Climate Risk Drives Cost of Capital, Reshaping Investment, Markets and “Risk-Free” Rates

Climate risk is increasingly shaping economic outcomes through a channel that sits at the heart of modern finance: the cost of capital. Evidence from decades of data suggests that rising concern about climate change does not only influence environmental policy or corporate sustainability plans—it also affects how much companies invest, where they choose to deploy funds, how investors price risk, and even the “risk-free” interest rates that anchor financial markets.

That framing places climate change squarely in the realm of macroeconomics and financial stability, an area where the policy debate has become sharply divided. In the United States, the Trump administration sought to downplay climate-related considerations in financial regulation and economic policy. In the United Kingdom, officials at the Bank of England have taken the opposite stance, warning that climate change can threaten the economy through channels central banks care about, including supply disruptions that may feed inflation. The question underlying these disagreements is empirical: does climate risk measurably move key economic variables?

The issue arrives at a moment of heightened concern among policymakers about weak productivity growth, subdued business investment, and uncertainty over the future trajectory of interest rates—topics recently emphasised by the Organisation for Economic Co-operation and Development and the Bank of England. Meanwhile, central banks and international bodies have been elevating climate-related financial risk as a possible source of macroeconomic and financial instability, notably through work associated with the Network for Greening the Financial System and the International Monetary Fund.

Research by Davide Avino, Rongxin Chen and Hafiz Hoque contributes to this debate by examining how climate risk interacts with corporate investment and the broader financial conditions that shape it. Using long-run evidence from US listed companies and Treasury markets, their work finds that climate risk has become a progressively more important factor in both investment behaviour and the financial environment in which firms operate.

Business investment is a cornerstone of long-term economic performance: spending on factories, machinery, new technologies and R&D influences productivity and future growth. But these decisions are often difficult to reverse. When uncertainty rises, companies commonly delay large commitments rather than risk locking in spending that may prove unprofitable.

To study how climate-related uncertainty affects firms, the researchers use a climate risk indicator developed by Robert Engle and co-authors, which is constructed from climate-related news coverage. Tracking fluctuations in that measure over more than three decades, they identify a consistent relationship: higher climate risk is followed by lower corporate investment.

The magnitude is notable. A one-standard-deviation increase in climate risk is associated with an approximately 8% drop in capital expenditures in the following quarter, relative to the average investment rate. The decline is not fleeting; the effect remains statistically meaningful for several years, indicating that climate-driven uncertainty can weigh on investment for an extended period.

A central mechanism is financing. When climate risk rises, investors require higher expected returns from firms more exposed to climate-related threats, raising those firms’ cost of capital. As funding becomes more expensive, fewer potential projects clear the return hurdle needed to justify investment. The effect is even stronger among financially constrained companies—those already facing difficulty accessing external finance—who appear especially prone to postponing spending when climate risk increases. In that sense, climate risk operates like other uncertainty shocks, but with more persistent consequences.

Why it matters

If climate risk systematically increases the cost of capital, it can suppress investment that drives productivity, wages and long-run growth—affecting firms, workers and households. The findings also imply that debates over whether regulators and central banks should integrate climate considerations are not merely about environmental priorities, but about core macroeconomic stability. What to watch next is how climate risk pricing evolves in financial markets, and whether policy frameworks amplify or dampen its impact on investment and interest rates.