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Transition risks

Transition risks are the potential adverse impacts on future asset prices of the transition to a low-carbon economy. This transition will likely entail numerous policy, legal, technology, and market changes to prevent climate change. In this process, financial assets may lose revenues, have lower profits, or require higher returns to compensate investors who hold them. Assets may also lose revenue due to lower demand or almost all value if not aligned with a lower carbon economy (TCFD, 2017).

International organisations and financial institutions aim to quantify transition risks (Alogoskoufis et al., 2021; Jung et al., 2023; Kutlukaya et al., 2023). Most of these works use carbon emission levels and carbon taxes to proxy the exposure to transition risk. Carbon taxes are easier to track and more convenient for modelling purposes (Kutlukaya et al., 2023) but contrast with other sources of transition risk, such as legal, technological, and market changes, which remain understudied.

Tax-related transition risks for individual investors only arise if carbon taxes are introduced abruptly or unanticipatedly. Conversely, if carbon taxes were fully anticipated, with timing and levels fully known, the tax-related transition risk would be zero, as investors could predict and prepare for its impacts (Kutlukaya et al., 2023).

Alogoskoufis, S., Dunz, N., Emambakhsh, T., Hennig, T., Kaijser, M., Kouratzoglou, C., … Salleo, C. (2021). ECB economy-wide climate stress test. Methodology and results. Occasional Paper Series. European Central Bank, 281.

Jung, H., Santos, J.A.C., & Seltzer, L. (2023). U.S. banks’ exposures to climate transition risks. Federal Reserve Bank of New York Staff Report, 1058, 1-68.

Kutlukaya, M., Fornino, M., Shirono, K., Prasad, A., & Seneviratne, D. (2023). Carbon footprint of bank loans – A measure of transition risks for the financial sector. In S. Arslanalp, K. Kostial. & G. Quiros-Romero (Eds.), Data for a Greener World: A Guide for Practitioners and Policymakers (pp. 113-139). Washington, DC: International Monetary Fund.

TCFD. (2017). Recommendations of the Task Force on Climate-related Financial Disclosures. Final Report. TCFD.

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