This is one part of the Global Investment Outlook series. The other sections are focussed on Prosperity and Inclusive growth.
In order to minimise the potentially devasting physical impacts of climate change, long-term structural changes are required that will influence the value of physical and financial assets, revenues, royalties, tax flows and jobs. The risk of value reductions brought about by the transformation to a low carbon economy is often referred to as “climate transition risk”.
Three strategic considerations for financial institutions
Reducing the financial risk resulting from climate change requires managing climate transition risk and opportunity, using finance as a catalyst, and encouraging market reform.
- Measure climate risks and develop new tools and financial instruments to help price and mitigate risk
- Real world pricing of transition risk will improve investment decisions, reduce the concentration of risk, and increase economic resilience
- New financing solutions can overcome investment barriers and reduce the cost of capital
- Financial innovation includes new financial instruments, portfolio designs or hedging products
- Build markets tailored to low-carbon solutions and create better incentives
- By building climate aligned portfolios, businesses are incentivised to make investments that align with and accelerate the transition
Risk measurement is an essential first step towards opening opportunities to manage climate transition risk
Account for four characteristics when measuring the impact of climate transition risks and opportunities on financial investments, assessing the economic impact at the sovereign country level, or applying strategic risk evaluation tools to help corporates.
Risks materialise at the micro level driven by macro forces
- Measuring transition risk requires a hybrid approach to understand how macro changes will affect the value of individual assets
Risks are often driven by non-linear, structural change
Risks depend on the timing and path of the transition
- Incorporate multiple scenarios to evaluate the largest structural changes and the likely paths that a transition could take given the uncertainties around, and responses to, politics, policy, technology, and consumer and investor behaviour; the most likely transition paths are disorganised.
Risk transfer between stakeholders
- Valuation needs to map how risk flows at a national level, including impact on sovereign balance sheets, financial system stability, consumers, taxpayers, and workers
Read : Risks from disorganised climate transitions
Measurement of transition risk should depend on the nature of the business, industry, and risk
Scenarios should identify the effects of the transition on demand, costs or margins, pricing, investment needs, and the valuation of assets. Then assess how changes in asset value will be affected by policy, contracts, ownership, financing, and tax regimes, which allocate this change in asset value between equity owners, creditors, governments, and consumers. This is called Climate Transition Value at Risk (CVaR).
