Financial Actors Take Note: expanded carbon pricing poses real, but manageable, 'transition' risks

Authors: Ian COCHRAN , Morgane NICOL, and Romain HUBERT  

The financial sector should take a long and serious look at the CPLC's announcement on carbon pricing. Its vision of seeing an increase in the coverage of global GHG emissions from currently 13% to 25% by 2020 and to reach another doubling of coverage within a decade. This laudable and necessary expansion of carbon pricing to achieve international climate objectives poses real - but manageable - risks for their business models and should consider from today aligning their portfolios with a low-carbon pathway mean.

I4CE has published a series of three Climate Briefs on the management of climate-related risks by financial actors, focusing specifically on three questions:

  • Why should financial actors align their portfolios with a 2°C pathway to manage transition risks?
  • How could financial actors manage their exposure to climate risks? 
  • How should financial actors deal with climate-related issues in their portfolios today?

This blogpost rapidly summarizes these three Climate Brief presents an overview of the topics covered and the main conclusions. The three briefs are available on the I4CE website

What are transition risks for financial actors?

Since the industrial revolution, the accumulation of an unprecedented level of greenhouse gases in the atmosphere has been leading to global warming with multiple consequences on economies and companies around the world. To limit global warming below 2°C and thus limiting its economic consequences, policies that aim at triggering a low-carbon economic transition are gradually being put into place. These two trends are opposed, yet connected, as decreasing emissions will reduce potential physical Impacts, but lead to structural changes In the economy that will have impacts for all economic actors. As categorised by Mark Carney  and as show in Figure 1, climate-related risks can be divided into transition and physical risks.

Figure 1: Typology of Transition and Physical Climate-Related Risks

The decreasing financial performance of certain actors today highly depending on a 'carbonized' economic model will translate into credit risk, counterparty risk, liquidity risk, operational risk and market risk for financial actors. These risks might materialise within the next decade, or even earlier, especially in case of a sudden market feeling that might cause a sharp depreciation of certain financial assets.

What does aligning a portfolio with a low-carbon pathway mean?

To limit global warming and its economic consequences, there is a limited “budget” for carbon that can be released into the atmosphere between now and the end of the century. A “low-carbon pathway” therefore refers to the pathway of an economy that is implementing efforts to sufficiently restructure its activities to significantly reduce greenhouse gas emissions. Among low-carbon pathways, the “2°C pathway” allows the achievement climate policy objectives, or a decarbonisation of the economy at a level that limits global warming below +2°C compared with the pre-industrial era.

In the context of a low-carbon pathway, each activity will see its carbon intensity progressively decrease, at a level and pace depending on its specificity and the technological breakthroughs occurring in its sector. An economic actor (who is the “counter party” to a financial actor) is aligned with a low-carbon trajectory (respectively 2°C pathway) if the decrease in greenhouse gas emissions associated with its activity follows the rate – specific to the activities being carried out – that corresponds to a low-carbon pathway (respectively a 2°C pathway). An aligned company is not necessarily one that today draws a significant proportion of revenues from very low carbon intensity activities.

Aligning a portfolio with a low-carbon pathway therefore means choosing – within a sector or category of financial assets – those counter-parties who are progressively beginning to implement the required decarbonisation efforts on their business sectors. Aligning a portfolio with a low-carbon pathway (and a fortiori with a 2°C pathway) is a gradual process that will only be possible to fully put into place once a sufficient volume of financial assets begins to be aligned with such a pathway.

In what way does aligning a portfolio with a low-carbon pathway constitute a management strategy for transition risks?

The alignment of a portfolio with a low-carbon pathway can limit transition risks, arising from the nature of the low-carbon pathway and the methods for implementing it. Encouraging exposure to those counter-parties who adopt a progressive and flexible strategy for aligning their activities reduces exposure to assets that do not follow a sector-based decarbonisation pathway. Provided that the strategy of the counter party remains flexible, its alignment does not penalize the asset’s future performance no matter the different possible decarbonisation pathways and scenarios of implementation. Since the alignment of the counter party can be done for each activity, the alignment strategy of the financial actors does not drastically change the portfolio’s sectoral exposure compared with the benchmark.

Laying the cornerstones of transition risk analysis will enable financial players to anticipate changes in the sector

Private financial players can immediately begin – and in fact some have already started – to measure and steer the alignment of their portfolio with a 2°C pathway. This can help limit their exposure to climate-related transition risks and seize the opportunities associated with the low-carbon transition. Even if, for now, certain constraints limit the ability of financial institutions to carry out a quantitative analysis of the impact of a 2°C scenario on financial performance, the first steps explored by I4CE in our Climate Brief can be implemented as of today and provide a cornerstone for a progressive deepening of the analysis.

About I4CE - Institute for Climate Economics

I4CE –Institute for Climate Economics is an initiative of Caisse des Dépôts (CDC) and Agence Française de Développement (AFD). This think tank provides independent expertise and analysis when assessing economic issues relating to climate & energy policies in France and throughout the world. I4CE aims at helping public and private decision-makers to improve the way in which they understand, anticipate, and encourage the use of economic and financial resources aimed at promoting the transition to a low-carbon economy.

All of our publications can be found in French and English free of charge at