This paper received an Honorable Mention from the 2024 E-Axes Forum Research Committee
In recent years, financial regulators, investors, and society at large have expressed growing concern about the threat that climate risks pose to financial stability (Stroebel and Wurgler, 2021). In Systemic Climate Risk, Tristan Jourde and Quentin Moreau introduce a market-based framework for assessing how extreme climate risks affect the financial sector. They distinguish between two primary types of climate risks:
- Physical risk, arising from climate-related hazards like floods, storms, and wildfires.
- Transition risk, resulting from policy changes, shifts in consumer preferences, and technological disruptions in the transition to a low-carbon economy.
Climate Risks and the Financial System
Climate risks can affect financial institutions in two critical ways:
- First-round effects, such as portfolio devaluations, increased insurance claims, and reduced borrower creditworthiness.
- Second-round effects, including contagion through interconnected financial institutions that amplify the initial shocks.
In contrast to the existing literature, the authors develop a framework that captures both dimensions, providing a more comprehensive view of systemic climate risk. The framework reflects the fact that common holdings among market participants, direct interdependencies between financial institutions, and potential fire-sale dynamics can amplify the impact of climate shocks on financial stability (e.g., Duarte and Eisenbach, 2021).
The model relies on market data to capture investors’ perceptions of climate risks–an important feature given that financial consequences often materialize through asset repricing (Carney, 2015). The authors construct long-short portfolios of nonfinancial stocks as proxies for transition and physical climate risk factors. A financial institution’s climate risk exposure is then defined by how sensitive its value-at-risk is to shocks in these risk factors. This market-based metric enables forward-looking, dynamic monitoring of systemic climate risk.
Transition Risk: A Growing Systemic Threat
Applying the framework to a large sample of European financial institutions from 2005 to 2022, the study identifies transition risk as an increasingly important driver of systemic risk. Europe was chosen as a regional focus because of its comparatively stronger environmental policy landscape (Amel-Zadeh and Serafeim, 2018), and because institutional failures there could have particularly severe economic consequences (Engle et al., 2015).
Transition risk exposure is particularly pronounced for banks and insurance companies. The authors notably argue that transition risk may be systemic in nature due to its simultaneous impact across institutions. Moreover, the results show that transition risk tends to increase tail dependence across institutions, raising the likelihood of joint distress–an essential feature of systemic risk.
Figure 1. Dynamic exposure to tail transition risk for European financial institutions
Note: The figure represents the average dynamics of financial institutions’ exposures to tail transition risk. A positive value means that adverse climate shocks lead to a deterioration in the tail risk of financial institutions. The black line represents the cross-sectional mean and the grey area is the 95% confidence interval for each period.
In contrast, the analysis finds no evidence of contagion associated with physical climate risk. This may reflect the more localized and asynchronous nature of physical events, which larger institutions can often mitigate through geographic diversification. However, the authors caution that their findings primarily reflect how investors currently perceive these risks, which may understate the future impact of climate change on financial stability.
Policy Implications: Monitoring and Mitigating Systemic Climate Risk
The study highlights the need for improved tools to effectively quantify and monitor systemic climate risk. The proposed framework enables regulators to monitor exposures to both physical and transition risks in near real time. This complements climate stress tests, which typically rely on scenario projections, by capturing evolving market sentiment and identifying institutions that are vulnerable to abrupt climate-related repricing. Such a dynamic prudential approach is particularly important given the uncertainty and fat-tailed nature of climate risks, including the potential for tipping points (e.g., Weitzman, 2009; Hansen, 2022).
Importantly, the study finds that financial institutions with stronger environmental, social, and governance (ESG) practices, greater transparency, and a longer-term strategic focus tend to be less exposed to transition risk. Mandatory sustainability reporting is also associated with reduced exposure. These findings suggest that regulatory initiatives to strengthen ESG practices and climate risk disclosure could play a central role in reducing climate-related financial risks. Should financial authorities consider imposing capital requirements linked to climate exposures, the authors recommend tailoring them to institution-specific characteristics such as size and leverage. Ultimately, the research supports a regulatory approach that integrates climate policy goals with financial stability objectives.