Transition Risks

Transition risks refer to the risks related to transitioning an economy into a low-carbon economy or embracing changes to withstand climate change. They aim to address the impending risks associated with disruptions to economies, financial markets, and industries due to policy change, market dynamics, and technological shifts concerning climate change.

It also helps develop strategies for mitigating climate change transition risks. Governments, fossil-fuel-based businesses, and institutions utilize it to secure investments, make wise investment decisions, and take advantage of transitioning to a sustainable future. The energy, financial, and transportation sectors can capitalize on it to sustain themselves without affecting the environment. 

• Risks associated with an economy's transition to a low-carbon economy or adopting reforms to survive climate change are referred to as transition risks. These risks can be both non-financial and financial.
• Its goal is to identify the danger of approaching shocks to economies, securities markets, and sectors brought on by changes in market dynamics and technology developments related to climate change.
• In contrast to physical risks brought on by the physical effects of climate change, transition risks include the risk associated with the transition to a lower-carbon economy. Some notable transition risks include regulation and policy, technological, market, financial, brand and reputation, legal, transition-induced volatility, supply chain, workforce, and strategic risks.
• Mitigating risks in several ways, including risk comprehension, risk management plan development, adopting new technologies, changing business practices, and being transparent with stakeholders, among others.

Transition risks can be technically defined as the extent and pace at which an economy adapts and manages the external and internal rate of change for reducing greenhouse gas emissions and shifting to renewable energy sources.

Many world climate change organizations have issued warnings and instructions to world economies to address the environmental degradation problem. As a result, governments have created policies and regulations to address these by shifting towards sustainable and environmentally friendly technologies and business practices. Therefore, businesses have started to face the transition risks while shifting to renewable energy and sustainability.

If they do not take adequate steps to address the environmental issue, their assets get stranded, and consumers may shift to companies using renewable technologies. Hence, business models may face disruption due to the inclination towards clean and green technologies.

Effect On The Financial World

The efforts to transition to sustainable practices create newer companies. They also create newer stocks related to green technologies, and a whole ecosystem centered around transitions to sustainable businesses. Investors may have to devise new strategies to trade green technology-based startups and companies. Carbon-intensive assets plus green initiative-oriented investments may add ambiguity to the markets.

Hence, financial and operational difficulties for sustainability are transition risks.

There are numerous risks involved while transitioning from a normal to low low-carbon state. Some of the notable ones are as follows:

1. Regulation and policy risks: Any change in legislation, government policies, & regulations concerning environmental protection, carbon pricing, renewable energy incentives, and emissions standards poses a risk to the operations of industries and financial efficiency. 
2. Technological risks: Traditional firms have the risk of getting their business model altered and competitiveness affected due to fast-paced advancements in technologies like automation and clean energy alternatives. 
3. Market risks: Certain traditional industries may experience reduced profits and stranded assets owing to increased demand for modern low-carbon solutions, providing companies with a way to address climate change transition risks.
4. Financial risks: Investment portfolios and asset valuations may fluctuate too often due to ambiguity in climate-transition-related policies and perception toward carbon-dependent assets' future. 
5. Brands and reputation risks: Consumers might lose trust in the brand, and their reputation may suffer if these brands do not adhere to climate change transition technologies.
6. Legal risks: noncompliance with environmental safety regulations or environmental damage may land companies in legal trouble and litigations.
7. Transition-induced volatility: Energy price change, fluctuating currency, and market volatility resulting from transition lead to financial stability.
8. Supply chain risks: Changing regulations may disrupt supply chains just like the availability of resources and natural calamity-led events do.
9. Workforce risks: As industries roll out new technologies and incorporate new environmentally friendly practices, workforce disruptions may occur due to skill shortages or changes in labor demand.
10. Strategic risks: Companies failing to align their business objectives and operations with the changed climatic regulations and environment are more likely to fail in the future and may even shut down.

Thus, organizations and stakeholders must effectively negotiate the shift towards a resilient and environmentally friendly future by comprehending and controlling these transition risks, including contract transition risks.

Let us take the help of a few examples to understand the topic.

Example # 1

Several nations have committed to switching to renewable energy sources in response to efforts made by the international community to reduce greenhouse gas emissions. Germany, for instance, wants to produce 65% of its power from renewable sources by 2030. However, this change might jeopardize its energy security because the nation depends so heavily on imported natural gas. Gas supply disruptions may affect the nation's capacity to produce power, leading to energy shortages and increased costs.

Example # 2

Consider a fledgling technology company that manufactures electric scooters. The firm is expanding into new markets as the company experiences fast growth. However, the business must deal with an unexpected supply chain interruption since it depends on rare earth materials to manufacture its scooters. Due to production delays and cost increases, the business's potential for expansion and revenue face adverse effects.

There are several ways to mitigate these risks, as listed below:

• Risk comprehension: First, understand the magnitude and depth of risk exposure to the organization that may impact the business for managing transition risks and mitigation.
• Risk management plan development: Next, develop an appropriate risk management plan to minimize the risk impact, having steps like identification, assessment, and managing the risks.
• Adopting new technologies: Adoption of new technologies like renewable energy sources can mitigate the risk.
• Changing business practices: The firm must change its business practices to suit the changing regulations and environment-friendly technologies for risk mitigation.
• Being transparent with stakeholders: Stakeholders must be aware of the transition risk exposure to the management and stakeholders. It may build the confidence and trust needed to reduce risks. 
• Climate risk evaluation: Stress testing and scenario analysis are requirements to evaluate climate risk.
• Diversification: Revenue streams and diversification of investments help to remove the withdrawal of reliance on carbon-intensive assets plus industries. Firms must prioritize investment in low-carbon plus climate-resistant assets to take the route of long-term sustainability.
• Regulatory compliance: Compliance with climate adherent policies and regulations is necessary to avoid reputational and financial penalties.
• Supply chain management: Suppliers and transporters should comply with sustainable practices, while the supply base must be diversified to decrease reliance on vulnerable regions.
• Training and education of employees: Employees should receive training to be sensitive to environmentally sustainable business practices. They should be able to adapt to climatic change and be aware of transition risks to contribute towards sustainability objectives.

Reporting and disclosures, building resilience, and regularly reviewing and monitoring mitigation strategies and reviews of climate risks are other ways to mitigate transition risks.

Let us have a look at the advantages and disadvantages of such risks:

• Pros: By recognizing the effects of transition risks, firms may get ahead in their business curve. They may adapt to sustain evolving market pressure plus regulatory policies. As a result, their reputation increased, and revenue also grew. It helps create new growth and investment avenues in the green economy, fostering innovative technologies and sustainable practices.
• Cons: The strategies to mitigate transition risk may take time and a lot of expenses. Furthermore, any unpredictable event may badly affect the risk mitigation plan. Additionally, companies may face social challenges, stranded assets, and economic disruptions during the transition.

The table below gives the differences between the two:

This has been a guide to what are Transition Risks. We explain its examples, comparison with physical risks, types, pros and cons, and how to mitigate it. You can learn more about it from the following articles –

• Net Zero Vs Carbon Neutral
• Carbon Offset
• Carbon Market