Limiting global temperature increases to 1.5°C will necessitate a transition away from fossil fuels and towards a net zero carbon energy system. While such a transition is necessary to avoid the catastrophic effects of climate change, it might also lead to a number of transition risks (as well as some transition opportunities). For example, a reduction in the demand for fossil fuels could lead to the stranding of fossil fuel related assets, reductions in the market value of fossil fuel firms, and defaults on fossil fuel firm debts. If large enough, these negative impacts could have (via their impacts on banks and financial markets) serious negative repercussions for the rest of the economy. In addition, a transition to net zero carbon energy system may lead to a decline in the energy return on energy invested (EROI) of the energy sector. Declines in EROI are likely to lead to increases in energy prices and so the general price level, which are in turn likely to negatively affect economic activity. On the other hand, the large levels of investment required for the transition are likely to lead to significant increases in demand and so employment and output.

Despite the fact the macroeconomic implications of a transition to net zero are not well understood, to date only a small number of models exist that attempt to simulate the potential economic effects of different types of energy transitions. The majority of these models, however, do not include a financial sector or financial assets, and instead focus purely on the ‘real’ side of the economy. In addition, to our knowledge none of these models are able to simulate how the potential benefits of an energy transition (increases in employment and output due to an increase in green investment) are likely to interact with all the different potential risks (asset stranding, loan defaults, changes in equity market values, and reductions in EROI). As such, the modelling of how asset stranding, changes in EROI, increases in green investment (and how that investment is financed) might affect both the financial and real sides of the economy (and how these impacts might feedback and interact with each other) remains something of a gap in the literature.

In order to address this gap, this paper presents a stock-flow consistent (SFC) model with an integrated input-output (IO) model for the study of the economic and financial impacts of energy transitions, with a particular focus on energy investment, investment financing, capital asset stranding, and changes in EROI. The model is that of a pure credit economy that consists of a household sector, a banking sector, and four firm sectors: a fossil fuel energy sector, a renewable energy sector, a capital goods sector and an ‘other’ firm sector that produces all the non-energy non-capital goods. Novel or semi-novel aspects of the model include multiple firm sectors and goods types, the integration of an input-output model and an almost ideal demand system into the larger SFC model, firms that produce distinct capital vintages which last for a given number of periods and have endogenously determined levels of labour productivity and material goods inputs, the endogenisation of firms’ markups based on target profit rates, the tracking of individual loans and loan repayments (with loan defaults that affect the bank’s capital position and so its lending rates), and the exit and bankruptcy of the fossil fuel sector during the transition process.

We use this model to investigate the economic impacts of different types of transitions to a low carbon economy. In the longer term the overall fall in EROI determines the extent of the increase in energy prices and so the increase in the steady state level of inflation. In the shorter run both the speed of the transition and the extent to which the transition is anticipated are important in determining the speed of demand reduction for fossil fuels and so fossil fuel firm asset stranding, loans defaults, and equity price changes on financial markets. In addition, the faster the transition, the more changes in energy prices that are driven by energy sector investment during the transition and reductions in EROI interact with the negative economic impacts that result from faster reductions in the demand for fossil fuels and their associated impacts on financial markets (such as asset stranding, loan defaults and equity price changes).