A Finance Approach to Climate Stress Testing
Forthcoming in Journal of International Money and Finance
47 Pages Posted: 6 May 2020 Last revised: 13 Jan 2023
Date Written: December 31, 2022
There is increasing interest in assessing the impact of climate policies on the value of financial sector assets, and consequently on financial stability. Prior studies either take a “black box” macro-financial approach or focus solely on equity instruments – though banks’ exposures predominantly consist of debt. We develop a more tractable finance (valuation) approach at the industry-level and use a Merton contingent claims model to assess the impact of a carbon tax shock on the market value of equity and debt instruments. We calibrate our model using detailed firm-level vulnerability data and apply the model to 2-digit sectoral exposures of Dutch banks. We find declines in the market value of banks’ assets of 3-14% of core capital for a €100 carbon tax shock, increasing to 9-32% for a €200 carbon tax shock.
Keywords: Climate stress test, contingent claims analysis, climate policies, carbon tax, banks
JEL Classification: G13, G21, H23, Q54
Suggested Citation: Suggested Citation