From disasters to volatility: Extreme climate events and European financial markets

This paper examines how climate-related risks shape the volatility dynamics of major European financial markets, with a particular focus on long-run volatility. We investigate whether climate-related risks translate into persistent financial uncertainty and why long-run volatility responses differ across markets. The analysis proceeds in two steps. In the first step, we use a double-asymmetric GARCH–MIDAS framework to test whether extreme weather events affect long-run volatility and whether the response is asymmetric between adverse (above-average) and mild (below-average) extreme realizations. We find that physical climate risk has non-linear and asymmetric effects on long-run financial volatility, with some markets exhibiting substantially greater sensitivity than others. To explain this heterogeneity, in the second step of the analysis we move from a time-series to a panel framework and incorporate climate transition risk alongside physical risk. To do so, we construct a long-run volatility measure from realised variance and relate it to transition and physical climate risk measures, allowing the effects to vary with energy structure, sectoral exposure, institutional capacity, and macro-financial conditions. The panel results indicate that transition risk acts as a source of long-horizon uncertainty, but its impact depends on structural characteristics. Fossil-fuel-dependent countries and highly exposed sectors experience stronger volatility responses, while markets with greater renewable energy penetration and stronger institutional capacity tend to absorb transition-related uncertainty more smoothly. Physical climate risk also affects long-run volatility but mostly when extreme weather coincides with elevated energy uncertainty or macroeconomic instability. Overall, our findings underscore that climate risk is neither uniformly destabilising nor fully neutralised in financial markets but instead depends on country-specific structural characteristics and state-dependent macroeconomic dynamics.