The international community has strengthened efforts to curb greenhouse gas emissions by adopting the Paris Agreement in 2015. In particular, the U.S., the EU, Japan and Korea have all recently drawn up plans to reach carbon neutrality by 2050, to limit the increase in the global average temperature to below 1.5℃ compared to pre-industrial levels (1850-1900). A transition to a low-carbon economy will reduce the physical damage caused by climate change, but could have negative impacts on industries that generate high levels of carbon emissions (hereafter, “transition risks”). Transition risks are particularly harmful to the Korean financial system as Korea is highly dependent on carbon-intensive industries, and since the exposure of the financial sector to these sectors is high. (in terms of loans, bonds, equity, etc.)

Using a scenario analysis, this paper examines what impact transition risks might have on the financial system. The results show that transition risks will have a negative impact on the economy and on the financial system over the long-term. Specifically, transition risks cause a decline in the value of financial assets of carbon-intensive industries, and hence reduce the capital adequacy ratios of domestic banks by 2.6%p-5.8%p in 2050, compared to 2020. In particular, bank soundness is predicted to deteriorate more severely after 2040, when the cost of reducing greenhouse gas emissions rises rapidly. Moreover, the more banks hold financial assets of carbon-intensive industries, the more vulnerable they will be to transition risks.

Our analysis suggests that given the current situation where emission reduction technologies to ensure carbon neutrality are not commercially available for manufacturing industries, transition risks could impose considerable damage on the economy and the financial system. Moreover, unless banks respond preemptively to transition risks, financial assets vulnerable to transition risks will likely deteriorate and cause large losses at banks. The negative impacts of transition risks could be significantly reduced if the development of emission reduction technologies accelerates with eco-friendly investment by the government and the private sector. Moreover, the shock from transition risks will likely be greatly eased once financial institutions reduce their holdings of assets vulnerable to transition risks, by establishing a risk management system that incorporates the climate change risks.