Dynamic relationship between climate policy uncertainty shocks and financial stress: A GMM-Panel VAR approach

Abstract

Europe is the fastest-warming continent in the world, facing significant challenges to its people, economy, and environment due to climate change. This study examines how climate shocks affect financial stress in European countries, focusing on three key factors: Climate Policy Uncertainty (CPU), Annual Surface Temperature Change (AST), and Atmospheric CO₂ Concentration (ACC). Using data from selected European countries between 2000 and 2022, the study applied the Generalized Method of Moment Panel Vector Autoregressive (GMM-PVAR) model to analyze these relationships. The results show that financial stress reacts differently to climate shocks in the short term and long term. Initially, climate shocks may temporarily reduce financial stress, possibly due to their effects on stock and currency markets. However, over time, they lead to increased financial stress across all financial sectors. The study also highlights the growing influence of CPU and AST on financial stress fluctuations. These findings underline the need for effective risk management strategies in the financial sector to address climate risks. Additionally, greater investment in renewable energy and energy efficiency is crucial to mitigate temperature increases and reduce CO₂ emissions.