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A climate stress-test of the financial system

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Stefano Battiston, Antoine Mandel, Irene Monasterolo, Franziska Schütze and Gabriele Visentini

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From the point of view of the physical sciences, it is clear that keeping global warming under 2°C means that a large part of the known reserves of fossil fuel are “unburnable” (1). The introduction of an ambitious climate policy therefore must lead to a significant depreciation of shares in the energy sector. More generally, the transition to renewable energy could lead to major changes in production structures and, as a consequence, in the value of a wide range of financial assets. Uncertainty about the possible scope of these impacts is a subject preoccupying financial regulation authorities, left particularly sensitive to the risks of spreading shocks by the subprime financial crisis (2).

In this article recently published in the journal Nature Climate Change, Battiston, Mandel, Monasterolo, Schütze and Visentini present an initial evaluation of climate risk for the financial system via a “climate stress test” carried out on the main financial institutions of Europe. In a first stage, they made use of the Bureau van Dijk® Orbis database, a database of private assets around the world, with which they can quantify the exposure of European financial institutions, through the share markets, in five sectors potentially sensitive to climate policy: fossil fuels, electricity, energy-intensive industry, real estate and transport. One observation is that the financial system’s exposure to the fossil fuel industry alone is low, but that exposure to the sectors taken all together is significant (around 40% of equity). Second, the authors analysed the spread via financial networks of a scenario of massive devaluation of shares in the fossil fuel and electricity sectors. The propagation mechanisms considered took into account the deterioration in the balance sheet of financial institutions and of the financial assets that they issue in order to refinance following losses on share markets. These processes could increase initial losses linked to a climate policy shock by a factor of two. However, the general effect would be limited if the initial shock remained restricted to the key sectors of greenhouse gas emission. A strong climate policy would thus not lead to a systemic financial risk if it could limit the spread of risk within the real sphere of the economy. From this perspective, it is important to clarify the socio-economic horizons of climate policy in order to reduce the uncertainty that investors face, and to allow them to make fine distinctions between the sectors potentially exposed to climate policy and those for which it would represent a growth opportunity.

(1) See also McGlade, C. & Ekins, P. The geographical distribution of fossil fuels unused when limiting global warming to 2 ◦ C. Nature 517, 187–190 (2015).

(2) See in particular the report of the European Systemic RIsk Board “Too Late, Too Sudden: Transition to a Low-Carbon Economy and Systemic Risk”.

Original title: « A climate stress-test of the financial system »
Published in: Nature Climate Change 7, 283–288 (2017)
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