Transition risks – does transformation cause risks?

No one needs to be convinced that climate change affects us on a daily basis. Just open any Internet portal and information about the occurrence of violent weather events appears avalanche by avalanche. There are days, like June 29 of this year, when as many as 12 news stories in the top 15 on the popular portal were about natural disasters – frozen water pipes in Peru or a violent storm disrupting a match at EURO 2024. Such phenomena are nothing more than the materialization of climate risks, and a real cost to businesses. This is something the financial sector – banks or insurers – pays close attention to. What is and what does transition risk depend on? And what does it have to do with climate change?

Types of climate risk

Climate risks are, on the one hand, catastrophic weather events and their derivatives, such as flooding, drought and landslides. We call them physical risks, which we wrote about earlier in the Water Matters.

In addition to physical, climate risk includes transition risk, known as transition risk. It is much more difficult to capture than physical risk, as it relates to the impacts associated with changes leading to a sustainable economy, including zero-carbon. It can be related to changes in the preferences of increasingly informed consumers, but also to uncertainty about the company’s direction, its costs or the type of services it offers.

The drivers of transition risk are issues:

• technological,
• reputation,
• marketable,
• regulatory.

What does the risk of transition depend on?

Transition risk can result from regulatory changes, such as the European Green Deal. For example, legislation to end the production of fossil-fuel cars by 2035. have a very strong impact on the automotive industry. So do the rest of the Clean Transportation Zones, which are becoming increasingly common in cities. This does not mean the disappearance of combustion cars in the next 11 years, but only pressure for faster behavioral changes, both by manufacturers and drivers.

Changes in the market also affect transition risk. Pressure is growing to replace services and products with those with a smaller carbon footprint. Failure to keep up with the market can cause a decline in customer interest. On the other hand, there is growing competitive rivalry in certain areas not only for customers, but also for critical resources, such as rare earth minerals, needed to build low-carbon technologies. The market also shapes the price of greenhouse gas emissions allowances.

Another factor generating transition risk is technological change. The transformation of the economy is associated with the rapid development of new technologies. At the start, it is not always clear which ones will be profitable or further developed. Thus, it may turn out that the solution the company bet on turned out to be wrong. Investing in new, less carbon-intensive technologies can also be more costly.

Reputational issues, which are extremely difficult to measure, are also a risk of transition. Falling behind in the transformation can cause consumers or business partners to turn away. Making false claims about the sustainability of a product or company’s operations has a similar effect. Such practices are collectively known as greenwashing, or in more Polish terms, environmentalism. Unfounded declarations involve reputational damage, as was the case in recent weeks with the Warsaw Marathon Foundation’s withdrawal from cooperation with 4F.

The decision was prompted by false assurances from a sportswear manufacturer about where the shirts were produced. Despite initial declarations, 4F has not delivered products sewn in Poland, but outside the European Union. Reputational risks sometimes result in consumer boycotts. However, the question of the effectiveness of such measures is difficult to answer.

The factors shaping the risk of transition intersect. The prices of_CO2 emission allowances, on the one hand, are related to the technologies used by companies, and on the other hand, they are strongly formally regulated at the EU level. A similar relationship binds market demand for energy-efficient buildings to lower their operating costs with rising energy or gas prices. Market expectations are reinforced at the European level by the Energy Efficiency Directive.

When the risk of transition happens

Climate risk, like any other risk, affects the operation of a business. It can cause an increase in costs, a decrease in demand for products and services, slower growth of the company, a decrease in the value of real estate, buildings, machinery and other equipment – fixed assets.

The result of the materialization of climate risks, for example, are the so-called “climate risks. stranded assets whose valuation has fallen so that they have lost their market value. An example of such assets, in the absence of remedial action, will be mines in the future.

The impact of climate on the value of companies can be significant. What distinguishes this type of risk is the time perspective. We cannot always assess the scale, severity and irreversibility of the occurrence of climate change impacts only in the short term of a few years. This applies to both physical risk and transition. The fact that many enterprises are currently located in an area that is not at risk of flooding does not mean that in 2040. will continue to do so. In Poland, the distribution of precipitation over time changes significantly.

The same is true for transition risk. For example, the fact that the buildings currently managed by a particular company are finding tenants seamlessly does not mean that in some time, as energy efficiency requirements tighten, this situation will not change. This will translate into revenue for companies. Transition risk will increase operating costs (e.g., with higher raw material prices), as well as decrease goodwill.

Banks look at the impact of transition risk on borrowers in their evaluations. There is a lot of pressure on financial institutions to manage climate risk in the next few years as well when securing capital to cover ESG risks.

Transition risk management

Like other risks, those associated with transformation can be managed. To this end, it is useful to keep track of market trends, developing technologies and regulatory developments. On this basis, climate risk can be integrated into a company’s business strategy. There is no single path for a company to grow with transition risk. It is possible, for example, to monetize transition-related technologies, such as gas, for as long as possible and invest the excess income in business conversion.

On the other hand, you can invest in the delivery of already sustainable services and thus gain a market advantage over your competitors. The choice of path should take into account not only the risk of transition, but also traditional financial and economic analyses. This is an opportunity of sorts to be seized in the future. Just don’t lose sight of the longer-than-a-few-year financial outlook.