Transition Risks

What are Transition Risks?

Transition risks are a specific category of climate risk facing the business community. Transition risks result from the relative uncertainty created by the global shift towards a more sustainable, net-zero economy.

Transition risks are very broad in nature and can be difficult to quantify or model. Regulatory, geopolitical, and even social pressures are creating material impacts on the operations of a business, its reputation, and the value of its assets, among others.

Understanding, reducing, and proactively mitigating climate risks (including transition risks) are core tenets of the ESG (Environmental, Social & Governance) framework.

Types of Climate Risks

Climate risk is broadly defined as the range of potential business and financial impacts that firms may face resulting from the effects of climate change; historically, these risks have been categorized as either physical risks or as transition risks.

Physical risks

A changing climate, including rising temperatures, changing weather patterns, and increased instances of extreme climate-related disasters, create physical risks for a business and its management team. These are often characterized as either acute or chronic.

Acute physical risks are things like storms (i.e., tornados or hurricanes), floods, and wildfires; these can damage physical infrastructure in real-time and present immediate business interruptions (plant shutdowns, transportation issues, etc.) as well as other financial impacts (like the destruction of inventory, the degradation of physical collateral, etc.). 

Chronic physical risks may not be felt every day, but they tend to compound over time. An example is an increase in the number and severity of droughts, which create very dry conditions. While agribusinesses may survive in the near term, over longer time horizons, this sustained physical degradation may render agricultural land completely useless across certain geographies. 

Transition risks

The physical risks presented by climate change have been deemed so material by many stakeholders that they’re influencing policy and strategy decisions. For example, many governments and management teams are making climate pledges like net zero or carbon neutrality in order to support the transition towards a more sustainable economic state.

But changes in the regulatory environment and other shifting stakeholder expectations that emerge from this transition are creating enormous uncertainty for organizations and their corporate governance functions.

Navigating new ESG disclosure requirements, energy procurement practices, potential carbon taxes, the availability of capital, and even changing consumer preferences are all creating new risks for organizations; these are, of course, transition risks.

Examples of Transition Risks

Some examples of transition risks include, but are not limited to:

Investor expectations 

There’s a growing recognition that the capital markets can exert significant influence over bad climate actors, either by restricting access to capital or making it extremely expensive. The proliferation of ESG funds and general pressure from investors and other capital providers have changed the way asset allocation decisions are made by some of the largest financial services firms in the world. 

This new and rapidly evolving funding landscape is a significant transition risk for many firms, particularly those operating in historically high carbon industries (like oil and gas or coal).

Regulation 

In many jurisdictions, publicly traded companies are mandated to track and disclose their scope 1, 2, and 3 greenhouse gas (GHG) emissions, a practice called carbon accounting. Staying on top of ESG disclosures requires significant cross-functional collaboration.

In some cases, firms are incurring massive costs to hire qualified staff and implement the infrastructure required to deliver in this new regulatory landscape.

Social 

Consider that many consumers are increasingly attuned to climate change and looking to purchase from forward-looking firms. This has increased pressure on consumer packaged goods companies to use more environmentally friendly packaging and provide more transparency around where they source ingredients for products, etc. 

Many global players are having to drastically change their business models to keep up with new expectations and to protect their corporate reputations.

Geopolitical 

After supply chain snarls plagued the global economy coming out of the Coronavirus pandemic, followed by Russia’s invasion of Ukraine in 2022, many firms are increasingly moving production steps back onshore (from abroad). This is particularly true for inputs that are integral to energy and food security, as well as the manufacturing of technology components that present cybersecurity risks (like 5G infrastructure and semiconductor chips). 

Of course, this is occurring against the backdrop of significant regulatory changes, particularly within energy and agriculture (think carbon taxes, etc.), as well as increased scrutiny around procurement practices more generally.

Transition Risks and Financial Analysis

Transitioning to a more sustainable, net zero economy presents considerable challenges for operators, as well as for the financial services firms (investors, lenders, etc.) that provide capital to these businesses. Many companies will experience existential threats during this shift.

As you may have noticed, a big issue for the analyst community is that the concept of a transition risk is notoriously difficult to translate into simple inputs or model assumptions, making them inherently difficult to quantify. 

We explore how to make sense of qualitative factors that impact a business using tools like PESTEL, and then leverage those characteristics into model assumptions, in CFI’s Analyzing Grow Drivers & Business Risks course. 

Additional Resources

• ESG Integration & Financial Analysis Course
• Carbon Markets
• Impact Investing
• Greenwashing
• See all ESG resources