What is transition risk and how to manage it?

Where does the term come from? 

On 6th April, 2018, Mark Carney gave a speech to the International Climate Risk Conference for Supervisors in Amsterdam, Netherlands. He titled it “A Transition in Thinking and Action” and used the opportunity to define the major risks linked to climate change. The increased risks from natural disasters and adverse weather events he termed “Physical Risk” but he also coined the term “Transition Risk” to describe a new category of challenges facing industry. 

These transition risks are business related risks that come with societal and economic shifts toward a climate friendly, low-carbon future. The risks include policy and regulatory risks associated with climate change, as well as technological and innovation risks. These are all risks that businesses need to account for as the government’s low-carbon agenda becomes increasingly aggressive and creates both capital and operational consequences for businesses. The implications of transition risks for business are still relatively unknown as most jurisdictions have yet to implement the climate policies needed on a large scale. With a host of legislation already in the pipeline, however, and governments legally committed to Net Zero by 2050, these risks are inevitable.

How is it different from physical risks? 

Transition risk is related to the need to transition industry regulators to reduce carbon emissions. Whilst physical risk refers to the more direct effects of climate change, including severe weather events such as flooding, droughts and storms, transition risk refers to the change in industry that governments will deliver as they seek to balance the scales. 

Transition risk drivers 

Transition risk drivers cover the regulatory changes required to create a low carbon, Net Zero economy. This includes changes in market dynamics as consumers demand Net Zero initiatives and products from the brands they buy from, voting with their wallets. It also includes investors and market reactions as the value of assets reliant on carbon emissions is threatened by changing government policies and consumer attitudes. In the medium term, these risks could also come from technological changes which supersede legacy business models and approaches.. Lastly, it covers the legal risk, including the threat of litigation, if businesses continue to act in a way that threatens Net Zero.

Managing transition risk in the residential lending sector

Transition risk is worst for financial institutions that have large exposure to GHG (greenhouse gas) emitting firms as well as limited flexibility to adjust their exposure in time. The built environment is one of the riskier areas for lenders, with residential property accounting for a fifth of all UK emissions and a lot of incoming legislation that’s designed to prompt the private sector to take action to reduce those emissions. 

This means that lenders need to support their customers to reduce household emissions on a large scale. Kamma estimates that, to hit the government proposed target of an average EER C amongst mortgaged portfolios, lenders will need to provide £48.3 billion in new funding. 

The first step, as with any new risk, is to quantify the size of it. For lenders with patchy property data this means closing blind spots through the acquisition of new datasets and high grade address-matching. Supported by more accurate and precise data, these lenders can then categorise and segment properties based on the size of risk, affordability and the support required for customers to reduce property emissions. For some lenders, this will simply mean supporting the education and behaviour change of their customers, for others it may mean funding to support home improvements. 

With lenders trying to establish their green credentials and markets starting to recognise green assets with a “greenium” the stakes have never been higher. Lenders with access to state of the art property data are able to make more informed decisions at every stage of this process, and are less likely to have their financial stability disturbed, all whilst delivering competitive advantage in the market of tomorrow.