The double materiality of climate physical and transition risks in the euro area

We analyse the double materiality of climate physical and transition risks in the euro area economy and banking sector. By tailoring the EIRIN Stock-Flow Consistent behavioural model, we provide a dynamic balance sheet assessment of the Network for Greening the Financial System scenarios. We find that an orderly transition achieves early co-benefits by reducing carbon emissions (12% less in 2040 than in 2020) while supporting growth in economic output. In contrast, a disorderly transition worsens the economic performance and financial stability of the euro area. Further, in disorderly transition with high physical risks, real GDP decreases by 12,5%in 2050 relative to an orderly transition. Second, by extending the concept of climate sentiments to firms, we analyse how expectations about climate policy credibility affect investment decision in high or low-carbon goods. Firms that trust an orderly policy introduction and anticipate carbon price scenarios switch earlier to low-carbon investments. This, in turn, accelerates economic decarbonization and decreases the risk of carbon stranded assets for investors. Our results highlight the crucial role of early and credible climate policies to signal investment decisions in the low-carbon transition. JEL Classification: B59, Q50