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Climate transition: how is the financial system handling risk?

Vincent Bouchet
Vincent Bouchet
Researcher at EDHEC Business School
Key takeaways
  • 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.

Sirinie Azouaoui

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