Following the financial crisis of 2007–2008, a deep analogy between the origins of instability in financial systems and complex ecosystems has been pointed out: in both cases, topological features of network structures influence how easily distress can spread within the system. However, in financial network models, the details of how financial institutions interact typically play a decisive role, and a general understanding of precisely how network topology creates instability remains lacking. Here we show how processes that are widely believed to stabilize the financial system, that is, market integration and diversification, can actually drive it towards instability, as they contribute to create cyclical structures which tend to amplify financial distress, thereby undermining systemic stability and making large crises more likely. This result holds irrespective of the details of how institutions interact, showing that policy-relevant analysis of the factors affecting financial stability can be carried out while abstracting away from such details.

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Pathways towards instability in financial networks

Climate risks and financial stability

Extreme weather anomalies act as threat multipliers, warning us to focus on low-carbon transition and sustainable development. This study analyses the dynamic bidirectional causality between climate policy uncertainty (CPU) and traditional energy, represented by oil, coal, and natural gas, as well as green markets, represented by clean energy, green bonds, and carbon trading. This research provides the first comprehensive assessment of CPUs across multiple dimensions of different energy properties, causal spillover directions, and temporal heterogeneity using the time-varying Granger test. The results indicate that significant dynamic causality exists within each series rather than the entire period, and that causality manifests differently between pairs of series. In addition, CPU is more inclined to act as a risk recipient than a sender in the market volatility spillover. Whenever extreme climate events or major climate policy changes are encountered, the causal relationship between CPU and the relevant markets will rise significantly. Overall, governments should pay attention to the role of climate policy implementation in energy transition as well as attempt to reduce uncertainty. 

Impact of climate policy uncertainty on traditional energy and green markets: Evidence from time-varying granger tests

The financial system—the ecosystem of investors (e.g., banks, investment funds, insurance), markets, and instruments—is often considered to play an enabling role in climate mitigation pathways to a low-carbon transition. But it can also have a hampering role, e.g., if investors’ perceptions of low risk from a missed transition and low opportunities from a transition fail to trigger a reallocation of capital into low-carbon investments. This increases the chance of the transition not occurring within the time window required to stabilize the climate or occurring in a disorderly fashion. Indeed investors, who can influence the realization of climate mitigation pathways, themselves rely on estimates of climate mitigation pathways from process-based integrated assessment models (IAMs). And IAMs do not model the financial system or investors’ decisions; thus, the feedback loop between the financial system and mitigation pathways is not taken into account, neither by the IAMs nor by the finance community. This limitation to our understanding of the dynamics and the feasibility of the low-carbon transition weakens the ability of IAMs to inform policy and investment decisions. We propose a framework to capture the interdependence between investors’ perception of future climate risk, depending on the credibility of climate policies, and the allocation of investments in the economy.

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Accounting for finance is key for climate mitigation pathways.

Abstract The distribution of ownership of transition risk associated with stranded fossil-fuel assets remains poorly understood. We calculate that global stranded assets as present value of future lost profits in the upstream oil and gas sector exceed US$1 trillion under plausible changes in expectations about the effects of climate policy. We trace the equity risk ownership from 43,439 oil and gas production assets through a global equity network of 1.8 million companies to their ultimate owners. Most of the market risk falls on private investors, overwhelmingly in OECD countries, including substantial exposure through pension funds and financial markets. The ownership distribution reveals an international net transfer of more than 15% of global stranded asset risk to OECD-based investors. Rich country stakeholders therefore have a major stake in how the transition in oil and gas production is managed, as ongoing supporters of the fossil-fuel economy and potentially exposed owners of stranded assets. 

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Luis O. L. Escobar-Farfán

Papers

Climate risk and financial stability in the network of banks and investment funds

How are network centrality metrics related to interest rates in the Mexican secured and unsecured interbank markets