May 24 2021
Researchers at the University of Zurich show how climate mitigation scenarios can be improved by taking into account that the financial system can play both an enabling or a hampering role on the path to a sustainable economic system.
To limit global warming, a profound transformation of energy, production and consumption in our economies is required. The scale of the transformation means that the financial system must have a proactive role. New green investments are needed, as well as a reallocation of capital from high to low-carbon activities. The Central Banks and Supervisors Network for Greening the Financial System (NGFS), of which the Swiss National Bank is a member, was recently established with the aim of better understanding and managing the financial risks of climate change.
The climate mitigation scenarios developed by the NGFS in collaboration with the Intergovernmental Panel on Climate Change of the United Nations (IPCC) have been a major step in providing financial actors with forward looking views on how low and high-carbon economic activities could evolve over the next decades. However, at this stage, these scenarios are based on large-scale Integrated Assessment Models (IAMs) that do not take into account the dynamic nature of the financial system and its actors. "We need to consider how the risk perception of the financial system from the scenarios can change the scenarios themselves," explains Stefano Battiston, professor at the Department of Banking and Finance at the University of Zurich.
Expansion of climate mitigation models
In their paper published in Science, Battiston and an international research group - with two authors being also authors of the upcoming IPPC Assessment Report - present a dynamic approach to complement climate mitigation scenarios. By describing what the world might look like in the coming decades, and being endorsed by financial authorities and large investors, climate mitigation scenarios have the power to change markets' expectations today. But this has an impact on the scenarios. "The economic system could go in the direction of the low-carbon transition, but it could also go the opposite way. It depends on what perception of risk the actors form from the scenarios," Battiston says. If investors find climate policies credible, they will adjust their expectations in a timely manner and reallocate capital to low-carbon investments early and gradually, which enables the transition to a more sustainable economy and a smoother adjustment of prices.
In contrast, investors could find the policies non-credible, delay revising their expectations, and do so later and in a sudden way. In particular, Battiston continues, "if financial actors collectively underestimate the risk of a late and sudden transition, the chance of this scenario materializing increases. This outcome could be a problem for financial stability and would therefore be more costly to society. It is thus also a concern for central banks and financial authorities. And it could lead to insufficient reallocation of capital into low-carbon investments. This is why it is so important."
Evaluate climate-financial risk and look at it dynamically
The authors of the study combine the current IAMs with a climate-financial risk assessment (CFR) in a circular way. In doing so, they show how the perception of the financial system and the timing of the introduction of climate policy measures interact in the low-carbon transition. The feedback loop map possible changes in investors' expectations and thus lead to more coeherent scenarios to assess climate-related financial risk.
The findings from the study have practical implications for the implementation of fiscal policy measures, and financial policy and regulation. They shed also new light on the discussion around the principle of "double materiality", which involves taking into account financial as well as non-financial opportunities and risks for financial firms.