Climate Driver

Transition Risk is driven by changes in climate-related policies, technologies, and market preferences, rather than physical climate impacts. Key drivers include:

  • Carbon pricing and emissions regulation
  • Mandatory disclosure and capital requirements
  • Rapid technological substitution (e.g., renewables vs fossil fuels)

Risk Transmission

Transition risk primarily enters the risk framework through credit and valuation channels, not merely environmental metrics. Key transmission mechanisms:

  1. Cash flow disruption: policy changes alter operating costs and demand, affecting debt service capacity.
  2. Asset stranding: long-lived assets may lose economic value before maturity.
  3. Credit migration: abrupt changes in regulatory expectations can trigger rating downgrades.
  4. Correlation shifts: firms exposed to similar transition pathways become more correlated under stress.

Importantly, these effects tend to be non-linear and policy-driven rather than gradually priced in.

Time Horizon

Transition risk does not follow a smooth long-term horizon.

  • Short term: regulatory announcements, stress test expectations, disclosure rules
  • Medium term: capital reallocation, refinancing risk, changes in market access
  • Long term: structural decline of carbon-intensive business models

Risk materialisation often occurs through policy-triggered repricing rather than slow deterioration.

Why It Matters

Traditional risk models often underestimate transition risk because:

  • Historical data does not reflect future policy regimes
  • PD/LGD models assume stable business models
  • Stress testing focuses on macro variables, not regulatory shocks

As a result, transition risk behaves more like an abrupt policy shock than a conventional cyclical risk factor.

Open Questions

  • How should banks distinguish between transitional stress and permanent credit impairment?
  • Can scenario analysis meaningfully inform capital decisions, or is it primarily a governance tool?
  • How should risk appetite frameworks reflect policy uncertainty rather than climate outcomes?

Sources

  • Basel Committee on Banking Supervision (BCBS). Principles for the Effective Management and Supervision of Climate-related Financial Risks, 2022.
  • Financial Stability Board (FSB). The Implications of Climate Change for Financial Stability, 2020.
  • Network for Greening the Financial System (NGFS). Climate Scenarios for Central Banks and Supervisors, 2023.
  • Bank for International Settlements (BIS). Climate-related financial risks: measurement methodologies.