The systemic risk of a late and sudden transition

New working paper in ESRB report

Is the international financial system at risk, if policy and markets react too late and too abruptly to climate change? A report, published yesterday by the European Systemic Risk Board (ESRB) “Too late, too sudden: Transition to a low-carbon economy and systemic risk” tries to find answers to this question.

Earlier analyses of the British Central Bank and the G20 Financial Stability Board have already raised this issue. In parallel, the “divestment” movement, which calls for the withdrawal of public and private funds from coal, oil and gas companies has further gained momentum worldwide.

If climate mitigation policies are too weak or implemented too late, the transformation towards a low-carbon economy might run disorderly and can lead to sudden market corrections with far-reaching consequences. Risks related to climate change can be of physical, political and regulatory nature and can materialise through different channels. One channel might be the sudden increase of energy or carbon prices or a loss in market share and therefore a decline in revenues. Another channel might be a sudden devaluation of carbon-intensive assets and companies.

Even if direct exposures of the financial system to the fossil-fuel extraction sector are not very high at the aggregate level (The report refers to estimates which say that European banks, pension funds and insurances together have an exposure of around € 1bn in the fossil energy sector and that they could face a loss in value of 15-20%), some financial institutions and some governments are more exposed than others. Additionally, energy-intensive industries that manufacture products using fossil fuels might also face revaluations of their invested capital.

The ESRB report concludes that, besides the disclosure of data, which provide information on the carbon intensity of companies, a sudden-transition policy scenario should be included in macroeconomic scenarios as well as in stress tests of financial institutions and the financial system as a whole. This can help to stimulate political action and to dissolve the “tragedy of the horizon” (a term used by Mark Carney in 2015).

A timely contribution by members of the Global Climate Forum and research partners (Battiston et al, 2016) is a recent working paper “A climate stress-test of the EU financial system”, which proposes a methodology to carry out such carbon stress-tests and shows first examples of such.

You can find a blog entry on the topic by Alexander El Alaoui (Germanwatch, Brot für die Welt) and Franziska Schütze (GCF) in German language here:

For further questions and comments please contact Franziska Schütze