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Net Zero: How to navigate transition risk

November 4, 2022

What is climate transition risk, how do you measure it and how should investors take action? Sarah Hopkins, Head of Equity Solutions, and Matt Scott, Senior Director in the Climate and Resilience Hub, help explain this crucial part of an investors net zero journey.
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Climate Risk and Resilience|ESG In Sight
Net Zero: How to navigate transition risk

Video transcript

Net Zero: How to navigate transition risk

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SPEAKER 1: Welcome to WTW's ESG In Sight Spotlight Series.

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SARAH HOPKINS: Hello, and welcome to this short video where we're going to be talking about climate transition and what that risk means for the financial system. This video is part of the net zero session, so a wider set of videos. So please check out some of those other videos as well if you find this interesting.

I'm Sarah Hopkins. I'm head of equity solutions at Willis Towers Watson, and I'm here with my colleague, Matt Scott, who's a senior director in the Climate Resilience Hub and an expert in all things transition risk. So before we get into this short video on transition risk, there's going to be three parts.

We're going to talk a little bit about what transition risk is, then we're going to move on to how we can measure it and price it, and then finally, just think a little bit about what investors in the financial system can do to take action when thinking about this risk over time. So before we get too technical, Matt, can I just bring you in to talk about what we actually mean when we say transition risk? What does that mean for investors?

MATT SCOTT: Yeah. What is transition risk? That's a great question, and one that's quite meaningful to me, actually. I've been thinking about these things for quite some time, having been at the Bank of England and helped to define the initial climate related risk framework, physical transition, and liability risks that came out around 2015 in the time of Governor Carney's famous tragedy of the tragedy of the horizon speech.

And I think really transition risk essentially is the possible change in asset prices that could result from the transition to net zero, so a whole bunch of structural changes that are underway, and therefore those can impact upon asset prices. And that's really what we're trying to measure within financial markets.

SARAH HOPKINS: OK. And would you say there's broad definition-- of broad agreement, sorry, on that definition? And is this one of the biggest risks that investors need to be thinking about when we're thinking about climate change?

MATT SCOTT: Yeah. I think there is broad agreement roughly around the definition. I mean, I think it's important to reflect the fact that it's not just about risks, it's also about opportunities of the transition as we look to halve emissions by 2030 if we can stay on course to the Paris Agreement.

And I think there is quite an evolving landscape, as I think most investors will be aware in terms of climate at the moment. There's discussion around decarbonization. There's discussion around alignment metrics. But I think the real value of transition risk is, firstly, investors-- just like any other risk-- part of your fiduciary duties is to price risk effectively and also to capture the opportunities of a whole range of different structural changes that are happening in the economy, and the transition is just one of those.

But also importantly, by pricing the risk effectively, we can then allocate capital efficiently. So for investors who are really looking to have a real-world impact and to help the economy as a whole get to net zero, then it's the effective pricing of risk that can really help to support an orderly transition. And that's in all of our interests to address the future risks that we're all facing from climate change.

SARAH HOPKINS: Yeah. I think it makes a lot of sense, and you can think about individual companies or individual businesses. And clearly, there's going to need to be significant changes to those as we go from where we are today to what is a net zero world. And in my role, I'm spending a lot of time thinking about how we can help clients manage their portfolios to take account of these risks and opportunities.

But I think what's quite difficult for people to think about is measuring that risk over time as there's going to need to be huge, system-wide structural changes that feel like, for some industries, they're quite far away. For some industries, they're quite nearby. How do we start to think about measuring that so that we can start managing it?

MATT SCOTT: Yeah. I think that's right, Sarah. And I think probably the first thing to acknowledge is that it's difficult to do that. The transition is complex-- many sectors and many different countries. And to price that effectively, we really need to move beyond just quite simple measures of carbon emissions. And perhaps we can talk a little bit more that as we go forward.

And that's why we've been investing significantly in this over in the climate resilience urban across the firm for many years. In fact, one of the firms that we brought in-- a company that-- an organization from the climate policy initiative I had the pleasure of working with almost a decade ago at the Bank of England when we were looking at how to do this effectively.

And over the space of close to a decade, the energy finance team now the team here at Willis Towers Watson has spent considerable amount of time really figuring out what the many different structural changes of the transition impact upon transition pri-- impact upon asset prices.

So for example, modeling the impact of over 30 different commodities and understanding what the implications of that would be and then looking at close to 500 different climate transition controversies-- everything from shifts in plant-based diets, consumer sentiment shifts, technology shifts, changes in renewable energy into energy storage, as well as regulation.

So really, to price that risk effectively, it really requires quite granular analysis bottom up across different assets, different sectors, and different countries.

SARAH HOPKINS: Yeah. And I think you mentioned there just around emissions and that actually being a backward-looking metric can not necessarily be the right measure of this forward-looking financial risk that we're talking about, thinking about positioning portfolios to take advantage of those forward-looking opportunities.

Can you just talk a little bit about the emissions approach? Because we're seeing that across the industry a lot with lots of low emissions benchmarks or predescribed decarbonization within indices and financial products being built around those. It'd be just interesting to hear a bit more about that.

MATT SCOTT: Yeah, for sure. And I think this is a really key distinction that is becoming more and more apparent, particularly as net zero agendas are set and firms are looking to see how to decarbonize. But in a way, that's not paper decarbonization, a way that is really smart decarbonization that drives the real economy to net zero.

So as we can see from the charts, if we plot carbon emissions against what we feel the difference would be in terms of the impact on asset prices, there's actually very little correlation. And that's because carbon reporting often reflects where you are in the supply chain. So for instance, you can be a quite low reporting carbon company because you're in the service sector, but you may be servicing fossil fuel clients. So you're still quite exposed to transition risks.

Those are the sorts of firms in the bottom left-hand of the chart. On the other hand, you could be relatively high carbon because you're making things or you're digging things up out of the ground, which are high carbon activities, but that may actually be activities that are really useful for the transition, and, therefore, you're well positioned.

So think about mining lithium, think about mining copper, think about manufacturing steel wind turbines. Yeah, these are high carbon activities but are critical for the transition, and they're probably have financial upside. So that's why it's really important really to go beyond carbon, to be forward looking, and to get this granular financial analysis into financial markets so we can drive real-world decarbonization.

SARAH HOPKINS: And that measure that you talked about using all of those different scenarios, changes in taxation, regulation, behavior habits, that measure that you're coming up with there, that financial risk, that's the CTVaR metric that we've been talking about, isn't it?

MATT SCOTT: Exactly. Yeah. So CTVaR is exactly that metric of the financial measure of the impact on the transition, both upside and downside. And that's why we're so excited to be working with clients on that. And I think, Sarah, maybe it's helpful for you to perhaps talk about some of the things that we are doing and what investors can actually do to integrate this into their decision making.

SARAH HOPKINS: Yeah. As I mentioned before, we're spending a lot of time with all different types of clients from corporates and across asset owners and trustees of institutional assets around what they can do in integrating this financial risk into portfolios, and business strategy as well. So if we think about our corporate clients, the CTVaR biometric has been super helpful for them thinking about the different segments of their underlying business.

I think, Matt, you mentioned the granular bottom-up level of this analysis really helps identify different parts of a business that are more or less exposed to the transition risk and where there are opportunities as well. So that helps provide more information, helps provide additional backing for any decisions, reporting to shareholders around changes that you want to make for your strategy to make sure that you're well positioned for the long term.

And when we think about asset managers, everything that asset managers are looking to do is to create robust portfolios across a wide range of risks and opportunities that they see in the market. And I think we think about climate transition risk as just being another of those risks around interest rates, inflation.
All these risks need to be diversified and taken account of. So using a tool like CTVaR could help understand those risks across the whole portfolio. And that's not just applicable in equity markets. I know we've talked about companies, but we have the analysis, and are able to do that on fixed income portfolios to really understand where those risks are.

And I think the final area-- really, you've talked about it as well again-- on net zero commitments that are being made, lots of institutional funds are making net zero commitments, and how can you use CTVaR help with that. And although this is not based on emissions and not backward looking, the impact of using this financial risk does actually significantly reduce your emissions because, clearly, some sectors that are high emitters are also not going to be solutions as part of the climate transition.

So using this analysis can really help both make a financial case for taking action, seeking opportunities, improve risk-adjusted returns, but also has the impact of reducing your emissions significantly, which is what lots of reporting and regulations requiring, and also just the direction of travel for reputational risks as well.

So given all of these different ways that we've been starting to think about properly managing this risk, we haven't really touched on how these impacts and the actions that people are taking impact the wider transition. The stuff we talked about so far is quite inwardly focusing-- inwardly focused, focused on what our strategy and how that's going to be impacted by the transition.

Be interesting, Matt, just to hear what you think about this approach, the CTVaR, and what that means for essentially encouraging the transition to happen and thinking more widely, economy wide, about the impact we're having.

MATT SCOTT: Yeah. Certainly very happy to talk to that briefly to finish off. And I think what's happening is that people are getting clearer in terms of what it is they're trying to manage is managing the impact of the climate onto the firm-- which often isn't correlated with carbon emissions at all-- or is it actually managing the firm's impact on the climate, which is also really important.

But I think going back to-- so I guess Mark Carney's 2015 speech really that it's the effective pricing of risk that can help asset prices to adjust and, therefore, support an orderly transition, and that starts to address some of the systemic biases and gaps that we find in carbon reporting.

So the fact that you can be low carbon but actually enabling a high carbon economy if you're selling services into the fossil fuel sector, or you can be high carbon but enabling a low carbon economy if you're coming up with a innovation that's needed in hard to abate sectors-- steel and cement-- that will help to accelerate the transition.

So it's by pricing the risk effectively that we can make that link from the financial system into the real economy that can help then drive the whole economy to net zero rather than just individual portfolios. So I think-- yeah, really excited to see this come to market and to be part of the efforts.

SARAH HOPKINS: Yeah. I think probably just one final question for me is that corporates, asset owners, asset managers got huge amounts of things to think about. Sometimes it feels like using an emissions proxy. Gets you a bit of the way there, but it's a bit of an easy fix. And is when you've got such a limited governance budget for all the things you need to think about.

It maybe is an easy answer. Is there a way that we can think about this to help people just try and think about this in, I guess, a smarter way-- think about decarbonization in a smarter way.

MATT SCOTT: Yeah. Certainly. And I think smart decarbonization is really one way where you can work towards those cash flow analysis and build upon the scenarios that we know exist and integrate that into decision making. So really by turning physics into finance, we can make sure we manage the climate challenge.

SARAH HOPKINS: OK. Great. Thank you, Matt. I appreciate your time. And thank you, everybody, for sticking with us through that topic. We've been Sarah and Matt. Any questions that you have, please follow up with us directly, and also please do check out the other videos in this net zero series. Thank you very much.

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