Fiscal policy in a hotter world: why climate investment is the least risky option

Many fiscal frameworks are still designed for a world of temporary shocks and predictable cycles – making them unfit for purpose in a changing climate. Luiz Awazu Pereira da Silva and Fernanda Gimenes argue that in a hotter and more volatile world, fiscal policy itself must adapt, or risk amplifying the very instability it is meant to contain.

Climate change is no longer a distant environmental concern. It is already a macroeconomic shock, reshaping growth prospects, public finances and financial stability in ways that are becoming harder to ignore. Heatwaves, floods and droughts are becoming more frequent and more damaging, while the transition to net zero demands large and sustained upfront investment. In this commentary we draw on new analysis of how climate risks interact with debt dynamics to show why fiscal policy must adapt.

The scale of the challenge is clear. Staying on track for net zero while adapting to rising physical risks will require governments to invest steadily over many years, even as they face high debt levels, tighter financial conditions and growing social demands. In that context, the traditional recipe to choose fiscal restraint is understandable. But it is also becoming increasingly risky.

The uncomfortable truth is this: the biggest fiscal risk today is not investing too much in climate action, but investing too little and too late.

Climate change as a permanent fiscal shock

Fiscal policy has traditionally been designed for stabilisation purposes in a world in which shocks are temporary. Deficits rise in downturns and fall again as growth resumes. Climate change behaves very differently. It is a structural shock that affects economic capacity and public finances over long horizons, and it does not fade once the immediate crisis has passed.

Climate-related disasters repeatedly damage infrastructure, weaken tax bases and increase emergency spending. At the same time, the risks associated with the transition to a low-carbon economy can trigger sudden asset repricing, disrupt revenues and strain financial systems, especially where fiscal space is already limited. Over time, these pressures compound rather than dissipate.

This is why climate change matters for debt sustainability. Delaying investment in mitigation and adaptation tends to raise fiscal costs later on, while credible, well-targeted climate investment can strengthen growth and reduce volatility. Yet fiscal frameworks often fail to capture these dynamics, relying on short-term indicators that encourage procyclical responses and underinvestment in resilience.

The false choice between discipline and ambition

Climate spending is often presented as a trade-off between ambition and prudence. However, that framing is misleading because the real choice is between front-loading investment in a controlled, transparent way and absorbing far larger, more unpredictable costs later.

Rigid debt anchors are poorly suited to a world of persistent climate shocks. When disasters strike or adaptation needs surge, governments are pushed into ad hoc spending responses that impact public debt and currently push up markets’ pricing of sovereign risk. As global warming continues, there will be an accumulation of such spending. How governments will react is uncertain and in practice this uncertainty often matters more for borrowing costs than the debt level itself. Investors struggle not necessarily with higher debt per se, but with unclear policy paths and sudden reversals. In addition, climate investment increases resilience, which lowers risk premia.

What is needed instead is a fiscal framework that combines flexibility with credibility: one that allows temporary predictable increases in borrowing for climate investment, while clearly signalling how debt will stabilise over time.

A case for adaptive fiscal policy

An adaptive fiscal policy starts from a simple insight: not all debt is the same. Borrowing to fund current consumption is very different from borrowing to finance investments that raise future productivity and reduce exposure to climate damage, while increasing economic resilience. Treating the two as equivalent may simplify accounting, but it is both economically inefficient and fiscally short-sighted.

In practice, this means accepting a temporary ‘green debt hump’ as an intergenerational investment. The credibility of such an approach depends on how it is designed. Separating legacy debt from climate-related investment, ring-fencing green spending within transparent envelopes, and committing to clear re-entry paths to medium-term fiscal anchors all help reduce uncertainty.

Combined with realistic revenue strategies, including progressive climate-related taxation and subsidy reform, markets can price the transition as a managed process rather than a discretionary risk. Importantly, adaptive fiscal policy is not a licence for fiscal laxity. It is a rules-based approach that updates fiscal governance for a world of permanent shocks.

Equity is critical

It is also important to recognise that carbon pricing, adaptation costs and structural change disproportionately affect low-income households and vulnerable regions. This means that climate policy that ignores distributional impacts will not hold and is not sustainable from a political economy standpoint. Without credible compensation, social backlash can derail even well-designed policies, increasing political risk and fiscal uncertainty.

Embedding targeted transfers and social protection into climate fiscal frameworks is therefore not just a social choice, but also a macroeconomic one. Automatic and transparent compensation mechanisms help stabilise demand, preserve social cohesion and protect the credibility of climate policies over time.

Sharing climate risk beyond the sovereign balance sheet

No country can realistically manage climate risk on its own, especially when shocks are large, recurrent and increasingly correlated across borders. This is where multilateral development banks and international financial institutions become indispensable, not simply as lenders, but as risk-sharing partners. Through guarantees, insurance-type instruments and the use of callable capital, they can absorb tail risks that private investors are unwilling or unable to take, and in doing so make otherwise marginal climate investments viable, particularly when these tools are applied to clearly defined, ring-fenced portfolios rather than scattered projects.

Predictability is also important. Markets tend to price uncertainty more harshly than debt itself, and when governments fail to signal how climate investment fits into a medium-term fiscal path, borrowing costs rise accordingly. Publishing multi-year investment pipelines, being transparent about climate-adjusted debt trajectories and engaging more openly with investors can therefore make a real difference, by giving markets a clearer sense of direction.

A window for action

Climate change is already testing the limits of existing fiscal institutions. At the same time, geopolitical tensions are rising and fiscal space is tightening, making the temptation to postpone climate investment ever stronger. That instinct is understandable, but it would be a costly mistake.

The analysis underpinning this commentary shows that adaptive fiscal frameworks, i.e. those that combine credible anchors with flexibility for climate investment, can absorb a temporary increase in public debt while improving long-term debt sustainability. By contrast, postponing climate change mitigation and adaptation leads to weaker growth, higher volatility and rising risk premia, ultimately worsening fiscal outcomes.

Adaptive fiscal policy therefore offers a pragmatic way forward. It treats climate change as a structural macroeconomic reality and recognises investment in resilience and transition as a stabilising force, not a fiscal indulgence. The real risk is not doing too much, but waiting until the costs are unavoidable.

The views in this commentary are those of the authors and do not necessarily represent those of CETEx senior management or its funders. Any errors or omissions remain those of the authors.

A CETEx policy report, ‘Adaptive fiscal policy for a hotter world’ by Luiz Awazu Pereira da Silva, was published in December 2025 at www.cetex.org/publications/adaptive-fiscal-policy-for-a-hotter-world/