The Importance of Climate Risks in the State Budget

By Sofia Santos

Incorporating climate risk into the State Budget is no longer a technical option — it has become a requirement of sound financial governance. Extreme wildfires, prolonged droughts, sudden floods, recurring storms and heat waves already affect productivity, tax revenues, public expenditure and the sovereign cost of capital. Ignoring these impacts is, in practice, “under-budgeting” the future and overburdening taxpayers when crises occur.

The first component is Green Budgeting: a methodology that identifies, classifies and aggregates expenditures and revenues with environmental and climate relevance. Through this approach, the Ministry of Finance can understand how much it spends, where it spends it, and what results are achieved in terms of mitigation, adaptation, prevention and response to disasters. It also reveals how much is invested in activities and projects that positively contribute to climate objectives and other environmental goals.

This mapping delivers three immediate benefits: (i) Improved spending efficiency — directing the right resources to the right places; (ii) Greater transparency and accountability before Parliament and society; and (iii) A credible basis for innovative financial instruments, including catastrophe bonds (cat bonds), which transfer part of the risk to private investors and reduce budget volatility after extreme events. Without a solid inventory of climate-related spending and performance metrics, it becomes difficult to price risk, attract capital and negotiate fair conditions.

The second component is to incorporate climate risk into macroeconomic projections.

The macroeconomic framework of the State Budget should reflect both Physical scenarios (frequency and severity of climate events), and transition scenarios (carbon pricing, regulation, technological change) with direct implications for GDP, inflation, employment, trade balances and energy dependency.

This requires: (i) Models linking climate impacts to sectoral productivity (agriculture, tourism, energy, infrastructure); (ii) sensitivity matrices for tax revenues (VAT, fuel taxes, corporate income tax) under different climate shocks; and (iii) evaluation of impacts on the sovereign risk premium and borrowing costs. Countries that anticipate and quantify these risks negotiate more effectively with markets, international financial institutions and rating agencies because they demonstrate prudent risk management.

The third component is contingent risk management. As I argued in 2024 in the Jornal Económico, the time has come to create a Loss and Damage Fund with clear governance, eligibility criteria and automatic disbursement rules. This fund could combine: (i) annual budget reserves; (ii) parametric insurance and catastrophe bonds; (iii) contingent credit lines with multilateral institutions; and (iv) European co-financing, where applicable. The objective is to move from ad-hoc responses to a pre-financed, predictable and transparent system, stabilizing public finances after disasters and accelerating reconstruction.

The urgency is twofold. On the one hand, the impacts are already materializing — as seen in the costs associated with the storms that have hit Portugal in the first months of 2026. On the other hand, the window to secure sustainable financing under favorable conditions will not last forever. Investors increasingly demand data, metrics and governance. Those who move first help define the rules; those who wait must accept the price set by others.

For the Ministry of Finance, the benefits are tangible: (i) more robust multi-year planning; (ii) reduced volatility in extraordinary spending; (iii) improved dialogue with rating agencies and financial markets; (iv) alignment with international climate reporting standards; and (vI the ability to mobilize private capital for prevention and adaptation, reducing pressure on public revenues.

The path is clear: Green Budgeting linked to targets, macroeconomic scenarios integrating climate risk, and a Loss and Damage Fund to operationalize the response. Keeping up with these issues is not an academic exercise — it is about protecting taxpayers, safeguarding sovereign credit ratings and sustaining development in a climate that has already changed.

Article published in Ver