Transition risk
Higher commitments to reduce carbon emissions and the associated physical risk creates transition risk, which affects insurers, banks and pensions funds as large investors in energy majors and industrials. Transition risk materialises as risk to individual companies, and to the wider economy through the energy system as:
- Sudden economic obsolescence of the capital stock and sudden revaluation of fossil fuel reserves and revaluation of the market value of firms, according to their exposure to carbon-intensive resources, inputs or technologies (ESRB, 2016). During the 2020 pandemic related lockdown the transition was accelerated, with demand decline and overproduction reducing oil prices significantly, in turn affecting the stock market prices of oil majors.
- Energy system risk, around efficiency and price. Efficiency as congestion of the electricity grid and the risk of insufficient back- up capacity as output from flexible renewable energy sources outpaces investment in the electricity grid creating suboptimal solutions (or temporary switch off), while coal- and nuclear fired power plants are being decommissioned. In the UK, EU as well as the US, nuclear energy generation is rising in popularity for back- up capacity once more, however nuclear waste is an unwanted environmental problem. Price spikes from emission price increases and weather related variation is also a risk - the EU Emissions Trading System (ETS) observes record prices above EUR35 per ton of CO2 as trading commenced for 2021;
- Climate litigation, for example the Urgenda case in The Netherlands, creates mounting pressure to address the delay and divergence between promises and actions taken, increasing transition risk as countries could face a faster transition path.
For banks, insurers and pension funds, short term transition risks include:
- Increasing regulatory risk with central banks increasing reporting requirements (e.g. Bank of England (BoE) making Task Force on Climate-related Financial Disclosures (TCFD) reporting mandatory, where it was voluntary before), and EIOPA investigating minimum requirements for climate related capital.
- Implementation risk – with 2021 climate-related deadlines starting to bite (for example EU Sustainable Finance Disclosure Regulation (SFDR)) – the risk that we either miss the requirement, or need to spend significantly higher amounts on consultancy fees to meet them.
- Fierce competition for renewable projects results in lower margins and lower ROEs. The risk/reward ratio therefore falls under pressure and may become a risk in the future if this trend continues.
With the global focus on the corona pandemic, there is a risk to climate mitigation efforts that focus will be shifted to economic recovery, especially in emerging markets which are most exposed to the effects of climate change.
Model risk and financial risk
The underlying assumptions used in climate scenarios also poses some climate model risk. Global average surface temperature used as premise of the climate commitment to 1.5°C is calculated as a 50/50 average between the northern and southern hemisphere, using both ocean and land based temperatures. This averaging camouflages faster northern hemisphere warming, where climate tipping points of albedo effect and methane release from permafrost can cause warming at higher levels than current IPCC models estimate. This and other model shortcomings tend to underestimate the impact of increased emissions.
In addition to climate model risk, financial model risk to translate the climate forcing to a financial impact is substantial. The main drivers are the lack of historical data and the difficulty in correlating losses to climate events. Efforts to bridge the gap are being made with Actuarial Climate Indices (US ACI version 1 has been published, EUR ACI is in development), which track meteorological conditions which can cause physical damage, to eventually link these to financial losses incurred. These vary per region, and include increased variability in rainfall (both flooding and drought), hail, hurricanes, heat extremes and cold extremes.
In closing
Climate risk poses a systemic threat to economic growth and financial stability. Over the long term the threats come from physical impact such as flooding (acute) and labour productivity (chronic), and over a shorter horizon from the economic and financial impact of transition to a low carbon economy driven by international climate policy. In addition, the underlying models, both for climate and finance, are still in development and subject to high degrees of uncertainty.
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