To meet the Paris Agreement and reduce greenhouse gas emissions, we must transform the world’s energy systems over the coming decades. This will require substantial investments in fossil fuel-free technologies and solutions. Such a situation poses serious risks for investors, as assets with long lifetimes may lose value due to evolving climate policies and technological shifts. For example, a newly built ship running on bunker oil or liquefied natural gas (LNG) may see its profitability decline permanently under a CO₂ tax.
Furthermore, companies located in regions with more ambitious climate policies may see a significant decline in demand as they attempt to pass on costs to customers, who are in turn looking towards imports. We label these “transition risks”.
The ability to identify and measure transition risks has caught the attention of financial regulators. For example, a network of central banks, “Network for Greening the Financial System” (NGFS), is developing model-based scenarios that banks and regulators are using to assess climate risks.
In the EU, the European Central Bank (ECB), the European Banking Authority (EBA), and the European Commission are working on several initiatives, and legal proposals already on the table or in process. For example, in 2021 and 2022, the EBA and the ECB conducted their first set of large-scale climate stress tests on European banks. However, a unified approach to how financial institutions should analyse, report and address transition risks has yet to be established.
In this brief, we outline our perspective on how to approach measuring transition risks, drawing on results and insights from our global and multi-sector climate-economic model, INTERSECT℠, co-developed with Bain & Company. This model is designed specifically to analyse how climate policies and technological developments will determine the path and speed of the green transition.
Policies that reduce CO₂ emissions imply transition risks. However, the magnitude and scope of these risks will depend on how, when, and where these policies are implemented.
How?
Policy-makers will need to choose how to reach their climate targets. They can do so using a wide range of instruments at their disposal, including carbon trading, carbon taxes, energy taxes, mandates for low-carbon content, and subsidies for specific low-carbon technologies. Each instrument influences the incentives to move from black to green technology options in slightly different ways by effectively putting a price on carbon emissions (hence this is often referred to as Effective Carbon Rates, ECR). More comprehensive emissions cuts have to be implemented by a higher carbon price, hence increasing transition risks.
When?
When also matters for transition risks, as a faster decarbonisation path will lead to increased transition risks. If the green transition is delayed, it may be necessary to increase the pace at a later stage, which raises the likelihood of a disorderly transition with heavy financial and real economic losses.
Where?
A more synchronised decarbonisation path across regions can reduce region-specific transition risks, such as carbon leakage, where emissions shift to areas with lower carbon prices. However, while simultaneous transitions can lead to more comprehensive emission cuts, they also increase systemic risk. Currently, most global emissions are not subject to effective carbon pricing, with existing policies largely targeting domestic energy use—like heating and personal transport—while heavy industry and long-distance transport remain under-regulated. These sectors face limited decarbonisation incentives, primarily due to the political sensitivity around potential job losses.
As a result, the economic incentives to decarbonise are highly diverse across industries and countries, and they are likely to remain so. That means there is not a “correct” climate policy scenario investors can solely rely on. Furthermore, the extent of the efforts to reduce emissions will vary among countries depending on the policy scenario in question. This is important, as the carbon price (or tax) needed to support the more ambitious scenarios increases significantly (see next section)
There is a wide gap between the expected emissions following the policies that the global community has committed to, such as the Stated Policies Scenario (STEPS), and an emission path consistent with the 1.5-degree limit increase in long-run average temperatures, the Net Zero (NZE). In the STEPS scenario, advanced economies such as the US and Europe would need to make substantial reductions in emissions over the next decade (see Figure 2). China, as a developing economy, would only need to make smaller CO₂ reductions.
However, to reach NZE by 2050, China and other large economies would need to cut emissions significantly as they are currently the largest global emitters of CO₂.
The more ambitious the scenario is in terms of reducing emissions, the more radical the required changes in energy and economic systems will be. A measure that is often used is the so-called marginal abatement cost (MAC). This measures the cost (typically in USD) of reducing emissions on the margin, typically by an additional ton of CO₂. The MAC will increase as emissions cuts become more comprehensive. This occurs as ever more expensive technologies are needed to reach policy targets.
Under STEPS, our INTERSECT℠ model predicts slightly higher carbon prices for developing economies and somewhat similar for advanced economies compared to the the Network for Greening the Financial System (NGFS). These estimates are broadly in line with the International Energy Agency (IEA) and NGFS.
In the NZE scenario, however, we find significant discrepancies in estimated carbon prices between NGFS and our INTERSECT℠ model estimates (see Figure 3).
Our analyst suggests that the NGFS’s projected carbon prices may be significantly overestimated, given current assumptions and predictions about technology costs. Many backstop technologies, such as Power-to-X (PtX), Carbon Capture and Storage (CCS), and Direct Air Capture (DAC), are expected to become profitable once carbon prices exceed $300 per tonne in the NZE scenario, meaning prices would not need to rise much higher even in ambitious pathways.
This backstop effect is reflected in the INTERSECT℠ model as seen in figure 3, where carbon prices peak at $300–350, though some sectors with higher abatement costs may instead pay for offsets via DAC rather than decarbonise directly. Additionally, the risk of large asset impairments is concentrated in a relatively small number of industries.
Our conclusion is therefore to focus on industries with:
One of these industries is the shipping industry, and it provides for a solid deep-dive analysis.
In summary, rising carbon prices will increase fuel costs for all transport sectors, with shipping—though a major source of emissions—likely seeing smaller cost increases than aviation, potentially boosting its market share even as overall demand for long-distance freight may fall. While container shipping demand is expected to grow despite higher costs, oil transport will be more affected due to declining fossil fuel use, and investors in oil-driven ships face significant value impairment as newer vessels may not recoup their costs under ambitious climate policies. A strong challenge for shipping will come from shifting global trade patterns, rather than the direct impact of phasing out fossil fuels.
Integrating asset impairments into financial sector risk management is crucial to identifying vulnerabilities and maintaining regulatory compliance, while also fostering investor confidence to ensure resilience and a timely intervention of expected losses. This involves combining static and dynamic climate stress tests in the evaluation of asset impairments and integrating them into overall risk management.
For financial institutions, it would be natural to lean into the stress test approach used in prudential regulation. The principle here is to divide the assets into equity and debt-based investments, then rely on asset impairments to estimate (i) reduced equity returns and (ii) increased default risk for debt-based instruments in various scenarios, like transitioning from STEP to NZE.
In assessing risk to balance sheets, two approaches emerge: static and dynamic. In the past, the focus has been on the static approach, which involves examining the carbon intensity of a given industry and assessing how profits would be affected by a carbon price if firms did nothing over the next 30 years. However, this method can lead to a significant overestimation of risk and losses for financial institutions which have these firms as part of their portfolio. Conversely, the dynamic approach considers changes in behaviours by firms and banks, given a higher CO₂ price. I.e., it factors in how firms respond to higher carbon prices. Using this approach is, however, more complex and more dependent on assumptions (see Figure 4).
Currently, the debate focuses on how to combine these two approaches. However, the real assessment must be dynamic in nature and needs to be updated as its climate and energy policies are being changed, technology assessments are being updated, and industries change behaviour and asset compositions. In general, climate scenarios have a much longer horizon than a business cycle, and stress testing should reflect this. To create real value, stress tests must incorporate more plausible and transparent scenarios of how climate policies affect business assets. Such an analysis will require a technical evaluation of decarbonisation options and national/international policies which is largely absent from the current strand of analysis in this field.
Extending the risk assessment to a dialogue-based approach is especially relevant for the few industries and firms that are exposed to substantial risks of asset value impairment. For instance, industries involved in fossil fuel exploration, production of metals, cement, fertilisers, aviation, and maritime transport are few in number, but globally-oriented and capital-intensive.
Yet measuring the risk of asset impairment based on models such as our global climate model INTERSECT℠ can only get you so far. As such, for the high-risk firms and industries, we need to go from a model-based assessment of risk to a more dialogue-based approach, and a more granular approach to the impact of climate policies, based on the strategic choices and specific decarbonisation plans of firms is needed. This in turn entails understanding how industries and firms themselves evaluate risk and what steps they have taken to mitigate it.
In conclusion, our recommendation is that companies facing significant green transition risks should engage in detailed discussions within forums that include management, regulators and financial institutions. Many major corporations now include extensive carbon emission reduction plans in their financial disclosures, which are vital for investors to evaluate associated risks.
The green transition will, over time, dramatically change energy systems at a global level. This will directly or indirectly affect all businesses.
Yet for most businesses, and the vast bulk of economic activity, the risks of asset impairments to existing assets are minimal relative to other material business risks. Costs of shifting to low-carbon solutions are relatively low, options for retrofits for existing assets are substantial, and for most firms, energy costs are only a relatively small fraction of total costs.
We recommend that tests of asset impairments should be focused on industries at high risk, such as fossil fuel producers, energy-intensive industries, and energy-focused infrastructure. Even for these activities, the devil is in the detail, and a robust analysis demands a highly granular approach regarding a number of industries and firms that often operate on a global scale.
Stress tests and risk analyses should be based on a clear formulation of the most likely climate policy scenarios, with sufficient granularity to also cover the industries at risk. Moreover, any analysis of transition risk will also require some assessment of the technical options a given industry has at its disposal to decarbonise. The likelihood of these options to materialise over time will also need to be scrutinised, as fossil fuels and low-carbon solutions will co-exist for decades. How this will affect prices, markets, and ultimately profits for different assets is the big question.
Model-based “outside-in” analysis can only take us so far in terms of understanding business risks for specific firms. For large firms that will ultimately account for the largest risks, we suggest a dialogue-based approach where investors and regulators review the assessments the firms themselves are making of their chosen decarbonisation strategies. Are they clear enough? Have they identified relevant major risks? What has been done to mitigate them? these questions and more will ensure that climate stress testing is integrated into the ongoing dialogues and processes investors and regulators are already having regarding assessing business risks and opportunities.
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