Understanding financial stability: climate-related considerations and financial markets operations

Limiting global warming requires reducing substantially the greenhouse gases that our economies emit, particularly the emissions of firms driving economic activity. The European Union committed to reduce greenhouse gas emissions down to net zero by 2050 and Finland – by 2035. Meeting these commitments requires continued actions of governments and firms, but also of financial actors. The process of adjustment of our economy shall require changes in public sector policies, technological innovation and affordability, as well as changes in market sentiment of investors as well as of consumers. If the timing and speed of such changes are not well managed, financial risks may arise. Such risks are referred to as climate-related transition risk. They may negatively affect a firm’s performance, increase the credit risk associated with the firm, and cause losses for banks and financial markets participants.

In her research, Katia Vozian studies whether and how financial system participants account for climate-related transition risk in their assessment of credit risk. To facilitate an orderly transition to a low-carbon economy, the climate-related transition risk needs to be gradually priced in by financials system participants such as banks, investment funds, credit rating agencies. In the absence of a market-wide pricing of climate-related transition risk, an abrupt repricing of climate-related transition risk may lead to financial market losses and disturb the financial stability of our economies. After 2015, credit rating agencies, banks and other financial system participants have increasingly published commitments to support the low-carbon transition. One of the main challenges cited by financial market participants as impediment are the data needs for assessing the climate-related transition risk of firms. Indeed, caveats on availability, reliability, and comparability of data on GHG emissions, emissions reduction targets and other indicators of a firm’s transition exist. Yet, as emphasized by the Network for Greening the Financial System and the European Central Bank, such caveats should not prevent from better leveraging already available data sources, using proxies, and exploiting such data under informed methodological choices.

 Leveraging extensive quantitative data of firms’ emissions, on how firms plan to reduce their emissions, and on how financial market participants assess the credit risk of these firms, she empirically shows that starting 2016 – year when credit rating agencies committed to account for climate-related transition risk – firms with highest level of emissions in Europe saw their credit ratings deteriorate. This adverse effect was larger for European than US high-emitting firms, probably reflecting differential expectations around climate policy in the European Union versus the USA during the Trump-era. As such, credit rating agencies do seem to account to some extent for climate-related transition risk. However, when looking at the financial market of credit default swaps in Europe and its participants – which are mostly banks and investment funds – the pricing effect of emissions in CDS, albeit present, seems to be very small, while other relevant indicators of a firms’ transition risk do not seem to be assessed by market participants yet. This research has contributed to policy discussions by introducing new evidence on the pricing of climate-related transition risk. It has been disseminated at research conferences and workshops involving central banks (Bank of Finland, European Central Bank, Sveriges Riksbank) and policy-driven institutions (European Investment Bank).

Disclaimer: The opinions expressed in this article are those of the author only. They do not purport to reflect the opinions or views of any institution with whom the author is or has been affiliated.

Dissertation can be found here.