Transition Risks in a Small Open Economy: An EDSGE Model with Blue Firms, Financial Frictions and Macroprudential Policy

Abbrevations

DSGE: Dynamic Stochastic General Equilibrium; E-DSGE: Environmental Dynamic Stochastic General Equilibrium; DICE: Dynamic Integrated Model of Climate and the Economy; Bernanke, BGG: Gertler and Gilchfist; SIDs: Small Island Developing States; RBC: Real Business Cycle; ESG: Social and Governance; CSA: Climate Scenario Analysis; TNC: The Nature Conservancy.

Introduction

As the threat of climate change intensifies [1, 2], policymakers as well as governments around the world are turning to carbon taxation as a market-based instrument to reduce greenhouse gas emissions. While ambitious climate policies, such as carbon taxes and emissions regulations, are vital to mitigating global warming, their implementation often entails significant economic adjustments known as transition risks. These risks refer to the potential for abrupt changes in asset values, investment patterns and overall macroeconomic stability, as economies shift away from carbon intensive activities. As economies move toward more sustainable practices, the economic effects of such policies have become important, particularly within the context of their associated impact in small open economies.

Equally, countries have placed considerable emphasis on how transition risks can be mitigated. This can be achieved either through the use of counterbalancing fiscal and monetary policies, or through the presence of new or existing activity that assists with carbon neutrality. In particular, “blue firms”, which are companies that specialize in capturing and storing carbon, have gained traction in recent times, and are considered to have a positive effect on climate fighting initiatives through their ability to reduce emissions, revitalize the economy, and improve livelihoods and jobs [3].

There is a growing body of literature that explores climate change, climate policy and the impact of climatic events on the macroeconomic landscape. While the physical effects of climate change are relatively easy to measure, transitional risks are often less visible and therefore more difficult to assess. Transitional risks also tend to lag, as policies take time to come into effect, while physical impacts occur in real time and have lasting effects on output [4]. Recent studies examine the role of green and blue firms in shaping transition risks associated with climate change, offering insights into how these risks can be estimated. This research draws on several scholarly studies that explore the economic effects of a carbon tax in an economy including “blue firms”.

Carattini, et al. [2] develop a dynamic stochastic general equilibrium (DSGE) model that incorporates environmental externalities and financial frictions to analyze the macroeconomic implications of climate policy. The model is calibrated using parameters that mirror the US economy, and the simulations consider economies both with and without financial frictions to assess the role of financial stability. The authors conduct two sets of simulations: first, they examine the short-run response of the economy to the introduction of a carbon tax, alongside the role of macroprudential policies to mitigate adverse effects. Second, the authors solve for the efficient policy response to a carbon tax in both the steady state (long-run) and in response to business cycles driven by exogenous productivity shocks.

The findings suggest that ambitious climate policy can in fact trigger financial instability; however, the implementation of macroprudential policies can help to offset the impact of the policy. In particular, the implementation of a carbon tax in an economy with financial frictions can cause a reduction in investment in both green and brown firms, as the tax lowers the market value of carbon-intensive assets, and this forces banks to have to cut lending to all firms, due to their exposure to these assets. However, the imposition of macroprudential policies that shift banks’ portfolios away from brown firms and into green firms can help to offset this risk. If banks are less exposed to brown assets, the imposition of a carbon tax will not impact the asset value of their portfolio as much, and they therefore will not have to cut or suspend their net lending. Further, the authors found that the first- best outcome for the steady state is the implementation of macroprudential policy, which alleviates the transition risk associated with a carbon tax.

Building on the framework developed by Carattini, et al. [2], Ding, et al. [5] analyze how non-homothetic energy consumption preferences interact with carbon markets to effect carbon emissions and macroeconomic outcomes. The study addresses whether macroeconomic policy tools interact meaningfully with carbon markets. To this end, the authors develop an environmental dynamic stochastic general equilibrium (E-DSGE) model, which encompasses six sectors: households; intermediate product producers; and final product producers; carbon market; central bank with non-homothetic consumption preference; and government with non-homothetic consumption preference.

The findings reveal that carbon pricing behavior driven by the carbon market will impact the implementation effect of policy mixes and changes in household welfare, and this impact will vary based on non-homothetic preferences. In particular, the authors found that a positive shock to carbon prices can reduce emissions. Furthermore, when monetary policy includes carbon reduction objectives, it can reinforce the decline in emissions through the interest rate channel, as tighter monetary conditions suppress aggregate demand and output. Finally, the degree of non-homothetic preferences will determine how much it accelerates the transmission path of policies, as well as the relative size of welfare effects in the short and long-term.

Moreover, despite Ding, et al. [5] contributions, the study is constrained by several limitations. Most notably, its heavy reliance on U.S. specific data reduces the model’s applicability to developing economies, where energy consumption patterns and institutional contexts differ. Additionally, the model is theory-based, and lacks empirical validation, since it was not tested against observed emission reductions from real-world policy contributions.

In another strand of related literature, authors look at the effect of carbon sink trading in achieving economic and environmental benefits. Carbon sinks help to absorb carbon dioxide from the atmosphere, and as such, they help to reduce the overall level of greenhouse gas from the air. The impact of carbon sink trading on the macroeconomic landscape, based on impulse responses is explored by Xu, et al. [6] who also examine the influencing factors by way of a sensitivity analysis. The authors also use welfare analysis to assess the impact on financial market performance. To make their estimates, Xu, et al. [6] construct an ‘economic- financial-environmental’ framework through a DSGE model, combined with a dynamic integrated model of climate and the economy (DICE), to account for the carbon cycle mechanism. The authors introduce financial accelerators by using the Bernanke, Gertler and Gilchfist (BGG) model, which include capital producers, entrepreneurs, financial intermediaries and other departments.

In their findings, they show that ocean carbon sink trading can improve climate outcomes and social welfare under efficient carbon sinks. Further, they find that the efficiency of carbon sinks has a significant impact on environmental benefits, while carbon sink prices are seen to have a less significant impact. As for the financial accelerator effect, the findings reveal that the loss of social welfare is compounded by a decrease in output, driven by an exogenous shock in the financial market. Similar to Ding, et al. [5] the study is constrained by limited data, since empirical calibration is based on national data from China, which cannot be applicable from a global perspective.

Though relevant, these studies are subject to limitations deriving from their simplified representation of the financial system and transition risk. While financial frictions are modelled through a banking sector exposed to carbon- intensive assets, real-world financial systems involve a broader range of institutions-such as insurance companies and credit unions—and a more complex set of financial instruments. Further, representing transition risk solely through carbon taxation overlooks the politically constrained nature of policy transitions. Henceforth, future studies would benefit from more analyses on blue activity, as the authors only consider brown firms.

This paper contributes to the existing body of literature by applying a dynamic stochastic general equilibrium model (DSGE), following Carratini [2] to the Bahamian context—one of the countries that is most vulnerable to climate change. It represents the first study of its kind conducted for The Bahamas, thereby expanding a limited body of literature on transition risks in small island developing states (SIDs).

Specifically, this study aims to examine the transition risk of climate policy, and determine how this risk can be mitigated through the use of other policy measures. A DSGE model that integrates both environmental externalities and financial frictions and assess how these frictions affect the optimal nature of transition risk was developed. The study shows that financial frictions significantly alter the transition dynamics following the introduction of a carbon tax. In particular, constrained firms reduce investments more sharply, leading to amplified output losses and a slower reallocation of capital across sectors. These effects raise concerns about the short-run macroeconomic costs of climate action in financially fragile environments. Second, the role of macroprudential policy, which is modeled as a tax on bank assets, in stabilizing these dynamics was assessed. While such tools can dampen credit cycles and reduce volatility, they do not substitute for environmental regulation. Lastly, the impact of blue firm activity, which offsets the impact of climate change by reducing emissions was examined. Blue firms are seen to have a positive impact on output, and alleviate transition risks by enabling a smoother transition following a carbon tax, and enhancing overall welfare. The results underscore a need for coordinated policy design that jointly addresses climate externalities and financial distortions, particularly during the transition to a low-carbon economy.

The remainder of this paper is organized as follows: section II presents an overview of stylized facts to give context to the key themes in the model, while section III details the methodology for how the DSGE model was calibrated. Section IV presents a thorough discussion of the results and section V proposes a set of policy recommendations, before concluding in section VI.

Stylized Facts

Blue, green, and brown firms represent distinct approaches to business operations with different levels of environmental impact, sustainability, and resource utilization. Blue economies, like The Bahamas, are centered around industries that make sustainable use of oceanic resources, seas, and coastal areas for economic growth, improved welfare, and generate employment. Given its geographical location and heavy reliance on coastal sectors, The Bahamas is among the most climate-vulnerable ocean-based economies, facing significant risks from hurricanes, biodiversity loss, and rising sea levels [7]. These firms encompass industries such as renewable energy, fisheries, tourism, and maritime transportation which are essential in addressing challenges of climate change and biodiversity loss [8]. Similarly, green firms adopt principles of environmental sustainability in their operations, strive to use renewable resources, and attempt to minimize the negative environmental impacts of their activities [9]. In contrast, brown firms pertain to industries driven by economic growth and dependent on environmentally destructive activities, such as oil extraction, heavy metal processing, coal mining, and burning of fossil fuels [10]. These firms harm biodiversity and lead to environmental sustainability challenges. This section explores key stylized facts regarding these firms’ trends, their challenges, and their roles in fostering a sustainable future.

Discussion

In general, the findings reveal that transition risk associated with the implementation of a carbon tax in an economy with financial frictions has an adverse impact; however, the extent of the fallout can be alleviated with the use of macroprudential policy and the presence of blue firms. We make three main observations from the findings. Firstly, blue firms increase output. As can be seen in Table 2, in an economy with blue firms and without financial frictions or macroprudential policy, output, which is depicted as Y, increases by 36.46% when a carbon tax is implemented. This is intuitive, in that blue firms are not affected by the environmental tax, given that their operations do not contain the use of fossil fuels, or any other activity that will produce greenhouse gases. What is more, the imposition of a carbon tax will cause financial institutions to lower their investment in blue and brown firms, and increase their investment in blue firms, which will therefore support an increase in output. When financial frictions are introduced, the increase in output decreases to 26.09%. However, when macroprudential policies are added, the increase in output strengthens by almost 2 percentage points to 27.99%.

Source: Based on authors’ calculations. Table 2: Percentage Deviations from the Baseline.

Secondly, we observe that blue firms lower pollution (denoted as X) in all of the simulations, with the reduction highest in an economy with financial frictions, macroprudential policy and blue firms, by some 5.32%. In an economy with financial frictions and macroprudential policy, the reduction in pollution is smaller, at 1.70%, indicating then that macroprudential policies alone are not effective in lowering pollution levels. However, the addition of blue firms helps to correct the environmental externalities that cause pollution by offering products and services that reduce greenhouse gas emissions such as carbon sinks. Hence, in an environment with blue firms alone, pollution reduces by 3.46%.

The third observation is that blue firms offer gains in welfare. In an economy with financial frictions and blue firms, welfare gains (denoted as W) increase by 4.13%, which is higher than the 3.48% increase observed in an economy with blue firms alone. However, without blue firms, macroprudential policies in an economy with financial frictions only produce an increase in welfare gains of 1.69%. Therefore, the presence of blue firms appears to be more effective in delivering welfare gains, in that blue firms reduce the level of pollution, which thereby improves the overall environment and thus, welfare of individuals and households.

Based on these observations, we deduce that the most optimal outcome is achieved when there are financial frictions, macroprudential policy and blue firms. In this environment, output increases by 27.99% from the baseline, pollution decreases by 5.32%, and the welfare gain moves higher by 5.34% when compared to the baseline. When a carbon tax is implemented, banks reduce their lending to blue and brown firms, which ultimately decreases output. However, macroprudential policies that drive a shift in investment from the brown sector to the green sector can help to offset this decrease in output. Further, the addition of blue firms can help to improve the level of pollution by reducing emissions, which not only render improvements in output, but overall welfare. What is interesting is that the deviations in pollution appear to be closely correlated with the movement in welfare gains. When pollution decreases in any of the simulations, the welfare increases by nearly the same magnitude. This insinuates that the two share a negative relationship.

Policy Recommendations

Based on these findings, it is imperative that policies catered toward supporting blue firms are considered at the highest level, and implemented in the short- to medium-term. To this end, we present the following policy recommendations:

Firstly, given that the results confirm that the presence of effective macroprudential policies can help to alleviate the transition risks that follow the implementation of a carbon tax, there is a case to be made for ensuring regulators are approaching their macroprudential policy framework from the right stance. In particular, the more banks are exposed to brown assets, the more adverse the impact of a carbon tax is on their portfolio. However, if regulators employ macroprudential policies such as taxes on firms whose output derive environmental externalities through increased emissions, or subsidies to firms who have environmental, social and governance (ESG) frameworks that actively help to reduce their emissions, this can help to mitigate a deep or prolonged worsening in their asset portfolio in response to climate policy. If banks lend more to firms that are emission reducers, or involved in production that promotes sustainability, their exposure to brown firms will be less, thereby reducing the associated impact of a government tax on brown firms.

Other macroprudential policies that can be considered include implementing loan-to-value ratio caps, and upper limits on the debt service-to-income ratio. As an ex-ante policy, central banks can begin including climate considerations in their macroprudential stress-testing to assess the potential transition and physical risk to the financial system. Examples of this can already be seen in Europe with the Banque de France launching a pilot assessment of banks and insurance companies in 2020, and the Bank of England following in 2021 with an assessment that considered transition and physical risks. In 2023, the United States joined these efforts with the Federal Reserve conducting a pilot climate scenario analysis (CSA) [29] that examined US banks’ ability to measure and manage climate-related financial risks, and have joined other regulators in the jurisdiction to issue guidance on principles for climate-related financial risk management.

To complement this shift in macroprudential policy by regulators, the government can aid in promoting more blue firms over brown firms by unlocking new financing for investment in sustainable activity. Given that the blue economy and firms that specialize in sustainable products or operations are still relatively new, traditional banks have been somewhat conservative in lending to these types of firms. Therefore, to promote more of this activity, the government can partner with multilateral institutions to provide more financing to these firms by either guaranteeing traditional debt issued by commercial banks, or directly providing grants to blue firms. By providing more capital to these firms, they can expand their operations and reduce overall emissions, which can lessen the need for robust climate policy, and that essentially assuages transition risks associated with climate shocks.

Alternatively, the government can also issue blue or green bonds-which have gained prominence in recent years-to raise financing directly for blue activity such as marine conservation, renewable energy, or assisting existing companies in their transition to more sustainable operations. For example, in late 2021, Belize completed a debt conversion of USD 364 million 1 for ocean conversation, making it the world’s single largest debt refinancing for marine conservation to date. In the underlying transactions, the government of Belize repurchased 100% of an existing bond at a 45% discount, and this was financed by The [30] Nature Conservancy (TNC) as a blue loan. The savings from the refinancing is estimated to create approximately USD 180 million in conservation funding over a 20-year period, the proceeds of which will be used to fund conservation efforts, including protecting up to 30% of its ocean resources. As a result of the debt swap, Belize was able to reduce its overall debt level by 12% of GDP. Given that oceans are carbon sinks—which can help to absorb polluting gases from the atmosphere-initiatives like this allow for more investment in activity that will help to reduce emissions, thereby mitigating transition risks [31, 32, 33, 34].

Moreover, for countries like The Bahamas that emit very low levels of greenhouse gases, and house large bodies of water and greenery that act as carbon sinks, the trading of carbon credits can be an efficient and sustainable avenue for raising climate financing. Under the Kyoto Protocol2, all signatory countries are designated emission caps, in line with the overall target of reducing global emissions. However, for countries that produce less emissions than their cap, they are permissible to trade the excess to countries that produce more emissions than their allotment. This then allows the higher emitting countries to maintain their production levels, without driving an overage in the global level of emissions. For countries like The Bahamas, that emits relatively low levels of greenhouse gases, trading carbon credits can be a good source of revenue. In addition, given the mass body of water in the country’s composition, and the land mass of greenery, these carbon sinks can offer

¹ Case Study: Belize Debt Conversion for Marine Conservation - https://www.nature.org/content/dam/tnc/nature/en/documents/TNC- Belize-Debt-Conversion-Case-tudy.pdf ² Kyoto Protocol – An international treaty adopted in 1997 to com- mit industrialized countries to transition to reducing their greenhouse gas emissions inline with agreed targets.

more revenue opportunities, the funds of which can be earmarked to mitigation and adoption efforts that offset the impact of climate shocks.

Furthermore, parallel to supporting blue firms, it is also important to consider policies that will help to drive the transition away from the use of fossil fuels and other activity associated with brown firms, in line with the Paris Agreement3. While financing is paramount to materializing these efforts, there are other policies geared toward mitigation and adaptation that are equally important. In particular, advocating for capacity building through technical assistance from the international community is an essential enabler to achieving climate goals. For example, countries can benefit from knowledge transfers when it comes to developing their energy reform strategies, or drafting legislation for sustainable land use that protects and preserves forests or other carbon sinks. There is also a case to be made for the transfer of technology between countries that promote reduced emissions such as solar power, geothermal energy, and wind mass energy, among others.

Finally, all of these efforts will be mute without international cooperation and collaboration. In this vein, it will be prudent for the government, private sector, multilateral organizations and other international institutions to work cohesively toward the common goal of eradicating the risk of climate change. By mitigating the threat of climate change, the associated transition and physical risk are reduced, thereby limiting the corresponding economic and financial fallout.

Conclusion

This paper explores the complex relationship between climate policy, financial frictions, and transition risk, building on the work of Carattini, et al. [1]. Our analysis, emphasizes that while ambitious climate policies are essential to steer economies toward a sustainable low-carbon outcome, these efforts can produce transition risks, which can have an adverse impact on economic output.

The findings highlight the importance of integrating financial market considerations into climate policy frameworks. Macroprudential policies that reduce informational asymmetries, improve access to green finance, and provide clear, credible signals about the future regulatory environment can help to alleviate financial frictions and mitigate transition risks. Such approaches can facilitate an easier reallocation of capital toward sustainable

³ Paris Agreement – A legally binding international treaty on cli- mate change, championed by the United Nations Framework Convention on Climate Change (UNFCCC).

investments, reducing costs and accelerating the green transition. In addition, the presence of blue firms can help to further mitigate transition risk, but reducing the level of emissions and enhancing overall output, and welfare.

Further, a coordinated effort among policymakers, regulators and financial institutions to develop resilient financial systems that support an efficient transition to lower carbon economy • Acknowledgements: The authors would like to thank Mr. Carlos Madeira, former Visiting Economist at the Bank for International Settlements (BIS) Office of the Americas for his comments on the paper. • Conflict of Interest: The authors declare no conflict of interest. • Disclaimer: The views contained within this paper are the views of the authors and do not reflect the views of the Central Bank of The Bahamas.