Low-carbon Transition Risk and Central Bank Policy Regulation
ZHUANG Ziguan, ZENG Shiyan, LIN Boyuan
School of Finance, Zhongnan University of Economics and Law; School of International Trade and Economics, Central University of Finance and Economics; School of Economics and Management, Wuhan University
Summary:
Despite many countries have slowed down climate actions in response to the global economic downturn, the long-term trend of low-carbon transition will not change and is becoming increasingly urgent. Addressing financial risks stemming from the increasingly pressing transition process is a crucial issue for China's dual carbon targets. In this paper, we introduce multiple production sectors, environmental externalities, and financial frictions into an Environmental Dynamic Stochastic General Equilibrium model (E-DSGE). Based on this analytical framework, we first conduct scenario simulations of China's actual low-carbon transition process to explore the underlying transition risk. We further evaluate the effectiveness of the central bank's macroprudential policy and asset purchase policy in preventing and mitigating transition risk. This paper finds that: First, the temporary slowdown of climate policy not only prevents the economic downturn from evolving into a severe recession, but also reduces the potential aggregate losses during the Carbon Peak Stage (2021-2030). Second, a significant increase of climate policy intensity will cause a sharp depreciation of fossil financial assets, impair banks' balance sheet and threaten macroeconomic and financial stability, which is likely to trigger transition risk. The insufficient motivation of fossil energy firms in reducing carbon emission intensity will drive up carbon price and magnify transition risk. Third, ex-ante macroprudential policy can prevent transition risk by reducing banks' exposure to fossil assets. Ex-post asset purchase policy can mitigate transition risk by injecting liquidity into the financial market. The combination of ex-ante and ex-post policies can significantly stabilize the fluctuations of output and banks' net asset and improve social welfare, effectively mitigating transition risk. We propose the following policy suggestions: First, establish a transition risk assessment and monitoring system. On the one hand, encourage firms to strengthen the disclosure of carbon emission information, assess transition risk in time and take effective management measures. On the other hand, require financial institutions to actively conduct climate stress tests and enhance their ability to identify and control transition risk. Second, urge carbon-emitting firms to adopt efficient and clean production technologies and reduce the carbon emission intensity, promoting the orderly low-carbon transition. Third, construct a policy toolbox to deal with transition risk. Incorporate transition risk factors into the macroprudential regulatory framework.Levy taxes on banks‘holding of brown assets, provide subsidies for their holding of green assets, and gradually mitigate banks’ exposure to brown assets. Establish an early warning mechanism for the depreciation of carbon-related assets. Once the sharp depreciation of carbon-related assets threatens macroeconomic and financial stability, the central bank should intervene in time and provide targeted liquidity support through asset purchase. In addition, strengthen policy coordination. Macroprudential policy and asset purchase policy should work together to maintain the stability of the financial system and support the smooth transition. This paper may have the following academic contributions: First, we construct an environmental dynamic stochastic general equilibrium model that includes multiple production sectors, environmental externalities, and financial frictions, providing a theoretical framework to evaluate central banks' policy actions related to low-carbon transition. Second, in the theoretical model and scenario simulation, we depict the realistic process of China's low-carbon transition, which slows down in the early stage and becomes urgent in the later stage. By comparing the realistic scenario with the ideal scenario where policy implementation is not disturbed by the economic cycle, as well as the non-ideal scenario where fossil energy firms do not actively reduce carbon emission intensity, we highlight the importance and necessity of managing transition risk. Third, from the perspectives of ex-ante risk prevention and ex-post risk mitigation, we analyze the effects of macroprudential policy and asset purchase policy targeting differentiated financial assets. We further discuss the performance of the combination of these two policies. This research provides insights into the policy design of a stable low-carbon economic transition.
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