Blog Post

Climate change and financial markets

What’s at stake: Ever since the 2016 Paris Agreement to reduce emissions was signed, researchers have been looking at the impact that moves towards a low-carbon economy might have on financial markets and financial stability. We review these contributions here. 

By: Date: January 30, 2017 Topic: Energy & Climate

In February 2016, the ESRB published a report estimating the impact of a transition to clean energy on financial markets. Keeping global warming below 2°C  – as agreed in Paris – will require substantial reductions in global greenhouse gas emissions over the next few decades. To reduce emissions, economies must reduce their carbon intensity. Given current technology, this implies a decisive shift away from fossil-fuel energy and related physical capital.

The ESRB argues that if the transition were to occur too late and/or abruptly, it could affect systemic risk via three main channels:
(i) the macroeconomic impact of sudden changes in energy use
(ii) the sudden revaluation of carbon-intensive assets
(iii) a rise in the incidence of natural catastrophes

To quantify the importance of these channels, the ESRB report proposed that policymakers aim for enhanced disclosure of the carbon intensity of non-financial firms. They called for the related exposures of financial firms be stress-tested under the adverse scenario of a late and sudden transition.

Using a sample of firms that covers the full range of carbon intensity from renewable energy firms to coal firms, Sowerbutts examines the effect of the Paris agreement on their returns in the framework of an event study. Comparing the cumulative abnormal returns experienced by a petroleum refining company (CVR Energy) and a wind turbine manufacturing company (Nordex) in the immediate aftermath of the announcement of the Paris Agreement on 12 December 2015, he finds that the reaction was immediate and persistent. Prices jumped immediately on the first trading day, meaning a positive abnormal return of 4% for Nordex and a negative abnormal return of 4% for CVR energy, with gradual declines to end up at a cumulative abnormal return of 6% over the whole period (see figure below).

Baranova, Jung and Noss argue that there is a risk that adjustment in financial market prices will be abrupt and likely to pose risks to financial stability, because financial valuations can move sharply even if the transition to sustainable energy were smooth. They argue that exposures are sufficiently large to warrant attention from both investors and policymakers. Using scenarios for carbon emission limits, they assess their impact on different industrial sectors and the consequent effect on financial asset valuation.

Their computations yield a large re-pricing of energy stocks: even under a smooth transition, affected firms’ equities would lose around 40% of value, equivalent to a fall of around 11% in global equity market capitalisation. If this were to happen rapidly, such a re-pricing could pose financial stability risk. Turning to credit markets, the most affected companies have earnings that would likely be sufficient to service interest payments on their existing debt even in the case of a significant fall in revenues. But if the shock to revenues/profits were permanent – as might be the case under the crystallisation of climate transition risks that posed a longer-term risk to the viability of some firms – a rise in refinancing costs could ultimately result in an increase in defaults, with associated implications for financial stability.

Battiston et al. (2016) propose a novel methodological framework to assess the exposure of the financial system to climate policy risks. They aim to capture both the direct effects on the fossil fuel production sector and the indirect effects on key economic sectors such as energy-intensive sectors, housing and finance. Using empirical data from the euro area, they show that while direct exposures to the fossil fuel sector are small (3-12%), the combined exposures to climate-policy relevant sectors are large (40-54%), heterogeneous, and possibly amplified by indirect exposures via financial counterparties (30-40%). These results suggest that climate policies could result in potential winners and losers across financial actors. However, they would not have an adverse systemic impact as long as they are implemented early on and within a stable framework.

An external report commissioned by the German Finance Ministry builds on the same framework. It indicates that the direct physical effects of climate change are highly unlikely to pose a risk to the stability of German and European financial markets over the short to medium term (up to 2030), but transition risks are higher. Emissions-intensive industries make up a major part of German industry. In fact, emissions-intensive companies in the chemical (20%), industrial goods and services (13%), automotive (14%) and utilities (3%) sectors account for nearly half of the DAX 30 index. The report estimates that transition risks are likely to cause financial market assets (equity and bonds) to lose a maximum of 2%–5% of their value, meaning that such risks by themselves pose a minor risk to financial market stability. However, depending on the structural characteristics of the financial system, there could be secondary effects – combined with other downside risks – that could very well lead to serious repercussions and cumulative risks.

Dietz et al. take a different point of view and ask a different question: what might be the impact of climate change itself on asset values? They find that the expected ‘climate value at risk’ (climate VaR) of global financial assets today is 1.8% along a business-as-usual emissions path. Taking a representative estimate of global financial assets, this amounts to US$2.5 trillion. However, much of the risk is in the tail. For example, the 99th percentile climate VaR is 16.9%, or US$24.2 trillion. These estimates would constitute a substantial write-down in the fundamental value of financial assets. Cutting emissions to limit warming to no more than 2 °C reduces the climate VaR by an expected 0.6 percentage points, and the 99th percentile reduction is 7.7 percentage points. Including mitigation costs, the present value of global financial assets is an expected 0.2% higher when warming is limited to no more than 2 °C, compared with business as usual. The 99th percentile is 9.1% higher. Limiting warming to no more than 2 °C thus makes financial sense to risk-neutral investors—and even more so to the risk averse.

In a speech given for the Arthur Burns Memorial Lecture, Mark Carney highlighted paradoxes in addressing the financial risk from climate change. The first paradox is that “the future will be past”: climate change imposes a cost on future generations that the current one has no direct incentive to fix and once climate change becomes a clear and present danger to financial stability it may already be too late to stabilise the atmosphere at two degrees. The second paradox is that “success is failure”: a too rapid a movement towards a low-carbon economy could materially damage financial stability. Carney stressed that smooth adjustment is crucial because transition risks are how success could turn into failure, and that an obstacle to a smooth adjustment has been the absence of information to help market participants make a market in climate-related financial risk.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Podcast

Podcast

Brexit consequences for EU climate and energy policy

Bruegel fellow Georg Zachmann joins Richard Tol, professor in the Department of Economics at the University of Sussex, and Pieter-Willem Lemmens, head of analysis at the climate policy think-tank Sandbag, for this episode of 'The Sound of Economics', to discuss the impact of Brexit on climate and energy policy in the European Union.

By: The Sound of Economics Topic: Energy & Climate Date: February 15, 2018
Read article More on this topic More by this author

Opinion

Climate policies risk increasing social inequality

The aggressive political interventions needed to effectively counteract climate change will make the rich richer and the poor poorer, if social concerns are not given greater prominence in policy debates.

By: Georg Zachmann Topic: Energy & Climate Date: February 8, 2018
Read article More on this topic More by this author

Blog Post

Economies of States, Economies of Cities

Both in Europe and the US, economists are starting to notice how the economies of cities have been sometimes diverging from the economies of states. While some areas thrive, others may be permanently left behind. Maybe it is time to adopt a more clearly sub-national perspective. We review recent contributions on this issue.

By: Silvia Merler Topic: Global Economics & Governance Date: February 5, 2018
Read article More on this topic More by this author

Blog Post

EU budget: Expectations vs reality

The public's impressions of where money is spent in the European Union can often be wide of the mark. But whether this is a result of wishful thinking or just a lack of information remains unclear.

By: Yana Myachenkova Topic: European Macroeconomics & Governance Date: January 29, 2018
Read about event More on this topic

Past Event

Past Event

EU long term climate change strategy

This meeting, which will take place in Czestochowa, is part of the project “Developing the EU long-term climate strategy”.

Topic: Energy & Climate Location: Czestochowa, Poland Date: January 29, 2018
Read article More on this topic More by this author

Blog Post

Rebuilding macroeconomics: Initial reflections on a major theory project

The ‘Rebuilding Macroeconomic Theory Project’ came to an end in the most recent volume of the Oxford Review of Economic Policy; how were the various papers’ conclusions received?

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: January 29, 2018
Read about event More on this topic

Past Event

Past Event

EU Long Term Climate Change Strategy

This meeting, which will take place in Copenhagen, is part of the project “Developing the EU long-term climate strategy".

Topic: Energy & Climate Location: Copenhagen, Denmark Date: January 26, 2018
Read article Download PDF More on this topic

External Publication

Reconciling risk sharing with market discipline: A constructive approach to euro area reform

This publication, written by a group of independent French and German economists, proposes six reforms which, if delivered as a package, would improve the Eurozone’s financial stability, political cohesion, and potential for delivering prosperity to its citizens, all while addressing the priorities and concerns of participating countries.

By: Agnès Bénassy-Quéré, Markus K. Brunnermeier, Henrik Enderlein, Emmanuel Farhi, Marcel Fratzscher, Clemens Fuest, Pierre-Olivier Gourinchas, Philippe Martin, Jean Pisani-Ferry, Hélène Rey, Isabel Schnabel, Nicolas Véron, Beatrice Weder di Mauro and Jeromin Zettelmeyer Topic: European Macroeconomics & Governance Date: January 17, 2018
Read article More on this topic

Blog Post

Climate change adds to risk for banks, but EU lending proposals will do more harm than good

Climate change is a relevant risk factor for the banking sector, but the European Commission's plan to lower capital requirements for greener investments is irresponsible in encouraging banks to forego proper risk management.

By: Arnoud Boot and Dirk Schoenmaker Topic: Energy & Climate Date: January 16, 2018
Read article More on this topic More by this author

Blog Post

A few good (wo)men – on the representation of women in economics

Last week, the American Economics Association Annual Meetings held a session on Gender Issues in Economics and later announced that a new code of professional conduct is in the pipeline. In this blogs review we revise the recent contributions on female representation and perception in economics.

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: January 15, 2018
Read article More on this topic More by this author

Blog Post

The Republican Tax Plan (2): The debate rumbles on

Reactions to the Republican tax plans continue, concentrating on different aspects of the proposed legislation. We review the latest contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: December 18, 2017
Read article More by this author

Blog Post

The DSGE Model Quarrel (Again)

Dynamic Stochastic General Equilibrium models have come under fire since the financial crisis. A recent paper by Christiano, Eichenbaum and Trabandt – who provide a defense for DSGE – has generated yet another wave of reactions in the economic blogosphere. We review the most recent contributions on this topic.

By: Silvia Merler Topic: European Macroeconomics & Governance, Global Economics & Governance Date: December 11, 2017
Load more posts