Capital structure under climate risk: testing pecking order and trade-off theories with physical exposure and climate-structural-adjusted credit risk

This study examines whether traditional capital structure theories such as the Pecking Order and Trade Off theories, remain valid when climate risk is incorporated into firms’ financing decisions. Using firm level data from 75,024 enterprises across 41 developing countries, the analysis integrates physical climate risk exposure and a climate-structural-adjusted probability of default that accounts for both climate vulnerability and firm adaptation capacity. The results show that profitability and risk remain key determinants of leverage, providing partial support for both theories. However, climate risk significantly alters financing behaviour by reducing formal debt access and increasing reliance on informal borrowing. Interaction effects further indicate that climate risk weakens the traditional relationship between profitability and leverage. The findings reveal a dual credit structure in which firms switch between formal and informal financing under climate stress. This study contributes to the literature by integrating climate risk into capital structure theory and highlights the need for climate informed credit assessment and improved financial access to support firm resilience in developing economies.