The Economic Costs of Extreme Weather: Beyond Environmental Damage

Extreme weather is something that people usually think about as a problem for the environment. We discuss wildfires, floods, and heat waves in terms of their physical impacts on the Earth. However, these occurrences are increasingly causing economic shocks that distort prices, upset labor markets, and even increase inequality.

With climate change, extreme weather events are becoming more severe and frequent, with increasing effects on the economy. The issue is not simply that the weather causes damage, but that markets are poorly equipped to adapt to such extreme climate events.

One way to think about the economic impact of extreme weather is as a negative supply shock - something suddenly makes it harder or more expensive to produce goods. Examples include heat waves that reduce labor productivity and floods that disrupt transportation networks. These shocks can cause the short-run aggregate supply curve to move to the left, which increases costs while decreasing output. That in turn decreases overall GDP. 

Supply shocks are a lot more challenging for policymakers to deal with. Demand shocks could be fixed somewhat quickly through fiscal or monetary policy, but supply shocks cannot be changed so easily. Lower output creates higher prices, which in turn leads to inflation and slower economic growth. Monetary policy can’t easily fix the effects on both output and prices. Moreover, these shocks are no longer rare. Long-run growth is diminished as extreme weather becomes more common since the economy is repeatedly impacted before fully recovering from prior disruptions.

The labor market is another direct economic channel that is affected by extreme weather. High temperatures have been shown to reduce both physical and cognitive performance. Outdoor workers also face greater health risks as well as shorter working hours. Indoor workers face declines in concentration and, therefore, task efficiency. From a labor economics perspective, extreme weather limits how much people can work. When conditions like extreme heat make workers less productive, each worker produces less output, while their wages don’t fall by the same amount. This mismatch makes labor more expensive relative to production, creating inefficiencies in the market that can’t easily be fixed.

Another economic consequence of extreme weather appears in insurance markets. In theory, insurance spreads risk across many people so that no one person takes the full hit. However, climate-related risks are becoming more difficult to insure. As extreme weather events become more predictable in certain areas, adverse selection worsens. This means that insurers are left to cover a pool of customers who are more likely to experience losses, making insurance significantly more expensive. Insurers respond by increasing premiums or withdrawing from markets entirely. When private insurance becomes too expensive or disappears altogether, governments often step in as insurers of last resort.
This raises a moral hazard issue. If individuals and businesses can rely on government assistance during disasters, they may be less likely to avoid risky areas or make investments to safeguard themselves against disasters. Thus, private insurance markets fail to function properly, and public intervention, despite its need, can become a source of new economic distortions.

Housing markets are also affected by weather extremes. In theory, homes in areas with a higher risk of floods or wildfires should sell for less than homes that don’t have these risks. Yet housing prices often do not reflect these climate risks.

Several factors explain that mispricing. Buyers may underestimate the possibility of risk in the long-term because they do not know what the future holds for the environment. Government disaster aid can also reduce the perceived cost of living in risky areas, keeping demand for those properties high. At the same time, the availability of property may be limited, particularly around towns or universities, which pushes prices up even in high-risk locations.

The costs of weather extremes are not shared equally amongst individuals. Low-income households, for example, face greater climate risk since they often live in poorer quality homes, are less insured, and have fewer savings. It is also harder for them to move away from dangerous areas.

Extreme weather thus functions as an uneven shock. Because those who can least afford the losses bear the burden, inequality rises even if the average income remains unchanged. That raises some key economic questions about who should pay for adaptation and how those costs should be shared. Indirect costs from climate costs, such as missed work hours, interrupted education, or increased living expenses, may be greater for individuals from lower-income backgrounds. 

Many climate investments to prevent extreme weather, such as cooling systems, flood protection, and more resilient public transportation, have benefits that outweigh their costs from an efficiency standpoint. But these investments are frequently not made.

The economic reason is simple. Adaptation measures act like public goods. They cost a lot upfront, pay off over the long-run, and often benefit people who didn’t directly pay for them. Politicians have little incentive to invest in projects whose benefits won't show up until after they leave office. As a result, necessary investments are postponed until a disaster forces action. By then, costs are higher, and responses are less effective.

Ultimately, extreme weather is no longer just an occasional shock to a stable economy. Due to climate change, it has become a recurring feature that affects production, labor markets, asset prices, and inequality. The main economic challenge is that markets frequently ignore climate risks and don’t invest enough in preparing for them. Addressing those failures requires better risk-pricing, sustained public investment, and institutions capable of managing uncertainty that private markets cannot efficiently absorb. Pretending these factors do not exist is not only environmentally costly but economically inefficient.

Sources:

Bank of Canada. (2025, February). Structural change, supply shocks, and hard choices. https://www.bankofcanada.ca/2025/02/structural-change-supply-shocks-and-hard-choices/

European Environment Agency. (n.d.). Economic losses from climate-related extremes. https://www.eea.europa.eu/en/analysis/indicators/economic-losses-from-climate-related

The Guardian. (2025, September 15). Europe’s summer of extreme weather caused €43bn of short-term losses, analysis finds. https://www.theguardian.com/world/2025/sep/15/europes-summer-of-extreme-weather-caused-43bn-of-short-term-losses-analysis-finds

OECD. (n.d.). The macroeconomic implications of extreme weather events. https://www.oecd.org/en/publications/the-macroeconomic-implications-of-extreme-weather-events_5e24a2d8-en.html

Oxera. (2024, November). The economic cost of climate-related extreme weather. https://www.oxera.com/wp-content/uploads/2024/11/Oxera_The-economic-cost-of-climate-related-extreme-weather.pdf

World Economic Forum. (2025, January). Insuring extreme heat: Navigating risks. https://www.weforum.org/stories/2025/01/insuring-extreme-heat-navigating-risks/

Tsai, F., & Ezzati, M. (2002). Economic implications of climate-related health risks. PMC Articles. https://pmc.ncbi.nlm.nih.gov/articles/PMC12243420/