Ambitious climate policy, coupled with financial frictions, has the potential to create macrofinancial stability risk. Such stability risk may expand beyond the economy implementing climate policy, potentially catching other countries off guard. International spillovers may occur because of trade and financial channels. Hence, we study the design and effects of climate policies in the world economy with international trade and financial flows. We develop a two-sector, two-country, dynamic general equilibrium model with financial frictions, climate policies, including carbon tariffs, and macroprudential policies. Using the calibrated model, we evaluate spillovers from unilateral domestic carbon pricing to foreign economies and back. We also examine more ambitious climate architectures involving carbon tariffs or a global carbon price. We find that accounting for cross-border financial flows and frictions in credit markets is crucial to understand the effects of climate policies and to guide the implementation of macroprudential policies at the global scale aimed at minimizing transition risk and paving the way for ambitious climate policy.
Climate change is expected to have increasing impacts on our economies and societies. The extent of such economic impacts has generally been analyzed with integrated assessment models. These models have substantially improved over time to account for various features that may lead them to underestimate the extent of climate damages. There is, however, in our view, one crucial feature that so far has not yet been accounted for: financial frictions. We consider that financial frictions may amplify the impact of climate damages on the affected economies, to an extent that has not yet been measured. Hence, the main goal of this project is to extend integrated assessment models of climate change to include financial frictions, to measure the possibility that physical risks, the impact on financial assets that arise from climate- and weather-related events, may lead to financial crises, and what measures may be introduced to limit such possibility. Further, to better assess the impact of such financial crises, which add to the direct effect of the climate- and weather-related events that trigger them, the integrated assessment model is conceived to include income categories, an important aspect too often neglected in this literature and necessary to account for inequalities in how climate damages may affect people’s livelihoods. The integrated assessment model is also conceived to include a widely used regional decomposition. The project aims to provide clear policy lessons, analyzing the impact of a wide range of policy levers, including financial institutions, macroprudential policy, insurance schemes, and adaptation efforts, and their ability to mitigate physical risks.