Modelling developments linked to the role of finance in addressing climate change
date: 24/06/2019
- The financial intermediation necessary to the accomplishment of a horizon of global carbon emission neutrality during the second half of the century is still far from clear. In a 2018 article, the French Development Agency (AFD) proposes to address this research gap through a critical analysis of the most recent research papers attempting to integrate the specificities of finance and money in the climate-economy nexus. The article poses that current Integrated Assessment Models (IAMs) derived from the famous Dynamic Integrated Climate-Economy model (DICE) are not appropriate to clearly represent the different channels by which finance and money could destabilize the well-established equilibriums between growth and climate damages. New possibilities are therefore explored borrowing from the post-Keynesian thinking for the key role they give to money, to more complex systems for their capacity to tackle the interactions between financial balance sheets, and ecological economic thinking which fully considers the non-substitutability between financial and natural capitals. The paper advocates for greater convergence between the financial sector reform’s agenda (in particular, to dampen the intrinsic financial instability linked to climate change) and climate policy design (in particular, the need for finance flows to be consistent with a pathway towards low GHG emissions and climate-resilient development as set out under Target 2 of the Paris Agreement)[1]. (France)
- The “General Monetary and Multisectoral Macro-dynamics for the Ecological Shift” (GEMMES) developed by the French Development Agency (AFD) is one of the few economic modelling tools to integrate the impact of climate change into country GDP and debt forecasts. The model makes it possible to combine the impact of global warming and the increased scarcity of natural (energy and mineral) resources with the dynamics of capital, private and public debts, and under-employment. Finally, it takes into consideration the way in which the reduction of inequalities facilitates the resilience of a national or regional economy. There are currently three versions of GEMMES: one at the global level, one at the European level, and a third version adapted to the Brazilian economy.
- Recent developments of the GEMMES include:
- Since end of 2018, the model is available in an online application accessible to all. Three modules - climate, economic and political - enable users to "play" with the data to visualize their impacts on the economy or greenhouse gas (GHG) emissions.
- Other GEMMES model applications are being studied for Côte d’Ivoire, Vietnam, and Colombia. Their specific features are being developed thanks to partnership with local economists.
- The GEMMES model has been calibrated to the world economy in an article by Bovari et al. (2018). The model combines the effects of global warming with the pivotal role of private debt to simulate various planetary scenarios. The application of GEMMES at global scale shows that: i) the +2 °C target is already out of reach (absent negative emissions); ii) the long-term (resp. short-term) results of climate change on economic fundamentals may lead to severe economic consequences without the implementation (resp. in case of too rapid an application) of proactive climate policies. Global warming (resp. too fast transition) forces the private sector to leverage in order to compensate for output and capital losses (resp. to lower carbon emissions), thus endangering financial stability; iii) Implementing an adequate carbon price trajectory, as well as increasing the wage share, fostering employment, and reducing private debt make it easier to avoid unintended degrowth and to reach a +2.5 °C target.
- The Cambridge Econometrics (CE) team has further improved their E3ME Global Macro-econometric Model to better recognise the role of the financial sector in providing resources for any investment-intensive transition. Until now, E3ME has only implicitly taken into account the treatment of money – investment has been largely determined by expectations of future output levels based on current activity as explained in Pollitt and Mercure (2017)[2][3]. Ongoing developments are therefore seeking to introduce a full set of financial balances to better represent the interactions with the financial sector and the process of money creation. Furthermore, researchers are currently trying to connect E3ME with the first of a new generation of financial network models to assess the potential global loss in value of fossil-fuel assets and the uptake of key low-carbon technologies in the most emissions-intensive sectors. This is conducted under the “Financial risk and the impact of climate change” project funded by the UK Natural Environment Research Council (NERC)[4].
- Researchers from the University of Zurich and Boston University published an article in November 2018 analysing the use of climate finance in Socio-Economic Shared Pathways (SSPs). While SSPs have emerged as the standard framework to describe the trajectories that will deliver the necessary transformation of production and consumption, research suggests that the gap between climate targets and the actual world socio-economic trajectory is widening. The article poses that this is mainly explained by the fact that SSPs have so far neglected the role of the financial sector. To narrow the gap, the authors propose a novel research agenda to account for the role of the financial sector and its expectations in the SSPs. (Switzerland, United States)
- The role of finance in addressing climate change and the need to represent the financial sector in financial risk assessment models is increasingly recognised by academia and financial organisations alike.
- Researchers from the University of Zurich and the Boston University published an article stressing the lack of methodologies to price climate risks and opportunities in the value of financial contracts as one of the main barriers to align finance to sustainability. As traditional financial pricing models cannot accommodate the deep uncertainty that characterises climate risks, as well as the presence of incomplete markets and endogeneity that characterise the low-carbon transition, authors propose to develop a climate risk assessment methodology under uncertainty that contributes to fill this gap. Using IAMs the authors find that investments alignment to a credible 2°C trajectory can strengthen the sovereign fiscal and financial position by decreasing the climate spread, while a misalignment to a 2°C trajectory can increase it, with financial risk implications for its investors. This analysis is intended to support investors and financial supervisors in the understanding of the conditions for the onset of climate-related financial risks and strategies for their mitigation.
- The lack of sound and transparent metrics to assess development finance institutions’ exposure to climate risks and their impact on global climate action has been further emphasised by Monasterolo et al. (2018) in a paper published in November 2018. By applying a novel climate stress‐test methodology for portfolios of loans to energy infrastructure projects of two main Chinese policy banks, the authors show the banks’ exposure to economic and financial shocks that would result in government inability to introduce timely 2°C‐aligned climate policies and from investors' inability to adapt their business to the changing climate and policy environment. It is demonstrated that negative shocks are mostly concentrated on coal and oil projects and vary across regions. Given the current leverage of Chinese policy banks, these losses could induce severe financial distress, with implications on macroeconomic and financial stability.
- In a research paper published in March 2019, Swedbank AB highlights that banks are exposed to climate-related financial risks through i) physical effects from extreme weather events or changing climate conditions and (ii) the impact of transition to a lower-carbon economy. The report points to the lack of data and the inability of standard central bank macroeconomic models to take climate change into consideration as the main challenges for quantitative assessment of the risks associated with climate change. Swedbank also encourages central banks to step up in research, improve disclosure and asses their own balance sheets to mitigate climate-related risks, and highlights the key role of central banks in influencing the financial systems. (Sweden)
- In an Economic Letter published in March 2019 the Central Bank of Ireland highlights the need to adapt current modelling tools to incorporate the impact of both short-term weather events and long-term climate change. The need to improve climate-related risk assessments to guide future financial regulations and the policies of central banks has been formulated in an article published in 2018 by Campiglio et al. (Ireland & United Kingdom)
[1] The issue of endogeneity of money has been further discussed in follow-up paper published in 2019. The paper provides a critical analysis of the ecological economic thinking according to which more accurate reflection of money and finance in modelling frameworks is needed. The paper suggests overcoming the limitations through institutionalist perspectives that understand money as a language through which value is created and legitimized.
[2] Pollitt, H., Mercure, J-F., 2017. The role of money and the financial sector in energy-economy models used for assessing climate and energy policy. Climate Policy. Volume 18, 2018 - Issue 2Available at: https://www.tandfonline.com/doi/full/10.1080/14693062.2016.1277685.
[3] A follow-up paper led by Jean-Francois Mercure building on the results from current EU research (with DG ENV) will soon be published in the Climate Policy journal.
[4] This project aims to develop a robust characterisation, quantification and communication of climate-related transition risks, in particular linked to UK's financial and economic stability.