Climate Transition Risk, Climate Sentiments, and Financial Stability in a Stock-Flow Consistent approach

It is increasingly recognized that banks might not be pricing adequately climate risks in the value of their loans contracts. This represents a barrier to scale up the green investments needed to align the economy to sustainability and to preserve financial stability. To overcome this barrier, climate-aligned policies, such as a revision of the microprudential banking framework (for example a Green Supporting Factor (GSF)), and the introduction of stable green fiscal policies (for example a Carbon Tax (CT )), have been advocated. However, understanding the conditions under which a GSF or a CT could represent an opportunity for scaling up green investments, while preventing trade-offs on risk for financial stability, is still insufficient. We contribute to fill this knowledge gap threefold. First, we analyse the risk transmission channels from climate-aligned policies, a GSF and a CT, to the credit market and the real economy via loans contracts. Second, we assess the reinforcing feedbacks leading to cascading macro-financial shocks. Third, we consider how banks could react to the policies, i.e., their climate sentiments. In this regard, we embed for the first- time banks climate sentiments, modelled as a non-linear adaptive forecasting function into a Stock-Flow Consistent model that represents agents and sectors of the real economy and the credit market as a network of interconnected balance sheets. Our results suggest that the GSF is not sufficient to effectively scale up green investments via a change in lending conditions to green firms. In contrast, the CT could shift the bank's loans and the green/brown firms' investments towards the green sector. Nevertheless, it could imply short-term negative transition effects on GDP growth and financial stability, according to how the policy is implemented. Finally, our results show that bank's anticipation of a climate-aligned policy, through stronger climate sentiments, could smooth the risk for financial stability and foster green investments. Thus, our results contribute to understand the conditions for the onset and the mitigation of climate-related financial risks and opportunities.Series: Ecological Economic Paper

The double materiality of climate physical and transition risks in the euro area

The analysis of the conditions under which, and extent to which climate-adjusted financial risk assessment affects firms’ investment decisions in the low-carbon transition, and the realisation of the climate mitigation trajectories, still represent a knowledge gap. Filling this gap is crucial to assess the “double materiality” of climate-related financial risks. By tailoring the EIRIN Stock-Flow Consistent model, we provide a dynamic balance sheets assessment of climate physical and transition risks for the euro area, using the climate scenarios of the Network for Greening the Financial System (NGFS). We find that an orderly transition achieves important co-benefits already in the mid-term, with respect to carbon emissions abatement, financial stability, and economic output. In contrast, a disorderly transition can harm financial stability, thus limiting firms’ capacity to invest in low-carbon activities that could decrease their exposure to transition risk and help them recover from climate physical shocks. Importantly, firms’ climate sentiments, i.e. their anticipation of the impact of the carbon tax across NGFS scenarios, play a key role for smoothing the transition in the economy and finance. Finally, the impact on GDP of orderly and disorderly transitions are highly influenced by the magnitude of shocks in NGFS scenarios. Our results highlight the importance for financial supervisors to consider the role of firms and investors’ expectations in the low-carbon transition, in order to design appropriate macro-prudential policies for tackling climate risks

The double materiality of climate physical and transition risks in the euro area

We analyse the double materiality of climate physical and transition risks in the euro area economy and banking sector. First, by tailoring the EIRIN Stock-Flow Consistent behavioural model, we provide a dynamic balance sheet assessment of the Network for Greening the Financial System (NGFS) scenarios. We find that an orderly transition achieves early co-benefits by reducing CO2 emissions (12% less in 2040 than in 2020) while supporting growth in economic output. In contrast, a disorderly transition worsens the economic performance and financial stability of the euro area. Further, in a disorderly transition with higher physical risks, real GDP decreases by 12.5% in 2050 relative to an orderly transition. Second, we analyse how firms’ expectations about climate policy credibility (climate sentiments) affect investment decisions in high or low-carbon goods. Firms that trust an orderly policy introduction do anticipate the carbon tax and switch earlier to low-carbon investments. This, in turn, accelerates economic decarbonization and decreases the risk of carbon-stranded assets for investors. Our results highlight the crucial role of early and credible climate policies to signal investment decisions in the low-carbon transition

Derisking the low-carbon transition: investors’ reaction to climate policies, decarbonization and distributive effects

The role of climate finance policies and instruments in scaling up and derisking low-carbon investments has received growing research attention. However, financial actors’ reaction to climate finance initiatives, and their implications on decarbonization of the economy and on inequality, has not been assessed yet. Our manuscript contributes to address this knowledge gap by analysing under which conditions government’s climate finance policies and investors’ climate risk adjustment can affect the success of the low-carbon transition and the ability to close the green investment gap. We further develop the EIRIN Stock-Flow Consistent behavioural model with a financial market, an energy market and investors’ portfolio choice of financial contracts, for the European Union. First, we study the macroeconomic impacts of government’s green subsidies that can be financed either by introducing an unanticipated carbon tax or by issuing green sovereign bonds. Then, we assess how investors adjust firms’ risk assessment in reaction to the carbon tax introduction, and how this affects firms’ low-carbon investment decisions. We find that both a carbon tax and green bonds financing can give rise to trade-offs in terms of decarbonization of the economy (absolute emission reductions), distributive effects and public debt sustainability. The channels of transmission differ and are policy and instrument specific. Green subsidies that are financed by green sovereign bonds issuance generate positive spillovers on GDP growth and less distributive effects than a carbon tax. Nevertheless, due to the relative decoupling of the economy, GDP growth impairs emission reduction efforts. Finally, investors’ climate risk adjustment helps to smooth this trade-off, contributing to a full decoupling

The Role of Green Financial Sector Initiatives in the Low-Carbon Transition: A Theory of Change

Green financial sector initiatives, including financial policies, regulations, and instruments, could play an important role in the low-carbon transition by supporting countries in the implementation of economic policies aimed to decarbonize their economy. Thus, it is fundamental to understand the conditions under which and the extent to which green financial sector initiatives could enable the scaling up of green investments and the achievement of national climate mitigation objectives, while, at the same time, avoiding unintended effects on macroeconomic and financial stability. However, this understanding is currently limited, in particular in the context of emerging markets and developing economies. This paper contributes to filling this knowledge gap by analyzing opportunities and challenges associated with the implementation of green financial sector initiatives. It also considers the specificities of green financial sector initiatives in emerging markets and developing economies, which are often characterized by budget constraints, debt sustainability concerns, and limited access to finance. The analysis focuses on green macroprudential policies, green monetary policies, and green public co-funding. For each green financial sector initiative, the paper qualitatively investigates the transmission channels through which it affects the availability and cost of capital for high- and low-carbon goods, but also investments, output, and greenhouse gas emissions, considering the design and implementation of the green financial sector initiative. For each green financial sector initiative, the paper further identifies its entry point in the economy and its direct and indirect impacts. Building on these insights, the paper develops a theory of change about the role of green financial sector initiatives in climate mitigation and in the low-carbon transition, identifying the criteria for applicability and conditions to maximize impact