Assessing the double materiality of climate risks in the EU economy and banking sector

Abstract

Financial supervisors and policy makers, including the Network for Greening the Financial System (NGFS), have recognized the existence of a double feedback between climate change and the financial system, i.e. the impact of climate risks on financial stability, and the impact of financial institutions on climate scenarios. This feedback loop is known as the "double materiality of climate risks". While recent studies contributed to understand the macro-financial relevance of climate scenarios, a methodological framework to assess the double materiality of climate risks is not available yet. We contribute to fill this gap by developing a dynamic climate assessment of NGFS climate physical and transition risks scenarios, for of the euro area economy and banking sector. By tailoring the EIRIN Stock-Flow Consistent model, we quantitatively assess the feedback from banks’ expectations about investment risk across NGFS scenarios and risk internalization (i.e. their climate sentiments), on (i) firms’ capital costs and performance, (ii) the decarbonization of the economy and banks’ lending portfolios, and (iii) the realization of climate mitigation scenarios. We find that, under the model conditions, an orderly transition achieves important co-benefits already in the mid-term, with respect to CO2 emissions abatement, banks’ financial stability and distributive effects. In contrast, a disorderly transition fosters banks’ financial instability. This, in turn, leads to indirect, spillover effects to the economy, affecting firms’ ability to invest in the low-carbon transition, fostering the realization of stranded assets, and increasing households’ inequality. Second, investors’ climate sentiments can affect climate policy effectiveness. Banks’ early adjustment of the cost of capital to reflect firms’ exposure to climate risks leads to alternative transition pathways, costs and co-benefits. Our results highlight the importance for financial supervisors to consider the role of investors’ expectations in the finance-economy-climate feedback, in order to design appropriate macroprudential policies for tackling climate risks.