What is transition risk and how can today’s organizations tackle it?

Transition risk is a recognized challenge for today's organizations. It's widely agreed that the corporate world needs to tackle climate change by adopting models with reduced environmental damage. But managing the transition to the low-carbon economy is not without its risks.

In an era of increased imperatives around climate-related and ESG reporting and growing pressure on companies to adopt ESG-led approaches, businesses in all sectors are keen to reduce their reliance on carbon and evidence their ESG credentials. However, the transition itself is a recognized risk; in a 2020 article, Forbes claimed that ignoring the risks inherent in a transition to low-carbon 'imperils global financial stability' — quite a bold statement.

What is transition risk?

In the context of climate change, transition risk is the risk inherent in changing strategies, policies or investments as society and industry work to reduce its reliance on carbon and impact on the climate.

When it comes to shifting focus to address climate, transition risks might include:

• Changed land-use policies or water conservation practices impacting the agricultural sector
• The costs the energy industry faces in developing low-carbon technologies
• A reduction in the value of investments in carbon-heavy industries
• The requirements of additional regulation and reporting

In the past, much discussion around climate-related risk has focused on the direct and physical risks of climate change. But Forbes cites research by the Financial Stability Board, which puts transition risk on a par with climate risk, threatening financial stability across the economy. Organizations have a compulsion to act.

What types of industry face transition risks?

We might assume that transition risk is something that only impacts heavily polluting sectors. In fact, transition risk is a broader threat that can affect organizations in all industries.

The Bank of England notes that:

Transition risks can occur when moving towards a less polluting, greener economy. Such transitions could mean that some sectors of the economy face big shifts in asset values or higher costs of doing business.

Therefore, the risk isn't confined to businesses that implement — or fail to implement — a transition to a lower-carbon approach. Types of transition risk exist within the broader economy.

For instance, as the Bank of England points out, if government policies worldwide changed in line with the Paris Agreement, two-thirds of the world's known fossil fuel reserves couldn't be burned. As well as affecting energy companies, this might change the value of investments held by banks, insurers or pension funds in coal, oil or gas companies.

The good news is that, as the Task Force on Climate-related Financial Disclosures (TCFD) notes, while changes associated with a transition to a lower-carbon economy 'present significant risk,' they also "create significant opportunities."

Although the impacts of transition risk cannot be ignored, the TCFD believes that companies that tackle transition risk as part of a broader ESG initiative "will be better prepared to mitigate these impacts."

What are the four types of transition risk?

The TCFD groups transition risks into four categories:

1) Policy and legal risk

• Carbon pricing and reporting obligations
• Mandates on and regulation of existing products and services
• Exposure to litigation

2) Technology risk

• Substitution of existing products and services with lower emissions options
• Unsuccessful investment in new technologies

3) Market risk

• Changing consumer behavior
• Uncertainty through market signals
• Increase cost of raw materials

4) Reputation risk

• Shifts in consumer preferences
• Increased stakeholder concern/negative feedback
• Stigmatization of sector

These risks may influence organizational ESG strategy, capital allocation and the time and resource dedicated to ESG metrics and reporting. 4 Steps for Building a Framework to Tackle Transition Risk How do you mitigate transition risks? As we've shown above, it is relatively straightforward to categorize transition risks, and mitigation can be similarly broken down into bite-sized chunks.

1) Take an integrated approach

Addressing transition risk as an integral part of a broader ESG strategy improves your chances of success. If you implement a robust strategy to tackle your environmental, social and governance obligations, transition risks should be identified as part of that process, and mitigating measures put in place.

2) Consider all the impacts

As we've seen, climate transition risk doesn't only impact carbon-reliant sectors. It has knock-on effects for the insurance, investment and other industries, with networks like ClimateWise being set up to tackle the effects in indirectly affected sectors.

Your approach will depend on where in this ecosystem your organization sits and which of the TCFD's four risks are most relevant. Whether it's addressing fundamental changes to your operating model or adapting to the requirements of TCFD reporting, your business needs to identify and prioritize your most crucial transition risks.

3) Build your strategy on robust data

Accurate and reliable data is the crucial foundation of an ESG strategy — but can also be a sticking point. Deloitte believes that data availability is "one of the biggest challenges firms face" regarding transition risk, often because ESG efforts can be spread across teams and business entities, with no central measurement or like-for-like data.

4) Train your board and leadership teams

Setting the tone from the top and ensuring transition risks are thoroughly considered by the board of directors against the organization’s strategy is key. To do this, boards and leadership teams require foundational knowledge on the key policy and legal, technology, market, and reputation risks the organization faces when transitioning to a lower carbon economy. 

The Diligent Institute Climate Leadership Certification provides the essential information modern leaders need to know to effectively oversee climate risk and strategy, including thinking about transition risks in a strategic manner. 

The good news is that as this grows as an area of strategic importance for firms, there are increasingly sophisticated solutions that can deliver the actionable intelligence you need.