risk dataset covering 52 developed and developing countries over the last two decades. Our analysis focuses on two types of climate risk: transition risk and physical risk, considering in particular the unique dynamics in developing economies.

Transition risk is measured using carbon emissions intensity. Physical risk is categorised as chronic or acute. Chronic risk refers to long-term climate shifts, measured by annual temperature changes relative to the mean temperature recorded between 1951 and 1980. Acute risk is assessed by the frequency of climate-induced natural disasters and their economic and human impacts.^[1]

To examine the financial effects of climate-related events, we look at annually collected data on the yields of sovereign bonds with a ten-year maturity. The first part of our study analyses how bond yields respond to the three different types of climate risk across a range of countries and over time, while isolating the impact from other factors that influence bond yields, such as inflation and economic growth. We find that sovereign debt investors are increasingly pricing in transition risks: countries with higher emissions tend to face higher yields, with these effects being more pronounced in emerging and developing economies. Chronic physical risks, measured through temperature anomalies, do not appear to influence yields.

In the second part of the analysis, we investigate yield changes up to five years after a shock stemming from a climate-related disaster – such as floods, storms, drought or wildfires – measured by the total economic impact of the disaster. Our results show that specific disasters can increase borrowing costs in the medium term, though the effects vary depending on the type of event. Furthermore, bond yields react differently to climate-related disasters depending on a country’s debt level. Overall, our systematic cross-country analysis yields several novel insights with direct implications for fiscal and climate policy.

Climate risk and sovereign risk: cross-country evidence

Before focusing more closely on our results, let’s briefly revisit how climate shocks affect financial markets and, consequently, public finances. This interplay can best be understood by examining a number of empirical examples. For instance, the 2011 floods in Thailand – one of the most devastating climate-related disasters on record – resulted in losses exceeding €35 billion. These floods disrupted global supply chains and led to substantial spending on reconstruction, which significantly affected investor confidence.^[2] A similar pattern emerged after the 2022 floods in Pakistan, which affected more than 30 million people, resulted in significant loss of life and caused economic losses equivalent to nearly 10% of the country’s annual GDP. This placed substantial strain on public finances and raised concerns over Pakistan’s debt sustainability.^[3]

But even advanced economies are not immune to the effects of climate shocks. The 2023 heatwaves in Europe, accompanied by widespread wildfires, resulted in significant infrastructure damage, major agricultural losses and a surge in emergency spending in several EU Member States. These events illustrate the channels through which climate shocks – whether sudden or gradual – can affect sovereign borrowing conditions. However, systematic cross-country evidence on how such risks are priced in global bond markets has so far been limited.

Our research connects the traditional study of sovereign bond yield determinants focused on macroeconomic and financial fundamentals and the emerging literature that examines climate-related risks as a distinct and increasingly important source of sovereign risk. We show that there is a significant positive relationship between transition risk and ten-year sovereign bond yields. This suggests that strengthening climate transition efforts can reduce the transition risk premium incorporated in those yields. In other words, effective climate policies can help mitigate increases in the cost of debt servicing.

We also find that the effect of transition risk on the cost of public debt is more pronounced for developing countries. This indicates that markets are concerned about the impact on such economies of transitioning to a lower-carbon regime and the potential effects on their future tax revenues. In contrast, developed economies show a more subdued response, possibly reflecting their earlier progress in decarbonisation. Moreover, our analysis shows that, for the countries facing greater transition risks, the link between carbon emissions and sovereign yields has become stronger since the Paris Agreement. This suggests that credit investors are increasingly recognising the importance of this source of risk for sovereign bond valuations.

On physical risk, we find that increased chronic risks are not associated with higher sovereign risk. Acute physical climate risk, on the other hand, is partially priced into sovereign yields, with a difference depending on the significance of frequency and severity of natural disasters as well as between advanced and developing countries.

Short to medium-term impact of natural disasters

Our analysis shows that, on average and over a long period, acute physical risk measures appear not to have a systematic impact on sovereign borrowing costs. However, we also look at the short to medium-term impact of shocks stemming from a climate-related disaster – such as floods, storms, drought or wildfires – measured by the total economic impact of the disaster on sovereign bond yields. In particular, we look at the changes in sovereign bond yields from one year to five years following a climate shock related to an average total damage. The effect is immediate and steeper for more severe events, such as droughts, and more frequent ones, such as storms.^[4] Moreover, the response is more immediate and pronounced for developing countries, highlighting the challenges these economies face as a result of geographic vulnerability and high dependence on agriculture and natural resources.

In addition, we explore whether a country’s fiscal position at the time of the climate shock influences the impact on sovereign bond yields. Chart 1 plots the estimated response of ten-year sovereign bond yields to different types of climate shock. The horizontal axis shows the number of years after the shock, allowing us to see how quickly yields react to climate-related events and how long the effects last. The vertical axis shows the change in yields, expressed in log points. The lines in the chart compare countries with low and high public debt. This highlights a key insight from our results: how the availability of fiscal space influences the magnitude and persistence of the impact of climate shocks on sovereign yields.^[5]

Chart 1

The impact of climate shocks on sovereign yields (in logarithmic scale): the role of fiscal capacity

In low-debt countries, natural disasters have, on average, a smaller impact, as governments have the fiscal capacity to implement mitigation strategies and withstand economic disruptions caused by climate-related shocks. To put these effects into context, we can translate these log point changes into yield changes using the average ten-year sovereign yields in our sample, which allows us to see how the effects would look for a typical advanced or emerging economy.^[6]

In the case of floods, high-debt countries may even initially see lower yields, reflecting expectations of external support and short-term emergency financing. But as fiscal pressures accumulate, yields begin to increase and remain elevated, signalling rising risk premia. In low-debt countries, a short-term increase in borrowing demand pushes yields up. But the initial rise in yields tends to level off after a few years, suggesting that markets recognise the government’s ability to absorb the shock without putting debt sustainability at risk.

Storms, however, show a more nuanced picture. In response to storms, high‑debt countries experience the largest and most persistent yield increases in our sample, with the response peaking at around 0.2 log points in the second year. This corresponds to a rise in yields of approximately 22% – around 66 basis points for a typical advanced economy with an average ten-year yield of 3% and more than 140 basis points for a typical emerging economy with an average ten-year yield of 6.4%.

Droughts also produce sizeable effects, but with a differing pattern depending on debt levels. In low‑debt countries, yields rise sharply to around 0.2 log points in the second year before declining abruptly, while in high‑debt countries the response peaks at a similar level but more quickly. The broader picture remains clear. Low‑debt countries typically face modest and temporary increases in borrowing costs after climate shocks. High‑debt countries experience larger and more persistent effects. This is particularly evident in the case of storms and droughts, where fiscal vulnerabilities amplify the perceived risks.

Implications for policymakers

As we have seen, climate change is a significant risk factor, especially for high-debt, fiscally vulnerable countries. Moreover, the increasing frequency and intensity of extreme weather events and natural disasters – a trend that may continue or even accelerate in the coming decades – pose further challenges. High-debt countries are less equipped to manage the impacts of severe weather events alongside the financial and fiscal demands of the green transition. Policymakers must deepen their understanding of how transition efforts affect borrowing costs and intensify their international efforts to address both climate and sovereign debt challenges.

The views expressed in each blog entry are those of the author(s) and do not necessarily represent the views of the European Central Bank and the Eurosystem.

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