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The Big Question: What is the most effective way of reducing exposure to transition risk? With Joseph Noss, senior director in the WTW Climate and Resilience Hub

09.03.23 The Big Question

A phrase that crops up with increasing frequency these days is that of ‘transition risk’. Broadly speaking, transition risks are business-related risks that follow societal and economic shifts toward a low-carbon and more climate-friendly future. These risks can include policy and regulatory risks, technological risks, market risks, reputational risks, and legal risks.

What this means in practice for (re)insurers can really be drilled down into two sub-sectors. Firstly, transition risk is being driven by investors seeking a greater level of transparency from companies so that they can reduce their exposure to industries that are heavily dependent on fossil fuels and other sources of greenhouse gases. In addition, regulatory bodies are increasingly concerned as to the potential risk of falls in asset values for general insurer investments, driven by the rapid decarbonisation of the economy.

In this week’s Big Question, we look at this increasingly important emerging risk for the market, which I’m sure, will only grow in importance as we continue on our journey to net-zero. Clearly, as far as carriers are concerned, there is growing impetus to move away from insuring certain industries, which is itself being driven by a heady cocktail of activism and policy change. Managing this risk will be crucial for carriers in the years ahead, as WTW’s Joseph Noss – previously a senior official at the Bank of England and the G20 Financial Stability Board – explains.

Ian Summers, Global Business Leader, AdvantageGo

“The risks that climate change poses to the global economy are becoming increasingly severe,” says Noss. “There is widespread recognition that financial firms and authorities need to develop data and tools to measure and manage the implications of climate change. These include transition risk – the risk of decline in the asset values due to changes in consumer preferences, technology and official-sector policy designed to foster the transition to net-zero emissions.”

He adds that some financial institutions have started to reduce their exposure to emissions-intensive assets and firms: “This does not, however, necessarily reduce their exposure to transition risk. This is partly due to shortcomings of emissions as a measure of individual firms’ transition risk. Emissions tend to be reported on a backward-looking basis, thereby taking little account of steps being taken to reduce future emissions (e.g., steel or cement manufacturers that plan to shift operations towards renewable sources of power). Reported emissions are also subject to systematic gaps and biases.”

“For example, some companies may create very few emissions as part of their own operations (e.g., those in the service sector). However, if they serve customers in high emitting sectors (e.g., providing services to oil companies), they may experience a sharp decline in revenues due to the transition.

What is required, he suggests, is a more robust measure of transition risk on which financial institutions can base their investment decisions. The Climate and Resilience Hub at WTW has developed its own measure of climate transition risk – termed Climate Transition Value-at-Risk (CTVaR). Instead of being based on the cost of firms’ emissions, CTVaR is based on a more robust estimate of the expected future cash flows of an asset or firm under a climate transition scenario minus those expected under a business-as-usual scenario that is consistent with its market price.

This approach, Noss adds, offers the potential to improve the measurement and management of transition risk across both the private and public sectors. Estimating risk at the level of individual assets allows financial institutions to account for the effects of climate transition as part of their investment and expansion plans, including by divesting/avoiding investment projects whose transition risk is large compared to their future profitability. Financial institutions would also be able to manage their individual exposures to transition risk in a manner that supports the transition to net-zero, thereby reducing the exposure of transition risk of the overall financial system.

“Using a tool with these capabilities as a lens through which to measure transition risk might also help ensure that the financial system enables transition to net-zero emissions in the real economy,” he says. “This is because some firms that currently have high emissions may plan to reduce emissions in future (e.g., those in the steel or cement industries). Others might be supporting innovation that will reduce future emissions in hard-to-abate sectors (e.g., mining lithium to accelerate the electrification of transportation).”

“Going forward, climate transition risk measurement should also have the potential to help assess transition risks to sovereigns and public-sector financial institutions, such as central banks and sovereign wealth funds. If left unmanaged, transition risks have the potential to negatively affect sovereign finances via their impact on investment, economic growth and tax revenues. Governments in jurisdictions that are particularly exposed to transition risks – for example, where economies are reliant on the export of certain commodities – may face pressure to intervene to support stricken industries.”

“It will also be vitally important to be able to capture some of the unintended consequences of transition to net-zero. There is a growing risk of imbalance between the pace of growth in investment in low emissions products and services. One concern is that the reduction of investment in high emitting sectors (including fossil fuels) could outpace growth in alternative sources of energy. This could lead to acute energy shortages, as well as high and volatile commodity prices. Such a ‘disorganised’ transition could have a destabilising effect on the financial system and macroeconomy. “

Noss adds that, by capturing the effect of transition on individual sectors, a robust methodology would be able to capture the risk of such a mismatch between investment in, and demand for, low-emissions products and services and how this might vary across different transition scenarios. Crucially, he suggests, this will enable the flow of investment to firms supporting, and likely to profit from the transition, thereby driving the global transition to lower emissions in the real economy.

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