Enabling or Hampering? Climate Risk and the Role of Finance in the Low-Carbon Transition

Abstract

While there is a broad understanding that the financial system can play a major enabling role in achieving the low-carbon transition, it is not well understood under which specific conditions such an orderly transition scenario when finance works as an enabler could occur. Even more importantly, it has not been clarified under which conditions the financial system could instead hamper the low-carbon transition. Overlooking the possible (even temporary) hampering role of the financial system in the low-carbon transition can lead to a large underestimation of climate transition risk. The set of scenarios that financial supervisors recommended to investors to analyse climate transition risk include scenarios labelled as ‘disorderly transition’. Nevertheless, there are important limitations in interpreting such scenarios in terms of a disorderly transition. In particular, since in the climate economic models currently used by financial supervisors, finance plays no role, it is not possible to investigate the conditions for the financial system to act as an enabler or as a barrier for the low-carbon transition. To shed light on this issue, here we analyse how the economic trajectories of these climate economics models are reshaped depending on the timing and the extent by which financial actors assess climate risk.

Keywords: climate transition risk, carbon price, climate finance, climate economic models, disorderly transition scenarios.

JEL Classification: G10, G32, Q54