Fiscal sustainability in a changing climate

Introduction

Climate change poses an increasing risk to public finances. Both the International Monetary Fund (IMF) and the European Commission recognise it as a macro-critical challenge (crucial to the achievement of macroeconomic and financial stability), given its capacity to generate “a profound threat to growth and prosperity.”^[1] Climate change affects public finances through its impact on growth (e.g. physical assets destruction, business interruption, public health and employment damages), public expenditure, revenues, financial stability, and contingent liabilities of governments (e.g. via increasing the probability that governments will have to step in for failing financial institutions).

The EU Debt Sustainability Analysis (DSA) framework is the central instrument used to identify risks to fiscal sustainability. However, despite its forward-looking ambition, the EU DSA framework does not systematically integrate climate-related physical and transition risks into the Commission’s assessment. Climate risks are mostly treated as peripheral stress events rather than structural drivers of long-term fiscal trajectories. If DSA is to remain a credible tool for safeguarding fiscal sustainability in a changing macroeconomic environment, climate risks must be fully integrated into its core assessments. Integrating these risks is a matter of fiscal prudence and long-term economic security.

I. When is debt sustainable?

A.    Debt Sustainability Analysis in context

The practice of conducting Debt Sustainability Analysis (DSA) was formalised in 2002 by the International Monetary Fund (IMF) and the World Bank with the primary objective of assessing borrowing countries’ capacity to service and repay their debt, particularly in low-and middle-income economies. The rationale for DSA is to reduce uncertainty surrounding sovereign default risk by providing a structured, forward-looking assessment of a country’s ability to meet its current and future debt obligations. By combining macroeconomic projections with scenario analysis and stress tests, these analyses seek to inform lending decisions of international organisations, shape fiscal policy recommendations, and guide risk pricing in financial markets.^[2] Debt sustainability analysis is therefore inherently probabilistic and forward-looking.^[3] The practice relies on “projections of, and judgments on, fiscal as well as macroeconomic and financial variables over a long-term horizon.”^[4] In general terms, public debt is considered sustainable when the government is both solvent – its budget constraint is satisfied in the short to long term – and liquid, meaning it can maintain stable access to financial markets at reasonable cost.

Despite its widespread use, DSA has significant limitations. Its conclusions depend on underlying assumptions and data inputs about how economies respond to policy choices and external shocks.^[5] In this context, the evaluation of long-term growth prospects and alternative policy paths involves considerable uncertainty. Moreover, the concept of “sustainability” is ambiguous in the literature. Different approaches emphasise distinct benchmarks for determining whether debt is sustainable. Some focus on the existence of a “steady-state debt ratio” towards which the economy would converge in the long term.^[6] Others stress the notion of a “natural debt limit” or available “fiscal space,” defined as the level of public debt that governments can service with certainty.^[7] In addition, the choice of variables and assumptions used in DSA is not neutral and reflects implicit theoretical perspectives on macroeconomic dynamics. For instance, the calibration of fiscal multipliers^[8] often excludes hysteresis effects, whereby past policies or economic crises may have persistent impacts on growth, and may rely on the assumption that higher public spending necessarily crowds out private investment.^[9] Finally, DSA is inherently forward-looking. It cannot deliver certainty about future debt outcomes. Sustainability assessments ultimately represent probabilistic judgements or “educated guesses”, given the unpredictability of growth, financial conditions, political decisions and external shocks.^[10]

In the European Union, the DSA framework incorporates a standardised set of macro-fiscal variables to assess the dynamics of Member States’ public debt over time.^[11] The framework is primarily designed to identify risks that public debt will not stabilise over the medium to long term and to highlight the potential need for policy correction. However, despite the range of fiscal and macroeconomic variables considered, climate risks, whether stemming from physical damages or transition costs, are not systematically integrated. While the approach enhances comparability across countries, it does not explicitly incorporate regular forward-looking elements associated with climate risks, thereby underestimating structural and long-term vulnerabilities affecting Member States’ public finances. However, practices are different for the United Kingdom and the IMF framework, as the next subsection shows. Examining these approaches helps identify both methodological innovations and remaining gaps, thereby demonstrating how climate risks could be more comprehensively embedded within the EU’s DSA framework.

B.    The integration of climate risks in the UK and IMF DSAs

The IMF was the original architect of DSA, developing a framework to assess member countries’ debt and deficit trajectories, including the maturity structure and repayment capacity. The initial objective was to identify vulnerabilities and, where necessary, evaluate alternative adjustment paths to stabilise debt. Over time, the IMF DSA framework has evolved to better account for how climate risks may affect a member country’s capacity to repay its obligations, notably through climate stress tests.^[12] This requirement was first applied to small states particularly vulnerable to natural disasters, as well as to low-income countries meeting specific eligibility thresholds. In 2022, the IMF further expanded its toolkit by introducing dedicated climate change modules within its Market Access Countries Sovereign Risk and Debt Sustainability Framework. The two modules aim at modelling the impacts of adaptation investments, as well as the fiscal and growth implications of efforts to reduce greenhouse gas emissions. They represent an important methodological innovation, as they attempt to integrate climate risks into medium-term macro-fiscal projections rather than treating climate shocks solely as exogenous events.

In the United Kingdom, the Office for Budget Responsibility (OBR), an independent public body, is responsible for providing economic and fiscal forecasts, and for assessing the long-term sustainability of public finances. A significant step in incorporating climate risks into public finance analysis was taken in 2021 with the integration of climate scenarios into the OBR’s long-term projections. These scenarios were based on the Bank of England’s adapted pathways developed by the Network for Greening the Financial System (NGFS). Over time, the systematic use of scenarios evolved in relation to both methodological improvements in NGFS scenario design and a broadening of the OBR’s analysis, from an initial focus on the effects of physical, climate-related damages to a comprehensive assessment of transition risks. Drawing on these scenarios has enabled the OBR to inform the government about the probabilistic fiscal costs associated with achieving net zero emissions, especially their impact on public debt. The OBR’s scenario analysis has also consistently shown that higher warming pathways would have significantly more severe macroeconomic consequences, in particular larger GDP losses, higher public debt levels, greater indirect fiscal costs and less favorable financing conditions.

Although both the IMF and the UK have started integrating climate risks into their DSA frameworks, several limitations offer lessons for the European DSA framework.

First, the scope of analysis often favors natural disaster stress tests, particularly in the IMF’s assessments of low-income countries. This reflects the greater availability of historical data on natural disasters. However, relying predominantly on historical data may lead to an inaccurate assessment of future risks, especially given the possibility of tipping points. Moreover, the IMF’s climate modules are not systematically integrated across all country assessments.^[13] Its projection horizon, typically around 30 years, may also fail to capture long-term structural impacts of climate change.

Second, although the UK has made progress in incorporating climate scenario analysis, the continued use of a “no climate change” baseline in recent years is unrealistic and risks underestimating the country’s macro-fiscal exposure. Furthermore, while both physical and transition risks are considered, the rationale for scenario selection and the trade-offs between these risks that guide scenario design could be made more transparent.

Finally, in both frameworks, climate modules and scenarios remain largely diagnostic. They inform projections and policy discussions but rarely translate into operational changes within the logic of debt sustainability assessments. In practice, climate models tend to function as analytical exercises, as both frameworks lack an explicit policy reaction function: climate projections do not systematically inform the calibration of fiscal rules, the assessments of fiscal space, or the prioritisation of public investment.

II. The integration of climate risks within the EU fiscal framework

A.    The lack of systematic integration of climate risks into DSA

Within the European Union, DSA is embedded in a broader fiscal surveillance architecture centred on the Stability and Growth Pact (SGP). Since 2016, the European Commission has published Fiscal Sustainability Reports (FSR) every three years and Debt Sustainability Monitors (DSM) annually to assess short-, medium-, and long-term risks to Member States’ public finances.^[14] Together, these instruments inform the application of the EU fiscal rules. Discussion on integrating the climate dimension into the Commission’s DSA framework started to gain prominence in 2020, especially in view of the launch of the Green Deal. In 2021, the Commission followed the IMF in conducting dedicated climate stress tests focussing on physical risks, marking an initial attempt to analyse the potential effects of climate damages. However, these exercises remained exploratory and were not always incorporated into the DSA framework.

The reform of the SGP adopted in 2024 further strengthened the central role of DSA within the EU fiscal framework  in setting and monitoring Member States’ technical trajectories.^[15] In 2026, in its DSM 2025, the European Commission used NGFS scenarios for the first time to analyse the impacts of climate change over the 2025-2050 period. The approach relied on a simplification accounting only for the indirect macroeconomic physical and transition damages to Member States’ GDP, ignoring the direct costs incurred by governments in responding to climate-related disasters. From these scenarios, the European Commission concluded that currently implemented but insufficient mitigation policies, as well as other delayed transition strategies, would lead to weaker growth prospects and higher long-term macro-fiscal costs compared to timely action.^[16]

The introduction of NGFS climate scenarios in 2026 marked a significant step towards integrating climate risks into EU debt projections, but limitations remain.^[17] First, the baseline for climate scenarios continues to rely on a “no climate change” counterfactual, which risks underestimating macro-fiscal exposure. The fiscal baseline should reflect the most plausible current trajectory rather than a hypothetical absence of climate change. Second, the analysis focuses only on indirect macroeconomic impacts of climate mitigation and adaptation policies on Member States’ GDP. This may underestimate risks and obscure short-term vulnerabilities. Third, the choice of climate scenarios requires greater methodological clarity and transparency. Physical and transition risks should be explicitly reflected and justified in scenario selection. For example, orderly transition pathways (e.g. below 2°C) primarily capture mitigation costs, whereas higher-warming scenarios better reflect the scale of physical damages. Fourth, the projection horizon (2025-2050), although aligned with the EU’s climate ambitions, may fail to capture the full long-term effects of climate change on public debt. A longer horizon is necessary to assess both risks and potential benefits. Finally, while the DSM now provides scenario-based insights, climate risks are largely treated as ad hoc analytical exercises rather than operational inputs into fiscal surveillance, limiting the framework’s ability to inform proactive fiscal and investment decisions.

B.    Towards prudent integration of climate risks within DSA

Climate scenarios allow for the evaluation of the long-term impacts of mitigation and adaptation policies and can be used to integrate climate risks into DSA.  Finance Watch supports the systematic and prudent use of climate scenarios, ideally over a 50-year horizon (UK approach) and using NGFS scenarios as a methodological benchmark,^[18] while acknowledging their limitations. Such integration would allow the European Commission to assess a range of possible outcomes, capturing both adverse and favorable trends under low- or high-risk climate pathways. Although available scenario analysis approaches still present some methodological limitations and require further refinement, they can support comparative analysis of different policy options. In this way, debt scenarios can help policymakers avoid a “climate-debt doom loop” (see Annex 1) and guide fiscal decisions proactively based on a precautionary approach.

Finance Watch recommends that the baseline for climate scenario analysis be grounded in the European Commission’s macroeconomic projections under current policies, reflecting existing National Energy and Climate Plans (NECPS) or the nationally determined contributions. Accordingly, a selection of at least three representative scenarios is advised:

• Net Zero 2050: early policies limit global warming to 1.5°C by mid-century, with medium transition risk and low physical risks.
• Delayed transition: mitigation policies are postponed, resulting in medium physical risks and high transition risks.
• Fragmented world: a delayed and uncoordinated global response leads to high physical and transition risks.

The assessment of climate risks within EU DSA should include three steps:

1. Estimate the plausible impact on debt across scenarios, considering debt-to-GDP trajectories, gross financing needs, growth differentials and climate-related fiscal costs.
2. Calculate the relative “cost of delay,” highlighting the fiscal consequences of postponed mitigation and adaptation, as well as the positive effects of early policy action on debt sustainability.
3. Link the scenario results to a normative assessment of fiscal flexibility tailored for each Member State.^[19] Under this approach, investment in the sustainable transition could justify temporary deviations from the multiannual net expenditure path if it improves long-term growth, reduces future fiscal costs, and leads to better debt sustainability outcomes compared to scenarios where no mitigation/adaptation action is taken.

Finally, Finance Watch emphasises transparency. The EU DSA framework should report whether climate investment reduces long-term debt ratios, the magnitude of its potential impact under delayed action, and the relative net sustainability effect of climate investments. Limitations of scenarios should also be clearly disclosed. In this way, climate scenarios can serve as powerful tools to guide both fiscal policy and the assessment of flexibility within DSA, linking long-term climate objectives directly to debt sustainability.

Conclusion

Integrating climate risks into the European Commission’s Debt Sustainability Analysis framework is essential to ensure resilient public finances, prudent debt trajectories and long-term economic and monetary stability. Yet, climate risks remain insufficiently embedded in the current surveillance framework. While the introduction of NGFS scenarios in the latest Debt Sustainability Monitor is welcome, important limitations persist, notably regarding the baseline, scenario design, transparency and the lack of operational use of scenarios. Finance Watch therefore recommends the prudent use of NGFS scenarios, based on a realistic baseline and a limited set of scenarios capturing different levels of physical and transition risks. These should be integrated into the European Commission’s assessment of Member States’ debt and deficits and used to guide targeted fiscal flexibility.

Annex 1: Climate-debt doom loop

The figure below illustrates the climate-debt doom loop, a cycle in which natural disasters, caused or exacerbated by climate change, generate direct and indirect economic losses for countries. Over time, particularly when disasters occur repeatedly, such impacts weaken economic activity, reduce governments’ capacity to collect tax revenues and ultimately deteriorate sovereign creditworthiness.

Figure 1: The climate-debt doomloop