Climate transition: how is the financial system handling risk?
- Beyond the physical risks of global warming, there is a “transition risk” for the financial system resulting from the ecological transition.
- This transition risk arises from the various regulatory changes imposed in a transition to a low-carbon economy.
- Companies linked to the fossil fuel and power generation sectors are particularly exposed to transition risk.
- For these companies, investors already partially consider transition risk, which impacts the cost of their debt.
- Taking transition risk into account is necessary for governments, companies, and the financial system to avoid a systemic shock.
Transition risk is the set of risks associated with efforts to reduce global warming. One of the sources of this transition risk is regulation such as carbon pricing, taxes, thresholds and quotas, to encourage companies to reduce their greenhouse gas emissions. The transition to a low-carbon economy therefore implies many transformations for companies. From a financial point of view, these upheavals generate uncertainty, which translates into financial risks, with a fear of a drop in activity, then in income, and a possible effect on the financial system.
Why is transition risk an important concept to consider in the fight against global warming?
When we talk about global warming, we think first of physical risks, such as floods and natural disasters. However, to reduce greenhouse gas emissions, the emitting sectors will have to transform themselves, which will lead to economic upheaval. Transition risk is a consequence of political and societal efforts to mitigate climate change. In 2015, Mark Carney, then Governor of the Bank of England, spoke of the multiple transitions ahead, which could destabilise the economy and finance. The Paris Agreement was signed a few weeks later by 180 parties and included a commitment to keep the increase in average temperature to 2°C, with a target of 1.5°C, compared to the average temperature of the pre-industrial era.
Regulation is both a source of transition risk and a way to prevent it.
If institutional investors believe that a transition is going to take place, they may tend to sell the assets in their portfolio that are most exposed to this transition, such as oil companies. For the financial system, this can lead to sudden downgrades and have a domino effect on other financial institutions. The more radical the transition being considered, the greater the risk. There is therefore a tension between the transition needed to combat climate change and the transition risk. This notion can be used for both good and bad purposes.
What disruptions could companies face because of this transition risk?
The companies most at risk are forced to change their business model, otherwise they may experience a drop in business and then in revenues, or an increase in costs. Another, more subtle, effect may be the devaluation of assets, such as oil companies holding fossil fuel reserves. These companies suffer a direct effect from the risk to their sales, and a further effect linked to their future emissions. This future effect can already be analysed by looking not only at the reserves held, but also at the long-term investments made in fossil fuel extraction projects. In the financial markets, the value of a stock may fall, not because its activities have fallen today, but because the market believes that its activities will fall in the future and that its reserves will not be worth much in a low-carbon scenario.
Your study focuses on the relationship between financial actors and transition risk. What is the starting point of your work? What method did you use to study this relationship?
In a previous article, we first tried to find out which sectors were most exposed to transition risk. In particular, we highlighted the fossil fuel, power generation and materials sectors. We then asked ourselves to what extent these risks were already considered by financial players. Are investors aware of these particularly exposed sectors? To find out, we looked at the cost of debt – the interest rate on a loan. Between 2012 and 2017, we collected data on 200 companies belonging to sectors that are more or less sensitive to transition risk. We constructed two scores, a ‘current risk’, based on greenhouse gas emissions and fossil fuel production, and a ‘future risk’, based on fossil fuel reserves and oil and gas investments.
Do investors then reflect the transition risk in the cost of debt for the most at-risk companies?
Investors seem to partly incorporate transition risk into the cost of debt, which changes in line with current risk. In contrast, there is no correlation with future risk – either with oil reserves or investments in polluting energy. However, there seems to be a shift in 2015, a pivotal year, with Mark Carney’s speech and the Paris Agreement. The result should be treated with caution, however, as it is not clear from the study whether the cost of debt is rising sufficiently to cover the scale of the potential risks.
What role does regulation play in transition risk?
Regulation is both a source of transition risk and a way to prevent it. Through carbon pricing, for example, public authorities require financial and non-financial institutions to take this risk into account and to anticipate it. There are also regulatory requirements in terms of transparency on how this risk is managed: institutions must make plans and communicate on how they will manage these new rules. The regulator therefore ensures that economic players anticipate future transitions as well as possible to avoid major economic and financial shocks.
What do you recommend to ensure that the financial system is doing a better job of taking account of this transition risk?
The requirements for financial institutions to take climate risks into account should be reinforced, and more transparency should be demanded in order to avoid taking them into account too late, which could have systemic consequences. To do this, we need to increase the number of risk simulation exercises, such as stress tests. There have already been some, in France, but also at the level of the European Central Bank. On future transition risk, investors should be encouraged to extend their risk management horizons. At present, it is 2 or 3 years, but the risks – physical or transitional – are longer term: they should be managed over 10, 20 or 30 years.
