Impact of Climate Transition Risk on Banks: Regulatory Frameworks, Carbon Pricing and Credit Risk

Abstract

As the risk associated with climate change intensify, there is an observed trend of increased government and regulatory intervention targeted at mitigating the economic impacts of climate risk and facilitating the decarbonization process. These interventions primarily manifest in two ways. First is through government-imposed market-based instruments, such as carbon pricing, which apply a cost on carbon emissions to discourage pollution and ensure that emitters pay for their environmental impact. The other is through regulatory disclosure requirements that mandate specific sectors to disclose their climate-related actions, with regulatory authorities overseeing compliance within their respective jurisdictions. This research addresses these interrelated yet distinct approaches to managing climate transition risks by examining how market-driven policies, such as carbon pricing, influence bank lending practices and identifying gaps between emerging climate risk regulations and scientific research. It achieves this by assessing the impact of market-based tools, like carbon pricing, on key economies, especially those with high carbon emissions and substantial GDP reliance on carbon-intensive sectors and the impacts on various economic sectors across regions. It also evaluates how emerging regulations align with these policies by synthesizing and analyzing academic evidence on their effectiveness. Theoretically, this research contributes to the theories of credit risk, financial stability and adaptive governance, particularly in strengthening the economic resilience of critical sectors exposed to climate transition risk and enhancing the capacity of regulators and financial institutions to adapt and align their operations with the evolving climate risk regulatory landscape. This analysis provides insights into how lenders to critical sectors can improve their operational frameworks and how regulators can enhance climate regulations in response to the dynamic challenges posed by climate change.