A Climate Stress-Test of the Financial System
27 Pages Posted: 3 Feb 2016 Last revised: 12 Jul 2016
Date Written: July 11, 2016
We propose a novel methodological framework to assess the exposure of the financial system to climate policy risks. We extend the notion of climate policy risk scenarios in order to go beyond the mere fossil fuel production sector and encompass the indirect effects through key economic sectors such as energy-intensive sectors, housing and finance. Our methodology can be applied both bottom-up using micro-economic data and top-down using aggregate macro-economic sectoral data. As an illustration, we conduct and assessment of the exposures of European financial institutions through their portfolio of European and US equity holdings and loans. We find that the direct exposure to fossil fuel production sector and energy-intensive sectors, while limited overall, is important for investment funds. In turn, banks and pension funds have important exposures to investment funds, and thus bear important indirect exposure to fossil fuel. Further, the housing sector can potentially act as a trigger of a shock which then amplifies through the financial system.
Keywords: climate stress-test, climate policy risk, decarbonization, stress-test, stranded assets, carbon risk, climate-sensitive sectors
JEL Classification: C15, C23, G20, G21, G22, G23, G24, G28, H20, Q20, Q28, Q43, Q48
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