Low‐carbon transition risks for finance

TLDR

The shift to a low‑carbon economy will trigger large‑scale structural changes that can destabilize financial systems through asset revaluations, debt defaults, and bubbles, yet the risks from declining fossil‑fuel‑linked industries remain poorly understood. The study develops a theoretical framework to analyze how the phase‑out of carbon‑intensive industries affects financial stability and the broader economy. The authors review conceptual and historical literature and current policy efforts to protect finance from transition risks, highlighting gaps and research implications. Article categorized under Climate Economics > Economics and Climate Change.

Abstract

Abstract The transition to a low‐carbon economy will entail a large‐scale structural change. Some industries will have to expand their relative economic weight, while other industries, especially those directly linked to fossil fuel production and consumption, will have to decline. Such a systemic shift may have major repercussions on the stability of financial systems, via abrupt asset revaluations, defaults on debt, and the creation of bubbles in rising industries. Studies on previous industrial transitions have shed light on the financial transition risks originating from rapidly rising “sunrise” industries. In contrast, a similar conceptual understanding of risks from declining “sunset” industries is currently lacking. We substantiate this claim with a critical review of the conceptual and historical literature, which also shows that most literature either examines structural change in the real economy, or risks to financial stability, but rarely both together. We contribute to filling this research gap by developing a consistent theoretical framework of the drivers, transmission channels, and impacts of the phase‐out of carbon‐intensive industries on the financial system and on the feedback from the financial system into the rest of the economy. We also review the state of play of policy aiming to protect the financial system from transition risks and spell out research implications. This article is categorized under: Climate Economics > Economics and Climate Change