From Brown to Green: Climate Transition and Macroprudential Policy Coordination †

Abstract

We develop a dynamic, stochastic general equilibrium (DSGE) model for the euro area that accounts for climate change-related risk considerations. The model features polluting (“brown”) firms and non-polluting (“green”) firms and a climate module with endogenous emissions modeled as a byproduct externality. In the model, exogenous shocks propagate throughout the economy and affect macroeconomic variables through the impact of interest rate spreads. We assess the business cycle and policy implications of transition risk stemming from changes in the carbon tax, and the implications of the micro- and macroprudential tools that account for climate considerations. Our results suggest that a higher carbon tax on brown firms dampens economic activity and volatility, shifting lending from the brown to the green sector and reducing emissions. However, it entails welfare costs. From a policy-making perspective, we find that when the financial regulator integrates climate objectives into its policy toolkit, it can minimize the trade-off between macroeconomic volatility and welfare by fully coordinating its micro- and macroprudential policy tools.