Climate risks, investors’ expectations and financial stability

Climate-related financial risks now play a key role in the agenda of central banks and financial regulators. Here, we present results from a stream of work in complexity economics and finance that investigates the macro-financial criticality of climate risks.

First, we present results of a dynamic balance sheet assessment of the double materiality of climate risks for the Euro Area economy and banking sector. We tailor and apply the EIRIN Stock-Flow Consistent (SFC) behavioural model to the Network for Greening the Financial System’s climate scenarios. We also consider the impact of investors’ climate sentiments on investment decisions and decarbonization. We find that an orderly transition achieves early co-benefits by reducing carbon emissions (12% less in 2040 than in 2020) while supporting growth in economic output. In contrast, a disorderly transition worsens the euro area economic performance and financial stability. Furthermore, firms’ expectations about climate policy credibility affect their investment decision in high and low-carbon goods, and the realization of carbon stranded assets.

Then, we present a framework to analyse the interplay of investors’ expectations and climate policy credibility, and the impacts on transition scenarios and on financial stability. By connecting process-based Integrated Assessment Models with financial network-based climate stress-test, we find that neglecting investors’ expectations could lead to a wrong assessment of risks and opportunities in the transition, and thus to inconsistent climate policy and investment decisions.