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

Abstract

Aligning investments to the climate and sustainability targets requires the introduction of stable climate-aligned policies. In this regard, a global Carbon Tax (CT) and a revision of the microprudential banking framework via a Green Supporting Factor (GSF) have been advocated. However, our understanding of the conditions under which a GSF or a CT could contribute to scale up new green investments, or introduce new sources of risk for financial stability, is poor. In addition, the banking sector’s reaction to the policy announcements i.e. the climate sentiments via a revision of the lending conditions, have not been considered yet. Nevertheless, they could significantly affect the policies’ outcomes, credit supply and conditions, and financial stability at the bank and systemic level. We contribute to fill this knowledge gap by developing a Stock-Flow Consistent behavioral model of a high income country that embeds a non-linear adaptive function of banking sector’s climate sentiments. With the model, we assess the impact of the introduction of a GSF and a CT on the greening of the real economy and on the credit market conditions. We analyze the risk transmission channels from the credit market to the economy via loans contracts, and of the reinforcing feedback effects that could drive cascading macro-financial shocks. Our results suggest that the GSF could contribute to scale up green investments only in short term, while introducing potential trade-offs on financial stability. To foster the low-carbon transition while preventing unintended effects on firms non-performing loans and households’ budget, the introduction of a CT should be complemented with welfare measures. Finally, climate sentiments could be a game changer for the low-carbon transition by increasing investments’ alignment and preventing the risk of stranded assets.