Climate change is rapidly being recognised as a potential source of financial risk by regulators and supervisors (Claessens et al. 2022, FSB 2022, ESRB 2021a, 2022, ECB 2021a, BIS 2021a, 2021b).

Climate-related financial risks have two main dimensions. The first is physical risks: these stem from extreme weather (storms, floods, droughts, heatwaves etc.) or changes in climate patterns that affect firms, households and their physical assets, increasing their probability of default.

The second dimension is transition risk. This stems from the need to shift to a low-carbon economy (Pisu et al. 2022), causing some activities to be reduced or abandoned and leading the corresponding assets to lose value and become ‘stranded’.

The importance of addressing transition-related financial risk

These risks are of particular importance for bank supervisors and regulators as some financial institutions could be particularly exposed to affected geographies or economic sectors, and depending which financial institutions get in trouble, the consequences could be potentially systemic. Moreover, we argue that investors, being forward-looking, could anticipate transition dynamics and start shedding high-carbon financial assets already before the underlying physical assets become stranded. Recent research shows that so far, banks have been undervaluing stranded assets risks by continuing to finance fossil fuel firms (Ongena et al. 2021) while restricting credit to green innovators (Roukny et el. 2022), but this may not last forever....

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