Types of transition risks and their importance

Understanding the types of transition risks is critical for investment managers to identify which companies are most at risk from climate change, which are best prepared, and which are taking action.

Correctly pricing risk allows investors to make informed and efficient capital-allocation decisions. This is particularly true for long-term asset owners. Schedule a free call with our ESG integration experts to understand more.

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Types of transition risks and their importance

In 2017, the Task Force on Climate-Related Financial Disclosures (TCFD) released a landmark report with disclosure recommendations to help companies provide better data to support informed capital allocation. This critical document has served as a framework and guide for capital markets to define and integrate climate-related analysis into investment decisions.

Although the TCFD has since published implementation guides and annex documents updating and superseding the 2017 document, most of the definitions -including transition risks- used by financial institutions around climate risks are still based on the pivotal original document.

The Task Force divided climate-related risks into two major categories: (1) risks related to the transition to a lower-carbon economy and (2) risks related to the physical impacts of climate change. Among the first category -and the focus of this blog post-, the TCFD identifies four key types of transition risk:

  • Policy and Legal Risks
  • Technology Risks
  • Market Risks
  • Reputation Risks

 

 

Policy and Legal Risks

Climate-related policies are continuously evolving in every jurisdiction and for every industry. Policy actions vary depending on intent and financial impact. Generally, new policies/regulations attempt to (a) constrain actions that contribute to the adverse effects of climate change or (b) promote adaptation to climate change. Consider a government implementing a carbon price to tax externalities of carbon-intense sectors versus tax credits for consumers buying electric vehicles. Both policy actions vary on their intent and financial impact.

Organizations and investors should assess not only the potential direct effects of policy actions on operations, but also the potential second and third order effects on their supply and distribution chains.

Firms that don’t adapt to these policies will be exposed to legal risks, especially in the context of climate-related disclosures. Failing to mitigate adverse impacts, to adapt or to disclose these risks to regulatory parties and investors, may result in increased litigation.

Technology Risks

Technology risk is closely linked with productivity and competitiveness. Financial risks may arise if no new investments are made in new technologies that contribute to climate-related adaptation and risk mitigation. However, identifying disruptive technologies is not always a straightforward process and examples of emerging technologies will differ on a sector and industry basis. Similarly, financial risks may also arise from investments made in technologies that ultimately did not generate positive returns on investment.

According to the TCFD, as the world transitions to a lower-carbon economy, winners and losers will emerge as new technologies displace old systems and disrupt parts of the existing economic system. The timing of technology development and deployment, however, is a key uncertainty in assessing technology risk.

Market Risks

Capital markets are well-versed in identifying and assessing market risks. However, climate change will have unique implications in the supply and demand of certain commodities, products, and services. Market risks include everything from changes in supply and demand to increased costs for inputs such as water and energy.

While some of these impacts may be hard to predict, understanding the climate-related risks and opportunities on the supply chain will be key to mitigating these market risks.

Reputation Risk

For many companies, a good reputation is often their most valuable asset. Yet quantifying the financial impact on brand equity, intellectual capital, and goodwill is extremely hard to assess. Climate change has been identified as a potential source of reputational risk, customer and community perceptions will evolve depending on companies’ contribution to or damage to a more sustainable economy.  Negative changes in perception can lead to costly losses in market value.

 

Why do transition risks matter to investors?

Because transition risks are financially material. This implies that the effects of transition risks have the potential to destroy market value and increase market volatility, at a security and portfolio level.

The challenges investors face are the mapping of these risks and understanding how they interconnect with financial information to implement risk mitigation strategies and identify alpha generating opportunities. Investors need to keep in mind that transition issues can manifest differently across industries and a sector-specific approach is required.

Some examples representing the financial materiality of transition risks are:

  • Write-downs and stranded assets: As the global economy transitions to lower-carbon and renewable energies, recent studies have estimated that trillions of US dollars in assets may be left stranded. According to an analysis by the WSJ, “stranded assets range from coal-fired power shutting down before the end of their useful lives to buildings hit with repeated floods to farmland suffering from prolonged drought. Any asset that is producing less than expected because of climate change or rules set up to limit climate change could be a candidate for a write-down.”

 

 

  • Increased volatility and fire sales: National governments are rarely clear regarding expected policy actions. Similarly, uncertainty around climate-related regulation such as emissions reduction targets, carbon pricing and others will likely increase financial turbulence. In a worst-case scenario where transition risks crystallize abruptly, can cause systemic economic damages. In 2015 Mark Carney, ex-governor of the Bank of England and Bank of Canada, described a possible “Minsky moment” in which investors’ expectations about future climate policies adjust sharply, causing fire sales of assets and a widespread repricing of risk and higher borrowing costs.

 

  • Contagion risk and triggering crises: The potential value of financial assets exposed to transition risk is extremely large. According to Carbon Tracker, around US$18trn of global equities, US$8trn of bonds and US$30trn of private debt are linked to high-emitting sectors of the economy. That compares with the US$1trn market for collateralised debt obligations (CDOs) in 2007, which were at the heart of the global financial crisis. The impact of losses would depend on who owns these assets with regulators especially concerned about the exposures of “too big to fail” institutions.

 

  • Greenwashing: Firms that falsely claim -knowingly or unknowingly- to offer products/services with sustainability-related benefits are misleading costumers and investors. Greenwashing is a growing concern among regulators and stakeholders. Companies that can’t back their marketing statements will be exposed to financially material litigation and reputational damage.

 

To conclude, transition risks are caused by not responding to climate change and continuing unsustainable business-as-usual practices. Going forward, policies and regulations, as well as societal expectations and market pressure to move towards more sustainable practices, will continue to drive investors’ need for transition risk mitigation strategies.

 

How Invartis can help

In many ways, ESG investing is a data management and data analytics challenge. Identifying and monitoring these risks through the appropriate data helps investors to build the necessary foundation for risk management and alpha generation.

If your company needs support identifying and measuring transition risks or assessing transition plans, feel free to schedule a call with one of our ESG integration experts. Click here to book a free consult.

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