Understanding and Mitigating Transition Risks
Understanding and Mitigating Transition Risks:
Good afternoon everyone. I thank ESG Risk Management for giving me an opportunity to share my thoughts on this important topic of — Understanding and mitigating transition risk. Also, I would like to say the views shared here are my personal views only.
Today, Financial institutions are focused on transitioning their portfolio financed emissions to net zero by 2050 in alignment with Paris agreement.
This transition is fraught with risks and deeply uncertain. We will look at the transition risk drivers and the landscape and a framework to manage these drivers and navigate the net zero transition.
Climate change impacts real economy and financial system due to adverse consequences of rising temperature. Linkage between Anthropogenic emissions and rising temperatures has been established scientifically per IPCC1 recent reports.
To accomplish a Net Zero Future, we have to
· Reduce green house gas emissions by at least 45 per cent by 2030; and to net zero by 2050.
Many countries and institutions have pledged to net zero emissions either before 2050 or after. To reduce the emission we need to rewire the fossil fuel based energy system. There are risks and opportunities arising from this transition. Therefore, we need to understand what are these transition risk drivers and how financial risks manifest.
Transition risks: Focus of this conversation
Climate risk is primarily transmitted through two different channels, i.e., physical risk, and transition risk. Physical risk emanates from the interactions of climate-related hazards with corporate assets resulting in financial losses.
Transition risk is associated with the uncertain financial impacts that could result from transitioning into a low-carbon economy.
There are 4 specific drivers of this transition
· Policy changes associated with the timeline to phase out the usage of fossil fuels such as coal, price on Carbon emissions and other industry specific regulations.
· Technological developments resulting in cost of Renewables falling below fossil fuels, industrialization of Hydrogen as an alternative fuel and growth in usage of CCS
· Changes in consumer preference for Electric cars and investors preference for green assets.
· Also, Reputational/liability risks can be a standalone climate risk or can be considered part of the Transition risk.
These transition risk drivers will impact the fossil fuel industry, gasoline-fueled automobile manufacturers, and electric utilities, among others, leading to significant financial implications for their creditors and shareholders — including banks and financial services companies.
Transition risk drivers impact to financial performance is manifested through finacial risks, such as credit, market, counterparty, operational, liquidity and funding risks.
For instance, Transitions to lower-carbon economies could make large proportion of fossil fuel reserves uneconomical due to policy changes, creating so-called “stranded assets” that are no longer able to earn an economic return. As a result increasing their credit risk. Similarly, through economic transmission channels other financial risks manifest.
Requiring response from Regulators and financial institutions to navigate the transition landscape.
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Transition risk landscape: Industry, Governments and regulators are responding on multiple fronts to accelerate the net zero transition. Establishing forums to collaborate and understand how to coordinate actions to deliver the net zero transition.
Regulatory requirements for climate related risks are evolving from voluntary TCFD4 disclosures towards more prescriptive rule based.
Regulators so far are focused in the areas including
· Climate risk management and stress testing
· Reporting and disclosures.
· Carbon trading and Emission management
· Climate finance product Taxonomies
Recently, SEC9 and ISSB sent out its proposal for consultation focused on enhancing and standardization of climate related disclosures for investors.
SEC proposal, require various companies to provide information of climate related risks that may impact business and operations in their public reports. These requirements were in part modeled on TCFD and GHG emission protocols. This information should include, governance, business strategy, Transition plans, risk management and emission metrics disclosures.
Additionally, ISSB, unlike SEC’s proposal requires Scope 3 emissions to be disclosed and the target metrics to be compared with latest international agreements on climate guidance.
UK is leading an effort to develop elements of a good transition plan and to mandate the transition plans at the firm level. EU has been leading from the front by issuing rules around Climate products taxonomy.
Regulators and Central banks have started engaging financial institutions to understand the climate related risks. They have implemented stress testing programs and Some are underway as we speak.
All of these actions by regulators have kickstarted financial institutions to respond by implementing transition risk management programs to understand climate risks.
To manage transition risks from their financed emissions,
· Net zero methodology is established, it includes identification of scope 1,2 and 3 emissions and metrics, establishment of baseline targets, development of strategies to achieve emission reductions through client engagement in high emission sectors.
· Climate Risk management governance framework for Identification, measurement and management of transition risks in firm’s 3 lines of defense frame work is becoming a common practice, across financial institutions.
· Risks and opportunity identification area is evolving rapidly for clients in Energy, utilities, transportation and industry sectors who are witnessing emerging risks from the transition risk drivers. Financial institutions are developing analytical tools, frameworks and capabilities to measure and quantify the transition risks for these financed emissions.
· Stress testing: Regulators are pursuing stress testing (top down or bottom up) programs to assess the transition risks and how vulnerable are banks to these risks. Financial institutions are implementing climate stress testing programs in multiple jurisdictions.
· Lastly, collaboration within the industry, regulators through their public affairs is actively coordinated to highlight areas that require clarity in the policy to enable transition financing.
At this time, In fossil fuel sector financing globally around $742 billion dollars3 subject to losses in net zero transition impacting the stability of financial system and climate change goals.
Actions by regulators, financial institutions are necessitating need for understanding and enabling the development of key components in performing transition risk analysis.
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a) Transition Risk Framework:
Financial institutions with exposure to the energy and utilities sectors face the starkest challenges in navigating the transition. These sectors have long had the difficulty of trying to plan for long-term capital assets in an uncertain policy and resources landscape.
IEA published a pathway to net zero by identifying key milestones for various sectors. Now this clearly indicates the speed and level of transition to happen. Corporations within energy and utility sectors are leveraging this information and actively working on their decarbonization strategies.
According GFANZ3 analysis public and private investments of USD $ 125 trillion is flowing to low carbon energy supply to attain net zero by 2050. Also, approximately 32 T across high emission sectors to implement decarbonization strategies by 2030. On a good note IPCC confirmed that there are technology options available — Renewables, CCS, Hydrogen and alternative fuels to reduce emissions half by 2030.
However, there are some challenges to capture this scale of investment and opportunity. Also achieving portfolio financed emission reduction targets for Financial institutions
is easier said than done due to complexities involved with
· Engagement with clients in understanding their decarbonization plan.
· Collaboration with multiple stakeholders from regulators, and industry.
· Development of clear mandate with the key internal stakeholders.
This requires a framework comprising — Transition Risk Strategy / Scenarios /and Methodologies to understand and mitigate the risks.
Another challenge comes from lack of good quality decision-useful information for assessment of transition risks to finance investments of this scale for climate-related opportunities. This requires a clear decarbonization plan with good quality data.
Transition Risk Strategy
A clear vision to develop a transition risk strategy to inform the internal decision-making processes. This will enable operationalizing the Transition risk management across the enterprise with a clear-cut understanding of its implications.
Also, As a business imperative to gain competitive advantage a holistic approach to identify, measure, and manage transition risk drivers that can impact their prudential risks and financial performance should be part of this strategy.
This strategy should involve a set of forward-looking tactical operations to integrate the transition risk management into the enterprise risk management architecture. with a clear definition and ownership of Transition risk activities across the organization.
This integration involves, People, Due to its unique nature, Transition risk management can pose a set of challenges to bring in people with diverse skillsets including various areas of climate science, financial risk, engineering technologies, and energy markets. Holistic training programs for current staff, and a hiring strategy for new employees is imperative.
Next, Processes, involve an effective design of policies and procedures that are needed to integrate the transition risk into business decisions and operations across the enterprise. They should address three areas at enterprise level, as follows: (i) the corporate strategy in addressing the impacts of transition risk in the existing and future assets and financial positions of the institution; (ii) the compliance framework for mandated climate risk regulations including stress testing; (iii) corporate strategy in monetizing the transition risk-related opportunities in the markets.
The design of these policies and procedures should be done in consultation with the lines of business, and should be evaluated by internal or external auditors.
Once the policies and procedures for transition risk management framework is approved by the board of directors, implementation of the processes should be next logical step.
This includes, Development of in-house climate datasets, Public and vendor data and financed emission’s sectoral Decarbonization plans; Scenarios analysis capabilities; integrated assessment of physical and transition risks; developing quantification methodologies
This will support an integrated climate risk management framework to identify, measure, manage, and monitor the climate risk embedded in various functions across the organization.
We will take each of these items now.
Decarbonization Plan– Financed Emissions
Firms are conducting transition risk assessments based of publicly available information, vendor data and products to analyze credit risk. This analysis is not sufficient to understand impact of transition risk drivers. We need a richer set of information. SEC/ISSB and UK regulators are figuring out exactly this problem and developing rules through discussions with industry.
Decarbonization plan is a time-bound action plan that clearly outlines how an organization will achieve its strategy to pivot its existing assets, operations and entire business model towards a trajectory that aligns with the net zero targets. some of the key elements of the plan include
§ End to End planned roadmap and the phasing of the specific actions required to reach net zero (e.g. technologies deployed, energy efficiency measures taken)
§ Carbon credits and offsets — type of credits used, price applied, verification.
§ Investments: low-carbon capital investments, Retirement plans for high-emitting corporate assets.
§ Details including the potential financial impact and the costs to respond to these risks, based on Scenario Analysis and internal carbon pricing.
· There are some challenges need to be addressed in the development of transition plans. CDP5 survey highlighted that only a 3rd of organizations out of 4800 have developed low carbon transition plans.
· A recent study confirmed the emission data provided by various firms is not comparable and highly inconsistent.
· Managing the transition risk from potential mismatch between Financial institutions Emission reduction targets and Client’s decarbonization strategies.
· Good Quality Transition plans face another challenge of good quality data.
This weak disclosure amongst organizations signals a need for better information on plans as part of transition risk management.
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Decarbonization pathways are unique to each institution. The speed and shape of these pathways will power risk and returns in coming years and companies and investors need to navigate this. To do so, they must develop informed views about the evolution of transition risk drivers such as climate policy, societal preferences and technological innovation;
Each organization in a given sector should manage its financial performance by effectively understanding the transition risk related pathways. This includes the size and timing of mismatches in supply and demand between and within sectors and the timeframe and shape of the key energy transitions.
All of this requires an understanding of the Transition scenario design considerations. Which is our next topic.
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b) Transition scenarios Analysis: Scenarios have been in use in Capital stress testing programs and these days they are becoming increasingly common among Climate stress testing exercises.
NGFS2 Scenarios provide a common and consistent framework to explore the impact of climate change and climate policy on business models, financial performance. Most financial institutions and central banks are leveraging them as starting point in their scenario analysis. Also, scenario projections available from IEA6 and others. These scenarios are often at global level and required to be downscaled for individual local use purpose.
NGFS scenarios come with variety of flavors depending on the magnitude and impact of low carbon transition activities. If all sectors adopt low carbon policies and implement them in an orderly fashion then temperature rise will be limited to 1.5. However, at this time, there is only 50% chance to limit temperature per update from IPCC. Now there are other scenario possibilities that could be realized. They will have different order and magnitude of transition risks impacting financial performance. Currently in various supervisory regulatory examinations we see delayed transition and hot house world scenarios are being used to assess exposure to transition risks. Additionally, for analyzing transition scenarios we need to consider, possibilities such as a utility company phasing out coal, transportation company going electric and natural gas production with CCS technology. Each of these need to be analyzed with specific circumstances of the business. Hence, Scenarios should be considered based on their suitability and fit for purpose.
For instance,
a) Downside scenario: The ‘Disorderly’ adjustment scenario is likely to result in a high degree of transition risk, given the sharp and abrupt adjustment required to limit the increase in temperature to 2C. For risk management purposes, this scenario can help evaluate the impact of transition on valuations of assets and collateral and the default risk of loans and to calibrate risk appetite and explore the actions necessary to manage risk and alter the risk profile of the institution.
b) Alignment scenario: Firms are making commitments about decarbonising portfolios and developing business plans. Alignment scenarios could be used to identify appropriate business strategies and measure the achievability of plans to build sustainable businesses.
Under each of the scenarios we can look at the Transition risk input variables and take necessary additional actions to realign the business strategies
Transition Risk input Variables evolution across various scenarios will help us in understanding the transition risks for a given sector and hence to the portfolio.
For Energy sector that has to unwind coal and yet continue with Natural gas face transition risk drivers — Policy guidance and technological developments. This can be analyzed with Transition risk input variables — — Carbon price and carbon remove technologies evolution.
1) Carbon emission prices — Carbon price to the emissions is a key variable in the net zero transition. Price of carbon is being determined either in the form of Carbon tax or by emission traded price. Within the scenarios it is represented as a proxy to the policy intensity. In the NGFS scenarios it is expected that price of carbon to be around $160 by the end of this decade to limit the temperature at 1.5. Currently it is trading close to $100. Higher carbon price will help in making carbon removal technologies economical in conjunction with regulatory support. For instance, production of natural gas with CCS will become economical.
2) Carbon removal Technologies: Net zero transition to limit temperature to 1.5 is hinged on availability of carbon removal technologies. NGFS scenarios provides this feature to assess the transition pathways.
3) Energy Investments flows to add renewable infrastructure (including alternative fuels) and reduction on fossil fuel infrastructure is a key transition risk variable. We are aware, renewables (solar) prices have come down significantly, reduction in coal plants is underway in majority of economies. In 2050 IEA net zero scenario — Renewables (Wind /solar and others) are projected to contribute 68% of the global energy needs. However, renewable energy adoption rates are slower due to lack of government policy guidance. Similarly, for some countries displacing coal is becoming economically expensive.
These input variables will become key to perform the transition risk analysis.
One more driver of transition risks is physical risks themselves.
c) Integrating the physical and Transition climate risks. Climate risks — both physical and Transition do not manifest in isolation. Most of the current practice is around assessing these risks independently. However, NGFS has recognized this and incorporated in their scenarios a feature for impact of physical risks into Transition risks. Their approach has been to incorporate the physical risk effects such as temperature and productivity effects and adjust the carbon price. The impact of physical risks on each transition path also differ due to idiosyncratic characteristics of each sector. This requires more granular assessment at sector and location level. Also, the impact manifests in the form of direct impact to the transition related investments (infrastructure) and indirect effects from impact to other resources including natural resources and supply chain.
For instance, in the energy sector decarbonization transition pathway relies on reducing fossil fuel usage. it is not that simple to substitute away from using coal and natural gas to support our economic activity. Hence we need carbon capture technologies to coexist with the power production with fossil fuels. It is understood that these CCS technologies water intake is higher and impact to availability to water will impact the carbon capture thus impacting the transition risks. This integrated assessment should become part of the transition risk analysis.
Once we have understood what kind of scenarios, transition risk input variables and its interplay our focus should go to measuring these risks. This require quantification methodologies.
d) Quantification methodologies: IAMs and Stress testing approaches.
Models and methodologies used in Transition risk analysis are catering to a variety of needs.
To begin, financial institutions have adopted IAMs more recently due to their ability to describe the interactions between economic activity, GHG emissions and climate change. IAMs provide global coverage, have long time horizons and give adequate details on mitigation pathways that provide high-level overviews of tradeoffs and constraints.
These models are utilized by NGFS in their scenario design to project physical and transition risk input variables
Some commonly used IAMs are open source and there are others that require licensing.
From Climate risk to Macro-economic and then Sector level analysis is performed. In this case, the transition risk input variables such as Carbon price, Energy investments and Carbon removal technologies availability variables will become inputs at given sector level and organization within the sector.
Importantly, as part of the transition risk assessment, how these transition risk input variables will be impacting a firm’s financial position (cashflows, revenues and balance sheet) and helping them to define the strategies to be modeled. This analysis is highly dependent on the corporate decarbonization plans, balance sheet and financial statements information.
Financial institutions, using the financial models to produce credit risk parameters (PD/LGD/EAD) to manage their exposures to transition risks.
Overall, These models can be used in conducting Loan level analysis on impact of transition risk drivers.
Model risk management7 should understand how Transition risk assessment models are fit for given purpose. Climate models have their own set of challenges. One of them being that there is deep uncertainty associated with Climate risk models. Deep uncertainty usually involves decisions that should be made over time in dynamic interaction with the system. For climate risk models there are many plausible and even “unknown” system models and actual outcomes. Therefore, Current model risk management frameworks should be adapted to climate risk models. It should take into consideration some of the following items.
1) Assumptions: For transition risk assumptions on the policy changes (carbon price), technology evolution (Carbon removal technologies and energy investments) and socioeconomic changes (EV cars) should be tested through external discussions with lines of business, risk management, compliance and internal audit functions.
2) Interconnectivity: Inherent complexity and novelty of application of climate-related methodologies such as IAMs that combine multiple component interactions to portfolio exposures, will test the limits of conceptual soundness evaluation or fit-for-purpose assessments
Enterprise level approach:
1) Work with the enterprise risk management (ERM) team to develop an integrated risk management framework for transition risk analysis, where credit, market, liquidity and operational risk functions are aligned together with climate goals of financial institutions. That will help evaluate the validity and degree of uncertainty of model outcomes at the firm level.
2) Internal audit to partner and provide independent view on the transition risk management.
3) Model methodologies should evolve and contribute to the successful net zero transition similar to their contributions to Stress testing programs (Capital).
Conclusion: Net Zero transition is happening and market participants are focused on having a view on its evolution. This requires regulators providing a strong unambiguous policy guidance and Financial institutions embedding the transition risk management in their organization risk management frameworks.
On this note. Thank you all for taking time and listening.
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