There are two types of climate-related financial risks: physical and transition. Physical risks refer to the manifestations of a changing climate that may be acute, such as hurricanes, floods, or wildfires, or chronic, such as water scarcity, sea-level rise, extreme heat, or worsening air quality. Transition risks are every bit as important to understand and may be just as costly to companies and investors over time.
Transition to What?
As economies decarbonize to lower greenhouse gas (GHG) emissions and slow the global warming trend, companies will feel the effects of the “transition” to this lower-carbon world, presented with multifaceted financial pressures, as well as opportunities to differentiate themselves and potentially gain competitive advantages. Notable transition risks include:
Policy and Regulation
- Carbon pricing to reduce future emissions
- Carbon sinks to remove existing emissions
- Efficiency standards for automobile models and limits on urban automobile use
- Renewable energy production and power storage
- Electric vehicles
Consumer Behavior and Social Norms
- Switching to renewable energy and materials and purchasing energy-efficient products
- Reducing consumption of carbon-intensive products
- Difficulty attracting talent to climate-negative businesses
- Brand and reputational risk; social media “shaming”
Litigation and Insurance
- Lawsuits against carbon emitters and extractors
- Health-related claims
While protecting a business from physical climate risks typically requires adaptation measures to improve resilience and preparedness, addressing transition risks calls for mitigation. Mitigation efforts are generally geared toward the reduction, prevention, and removal of carbon emissions to stabilize atmospheric GHG levels. Organizations and individuals can employ various means of addressing transition risks:
- Installing efficient building systems
- Employing smart grids and meters for water and electricity
- Installing wind turbines and solar panels
- Sourcing alternative fuels, including biofuels
- Using electric vehicles
- Taking public transportation
- Choosing plant-based proteins over animal proteins
- Traveling by air less frequently
Why Investors Care
Companies that successfully mitigate transition risks may establish long-term competitive advantages. Markets will likely reprice climate-related risk, directly affecting asset prices and valuations. The cost of capital may rise for companies that are unprepared or slow to decarbonize, and fall for those that are prepared and proactive.
Today, carbon-pricing policies cover 46 national jurisdictions, including many of the largest economies, and carbon-disclosure requirements laws are in place in many countries.1 The United States’ national policy has lagged, but changes are occurring at the state level, and some of the country’s largest and most influential business leaders are recognizing the risks posed by climate change and the potential benefits of managing it strategically.
Asset owners and asset managers are working—together and independently—to engage with companies and encourage this approach across the board. At the same time, many of the world’s largest asset owners, including sovereign funds and public pensions, are encouraging—and in some cases requiring—asset managers to offer more sustainable investment approaches and provide transparency into their portfolios’ management of climate-related risks, including through disclosure of carbon footprints. As more asset managers comply by investing the stocks, bonds, and real assets of companies and issuers that have a thoughtful strategy for addressing climate change, we believe asset prices and valuations will reflect that shift.
1 "Carbon Pricing Dashboard," The World Bank, May 2020
Important Risks: Investing involves risk, including the possible loss of principal. • Risks of focusing on investments that involve sustainability and environmentally responsible investment criteria may influence investment performance relative to a fund’s benchmark or competing funds and expose a fund to increased risks related to downturns or other adverse developments in that market segment.
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