On Stranded Assets and Climate Risk: Are Financial Markets the Last Resort?

The objective of this paper is to examine how financial markets are affected by climate and energy transition risks. Our contribution is thus twofold. First, relying on the overlapping generations’ model, we develop a simple theoretical model by taking into account the interplay between environmental quality and assets market. We show that when agents are sensitive to the environmental quality, they take decisions about savings and investment in line with the need for higher environmental protection. Second, we empirically test this model by assessing the nature and magnitude of the climate and energy transition determinants of the risk premium associated with public debt, with a focus on countries of the Middle East and North Africa (MENA) region, being one of the most abundant regions in natural resources. Our main findings show that fossil fuel subsoil wealth is associated to a higher risk premium. Moreover, this risk increases also with a higher level of CO2 emissions per capita or lower level of environmental performance index (EPI). This confirms how financial markets are accounting for climate and energy-transition risks. We also show that the quality of institutions plays an important role in counterbalancing the effects of climate-related variables on the risk premium. Finally, we conclude that financial markets could foster energy transition and encourage the implementation of effective environmental policies.