Transition risks relates to the risks associated to transitioning to a lower-carbon economy, which may entail extensive policy, legal, technology, and market changes to address mitigation and adaptation requirements related to climate change.
What is Transition Risk?
Our first step is understanding that the Task Force for Climate-Related Financial Disclosures (TCFD) defines risk in three categories: climate, transition, and physical.
The framework separates climate-related risks into two distinct areas: those related to the global transition to a low-carbon economy and those related to the physical impacts of the climate crisis.
It then breaks down transition risks into four main categories: (i) policy and legal, (ii) technology, (iii) market, and (iv) reputation.
Finally, the TCFD identifies two physical risks: acute and chronic.
As the climate crisis continues accelerating, the physical risks of climate change (such as rising sea levels, floods, droughts, extreme weather events, etc.) will become more commonplace. This is easier for people to see. However, for businesses to survive in this new "normal", they must adapt not only to these physical impacts but also to the risks created by the global transition to this low-carbon economy.
Let's take a closer look at those four transition risks:
- Policy and legal risks
- A growing number of carbon disclosure mandates. For example, the SEC’s climate-related disclosure proposal and the EU’s Corporate Sustainability Reporting Directive (CSRD).
- A compounding increase in companies' exposure to litigation, as the cumulative number of climate-related court cases has doubled since 2015.
- Technology risk
- Substituting existing carbon-intensive products and services for low carbon ones, such as electric vehicles and renewable energy.
- Investing in new (and potentially risky) climate technologies.
- Market risk
- Rising costs of raw materials or increased price of low carbon raw materials.
- Changing consumer behavior; 69% of global consumers have changed the products and services they use due to climate change concerns.
- Reputational risk
- Changing consumer, employee, and stakeholder preferences; the majority of people now expect CEOs to do more to address environmental and social issues.
- Stigmatization of sectors, such as mining, fossil fuels, and chemicals.
Each of these examples will affect companies differently depending on many factors, like their sector, size, and operational jurisdictions.
Which Industries Face The Greatest Transition Risks?
All industries will face transition risks as the global shift to a low-carbon economy accelerates. Most companies will face reputational risks as consumers are increasingly likely to turn to more sustainable products and services. Likewise, the increased cost of raw materials will reach all sectors.
However, some sectors are more susceptible to transitional risks, especially carbon-intensive industries like oil and gas or transportation. These companies must gradually adapt their methods of operations (for example, from fossil fuel use to renewables or combustion engines to electric vehicles).
Some jurisdictions will also face transition risks more intensely and immediately than others. EU nations, for example, have implemented a carbon tax and will require emissions reporting through CSRD.
While there are extensive risks associated with the transition to a low carbon economy, there are also huge opportunities, including becoming more sustainable and providing products and services to mitigate/adapt to climate change. On the other hand, some climate transition risks can be so abrupt and far-reaching that they threaten the global economy itself.
What is a “Green Swan” Event?
Some transition risks are so rare, come so unexpectedly, and can be so pervasive that they jeopardize entire sectors. These events are called “green swans,” taken from the idea of black swan events in risk - which have such wide-ranging repercussions that they are considered as rare as a black swan. Green swan was coined by the Bank of International Settlements. The primary example of a green swan is stranded assets, which include coal and oil reserves that must be left in the ground to meet the goals of the Paris Agreement. Another example of a green swan is the switch to electric vehicles we have seen in recent years, which started very slow, but has exponentially gathered speed and has now disrupted the entire automotive industry to the point of no return.
What are the Potential Financial Impacts of Transition Risks?
Although some carbon-intensive companies will likely be impacted more by the transition to a low carbon economy, the cost of raw materials and new climate regulations will touch almost every company. The financial impacts of a high carbon price, for example, could mean companies face up to 283 USD billion in carbon pricing costs and put 13% of earnings at risk by 2025.
Each of the four categories of transition risks carries with them its own financial implications; these include abrupt and unexpected shifts in energy costs, reduced demand for goods and services as consumer preferences change, stranded assets, and capital investments in new and alternative technologies.
It will be up to each company to assess which of these impacts will affect its finances and adapt appropriately. In some cases, however, the financial opportunities can outweigh the risks. A 2018 study by CDP of 500 of the world’s largest companies found a total of $970 billion at risk from the 215 companies that reported climate-related transition risk, and $2.1 trillion in opportunities from the 225 that reported climate-related opportunities.
How can Organizations Mitigate Transition Risks?
More companies will be forced to manage climate risk as the financial implications of the physical impacts of climate change and the transition to a low carbon economy become increasingly apparent. The first step to mitigating climate risk is an accurate carbon footprint assessment and an understanding of where in the value chain emissions come from.
Follow these five steps to mitigate transition risks:
- Conduct a materiality assessment - Understand what is materially relevant to the business across operations, supply chain, and product or service life cycles.
- Use scenario analysis - Assess the range of hypothetical outcomes the transition to a low carbon economy will bring and develop plans and strategies to handle the range of possible future circumstances.
- Identify opportunities - Assess how your business operations and investments are aligned with global decarbonization goals, the preferences of your consumers, employees, and investors, and new and emerging markets.
- Set targets - Set ambitious carbon reduction targets; science-based targets show a real commitment to climate action and reduce exposure to transition risks.
- Disclose and engage - Disclose your carbon footprint and exposure to climate risks and opportunities in annual filings and ESG reports to improve transparency, mitigate reputational risk, and engage with your supply chain.
New tools to assess transition risks have emerged to assist companies with the process. One such tool is the UN Environment Programme Financial Initiative’s ‘Transition Check,’ which enables organizations to assess transition risks across their operations and portfolios through a scenario-based approach aligned with the guidance in the TCFD.
As the world marches toward a low carbon economy at an increasingly faster pace, it’s important for companies to take the first step in mitigating transition risks with an accurate carbon assessment. To find out how Persefoni can help you do that, schedule a demo.