Industry expectations of the market drop causing a confidence crisis.

Low-carbon transition risks for finance arise from the abrupt structural change toward low-carbon industries that alters expectations about future revenue streams in high-carbon industries. A comprehensive theoretical framework explaining such sunset industry systemic risks for finance has hitherto been lacking because the theoretical and historical literature has tended to focus instead on historically more important risks from sunrise industries. Current academic research into transition risks tends to address either the real-economy structural change, or the financial impact, but does not typically connect the two. We contribute to the conceptual understanding of transition risks by developing a consistent theoretical framework of the drivers, transmission channels, and impacts of the phase-out of carbon-intensive industries on the financial system.

High-carbon industries could abruptly become uncompetitive due to a rapid change in climate-mitigation policy, low-carbon technology or preferences, or a widespread change in expectations of their impacts. These transition drivers cause physical assets to lose their ability to generate revenue, and if this is unanticipated, they become stranded. Asset stranding combines with other transition costs, notably unemployment, losses in profits, and reductions in real incomes from price changes that generate significant risks for portfolio losses and debt default. Financial actors might become unable to service their own debt and obligations, creating loss propagation within the financial network. The adverse impact of credit tightening and lack of confidence as well as the direct impact of transition costs on the macroeconomy, could lead to a general economic crisis with further risks for finance. None of this suggests that financial markets would be better off without or with a limited transition: delaying climate-change action would only necessitate an even more rapid and potentially more damaging transition in the future, while exposure to physical risks under unmitigated climate change would be drastically increased. Targeted financial policies, however, can dampen some transition risks by direct regulation of the financial sector.