Projects: CFR1-JE1

Low-carbon Transitions and Systemic Financial Risk

The transition to a low-carbon economy has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Most notably, Mark Carney’s ‘Tragedy of the Horizons’ speech warned of the potential of a transition-driven ‘Minsky moment’ whereby a disorderly process leads to a sudden collapse in asset prices.

We identify the channels through which a transition shock could lead to a systemic disruption. These include the downward repricing of carbon-intensive (or green) assets and a reduction in emissions-intensive production. We outline the approaches developed by existing studies to assess systemic risk, including the tracking of transition risk indicators such as bank exposure to emissions-intensive sectors, stress-testing frameworks, and network modelling approaches.

There is still much uncertainty on how to best measure the level of systemic risk posed by the transition, and therefore the size of this risk. Paradoxically, the realisation of systemic risks is more likely when the source of risk is not well understood. It is therefore important to consider the possible channels and work on their potential implications.

Low-Carbon Transitions and Systemic Risk

The low-carbon transition has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Transition risk refers to the economic and financial risks associated with a disorderly transition to a low-carbon economy. Policymakers have highlighted that the systemic nature of transition risk could lead to an adverse impact on financial stability. In particular, several have warned of the potential for a transition-driven ‘Minsky moment’ whereby a disorderly transition leads to a sudden collapse in asset prices. This work draws on the frameworks of central banks and academic studies to identify the channels through which an adverse shock can lead to a realisation of systemic risk. Systemic risk can be defined as the risk of a shock that has negative externalities on economies and financial systems via networks. This risk can be realised when a large number of financial market participants are impacted simultaneously or when a sectorspecific shock leads to contagion and feedback loops that amplify the impact. The realisation of systemic risks can also be more likely when the source of risk is not well understood. This makes it inherently challenging to identify them ex ante, but therefore important to consider the multiple possible channels and work through their potential implications.
The report then considers the channels through which systemic risk could materialise under a low-carbon transition. The main sources of risk identified in the context of a low-carbon transition are a sudden downward repricing of carbon-intensive (orlow-carbon) assets and energy price shocks. The repricing of assets would lead to losses for those directly and indirectly exposed. Feedback loops can also amplify the initial losses and have a negative impact on the wider economy. Further, a disorderly transition could lead to an energy price shock which has a large negative impact on economic growth. Within these main sources, we outline the detailed transmission channels for systemic risk stemming from overlapping portfolios, lending between financial market participants, and the interaction between the financial system and the real economy.
While there is an extensive literature on systemic risk, the literature on systemic risk in relation to a lowcarbon transition is still in early stages of development. Since the financial crisis, there has been a growing emphasisin the literature on assessing the systemic financial risk triggered by unexpected shocks, such as the bursting of the subprime mortgage bubble in the US. Approaches include the development of marketbased indicators that capture the build-up and materialisation of systemic risk, general equilibrium models and stress testing frameworks. Whilethe literature focussing on transition risk in particular is more limited,
there are studies which have employed networks approaches to estimating systemic risk in the context of a low-carbon transition.
We identify the main gaps in existing methodologies for estimating the systemic risk posed by a low-carbon transition and recommend areas for future research. First, further data collection is required to better assess
the exposure of assets to transition risk. In addition, policymakersshould work to develop more comprehensive climate-related stress testing exercises, with more of a focus on second round impacts.
Where possible, these exercises could draw on historical events with similar characteristics, such as a large swing in energy prices. Further, the development of more comprehensive approaches such as multi-layered
models of financial and production networks, and frameworks that include both the impact of rising and declining industries have the potential to improve the assessment of systemic risk.