Climate transition risks pose a significant threat to financial stability. This report recommends investors and policymakers understand and manage these risks using scenario-based approaches to predict potential asset losses and systemic impacts.
Advance your career with a certificate that builds skills and expertise to integrate climate-related considerations into portfolio management, including transition finance, and to communicate complex concepts effectively to clients.
Report Overview
Climate transition risks—those risks related to the transition to a lower-carbon economy—represent a significant threat to financial stability. These risks arise from changes in policies, technological advancements, or shifts in market behavior that affect the value of assets, particularly those tied to fossil fuels.
Because they can impact investment and loan portfolios and have systemic effects in a highly interconnected financial system, it is crucial that investors understand these risks. For example, a transition scenario where climate-related policies target warming of 1.5 degrees Celsius above preindustrial levels instead of a 2-degree Celsius target can lead to a higher markdown in the value of fossil fuel–exposed assets held by financial firms.
Our CFA Institute Research and Policy Center report with the support of the UK Centre for Greening Finance and Investment (CGFI) advocates for a scenario-based approach to assess transition risks, rather than relying solely on historical market data. It is an approach that incorporates potential future changes in firm performance due to climate-related scenarios, providing a more accurate picture of potential losses.
Transition risks are of particular concern for financial institutions such as banks and insurance companies, which must consider these risks when setting risk premiums or aligning their operations with sustainability goals. Policymakers also need to account for these risks to ensure financial stability and to guide future regulations.
Our report uses a case study of developing Asian countries—a region with high exposure to transition risks—to model how these risks can cascade through the financial system. It emphasizes that transition risks are not isolated but can spread widely due to the interconnected nature of global finance.
The report’s analysis focuses on three layers where these risks manifest—the specific transition scenario, the broader economy, and the financial sector’s interactions:
- Scenario layer: This layer examines how transition risks affect energy firms directly. For instance, policies targeting a more aggressive climate goal can devalue physical assets such as coal, oil, and gas.
- Economic layer: Here, the focus is on how the devaluation of energy firms’ assets affects corporate profitability and the book value of firms’ equity.
- Financial layers: The first financial layer looks at how losses incurred by energy firms affect financial institutions that have lent to these firms. The second financial layer looks at how losses from the financial firm affected by the loans provided to energy firms spread to other financial institutions that hold counterparty asset holdings of the affected firm.
The report's framework aims to capture the complexity of how transition risks can propagate through the financial system, emphasizing the importance of understanding these dynamics for risk management. It includes a sensitivity analysis to explore uncertainties in the transition scenarios and financial networks. This analysis reveals that different assumptions about future scenarios and the structure of financial networks can lead to varying levels of projected losses, highlighting the need for financial firms to account for a range of potential outcomes.
Our report underscores the profound impact that climate transition risks can have on the financial system. It calls for financial firms and regulators to better understand these risks and to incorporate them into their risk management and regulatory frameworks. By accounting for the uncertainties and potential contagion effects in financial networks, firms can better prepare for the wide range of outcomes that could result from different climate transition scenarios.