Transition Risk: A Growing Threat to The Global Economy

In an era of increased focus on climate-related reporting and growing pressure on companies to adopt ESG-led approaches, businesses are keen to reduce their reliance on carbon and evidence their ESG credentials. However, the transition to a low-carbon economy has its risks.

The transition to a low-carbon economy is a major challenge requiring significant changes in how products and services are delivered. These changes will create new risks and opportunities for businesses, investors, and other stakeholders.

The Taskforce on Climate-related Financial Disclosures (TCFD) framework can help organizations identify and assess climate-related risks and opportunities they face in transitioning to a low-carbon economy. By disclosing information about these risks and opportunities, organizations can help investors and other stakeholders make informed decisions about their investments.

One of the key areas of focus for the TCFD is transition risks. Transition risks are those associated with the extent to which an organization manages and adapts to the internal and external pace of change to reduce gas emissions and transition their products and services.

Transition risks have 4 main drivers:

1. Policy and Legal.
2. Technology.
3. Reputation.

4. Market.

Organizations should consider these four categories within two layers when assessing transitional risks. The first layer is the direct business activities and the jurisdiction in which the organization operates, as well as the jurisdictions in which its primary customers are located.

The second layer is supply chain, which includes the risks associated with the organization’s suppliers, such as the availability of raw materials, the cost of production, and the reliability of suppliers.

A. Policy and Legal Risks

Climate change policy initiatives are still evolving. Their goals are often divided into two categories; policy activities that seek to limit acts that contribute to the adverse effects of climate change and policy actions that support adaptation to climate change. The nature and timing of the policy change also determine the risk and financial impact of policy changes. As the monetary value of loss and damage caused by climate change rises, so will the possibility of litigation.

The inability of organizations to minimize the effects of climate change, failure to adapt to climate change, and inadequate disclosure of significant financial risks are all reasons for such litigation.

Moreover, government policies reducing emissions are significantly impacting businesses of all sizes. There are policies in place all around the globe in different jurisdictions that limit the emissions of products and services provided over a time period. This leads to changes in how businesses operate, as they need to adapt to these new regulations.

One example of this adaptation in the UK is the phasing out of gas boilers in favor of heat pumps. Heat pumps transfer energy from the air into a property, which is more efficient than burning fossil fuels. Transitioning to heat pumps is a significant change for businesses that supply or install gas boilers, as they will need to adapt their products and services to meet the new requirements. Whether directly or indirectly, businesses involved in the heating and cooling field will need to adapt to the transition from gas boilers to heat pumps.

House builders will also need to change the way they design and build homes to accommodate heat pumps. This may include increasing the size of electrical circuits and installing new insulation.

Electricity grid operators will need to prepare for the increased demand for electricity that will result from the transition to heat pumps. This may include upgrading infrastructure and investing in new-generation capacity.

B. Technology Risks

Technological progress is expected to accelerate the transition to a low-carbon economy. This means that companies that rely on old, fossil-fuel technologies will be vulnerable to disruption unless they modify their operations. There are also technological breakthroughs that improve climate change resilience. Aside from the tremendous commercial opportunities that technology provides enterprises and investors, there is also the risk that the technology will not be widely accepted or will fail.

For instance, the transition to heat pumps poses several risks for businesses. There is a risk that the technology may only be compatible with some types of properties or heating systems. Additionally, the cost of heat pumps is still relatively high, which could deter some consumers from making the switch.

C. Market Risks

Changes in the supply and demand for goods, services, and commodities, as well as alterations in their relative prices, will accompany the transition to a net-zero economy.

Organizations that adapt to this complicated and dynamic environment will fare better than those that are slow to understand the nature of these changes.

A portrayal of market risks in the heating field lies in the increasingly competitive market, which could drive down prices and profits. There is also a risk that consumer behavior will shift due to the policy change. For example, people may be less likely to buy a property that runs on a gas boiler, as they will have to spend money to replace it with a heat pump.

D. Reputation Risks

Climate change may pose a reputational risk to businesses as consumer and investor views shift. Consumers may demand more climate-friendly items as they become more conscious of the effects of climate change. Organizations that are perceived as climate laggards may face a reputational backlash. Investor knowledge and expectations of corporations are also rising, with many including climate risk in their investment decisions.

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 gradually 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. Organizations in sectors with carbon-intensive industries will be affected the most, including those who work in the supply chains of these industries. For example, organizations that manufacture internal combustion engine vehicles or supply to these manufacturers will need to gradually adapt their methods of operations or face obsolescence.

Vulnerability and Financial institutions

An organization’s vulnerability to transition risk refers to its inclination to be negatively impacted by its exposure to a risk trigger. An organization heavily reliant on fossil fuels, for example, is significantly more vulnerable to transition risk than one already carbon neutral.

Furthermore, financial institutions will be affected by transition risk as a result of the transition’s impact on their counterparties and the assets they manage.

Transition Risk: The Challenges and Opportunities of a Low-Carbon Future.

It is vital to understand the challenges of transition risk under TCFD. Identifying key policies within jurisdictions and the supply chain and analyzing the potential financial impact poses several problems.

• Lack of data: Limited data on transition risks makes it difficult for businesses to assess their exposure to these risks.

• Ambiguity: Due to the unpredictability of the future impact of climate change, businesses find it challenging to estimate the effects of transition risks on their operations.

• Complexity: Transition risks are complicated and can have a wide range of consequences for organizations; it is difficult to report them in a clear and evident manner.

• Cost: Reporting transition risks can be costly since organizations must collect data, build models, and assess their exposure to these risks.

Despite these obstacles, certain advantages exist for organizations reporting on transition risks under TCFD.

These benefits include:

• Enhanced transparency: Reporting on transition risks can assist organizations in increasing transparency with their investors and other stakeholders.

• Lower risk: Organizations can minimize their transition risk exposure by identifying and measuring their risks ahead of time.

• Improved decision-making: Organizations may make better long-term decisions by understanding the risks and opportunities associated with transition.

Recommended Approach for Transition Risk Disclosure.

The most efficient strategy to tackle the disclosure of transition risks is through the following methods:

1. Describe climate-related risks and opportunities identified by the organization in the short, medium, and long term.

• Explain how climate-related risks and opportunities affect the organization’s operations, strategy, and financial planning.

• Describe the organization’s strategy on resilience considering several climate-related scenarios, including a 2°C or lower scenario.

From a policy perspective, businesses need to model their emissions and identify the gaps between their current emissions and their target emissions to understand the risks and opportunities associated with the transition to a net-zero economy.

The Science-Based Targets Initiative (SBTi) provides a tool that businesses can use to model their emissions and identify their target emissions. The SBTi tool uses temperature modeling to show businesses their current emissions trajectory and what they need to do to reach their target emissions.

Once businesses have identified their target emissions, they can allocate a price to the number of emissions they want to decrease. This can be done using carbon prices, which are the costs associated with emitting greenhouse gases. By understanding the cost of emissions, businesses can make informed decisions about reducing their emissions and mitigating their risks.

Therefore, by modeling their emissions and identifying the gaps between their current emissions and their target emissions, businesses can mitigate their risks and adapt to the transition to a net- zero economy.

How Can Organizations Mitigate Transition Risks?

More organizations 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.

The components needed to mitigate transition risks are the following:

• Conduct a materiality evaluation – Determine what is materially important to the business regarding operations, supply chain, and product or service life cycles.

• Using scenario analysis – organizations may assess the range of potential outcomes that the transition to a low-carbon economy will bring, and then design plans and strategies to deal with the content of conceivable future conditions.

• Identify opportunities – Examine how your business activities and expenditures match global decarbonization targets, consumer, employee, and investor preferences, and new and emerging markets.

• Set targets – Set rigorous carbon-cutting targets; science-based targets demonstrate an honest dedication to climate action and limit vulnerability to transition risks.

• Disclose and engage – Disclose your carbon footprint and exposure to climate risks and opportunities in annual ESG reports to improve transparency, mitigate reputation risk, and engage with the supply chain.

Looking to the Future: The Key to a Smooth and Equitable Transition to a Low-Carbon Economy.

Transition risks are complex and challenging, but by understanding these risks, we can help to ensure a smooth and equitable transition to a low-carbon economy.

As the world marches toward a low carbon economy at an increasingly fast pace, organizations need to take the first step in mitigating transition risks with an accurate carbon assessment.

To achieve mitigation, businesses, investors, and other stakeholders need to identify and assess their exposure to transition risks, develop strategies to reduce their exposure, and communicate their exposure to their stakeholders. Governments and consumers can also play a role by developing policies that support the transition to a low-carbon economy and demanding products and services from low-carbon businesses.

Although embedding climate financial risk into financial organization’s risk management frameworks remains a work in progress, the world is witnessing evidence of a growing level of climate sophistication at the leading organizations. With carbon emissions continuing to increase and transition risks rising in tandem, it is increasingly important for organizations to start investing in their climate risk management capabilities.