Low‐carbon transition risks for finance

Abstract

The transition to a low‐carbon economy will entail a large‐scale structural change. Some industries will have to expand their relative economic weight, while other industries, especially those directly linked to fossil fuel production and consumption, will have to decline. Such a systemic shift may have major repercussions on the stability of financial systems, via abrupt asset revaluations, defaults on debt, and the creation of bubbles in rising industries. Studies on previous industrial transitions have shed light on the financial transition risks originating from rapidly rising “sunrise” industries. In contrast, a similar conceptual understanding of risks from declining “sunset” industries is currently lacking. We substantiate this claim with a critical review of the conceptual and historical literature, which also shows that most literature either examines structural change in the real economy, or risks to financial stability, but rarely both together. We contribute to filling this research gap by developing a consistent theoretical framework of the drivers, transmission channels, and impacts of the phase‐out of carbon‐intensive industries on the financial system and on the feedback from the financial system into the rest of the economy. We also review the state of play of policy aiming to protect the financial system from transition risks and spell out research implications. This article is categorized under: Climate Economics > Economics and Climate Change

Reframing the climate policy game

“…The new energy geography has deep socio-economic and geopolitical implications, and changes game theoretical interpretations of political dynamics. First, in line with the great waves literature 37,38 and the Just Transition movement, the creative destruction effect of the low-carbon transition underway is likely to generate localised issues of post-industrial decline, particularly in the US, Russia, Canada. This suggests that comprehensive plans for regional redevelopment are likely needed along with economic diversi cation towards new technology sectors including catching up in the race towards low-carbon technology exports.…”

Central banks, financial stability and policy coordination in the age of climate uncertainty: a three-layered analytical and operational framework

“…First, non-equilibrium models can be used to represent specific channels of contagion of climate-related risks, an area of research still in its infancy (Semieniuk et al, 2020). For instance, Cahen-Fourot et al (2019) rely on network-based theory 5 to assess how stranding an asset in one specific sector can trigger a 'cascade of stranded assets' affecting many other sectors of the economy.…”

“…Also, an observer bias in the selection of the key interconnections is inevitably bound to creep in (Colander & Kupers, 2014, p. 15). As an example, in their evolutionary models of climaterelated risks, Campiglio et al (2018), Monasterolo et al (2019, p. 179) and Semieniuk et al (2020) all see Schumpeterian creative destruction as the main (or even sole) force behind the evolution of our complex and adaptive socioeconomic systems. Yet, other evolutionary forces may be at work in moving along the socioeconomic transition, as further discussed below.…”

“…A rapid shift to a low-carbon economy might hopefully avoid the worst of these physical risks but would not be exempt of a second type of risk: transition risks. These are associated with the uncertain financial impacts that could result from a rapid low-carbon transition, including radical policy shifts, reputational impacts, technological breakthroughs or unexpected limitations, and shifts in market preferences and social norms (for an overview of each of these sources of transition risk, see Semieniuk et al (2020)). In particular, the structural economic transformation required to move to lower emissions pathways means that a large fraction of proven reserves of fossil fuels cannot be extracted, becoming 'stranded assets' (Johnsson et al, 2019;McGlade & Ekins, 2015).…”

“…While the specific contagion channels of physical and transition risks still need to be better identified (see Semieniuk et al, 2020), it is already clear that climate-related risks can trigger multiple economic impacts on households, firms, and sovereigns (or governments), which could all impact financial activities (credit, market finance, liquidity provision, insurance, operational procedures) and generate second-round effects (Figure 1). Moreover, although physical and transition risks are usually treated separately, these are likely to interact with each other in practice.…”