Abstract

Abstract for: Weakening Persistent Climate-Driven Financial Default: Policy Mechanism Design Using FRIDA Integrated Assessment Model

Introduction Climate change can weaken macroeconomic performance through physical damage and financial channels. Climate-driven losses raise loan failures and defaults, triggering banks to tighten lending standards, slow investment, and create a persistent climate-driven financial default loop. Existing macro-financial models explain this process, but they do not fully capture the long-run endogenous feedback among climate damage, credit, investment, and macroeconomic performance. As a result, policy mechanisms for weakening the persistent climate-driven financial default feedback remain underdeveloped.
Approach To address this gap, this study applies a System Dynamics approach using FRIDA v2.1, a fully coupled disequilibrium IAM, to design and test insurance-based policy mechanisms. Three policies are introduced into FRIDA’s economy module: private insurance, central bank insurance, and government insurance for climate-caused risky defaults. Additionally, two combined policy scenarios are also simulated. All three individual insurance policies weaken the persistent climate-driven financial default mechanism.
Results Compared with the baseline without policy, they manage to absorb part of the climate-related default, reduce long-run lending tightness, improve GDP and employment. However, these policy implementations also increase inflation and debt-related pressure. Among the individual policies, private insurance performs best. Among the combined scenarios, private + central bank insurance performs slightly better than private + government, though neither clearly outperforms private insurance alone.
Discussion This study contributes to the climate-finance and System Dynamics methodology in two ways. First, it extends FRIDA from a model for explaining climate-financial instability baseline into a tool for policy design, directly into its endogenous macro-financial structure. Second, it provides a model-based policy insight. In a feedback-rich climate-finance system, effective policy must not only absorb losses but also weaken the transmission from climate damage to tighter lending and slower investment.

Introduction	Climate change can weaken macroeconomic performance through physical damage and financial channels. Climate-driven losses raise loan failures and defaults, triggering banks to tighten lending standards, slow investment, and create a persistent climate-driven financial default loop. Existing macro-financial models explain this process, but they do not fully capture the long-run endogenous feedback among climate damage, credit, investment, and macroeconomic performance. As a result, policy mechanisms for weakening the persistent climate-driven financial default feedback remain underdeveloped.
Approach	To address this gap, this study applies a System Dynamics approach using FRIDA v2.1, a fully coupled disequilibrium IAM, to design and test insurance-based policy mechanisms. Three policies are introduced into FRIDA’s economy module: private insurance, central bank insurance, and government insurance for climate-caused risky defaults. Additionally, two combined policy scenarios are also simulated. All three individual insurance policies weaken the persistent climate-driven financial default mechanism.
Results	Compared with the baseline without policy, they manage to absorb part of the climate-related default, reduce long-run lending tightness, improve GDP and employment. However, these policy implementations also increase inflation and debt-related pressure. Among the individual policies, private insurance performs best. Among the combined scenarios, private + central bank insurance performs slightly better than private + government, though neither clearly outperforms private insurance alone.
Discussion	This study contributes to the climate-finance and System Dynamics methodology in two ways. First, it extends FRIDA from a model for explaining climate-financial instability baseline into a tool for policy design, directly into its endogenous macro-financial structure. Second, it provides a model-based policy insight. In a feedback-rich climate-finance system, effective policy must not only absorb losses but also weaken the transmission from climate damage to tighter lending and slower investment.