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Climate 101: What Are Transition Risks?

June 2020 
By Chris Goolgasian, CFA, CPA, CIAI and Julie Delongchamp, CFA

As companies begin to transition to more climate-friendly policies they may encounter the dilemma of mitigating new costs.

Insight from our sub-adviser, Wellington Management
Chris Goolgasian, CFA, CPA, CIAI
Director of Climate Research
Julie Delongchamp, CFA
Research Associate


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

Technological Disruption

  • 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

 

Mitigation Tactics

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:

Energy Efficiency

  • Installing efficient building systems
  • Employing smart grids and meters for water and electricity

Renewable-Energy Generation

  • Installing wind turbines and solar panels
  • Sourcing alternative fuels, including biofuels

Low-Carbon Transport

  • Using electric vehicles
  • Taking public transportation

Conscious Consumption

  • 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.
  

For more insights on climate change and sustainable investing, please visit hartfordfunds.com/sustainable



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.

The views expressed herein are those of Wellington Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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