Preference Shocks and Policy Responses to Transition Risk

Central banks and financial surveillance authorities need to cope with the potential realization of financial stability risks, adopting preventive measures or using liquidity once crises materialize. Transition risk — the stability risk associated with decarbonization — is a case in point. Such risk not only comes from policy changes, but also from preference shocks. Hence, this paper develops an environmental DSGE model with financial frictions and examines responses to shocks, including a novel angle on preference shocks. We show that these market-driven transition shocks generate larger macro-financial instability than carbon pricing for a given change in emissions, while delaying environmental gains. We then compare policy responses according to their timing. Ex-ante macroprudential policies that reduce banks’ exposure to transition risk dampen financial amplification, whereas ex-post interventions, such as quantitative easing, provide only partial stabilization once losses have materialized. Overall, our results indicate that market-led adjustments to transition risk are more destabilizing than carbon pricing, whereas preventive financial measures limit macro-financial instability more effectively than ex-post interventions under the policy comparisons considered, supporting the case for early action.