A European climate bond

Europe faces a large climate investment gap. This column proposes filling this gap through the joint issuance of European climate bonds. These bonds would be funded by selling greenhouse gas emission allowances via the Emissions Trading System extended to all sectors. Access to the resulting funds would be conditional on countries’ implementation of climate projects. Such European climate bonds would meet the demand for a safe, liquid, and green asset, while accelerating climate investment, increasing EU resilience to sovereign crises, and greening both investors’ portfolios and monetary policy.

Tackling climate change requires huge resources and a quick policy response (IPCC Working Group III 2022): the faster greenhouse gas (GHG) emissions are reduced, the lower the eventual rise in global temperatures and the adaptation costs that countries will bear (Aerts et al. 2024b). The need to frontload climate investments suggests that debt issuance is required to fund these policies, as current tax revenues cannot cover the necessary spending.

The climate funding gap in Europe

In the EU, climate investment needs range between €550 billion and €912 billion per year (European Commission 2022a, 2021, 2022b). Nevertheless, such estimates mainly cover climate mitigation investments to reduce GHG emissions. In contrast, financing climate adaptation investments to build resilience to climate change is still largely neglected and imprecisely estimated. For instance, Bilal and Ka¨nzig (2024) argue that focusing on measures of global temperature implies drastically greater impacts of climate change and adaptation expenses than conventional estimates; similarly, Aerts et al. (2024a) suggest that the effects of climate change on economic output might have been so far underestimated.

The European Commission currently plans to fill part of these investment needs with ambitious programmes such as the Green Deal and NextGenerationEU (European Commission 2019, 2022c). However, the resources budgeted by the EU and its member states so far cover less than half of the relevant investment needs. Moreover, these programmes primarily focus on mitigation and fail to address the growing need for adaptation investments, which have the nature of public goods and thus require public funding.

The European climate bond and its fiscal backing

In a recent paper (Monasterolo et al. 2024), we propose a joint climate debt financing scheme to address this funding gap. Our proposal consists of three complementary reforms: (1) the introduction of a uniform EU carbon pricing scheme for all sectors, combined with (2) the joint issuance of European climate bonds to be serviced by the revenues of the common carbon pricing scheme, and finally (3) the implementation of a European long-term climate policy plan funded by the issuance of these bonds.

The proposed EU carbon pricing scheme is based on the extension of the EU Emissions Trading System (ETS) to all sectors, and the sale of carbon emission allowances traded on the ETS. 1 Compared to a system of national carbon taxes, this scheme would not be at the mercy of member states’ choices regarding the carbon tax rates and their transfers of the resulting tax revenue to the Commission. As such, ETS permit sales would effectively create the first form of EU common fiscal capacity while enabling the EU to fund its climate policies. This would prevent the weakening of climate mitigation targets driven by national political instability and the capture of member state governments by industrial and pressure groups.

To identify the potential fiscal capacity created by the sale of ETS permits, we compute the present discounted value (PDV) of the revenues that these sales will generate for the future path of carbon prices, based on Network for Greening the Financial System (NGFS) scenarios (Menon et al. 2022).  Figure 1 shows that, even under conservative assumptions, the PDV of future revenues could reach €2.2 trillion, matching current EU climate budgets. The estimated PDV could rise to €11.5 trillion in globally fragmented climate action scenarios, filling the EU climate financing gap for many years. Moreover, these figures underestimate the EU carbon-related fiscal capacity, as they do not consider the additional future revenues from introducing the Carbon Border Adjustment Mechanism (CBAM) to create a level playing field between domestic and foreign producers in the carbon price they face.

Figure 1 PDV of estimated revenues

Notes: The figure plots the PDV of the estimated revenues from the sale of ETS allowances from 2024 to 2100 for each NGFS scenario (in trillion euros). The red line drawn at €2 trillion corresponds to the EC’s budget as of 2023 over a six-year horizon.

The sale of ETS allowances will enable the Commission to service the European climate bonds. Since the revenues from these sales are inevitably uncertain, the issuance and servicing of these bonds would ideally be managed by a European supranational agency that can receive the revenue from the sale of ETS allowances, has appropriate debt management expertise, and has sufficient equity capital to assure investors about the safety of these bonds. Both the European Commission and the European Stability Mechanism (ESM) appear to be potential candidates for this role, though both are subject to shortcomings: the Commission lacks the last of these three attributes, while the ESM lacks the first.

Financial and macroeconomic stability benefits

Besides meeting the current funding gap for climate policies, European climate bonds would have additional benefits for the development of Europe’s capital markets, for its macroeconomic and financial stability, and for the conduct of monetary policy in the euro area. First, the issuance of European climate bonds would contribute to meeting the current demand for a European safe asset, addressing the scarcity in the supply of safe debt securities at the global level and even more within Europe.  2 Thus, these bonds can form the backbone for the development of an integrated European capital market, and of the long-awaited Capital Markets Union (CMU) in Europe. We expect the European climate bonds to be highly liquid, being issued regularly and in large amounts. Therefore, investors will perceive them as a safe sovereign asset issued by a supranational financial authority with a high credit rating and direct backing from the revenue from sales of ETS allowances. Furthermore, these bonds may satisfy the growing appetite of global investors for environmentally sustainable portfolios.

Second, these bonds will enhance European economic growth and fiscal capacity by enabling adequate spending on climate policies. In this regard, the loop in Figure 2 shows how investments in climate mitigation and adaptation can create a virtuous cycle, boosting a country’s resilience to climate disasters and supporting sustained economic growth. This higher resilience strengthens fiscal capacity, enabling further climate investments, which in turn can improve macroeconomic performance. These investments can also generate a ‘financial feedback loop’: higher fiscal capacity reduces perceived climate risk exposure, improving investor confidence and lowering sovereign debt yields. This reduces the cost of financing additional climate investments, further increasing resilience and closing the loop. 3

Third, the issuance of European climate bonds would benefit the conduct of monetary policy in the euro area, enabling the ECB to green its asset purchase programmes and expand its green asset portfolio (Abiry et al. 2022), avoiding sector and country bias.

Figure 2 The real and financial climate feedback loops

Notes: The arrows indicate causal relationships, while the signs indicate the direction of the effects, either reinforcing (+), or balancing (-).

Consolidating Europe’s lead in green policies

Lastly, funding sustainable policies via the issuance of climate bonds can help Europe to keep its current leadership in green technological innovation over the US and China, which it has developed as an ‘early mover’ in developing a manufacturing base for several clean technologies (Draghi 2022). This would enable Europe to strengthen its position as a global ‘climate champion’ at a time when the US is about to step back from green policies under the Trump administration, driving climate investment and emissions reductions not only within its own jurisdiction but also on a global scale (Coster et al. 2025). For instance, innovations such as the CBAM could enable European climate policies to generate spillover effects, extending their impact beyond EU borders.

References

Abiry, R, M Ferdinandusse, A Ludwig, and C Nerlich (2022), “Green QE and carbon pricing: Looking at potential tools to fight climate change”, VoxEU.org, 7 October.

Aerts, S, L Stracca, and A Trzcinska (2024a), “Economic losses from climate change are probably larger than you think: New NGFS scenarios”, VoxEU.org, 22 October.

Aerts, S, L Stracca, and A Trzcinska (2024b), “Measuring economic losses caused by climate change”, VoxEU.org, 2 October.

Battiston, S, I Monasterolo, K Riahi, and B J van Ruijven (2021), “Accounting for finance is key for climate mitigation pathways”, Science 372 (6545): 918–920.

Bilal, A and D R Ka¨nzig (2024), “Why global temperature matters”, VoxEU.org, 21 July.

Coster, P, J D Giovanni, and I Mejean (2025), “Carbon leakage through firms’ supply chain adaptation”, VoxEU.org, 2 January.

Draghi, M (2022), The future of European competitiveness, Part B: In-depth analysis and recommendations, European Commission.

European Commission (2019), The European Green Deal.

European Commission (2021), Proposal for a regulation of the European Parliament and of the Council on European green bonds.

European Commission (2022a), Climate mainstreaming in the EU budget: preparing for the next MFF.

European Commission (2022b), Digitalising the energy system - EU action plan. 

European Commission (2022c), The EU as an issuer: the NextGenerationEU transformation.

IPCC Working Group III (2022), Climate change 2022: Mitigation of climate change, Intergovernmental Panel on Climate Change.

Krishnamurthy, A and A Vissing-Jorgensen (2012), “The aggregate demand for treasury debt”, Journal of Political Economy 120 (2): 233–267.

Menon, R, C Holthausen, and S Breeden (2022), “Scenarios for central banks and supervisors”, Network for Greening the Financial System.

Monasterolo, I, A Pacelli, M Pagano, and C Russo (2024), “A European climate bond”, Economic Policy, forthcoming.

Footnotes

1. The extension is in line with current plans by the Commission (ETS2). This scheme would substitute for an EU-wide carbon tax.
2. This scarcity is witnessed by the fact that the most widely held safe asset, US Treasury bills and bonds, earns a ‘safe haven’ premium of 0.7% per year on average (Krishnamurthy and Vissing-Jorgensen 2012).
3. Battiston et al. (2021) stress the importance of taking into account and appropriately modelling this feedback loop between financial systems and mitigation policies.