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Article | Global Markets Overview

Global Investment Outlook: Climate transition

February 1, 2022

We show how to use company and financial analytics to price carbon-related risks, value the assets you own, and identify risk management solutions
Investments
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This is one part of the Global Investment Outlook series. The other sections are focussed on Prosperity and Inclusive growth.

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”.

Three strategic considerations for financial institutions

Reducing the financial risk resulting from climate change requires managing climate transition risk and opportunity, using finance as a catalyst, and encouraging market reform.

Managing climate transition risk and opportunity
  • Measure climate risks and develop new tools and financial instruments to help price and mitigate risk
  • Real world pricing of transition risk will improve investment decisions, reduce the concentration of risk, and increase economic resilience
Using finance as a catalyst
  • New financing solutions can overcome investment barriers and reduce the cost of capital
  • Financial innovation includes new financial instruments, portfolio designs or hedging products
Encouraging market reform
  • Build markets tailored to low-carbon solutions and create better incentives
  • By building climate aligned portfolios, businesses are incentivised to make investments that align with and accelerate the transition

Risk measurement is an essential first step towards opening opportunities to manage climate transition risk

Account for four characteristics when measuring the impact of climate transition risks and opportunities on financial investments, assessing the economic impact at the sovereign country level, or applying strategic risk evaluation tools to help corporates.

  • Risks materialise at the micro level driven by macro forces
    • Measuring transition risk requires a hybrid approach to understand how macro changes will affect the value of individual assets
  • Risks are often driven by non-linear, structural change
  • Risks depend on the timing and path of the transition
    • Incorporate multiple scenarios to evaluate the largest structural changes and the likely paths that a transition could take given the uncertainties around, and responses to, politics, policy, technology, and consumer and investor behaviour; the most likely transition paths are disorganised.
  • Risk transfer between stakeholders
    • Valuation needs to map how risk flows at a national level, including impact on sovereign balance sheets, financial system stability, consumers, taxpayers, and workers

Read : Risks from disorganised climate transitions

Measurement of transition risk should depend on the nature of the business, industry, and risk

Scenarios should identify the effects of the transition on demand, costs or margins, pricing, investment needs, and the valuation of assets. Then assess how changes in asset value will be affected by policy, contracts, ownership, financing, and tax regimes, which allocate this change in asset value between equity owners, creditors, governments, and consumers. This is called Climate Transition Value at Risk (CVaR).

Chart tracking transactional scenario and BAU price against transaction scenario demand, supply, and BAU demand. See Description below
Prices rice in all 3 scenarios with an increase in production.
Impact of changes in policy, technology, industry structure, or demand on the commodity and resource industries
Box depicting correlation between a shrinking sector and reduced margins, and conversely, a growing sector and increased margins. See Description below
Value is lost in a shrinking sector.
Impact of changes in policy, technology, industry structure, or demand on Manufacturing, marketing, and service industries with direct transition exposure

Service industries with clients exposed to transition risk

Box of four squares.
Box 1 reads "Commodities and resources".
Box 2 reads "Consumers.
Box 3 reads "Manufacturing, marketing and service," and
box 4 reads "government.
Derived exposure for client service
  • Growth/shrinkage of overall market
    for services offered due to changing client base from transition exposure
  • Change in market share
    as client base shifts to/from the key sectors that drive company profitability
  • Default/non-payment
    In extreme cases where sudden transitions cause client defaults (rare)
  • Reputation
    Where company/institution fails to identify, manage, or adapt to the transition and loses clients as a result
Impact of changes in policy, technology, industry structure, or demand on service industries with clients exposed to transition risk

New tools, hedges, and financial instruments to manage climate risk and improve value

Management of climate transition (and physical) impacts – whether through strategy, investment, diversification, or divestment – will de-risk both investments and companies and improve valuations.

Chart depicting scenarios of market valuations of porfolios with different degrees of climate risk management. See Description below
Those portoflios with a climate aligned strategy perform better in the event of major climate impact against those portfolios with no climate hedging strategies.
Managing climate uncertainty and risk and increasing asset and portfolio value

An investment approach

The WTW CVaR platform provides an investment approach that can measure climate transition risk for financial portfolios and businesses. It serves as the basis for new tools and investment solutions that will help investors and businesses price transition risk, reduce the concentration of risk, and limit the potential for economic disruption.

Risk Management Actions Risk management & measurement Stewardship Portfolio analysis
&
construction
Investment Solutions/
hedges
Insurance products
Avoid new high climate risk investments
Improve climate risk of existing investments
Divest high risk investments
Diversify to manage portfolio/
company level risk
Hedge risks that cannot be improved/
divested
Insure risks that cannot be otherwise managed


Dashboard

Emissions: food


-2%

The estimated Enterprise Value at Risk for businesses in the food value chain, if the world transitions to a low carbon economy consistent with a global temperature increase of 1.8°C.

Emissions: electrification of transport


-0.4%

The estimated Enterprise Value at Risk for businesses in the automobiles sector, if the world transitions to a low carbon economy consistent with a global temperature increase of 1.8°C.

Emissions: decarbonising industry


-3%

The estimated Enterprise Value at Risk for businesses in the industrials and materials value chains, if the world transitions to a low carbon economy consistent with a global temperature increase of 1.8°C.

Emissions: decarbonising power


-17%

The estimated Enterprise Value at Risk for businesses in the energy and utilities sectors, if the world transitions to a low carbon economy consistent with a global temperature increase of 1.8°C.

Emissions: protecting nature


6 gigatons

The annual carbon emissions that could be reduced if net-zero deforestation was achieved by 2030.1

1 The world is projected to emit 36.4 gigatons of carbon dioxide in 2021.

Emissions: removing carbon


5 gigatons

The volume of carbon dioxide emissions per year that would need to be removed by engineering by 2050 to help achieve a net zero (1.5°C) outcome. 1

1 The world is projected to emit 36.4 gigatons of carbon dioxide in 2021.

Accelerants: politics & policy


36%

The proportion of world GDP now covered by net zero emission policies in law.

Accelerants: innovation


$80 per kWh

The production cost of batteries used in electric vehicles by 2035 to help achieve a net-zero world (currently $140 per kWh).

Accelerants: investment


$2.7 trillion

The additional public-and private-sector subsidies and financing needed now to target a transition to a net zero global economy.

The other two sections of this report are available here: Overview, Prosperity and Inclusion.

Disclaimer

This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Willis Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. The information included in this presentation is not based on the particular investment situation or requirements of any specific trust, plan, fiduciary, plan participant or beneficiary, endowment, or any other fund; any examples or illustrations used in this presentation are hypothetical. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice.

This document is based on information available to Willis Towers Watson at the date of issue, and takes no account of subsequent developments. In addition, past performance is not indicative of future results. In producing this document Willis Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Willis Towers Watson’s prior written permission, except as may be required by law.

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