However, demand shocks like those seen in 2020 may pale compared to those due to climate change. Physical risks associated with climate change are already evident: more frequent and uncontrollable wildfires, droughts, floods, storms, and rising sea levels. If we are to avoid the catastrophic impacts of climate change, transformation to a low-carbon global economy is essential. But decisions taken today by policymakers, investors, and corporations will determine its speed and effectiveness.
In order to minimise the potentially devasting physical impacts of climate change, long-term structural changes are required that will influence the value of physical and financial assets, revenues, royalties, tax flows and jobs. The risk of value reductions brought about by the transformation to a low carbon economy is often referred to as “climate transition risk”.
Furthermore, climate transition risks can be concentrated, for example, within countries whose economies depend on fossil fuel exports or imports, investment portfolios that own high-carbon assets, or industrial sectors that emit high levels of carbon from their production processes, such as traditional steel manufacturing.
Integrating CPI EF’s transition tools into Climate Quantified™ complements the lead Willis Towers Watson is taking on the physical risks associated with climate and resilience. They provide solutions that can help clients identify these climate transition risks and help manage them more efficiently by:
The growing need for climate transition risk management is clear. But thankfully, there is also growing consensus among government and central banks that, alongside physical risks, climate transition risk could pose a material threat to global financial stability and voluntary initiatives to tackle these issues have started to become mandatory.
From next year, the UK will gradually implement mandatory reporting that aligns with recommendations from the Task Force on Climate-related Financial Disclosures (TCFD) with the goal of economy-wide reporting requirements by 2025. The transparency required for climate-related financial risks will then be in line with other disclosures of material risks required by regulation for the benefit of investors, who need good information in order to allocate capital efficiently.
However, shining a light on this information is no simple task. In recent years, many analysts have attempted to model the impact of these transitions by measuring the effect of carbon prices on asset valuations. Unfortunately, this simplistic analytical device does not stand up to scrutiny for several reasons that make the results almost meaningless to those seeking to measure and manage risk.
Carbon prices do not feed directly into the asset valuations as one would hope. In some industries – those that have inelastic demand or those that are regulated – the additional carbon price would be passed through to consumers via higher prices, with no impact on the asset’s volumes or margins. For example, oil demand is relatively inelastic compared to expected carbon prices, such that carbon prices several multiples of what is currently being contemplated would be required to have a sizeable impact on the short-term demand for oil. In other cases, particularly where low-carbon alternatives are readily available, relatively small carbon prices could wipe out the entire market for a product, with an asset losing all of its value. Thus, understanding the role of carbon prices within the context of market dynamics is essential to understanding transition risk.
In 2013, CPI EF began to develop models that went beyond modelling the impact of a carbon price on asset values and included scenarios based on the inputs and outputs of economies, industries and businesses that would be needed to limit global warming.
For every sector, CPI EF identified the effects of the transition on demand, pricing, costs or margins, and investment needs. Building up from each business line, they modelled each company to assess the impact of changes in technology, industry structure, demand or regulation on the valuation of its assets. CPI EF then assessed how this change in asset value will be affected by policy, contracts, ownership, financing, and tax regimes that effectively allocate this change in asset value between equity owners, creditors, governments, and consumers. The resulting change in asset value is what CPI EF call Climate Transition Value at Risk (CVaR).
CPI EF have extended this analysis across sectors, countries, and entire stock indices, comparing the impact that a given transition would have on each company in the index. CPI EF have also applied the CVaR approach to assess the economic impact of the climate transition at the sovereign country level.
The CPI EF CVaR platform brings together years of research into an investment approach that can measure climate transition risk for financial portfolios and businesses. It also serves as the basis for new tools, hedges, and financial instruments that will help investors, businesses, and policymakers price transition risk, reduce the concentration of risk, and limit the potential for economic disruption.
By investing in accordance with the platform, investors will de-risk their portfolio in response to a transition. At the same time, companies would be incentivised to make investments that align with a WB2C scenario, thus accelerating the transition.
Together, the CVaR platform and related instruments will help the financial system absorb the kinds of demand shocks we are seeing today, while keeping the climate transition on track and increasing economic resilience. When the next shock arrives, be it climate change or another pandemic, we have a chance to be better prepared with a greater range of options to manage risk.
David Hoile has been the Global Head of Asset Research since 2006 – it is the economics and capital markets research department for Investments and Willis Towers Watson. His role and team cover a variety of responsibilities, including: research and forecasts for all major economies; asset market forecasts over short and long-term horizons, stress tests and appropriate financial portfolio strategy responses; and analysing the risks and opportunities from climate change and broader sustainability-related trends for economies, industries, and asset markets.
