Climate sentiments, transition risk, and financial stability in a stock-flow consistent model

A successful low-carbon transition requires the introduction of policies aimed at aligning investments to the climate and sustainability targets. In this regard, a global Carbon Tax (CT) and a revision of the microprudential banking framework via a Green Supporting Factor (GSF) have been advocated but two main knowledge gaps remain. First, the understanding of the conditions under which the CT or the GSF could contribute to the scaling-up of new green investments or, in contrast, could introduce new sources of risk for macroeconomic and financial stability, is poor. Second, we don’t know how banks’ climatesentiments, i.e. their anticipation of climate policies’ impact in lending conditions, could affect the outcomes of the policies and of the low-carbon transition. To fill these knowledge gaps we develop a Stock-Flow Consistent model of a high income country that embeds an adaptive forecasting function of banks’ climate sentiments. Then, we assess the impact of the CT and GSF on the greening of the economy and on the banking sector analyzing the risk transmission channels from the credit market to the economy via loans contracts, and the reinforcing feedbacks that could give rise to cascading effects. Our results suggest that the GSF contributes to scale up green investments only in the short-run but it also introduces potential trade-offs on bank’s financial stability. To foster the low-carbon transition while preventing unintended effects on Non-Performing Loans and households’ budget, the introduction of the CT should be complemented with redistribution welfare policies. Finally, if banks revise their credit supply conditions based on the firms’ carbon profile ahead of climate policy introduction, they can contribute to align investments to the low-carbon transition and improve financial stability of the banking sector.