Transitional risks to businesses

Jan 31, 2023 / Blog

The risk to businesses from climate-related transition risks

Transition risks refer to business-related risks that follow societal and economic changes towards a low-carbon economy. Transition risks can come in multiple forms that may include increased disclosure requirements or risks associated with carbon pricing.

Climate disclosures

In November, the UK government-mandated Transition Plan Taskforce (TPT) launched a disclosure framework for best practice climate transition plans by private sector companies. The TPT was established by the UK Treasury to encourage companies to develop plans that detail how they will adapt and decarbonise as the country works towards a net-zero economy by 2050. 

The Financial Conduct Authority (FCA) will be incorporating the recommendations from the TPT into its own disclosure requirements. The FCA has incorporated the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations into its Listing rules for major listed companies and similar reporting rules have been extended to other firms. The new rules kicked off in April 2022 and will require UK AIM firms with more than 500 employees to disclose climate-related financial information for the upcoming financial year.

Following COP15, there is also a greater chance of regulators introducing nature-related disclosures. At the conference, countries agreed on the Global Biodiversity Framework which called on governments to take policy measures to encourage companies and financial institutions to disclose their risks, dependencies and impacts on biodiversity. The Taskforce on Nature-related Financial Disclosures (TNFD) launched the third iteration of its beta framework for nature-related disclosures in November and aims to publish its final recommendations in September 2023.

The risk of stranded assets

Stranded assets are assets that are no longer used and may end up as liabilities before the end of their expected economic lifetime. It has been estimated that about 50% of the world’s fossil fuel assets could be worthless by 2036 as the world moves towards net-zero emissions.

Water stress has been identified as a driver of stranded assets. A report from the CDP (Carbon Disclosure Project) has estimated that business-as-usual levels of water use and economic growth will put 45% of global GDP at risk by 2050. The report outlined four different water risk factors that could result in stranded assets: physical risks, regulatory risks, reputational and market risks, and technological risks.

An example of this can be found at Oyster Creek nuclear power station. Here, 1.4bn tonnes of water was drawn into the plant each day to be used as coolant and released at a warmer temperature. y New Jersey enforced regulation to prevent the damaging effects of the warmer water on local ecology, leaving the plant's owners with an expensive ultimatum: invest $800m into water cooling towers or close the plant early and lose 10 years of extended-life optimal return. The plant soon became a stranded asset.

Transition risk from carbon pricing

In a CDP questionnaire on whether companies are prepared for climate-related risks, the most reported transition risk was the increased pricing of GHG emissions. In Europe, carbon prices in the EU’s Emissions Trading System (ETS) have risen from around €33 (£29) per tonne in January 2021 to around €85 per tonne currently.

Rising carbon prices can impact a range of carbon-intensive firms that are now required to compensate for their polluting activities. Recent analysis has estimated that global equity valuations for heavily polluting sectors could fall by up to 30% if the carbon price rises to $100 per tonne.

Regulation targeting supply chains

Businesses are likely to see an increase in regulation scrutinising the sustainability of their supply chains in the future. In December, the European Parliament passed a law preventing the sale of deforestation-linked products in the EU. The legislation will require companies to issue a due diligence statement when selling products such as coffee, cocoa, beef, and wood in the bloc. Firms must be able to show a certificate based on GPS coordinates and satellite images confirming the origin of the commodity when crossing the border of the EU's internal market. 

Additionally, the EU Corporate Sustainability Reporting Directive came into force at the beginning of 2023, which will enforce mandatory environment, social and governance (ESG) standards on large companies. The new legislation, deemed to most ambitious standards globally, will also hold EU companies supply chains accountable. This means non-EU private companies will be required to respond to ESG disclosures, too. For those in the UK, businesses generating over €150m in revenue in the EU will need to disclose from 2029, with the aim of enabling investors to make green choices. 

What can businesses do?

Presently, AIM-listed UK companies grossing under £500m in the UK or €150m in Europe and employing less than 500 people have no climate regulation on the horizon. However, the policy discussed above paints a portrait of the current regulatory landscape, offering an insight into how smaller businesses may be affected in the future.

Those that are eligible for TCFD or CSRD should ensure they are prepared for incoming climate disclosure rules and that they have adequate expertise and data to fulfil any reporting requirements. They must also assess their supply chains and customers to estimate their exposure to stranded asset risks and the risks from higher carbon prices. PwC has released a “Where do I start?” guide that provides an overview of the TCFD/climate change reporting rules that currently apply or will apply in the future for businesses.