A finance approach to climate stress testing

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-financial approach or focus solely on equity instruments – though banks’ exposures predominantly consist of debt. We develop 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 equity and debt instruments. We calibrate our model using detailed firm level vulnerability data and apply the model to 2-digit sectoral exposures of Dutch banks. We find declines in the market value of banks’ assets of 2–13% of core capital for a €100 carbon tax shock, increasing to 6–29% for a €200 carbon tax shock.