Top-Down Scenario Analysis of Climate-Related Financial Risks: Perspective from Time Horizon and Inter-Industry Spillovers

The use of scenario analysis for climate-related financial risks is progressing in various jurisdictions. In this paper, we conduct a top-down scenario analysis of transition risk for Japanese banks. We analyze a short-term (5-year) scenario, while long-term scenarios of about 30 years are often used in climate-related scenario analysis. In our analysis, we examine two cases regarding the extent to which firms adjust smoothly to carbon price increases: a smooth adjustment case and a slow adjustment case. In addition, we use a multi-sector dynamic general equilibrium model to account for inter-industry spillovers. There are two main findings of this paper. First, we find that the degree of firms' adjustment leads to substantial differences in credit cost ratios of banks. This suggests the importance of accounting for the degree of adjustment to carbon price increases. Second, we find that the carbon price increase not only has an impact on the directly affected key sectors, but also spreads indirectly to other sectors through inter-industry linkages, resulting in an increase in the credit cost ratio. This suggests that even regional banks with relatively small exposure to key sectors need to pay close attention to the transition risk.