Accounting for finance is key for climate mitigation pathways

Abstract

The financial system, the ecosystem of investors (e.g., banks, investment funds, insurance), markets, and instruments, is often considered to play an enabling role in climate mitigation pathways to a low-carbon transition. But it can also have a hampering role, e.g., if investors’ perceptions of low risk from a missed transition and low opportunities from a transition fail to trigger a reallocation of capital into low-carbon investments. This increases the chance of the transition not occur-ring within the time window required to stabilize the climate or occurring in a disorderly fashion. But investors, who can influence the realization of climate mitigation pathways, themselves rely upon estimates of climate mitigation pathways from process-based Integrated Assessment Models (IAMs). And IAMs do not model the financial system nor investors’ decisions, thus the feedback loop between the financial system and mitigation pathways is not taken into account by the IAMs nor by the finance community. This limitation to our understanding of the dynamics and the feasibility of the low-carbon transition weakens the ability of IAMs to inform policy and investment decisions. We propose a framework to capture the interdependence between investors’ perception of future climate risk, depending on the credibility of climate policies, and the allocation of in-vestments in the economy.

Keywords: climate finance, financial risk, mitigation scenarios, energy technology, systemic risk, integrated climate financial risk assessment

JEL Classification: G01, G20, Q43, Q54