polar bear and climate risk

Accounting for investors’ expectations in climate scenarios is vital to risk supervision.

Limiting global warming below 2 degrees centigrade requires a profound transformation of energy and production systems, and of consumption patterns in our economies, in order to bring about zero greenhouse gases emissions. It requires a transition towards a new system.

The paths forward to achieve this goal are called climate mitigation scenarios. It is crucial to understand that these are not predictions. Based on some assumptions on technology and policies, scenarios describe quantitatively some possible ways in which the transition could unfold, or fail to materialise, and their consequences. 

Because of its scale and pace, there are several factors that could make this a disorderly transition, which might lead to shocks that cannot be fully anticipated or hedged. We introduced the use of mitigation scenarios to estimate such shocks on financial institutions in 2017, in our academic research into the climate stress tests of the financial system.

Financial institutions are exposed because the transition affects a wide range of economic activities. Specifically, these are described by the Climate Policy Relevant Sectors, which is a formal definition used by a number of central banks and financial regulators, and includes sectors such as energy and real estate. Financial institutions’ exposure, therefore, goes beyond the stranding of assets simply related to fossil fuels reserves and infrastructures.  

Proactive role 

However, the scale and pace of the transition also implies that the financial system has a proactive role to play, both through new green investments and the reallocation of capital from high- and low-carbon activities. This is where scenarios connect to financial risk, which drives financial actors’ investment decisions.

The climate mitigation scenarios developed by the platform of financial authorities known as Network for Greening the Financial System (NGFS) are now a reference for financial supervisors and investors to assess climate-related financial risks. They are based on scenarios assessed by the Intergovernmental Panel on Climate Change and provide knowledge on the possible evolution of low- and high-carbon activities. At this stage, these scenarios do not yet consider the role of the financial system in the transition. 

According to our more recent research, ‘Accounting for finance is key for climate mitigation pathways’, published in Science in May, it is important to complement these climate mitigation scenarios by capturing the key role of investors’ expectations and the credibility of climate policies. Indeed, because they are endorsed by many financial authorities and investors, these scenarios now have the power to shift financial actors’ expectations (in terms of the relation between risk and return).

Expectations drive decisions

In turn, expectations drive investment decisions in low- and high-carbon activities, which impact on the scenarios themselves. In other words, there is feedback from investors’ expectations onto scenarios which, if unaccounted for, can even make the difference between achieving or failing the transition. 

Investors’ expectations on climate risks and policy credibility can lead to an enabling or a hampering role of the financial system in the transition. If investors find the policy credible, they can adjust expectations timely and reallocate capital into low-carbon investments early and gradually, thus enabling the transition. If, in contrast, investors find the policy not credible, they could hinder the transition by delaying to revise their expectations, only to eventually do so in a sudden way, as happened for instance in the 2008 financial crisis. This may lead to financial instability. If ignored, this dynamic could fail to trigger a sufficient reallocation of capital into low-carbon investments, making the transition more costly for society — or even missing it completely.

As part of our research, we developed a framework that can be applied to the NGFS scenarios, complementing them to strengthen their relevance for climate stress testing. It sheds new light on why achieving the transition requires policy signals that are clear and strong enough to trigger the adjustment of expectations in the financial system. It has implications for the criteria used by central banks to identify eligible assets in their collateral frameworks and purchasing programmes, as well as in introducing climate in their macroprudential decisions (such as capital requirements). Finally, the framework highlights the importance for financial authorities to monitor and tame the possible moral hazard in the dynamics of the low-carbon transition. 

Irene Monasterolo is assistant professor, climate economics and finance, at Vienna University of Economics and Business, and visiting fellow at Boston University; Stefano Battiston is associate professor at the University of Zurich and at Ca’ Foscari, University of Venice, and IPCC lead author chapter Finance and Investment.

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