Abstract

This paper addresses climate transition risks in portfolio management by introducing a model that integrates firm-specific ‘green’ revenues, aligned with the European taxonomy, with economic and energy variables from adverse transition scenarios. Unlike short-term climate stress tests focusing on carbon pricing, our model incorporates operational cost and revenue transmission channels to derive a conditional transition loss metric. Applied to 1,287 listed companies, our analysis reveals significant implications for equity portfolio risk management. Aggregate portfolio impacts range from 0.5-6%, with sector-specific losses as high as 10-60% in vulnerable sectors such as Utilities. Integrating such forward-looking scenario analysis results with backward-looking financial factor models offers a promising avenue to capture shifts in investor perceptions and enhance equity portfolio risk management.

Key takeaways:

• Climate transition risks, driven by shifts in policy, technology, and consumer preferences, present significant challenges for portfolio management. Existing short-term climate stress tests focus predominantly on carbon pricing and its impact on operational costs, often neglecting longer-term transmission channels related to demand-driven changes in firm revenue dynamics.
• This paper introduces a model that integrates firm-specific ‘green’ revenues, aligned with the European taxonomy, with economic and energy variables derived from adverse transition scenarios. By capturing the interplay between revenue and operational cost transmission channels, the model derives a conditional transition loss metric.
• Applied to the 1,287 constituents of the MSCI World Index, the analysis highlights three main results: revenue impacts are as influential as carbon pricing in shaping transition risks; heterogeneous effects within sectors show some firms benefiting under ambitious transition scenarios; and uncertainty around socio-economic pathways significantly affects conditional transition loss estimates.

Introduction

Climate-related transition risks, which encompass the economic and financial challenges associated with the shift to a low-carbon economy, are increasingly central to equity portfolio management. These risks, driven by policy changes, technological innovations and evolving consumer preferences, pose potential disruptions while offering opportunities for firms strategically aligned with climate goals. For equity portfolio managers, transition risks are not merely theoretical concerns but material considerations affecting valuations, sectoral dynamics and risk-return profiles. Understanding and quantifying these risks are crucial for portfolio allocation.

Over the past decade, academic research and financial industry practitioners have increasingly recognised the importance of transition risks. Early contributions, such as the Carbon Tracker Initiative’s identification of the ‘carbon bubble’, highlighted the financial implications of unburnable fossil fuel reserves (Leaton, 2011). This was followed by Mark Carney’s landmark speech1 in 2015, which underscored the systemic consequences of climate-related risks, including transition risks. The establishment of the Task Force on Climate-related Financial Disclosures (TCFD) in 2017 formalised these risks and catalysed further research.

The existing literature provides mixed evidence on the pricing of transition risks in equity markets. Studies such as Bolton and Kacperczyk (2021) have identified a carbon risk premium, whereby firms with higher greenhouse gas (GHG) emissions are valued with a discount. Conversely, other studies, such as Bernardini et al. (2021) and Bauer et al. (2022), suggest that green stocks have outperformed brown stocks, indicating that transition risks may not be uniformly priced. These contradictions are often attributed to differences in realised versus expected returns, as highlighted by Ardia et al. (2023) and Pástor et al. (2022). The latter emphasise that unexpected shifts in climate concerns can lead to a revaluation of assets, benefiting green firms while penalising brown ones. Furthermore, reviews by Campiglio et al. (2023) and Thomä and Chenet (2017) reveal structural barriers to pricing transition risks, including inadequate risk models and intertemporal inconsistencies.

Long-term scenario analysis has emerged as a critical complementary tool for addressing these challenges, offering forward-looking insights into how transition risks might materialise under different climate policy and technological pathways (Campiglio et al., 2023). While short-term climate stress tests focus primarily on carbon pricing and its impact on operational costs, long-term scenario methodologies extend the analysis to include demand shifts across activity segments and broader economic and energy interdependencies. Recent efforts by regulatory bodies such as the Network for Greening the Financial System (NGFS) have advanced integrated assessment models that capture both direct and indirect effects of transition drivers. However, these approaches often lack granularity at the firm level, particularly in differentiating impacts within the same sector. This analysis therefore aims to address the following research question: How might firms be affected by both the opportunities and costs associated with the climate-related transition, and how does this impact differ both across and within sectors?

This paper contributes to the literature in two ways:

First, it introduces a model that integrates firm-level revenue data, ‘green’ revenues from the European taxonomy, alongside carbon intensity metrics. By linking the firm revenue dependencies to variables derived from NGFS scenarios, the model captures the effects of demand fluctuations on firm revenues, providing a more nuanced and comprehensive perspective compared to traditional models that rely solely on emissions intensity metrics.

Second, it evaluates the sensitivity of the resulting conditional transition loss to the choice of scenario, time horizon, and model uncertainties, acknowledging the significant influence of these parameters on outcomes (Bingler et al., 2022b; Campiglio et al., 2023). To this end, the analysis considers both medium-term (2030) and long-term (2050) horizons across four scenarios and three models.

The analysis of the 1,287 companies in the MSCI World Index highlights three main results:

• First, the revenue transmission channel, often underexplored, plays a critical role in shaping transition risks, both for sectors with low direct emissions, such as Healthcare and Technology, and for transition sensitive sectors like Energy and Utilities.
• Second, incorporating both revenue and carbon cost effects uncovers heterogeneous impacts within sectors, with some firms benefiting from the transition while others face significant losses. This heterogeneity underscores the limitations of using carbon intensity as a standalone proxy for transition risk.
• Third, the sensitivity analysis shows that transition risk impacts are highly dependent on scenario and time horizon assumptions, while the choice of the integrated assessment model has a limited impact.

Based on these results, several recommendations can be made for academics, regulators, and practitioners.

• First, forward-looking metrics that incorporate both revenue and operational cost transmissionchannels should be prioritised to enhance risk assessment frameworks.
• Second, given the uncertainty surrounding socio-economic pathways of the energy transition, utilising a set of complementary scenarios allows for a relevant estimation of potential transition outcomes and their implications for equity valuations, that can serve as the starting point of a risk management strategy.
• Third, the sensitivity analysis reveals that most transition risks materialise from cash flows beyond 2030, despite the mitigating effects of discounting. This finding suggests that the ‘tragedy of the horizon’ is not an inherent flaw of the discounting principle but rather a reflection of the prevalent focus on short-term horizons in current risk assessments.

The rest of this paper is organised as follows. In Section 1, we review the existing literature on transition risks, highlighting how this analysis aims to extend existing results by focusing on the interplay between carbon cost and revenue transmission channels. Section 2 introduces the model and data, detailing the integration of firm-level revenue data with sectoral variables derived from NGFS scenarios and the calibration of key parameters. Section 3 presents the results, highlighting the significance of the revenue transmission channel, the heterogeneous impacts within sectors, and the sensitivity of outcomes to scenario design, time horizon, and model uncertainties .Finally, Section 4 concludes by discussing these results in light of the current literature and offering recommendations for future research.

Authors

Matteo Bagnara, PhD
Quant Researcher,
Scientific Portfolio ……………………………………….
…
….

Shahyar Safaee
Deputy CEO and Business Development Director,
Scientific Portfolio

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