Low-Carbon Transitions and Systemic Risk

The transition to a zero-carbon economy will require policy, market and social changes that could lead to financial and economic instability. This could include a ‘Minsky moment’ leading to a sudden collapse in asset prices. This report from Vivid Economics reviews the literature on approaches used to assess these systemic transition risks, offering a detailed and comprehensive assessment of the indicators and modelling frameworks explored to date.

Drawing on academic studies and the frameworks of central banks, the authors identify the channels through which systemic risk could materialise during a low-carbon transition. These include energy price shocks and a collapse in carbon-intensive asset values, possibly amplified by feedback loops that affect the wider economy. The review finds that specific transmission channels for systemic risk stem from overlapping portfolios, from lending between financial market participants, and from the interaction between the financial system and the real economy.

Indicators and modelling frameworks used to explore systemic transition risk include climate-related stress testing and the monitoring of banks’ exposure to high-carbon sectors. Integrated assessment models have been used to estimate first-order financial impacts. Models of production and financial networks have been developed to estimate potential second round effects from financial contagion.

Finally, the report highlights several areas for future research, including the need for better monitoring of exposure to carbon-intensive assets. Feedback loops between financial market participants, and between the financial system and the real economy, also require further study. New and multi-layered modelling approaches are needed to include both production and financial networks, as well as the potential impacts of both rising and declining industries.