Uncertain Climate Policy and the Role of the Financial Stress Transmission Channel

We investigate the transmission channels of climate policy uncertainty (CPU) to the U.S. capital market using a Bayesian Structural VAR estimated on monthly data from 1994 to 2023. By jointly modeling CPU alongside the VIX and the Financial Stress Index (FSI), we isolate the mechanisms through which climate-related regulatory uncertainty affects equity valuations. Three findings emerge. First, CPU shocks significantly depress the S&P 500 index and price–dividend ratios while raising financial stress. Second, unlike conventional uncertainty shocks– which produce demand-type disinflationary contractions– CPU innovations generate supply-driven recessions, characterized by rising goods prices alongside falling asset prices, consistent with transition-cost pressures. Third, counterfactual exercises that selectively mute financial channels reveal that systemic financial stress is the dominant propagation mechanism: shutting down the FSI channel renders equity-market responses statistically insignificant, whereas muting the VIX leaves them intact. The findings are robust across a range of identification and specification exercises, including the construction of economic confidence bands from 240 alternative recursive specifications. These results establish CPU as a structurally distinct driver for financial markets, whose transmission to valuations is critically mediated by credit and intermediation frictions rather than by forward-looking volatility.