Representation of financial markets in macro-economic transition models—a review and suggestions for extensions

Abstract

As the energy transition accelerates and renewable energy technologies become cost-competitive with fossil fuels in many countries, the availability of finance could become a bottleneck. Integrated assessment models (IAMs) and other macro-economic transition (MET) models typically do not feature detailed financial markets and do not sufficiently consider financing barriers and opportunities for the transition to carbon neutrality. While progress has been made in the representation of financial markets in macro-models since the financial crisis of 2008 the focus has been on financial (in)stability of the financial sector, not its ability to finance investment projects in the energy transition. Hence, a crucial gap remains, preventing macro model-based analysis of financing barriers and policy interventions that may accelerate the energy transition. In this article we review how state-of-the-art macro-economic models consider the financial sector. From this review we identify what elements are still missing to adequately model the financial dynamics and challenges for the energy transition specifically. Based on a discussion of relevant parts of the finance literature, we then propose four steps to improve the representation of finance in global IAMs and MET models more generally.

Keywords

• integrated assessment modeling
• differentiated financial markets
• energy transition
• CAPM
• term structure
• pecking order theory