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Climate Transition Risk and Avoiding the Trap of Misleading Metrics

Tania Romero Avila, Senior Associate at WTW, looks at the limitations of existing climate-related metrics and how a forward-looking approach can accelerate progress to net zero.

Climate-related risks that threaten the financial system are subject to increasing scrutiny from market participants, financial authorities and civil society. Equally, there is a growing expectation that financial institutions should demonstrate the progress they are making in measuring climate risks and supporting the economy-wide transition. Climate risks include climate transition risks, which are the potential negative impacts on an organisation, or asset values, associated with the transition to a lower-carbon economy.

In order to do this, financial institutions and authorities will need to develop data and tools capable of measuring and managing these risks, while allowing them to monitor the degree to which their activities facilitate the transition to lower emissions in the real economy. In addition, there is a growing pressure for financial institutions to monitor and disclose their progress against their transition plans and climate commitments.

Financial institutions already identify, measure and monitor transition risk using a variety of data and tools – both at the level of individual clients and their overall portfolio. However, there is little consensus as to which metrics are the most suitable to use from a risk, disclosure, engagement or monitoring perspective.

To date, numerous alternative classifications of metrics have been advanced by different groups, including those led by market participants (e.g. Task Force on Climate-related Financial Disclosures and the UK Climate Financial Risk Forum), regulatory standards and exercises (e.g. International Sustainability Standards Board disclosure standards, European Banking Authority Pillar 3 reporting template for banks, and jurisdictional climate scenario analysis exercises), as well as broader financial authorities’ and bodies’ overview reports (e.g. from the Financial Stability Board and Network for Greening the Financial System).

Navigating the climate metrics challenge

The challenges associated with measuring climate transition risk are currently greater than for other sources of risk. The forward-looking nature of transition risk means that its assessment generally relies on scenario analysis involving estimation using a number of assumptions and parameters. There are also very high levels of uncertainty associated with different transition pathways, their implications for economies, as well as companies’ responses to these. Together, this poses a range of challenges in transition risk measurement.

Emerging metrics differ in the degree to which they provide information on climate transition risk. Many of the climate-related metrics are based on greenhouse gas (GHG) emissions. However, these do not provide a comprehensive indication of a company’s overall exposure to transition risk.

In fact, research by the Institute of International Finance and WTW finds little empirical correlation between measures of a firm’s emissions intensity and direct measures of its climate transition risk.

This is true for a number of reasons. First, the reporting of emissions is subject to systematic biases and gaps. As depicted in Figure 1, a software company serving firms in the oil and gas industry, for example,  might report only very limited operational emissions. But to the extent that demand for its services is likely to reduce under climate transition, it might be exposed to substantial climate transition risk. According to analysis by IIF and WTW, 30% of firms with below-average emissions are projected to lose value as a result of transition.  Even ‘scope 3’ emissions – which seek to reflect emissions arising from the entirety of firms’ value chains – struggle to capture emissions arising from the activities of firms that use a product or service, and are subject to various data gaps.

Second, current and historical emissions are backward-looking and give only very limited insight into future changes in a firm’s business models. Future changes in emissions can be a crucial determinant of the transition risk to which they are exposed. For example, a manufacturing firm that is currently heavily reliant on energy from fossil fuels might be planning to switch to using renewable energy.

Third, and importantly, an increase in the cost of emissions may not necessarily be associated with an increase in the transition risk to which a company is exposed. This is partly because some firms might experience a large increase in the cost of emissions, say as a result of the imposition of a carbon tax, but nonetheless still see continued (or increasing) demand for their products, or otherwise be able to pass through increased costs without impacting profitability.

Moreover, our analysis shows that 10% of high-emitting firms are projected to increase in value as a result of the transition. Roughly half of all firms in the metals and mining sector – a sector with higher-than-average emissions – actually stand to increase in value as a result of the transition as demand for certain commodities needed in the production of low-carbon technologies is expected to grow.

Measuring real-world impact

As a direct measure of transition risk, GHG emissions-based metrics have limitations. While emissions-based metrics have the advantage of being relatively more verifiable and objective, they are only capable of providing an indirect measure of a firm’s exposure to transition risk. They also do not capture the degree to which real-economy firms (including those that are relatively high emitting) may facilitate transition elsewhere in the economy.

Firms involved in mining lithium or cobalt for batteries might give rise to high emissions in the near term. Yet, because the materials they extract are enabling reductions in emissions elsewhere in the economy, for example via the manufacture of batteries for electric vehicles, a financial institution’s funding of such activities might both represent a profitable investment opportunity (rather than transition risk) and facilitate transition in the real economy.

Forward-looking metrics, such as climate transition value at risk or outputs of a financial institution’s internal climate scenario analysis, are more risk-sensitive: that is, they can provide a more forward-looking and granular estimate of transition risks to which financial firms are exposed. These benefits, however, come at the cost of greater complexity, because they tend to be based on a larger number of data sources and require a greater degree of judgement in assessing how different firms and sectors will be affected by the net zero transition.

Guarding against unintended consequences

As with other aspects of financial risk, more complex and risk sensitive metrics may be better suited to financial institutions’ internal measurement and management of transition risk. Metrics that are more verifiable and objective have the benefit of enabling comparison across firms; they may, therefore, be better suited to use in financial institutions’ disclosures.

As work on climate risk management expectations and disclosure standards continues, financial institutions and authorities should remain mindful of the relative strengths of different metrics, and use metrics for purposes to which they are best suited. Were financial authorities to assess the safety and soundness of financial institutions based solely on their operational or financed emissions, this might give a misleading representation of transition risks.

Taking emissions-based metrics as direct measures of transition risk could have other unintended consequences – both for an individual firm’s risk management and for the broader climate transition. A financial institution that seeks to manage its exposure to climate transition risk by relying on emissions-based metrics might stand to reduce its exposure to high-emitting industries even when some of these investments could be profitable during the transition. This could also disincentivise financial institutions from engaging in transition financing activities that may currently be high emitting, yet play a valuable role in supporting the economy-wide transition.

The article is co-authored by Katie RismanchiDeputy Director, Regulatory Affairs DepartmentInstitute of International Finance.

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