Climate risk influences the economy through the cost of capital

Climate risk is a powerful macroeconomic force which influences not only how much firms invest, but also where they invest, how investors allocate capital and even the level of risk-free interest rates that underpin financial markets. Davide Avino , Rongxin Chen and Hafiz Hoque argue that climate change should be viewed not only as an environmental challenge but also as a macroeconomic and financial one.

The role of climate risk in economic policymaking has become increasingly contested. In the United States, Donald Trump’s administration has moved to reduce the prominence of climate-related risks in financial regulation and economic policy.^[1]

By contrast, Bank of England officials have warned that climate change poses a growing threat to the British economy , including through inflationary supply shocks that matter for central banks. Against this backdrop, an important empirical question remains: does climate risk materially affect economic outcomes?^[2]

This question has become increasingly important at a time when policymakers are concerned about weak productivity growth, sluggish business investment and the future path of interest rates, issues highlighted in recent assessments by the Organisation for Economic Co-operation and Development and the Bank of England . Recent discussions by central banks and international organisations have increasingly highlighted climate-related financial risks as a potential source of macroeconomic and financial instability, as emphasised by the Network for Greening the Financial System (NGFS) and the International Monetary Fund (IMF). Yet climate risk is often viewed primarily as an environmental challenge.^[3][4][5][6]

Our recent research on corporate investment and risk-free interest rates suggests that climate risk is also a powerful macroeconomic force. It influences not only how much firms invest, but where they invest, how investors allocate capital and even the level of risk-free interest rates that underpin financial markets.^[7][8]

Drawing on evidence from American firms and Treasury markets over several decades, we show that climate risk has become an increasingly important determinant of both corporate investment and the broader financial environment in which investment decisions are made.^[9]

Climate risk and corporate investment

Investment is one of the most important decisions firms make. New factories, equipment, technologies and research projects determine future productivity and economic growth. However, many investments are costly to reverse once undertaken. When uncertainty rises, firms often prefer to wait before committing resources.

Using a measure of climate risk devised by Robert Engle and colleagues by analysing climate-related news coverage, we examine how fluctuations in climate risk affect investment decisions among listed firms over more than three decades.^[10]

Our analysis reveals a clear pattern. Increases in climate risk are associated with lower corporate investment. Quantitatively, a one-standard-deviation increase in climate risk reduces capital expenditure in the following quarter by approximately 8 per cent relative to the average investment rate. The effect is highly persistent, remaining significant for several years as shown in Figure 1:

Source: Avino et al. (2024)^[7]

Why does this happen?

One explanation is that climate risk increases firms’ cost of capital. Investors demand higher returns from firms that are more exposed to climate-related risks, making financing more expensive. As financing costs rise, fewer investment projects meet firms’ required return thresholds.

Financial constraints further amplify these effects. Firms that already face difficulties accessing external finance are particularly likely to delay investment when climate risk increases. In this sense, climate risk acts through many of the same channels as traditional sources of uncertainty, but with stronger and more persistent consequences.

Yet the relationship is not static. We find evidence that the impact of climate risk on investment has evolved over time.

Following the publication of the Stern Review on the Economics of Climate Change , in 2006, which fundamentally changed the public debate around the economics of climate change, climate issues became substantially more salient to investors, policymakers and other stakeholders. As climate concerns gained prominence, the negative relationship between climate risk and investment weakened. In particular, carbon-intensive firms became less likely to cut investment when climate risk increased.^[11]

Importantly, these firms did not simply continue business as usual. Instead, they reduced their emissions intensity, consistent with reallocation of investment towards cleaner production processes. Greater stakeholder pressure, regulatory expectations and public scrutiny encouraged firms to adapt rather than simply postpone investment.

This suggests that climate risk creates two opposing forces. On one hand, it raises uncertainty and financing costs, discouraging investment. On the other, it increases incentives for firms to adapt and transition towards lower-carbon activities. Which force dominates depends on the broader economic and institutional environment.

Climate risk and interest rates

Climate risk also affects the economy through another channel that receives far less attention: risk-free interest rates.

Economic theory predicts that when households and investors become more concerned about future risks, they increase precautionary saving and demand for safe assets. Climate change may strengthen these incentives because it introduces additional uncertainty about long-term economic outcomes.^[12]

To investigate this possibility, we examine the relationship between climate risk and US Treasury yields. The results reveal a strong negative relationship. A one-standard-deviation increase in climate risk is associated with Treasury yields that are, on average, about 30-basis-point lower, an effect substantially larger than that associated with conventional measures of economic policy uncertainty.

This finding is consistent with investors seeking the safety and liquidity of government bonds during periods of heightened climate concern. Examples include periods surrounding major climate-related events, intensified public debate about climate risks, and heightened awareness of the economic consequences of climate change. Effectively, climate risk increases demand for safe assets, pushing their prices up and their yields down as shown in the following figure 2:

Source: Avino et al. (2025)^[8]

We also find that the effect becomes particularly strong when economic uncertainty is already elevated, consistent with Lalwani , who shows that the pricing of climate-related risks in corporate bond markets is more pronounced during periods of heightened economic policy uncertainty. For example, the COVID-19 pandemic coincided with record-breaking wildfires in the western United States in 2020, illustrating how climate-related concerns can arise against a backdrop of exceptionally high economic uncertainty .^[13][14]

Climate risk is changing the cost of capital

Taken together, our findings point to a broader conclusion. Climate risk influences the economy through the cost of capital.

For firms, higher climate risk raises financing costs and can discourage investment. For investors, climate risk increases demand for safe assets, lowering risk-free rates. In other words, climate risk affects both sides of the capital allocation process: the willingness of firms to invest and the willingness of investors to bear risk.

This helps explain why climate change is becoming increasingly relevant not only for environmental policy but also for productivity growth, corporate strategy and financial stability.

What business leaders and policymakers should take away

Climate risk is already affecting economic behaviour through financial markets, investment decisions and the demand for safe assets.

Executives should not treat climate risk solely as a compliance or sustainability issue delegated to ESG teams. It increasingly affects firms’ cost of capital, access to finance, investment opportunities and competitive positioning. Companies that proactively adapt their asset base and business models may be better positioned to attract capital and sustain investment as climate-related risks become more prominent.

For policymakers, the results carry an important implication. Achieving the large-scale private investment required for the net-zero transition is not simply a matter of creating incentives for green investment. Policymakers must also recognise that climate risk itself can discourage investment by raising uncertainty and financing costs. Stable and credible climate policies can therefore play a dual role: accelerating the transition while reducing the uncertainty that discourages firms from investing.

More broadly, climate change should be viewed not only as an environmental challenge but also as a macroeconomic and financial one. The way climate risk shapes investment decisions and interest rates may ultimately prove just as important as its direct environmental consequences for determining future economic growth and prosperity.

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