Some critical reflections on the concept of transition risk

Transition risk is on everyone’s lips. How helpful a concept is it though? And what degree of concern for the financial system does it warrant?

The ongoing transition to a low-carbon and more circular economy will bring both opportunities and risks for the economy and financial institutions (ECB 2020). Understanding and managing the risks associated with this transition has emerged as a crucial focus of attention in recent years.

Within the finance community, the distinction between two main types of climate-related financial risks –physical risks and transition risks – is now well established. However, one can question how helpful a concept transition risk truly is. The reason is that transition risk is often regarded as the sum of two types of risks that at times partially overlap: technological change risks and policy change risks.

Similar to the intricate nature of climate change, transition risks are complex, dynamic and globally interconnected, effortlessly crossing borders (Yang, Caporin and Jiménez-Martin 2023). Problems of measurement validity can be found everywhere in the climate risk arena, although they are perhaps the most obvious in ESG ratings (Berg, Kolbel and Rigobon 2022). Transition risks are no exception: operationalising transition risks and defining metrics that are relevant and comparable are challenging.

Against the background of an uneasy conceptualisation of transition risks, some contributions to the literature have looked at the extent to which “the use of different metrics delivers heterogenous results, and which factors impact the assessment of risk” (Bingler, Colesanti Senni and Monnin 2021). The lack of a clear definition and framework for assessing transition risks hampers comparability and impedes efforts to make informed decisions and to develop comprehensive risk management strategies. A pivotal question is whether transition risk assessment can be improved with better metrics and more disciplined data collection on these metrics or whether the same objective can be achieved with a more thorough and meticulous conceptual delineation.

Giovanni Sartori, arguably one of the most rigorous conceptualisers in the history of comparative politics, used to stress the importance of logic as a first step in any social inquiry. He used to put much importance on avoiding “conceptual stretching, or conceptual straining, i.e. (…) vague, amorphous conceptualisations” (Sartori 1970, 1034). Addressing this twin analytical and policy problem will require concerted efforts by different stakeholders, such as governments, financial institutions and regulatory bodies, to establish a framework defining transition risks. In the end, this definition will not only be a theoretical element but also a tool for “fact gathering” and a “data container” (Sartori 1970, 1052). This will be indispensable to enhance transparency and consistency.

As the financial sector grapples with the imperative of aligning with climate goals, defining transition risks emerges as a critical step in contributing to making the financial system more resilient and stable for the benefit of the wider public.

References

• Berg F., Kolbel J. and Rigobon R. 2022. “Aggregate Confusion: The Divergence of ESG Ratings.” Review of Finance 26, 6 (November): 1315-1344.
• Bingler, Colensati Senni and Monnin. 2021. “Climate Transition Risk Metrics – Investigating Convergence and Estimation Drivers.” Paper presented at the International Conference on Statistics for Sustainable Finance, The Bank of International Settlements and the Irving Fisher Committee on Central Bank Statistics, Paris, 14-15 September 2021.
• 2020. Guide on climate-related and environmental risks: Supervisory expectations relating to risk management and disclosure. 
• Yang R., Caporin M. and Jiménez-Martin J. 2023. “Measuring Climate Transition Risks Spillovers.” Review of Finance. 
• Sartori G. 1970. “Concept Misformation in Comparative Politics.” American Political Science Review 64, 4 (December):1033-1053.