Climate governance now shapes governments’ borrowing costs

“Financial markets already price climate transition risk into sovereign bond yields. Carmelo Arena, Stefania Basiglio, Andrea Comandé, Giray Gozgor and Jing Li show how investors reward credible governance and green infrastructure, not climate ambition alone, and argue that sovereign bond markets may yet become one of the most powerful accountability mechanisms shaping climate governance. The transition to a low-carbon economy is usually framed as an environmental or technological challenge. But it is increasingly becoming a financial story that plays out in sovereign bond markets. Our new research shows that while financial markets already price climate transition risk into sovereign bond yields, investors reward credible governance and green infrastructure, not climate ambition alone. According to the Intergovernmental Panel on Climate Change (IPCC), limiting global warming requires a rapid structural transformation across energy, industry and infrastructure. Estimates from the McKinsey Global Institute suggest that achieving net zero could require trillions of dollars in annual investment over the coming decades. A substantial share of this adjustment will affect public finances. This raises a crucial question: do financial markets price climate transition risk into sovereign borrowing costs? To answer that we examined the economies of 31 members of the Organisation for Economic Co-operation and Development (OECD) between 2001 and 2020. We found that financial markets are already incorporating climate-transition risk into sovereign-bond pricing. More importantly, investors distinguish between credible governance capacity and broader social adaptation commitments. Climate risk is becoming sovereign risk Sovereign bond yields reflect how investors assess a country’s macroeconomic and institutional stability. Traditionally, this assessment has focused on public debt, economic growth, inflation and political institutions. However, the shift toward a low-carbon economy introduces additional structural uncertainty. As defined by the Basel Committee on Banking Supervision , transition risk arises from policy, technological and market adjustments required to move away from carbon-intensive production. These adjustments include large public investments in clean energy and infrastructure, fiscal reforms, such as carbon pricing, potential stranded assets in the fossil fuel sectors and regulatory and political uncertainty. If investors perceive that these factors weaken fiscal sustainability or create policy inconsistency, they may demand higher returns to hold a country’s debt. Our paper uses the GAIN Country Index , developed by the University of Notre Dame (ND-GAIN), a widely recognised measure of climate vulnerability and adaptive capacity. We find that countries experiencing a deterioration in climate resilience face higher borrowing costs. This result holds across multiple empirical approaches. Even among advanced OECD economies with deep and liquid financial markets, such as America, Britain and most European Union countries, climate risk is priced into financial markets. Our findings complement emerging evidence which documents similar effects in low-income countries. Investors reward governance, not just ambition A key insight emerges when we unpack climate readiness into its underlying components. The ND-GAIN framework distinguishes between vulnerability and readiness. Readiness itself includes economic readiness (including macro-financial strength and investment climate), governance readiness (including institutional quality and regulatory effectiveness) and social readiness (including education, innovation, and social development). Financial markets respond differently to each. Countries exhibiting stronger governance and economic readiness – such as Northern European economies and New Zealand – tend to face lower sovereign borrowing costs. The relationship is more pronounced for governance readiness, where a ten-point decline in the climate risk index is associated with an increase of around two basis points in sovereign bond yields. Investors appear to reward institutional credibility, policy coherence and economic capacity to manage the transition. By contrast, social readiness does not reduce borrowing costs and in some cases is associated with higher yields. This asymmetry suggests that markets do not reward climate ambition per se. Instead, they reward credible transition management embedded within a fiscally sustainable framework. From a fiscal perspective, this finding aligns with research on “fiscal fatigue” in advanced economies, which shows how high long-term commitments may constrain fiscal flexibility. In short, credibility matters more than rhetoric. Green infrastructure strengthens credibility We also examine whether climate readiness reduces borrowing costs equally across countries. The answer is no. Improvements in climate resilience reduce sovereign yields only in countries with high-quality green energy systems, as seen in Switzerland. In countries with weaker energy structures, such as Greece and Poland, readiness alone does not lower borrowing costs. This indicates a complementarity between institutional capacity and tangible investment. Markets respond not only to policy frameworks, but to demonstrated progress. Green infrastructure serves as a credible signal that transition commitments are operational rather than aspirational. This result resonates with research on green bond pricing , which finds that credible green instruments can lower financing costs. A potential climate–fiscal feedback loop One of the most concerning implications of our findings is the possibility of a self-reinforcing dynamic. If higher climate vulnerability raises borrowing costs, governments face reduced fiscal space. Reduced fiscal space limits investment in adaptation and clean energy. Lower investment increases future vulnerability, which may further elevate perceived risk and borrowing costs. This climate–fiscal feedback loop has also been recognised in recent discussions by the European Central Bank’s Financial Stability Review , which identified transition costs as a source of macro-financial risk. Breaking this cycle requires co-ordination between fiscal governance and climate strategy. Debt management offices, finance ministries and environmental regulators must operate within a unified framework that signals long-term credibility. Why this matters for business and policymakers For business leaders , sovereign climate risk shapes the broader investment environment. Higher public borrowing costs may influence taxation, regulation and infrastructure provision. For investors the results confirm that climate governance is already embedded in sovereign risk assessments. Institutional strength and green infrastructure increasingly shape perceptions of creditworthiness. For policymakers, the message is clear: climate governance is now part of macroeconomic policy. Climate strategy is not only about emissions targets. It is also about fiscal reputation and financial stability. Financial markets reward governments that demonstrate coherent and credible transition frameworks. Those that fail to do so may face a growing climate risk premium, making the transition even more costly to finance. As the net-zero agenda accelerates following the Paris Agreement , sovereign bond markets may become one of the most powerful accountability mechanisms shaping climate governance. This article gives the views of the author, not the position of LSE Business Review or the London School of Economics. You are agreeing with our comment policy when you leave a comment. Image credit: chayanuphol provided by Shutterstock. 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