DP14609 A Finance Approach to Climate Stress Testing

Author(s): Henk Jan Reinders, Dirk Schoenmaker, Mathijs A Van Dijk
Publication Date: April 2020
Keyword(s): banks, carbon tax, Climate policies, Climate stress test, contingent claims analysis
JEL(s): G13, G21, H23, Q54
Programme Areas: Public Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14609

There is increasing interest in assessing the impact of climate policies on the value of financial sector assets, and consequently on financial stability. Prior studies either take a "black box" macro-modelling approach to climate stress testing or focus solely on equity instruments - though banks' exposures predominantly consist of debt. We take a more tractable finance (valuation) approach at the industry-level and use a Merton contingent claims model to assess the impact of a carbon tax shock on the market value of corporate debt and residential mortgages. We calibrate the model using detailed, proprietary exposure data for the Dutch banking sector. For a ?100 to ?200 per tonne carbon tax we find a substantial decline in the market value of banks' assets equivalent to 4-63% of core capital, depending on policy choices.