As the climate-related crisis is gaining momentum, many countries are aggressively try to achieve decarbonisation targets. The shift towards a low-carbon economy and society is the foremost measure taken by countries to address the challenges encountered by climate change. The “low-carbon transition” comprises all those policies and actions targeted to achieve the primary goals set in the ‘Paris Agreement.’ Alongside taking climate resilience and adaptation measures, the governments and businesses should also focus on the possible unintended negative impacts that could hinder or disrupt the transition process known as ‘Transition Risks’. Transition risks happen from the relative uncertainty caused by the global transition towards a low-carbon economy. Global policymakers and climate regulators must recognise that it's high time to seriously consider all the risks that may arise from low-carbon transitions. Moreover, optimal management strategies should be adopted as an essential element to ensure successful implementation of climate transition plans to minimise or eliminate ‘transition risks’ [1], [2].

Understanding Transition Risks Within The Low-Carbon Economy Landscape

The 2015 Paris Agreement is considered to be a noteworthy achievement for the global community that sets a landmark goal to accomplish net-zero emissions by 2050. It was adopted and signed by 196 countries and the European Union (EU), which includes all those policies and actions that aimed to limit the rise in the global average temperature to well below 2°C and ideally to 1.5°C above pre-industrial levels. Despite significant reductions in greenhouse gas (GHG) emissions, the global community is still missing the pathway to achieve this goal. If these patterns continue, the damage and destruction caused by climate change will become more frequent and intense, leading to extreme weather events, natural disasters, and widespread consequences for societies and economies worldwide [3], [4].

Currently, policymakers are focussing more on mitigation and adaptation efforts that mostly address the ‘physical risks’ associated with climate change. While transitioning to a low-carbon economy may lower climate-related physical risks, but it will also create ‘transition risks’ that must be carefully managed. Addressing these risks won't detract from the low-carbon transition; rather, it helps to smooth the transition process and minimise potential failures. Therefore, transition risk management must be a crucial part of climate change policy. There exists a serious policy challenge in advancing both decarbonisation and transition efforts at the same time while also addressing ongoing climate change impacts. Furthermore, these challenges are further complicated by broader global changes like rapid technological progress and shifting economic patterns. However, the transition to a low-carbon economy also brings added advantages and opportunities, which can be further augmented by effective risk management [5].

The 4 Main Drivers of Transition Risks

The Task Force on Climate-related Financial Disclosures (TCFD) established by the Financial Stability Board (FSB) in 2015 set out recommendations for helping businesses improve and increase reporting of financial information about the risks and opportunities presented by climate change. The Task Force categorised the climate-related risks into two main types: physical risks and transition risks. Physical risks are associated with natural changes in environmental patterns and extreme weather shifts, which can be further classified by TCDF as acute and chronic. Transition risks are those that arise in response to actions to reduce GHG emissions and shift the economy towards sustainable energy utilisation. Transition risks may represent multiple levels of financial and reputational threats to businesses depending on their nature, type, pace, and magnitude. As per TCFD’s recommendation, transitioning to a low-carbon economy might involve major changes in public policy measures, legal framework, technological advancements, and market dynamics to accommodate climate change mitigation and adaptation conditions. These four drivers are considered to be the primary classification of transition risks and are further elaborated [6], [7]:

1. Technology Risk

Technological advancements and innovations are the backbone of today’s fourth industrial revolution era. Technology is changing at a fast rate, and with its dynamic nature, it is continuously influencing the way human beings live on Earth. Technology has positively affected every segment of the economy and society. Similarly, technological improvements have undeniably supported many countries to address climate change impacts and to implement successful climate adaptation strategies. As new technology upgrades replace outdated ones, it may disrupt certain areas of the present economic system. For instance, technological transformation will impact climate change adaptation and mitigation efforts of governments and businesses, where some stakeholders will get positive benefits while others will suffer from its negative consequences [7].

• Potential Impacts of Technology Risks

Technology risk includes all the potential challenges that happen due to technological developments or innovations that help to transition towards a low-carbon and more sustainable economic system and can substantially impact businesses and societies. Technology risks related to low-carbon transition may cause the following potential socio-economic impacts on the economy [5], [8]:

• Competitiveness: Technology risks in low-carbon transitions can undermine competitiveness by making outdated assets obsolete, increasing operational costs, and disrupting traditional business models. Businesses that fail to invest in new technologies may lose market share to competitors embracing innovation and sustainability.

• System Design Flaws: The deployment and upgrading of emerging low-carbon technologies may possess offsetting risks, including during the innovation process. For example, accidents that happen due to design flaws, and unpredictable costs during technology adoption.

• Time Frame Selection: The selection of an exact timeframe for technological development and deployment is a significant source of uncertainty when considering technological risk.

• Capital Investments: There is a cost associated with adopting/deploying emerging low-carbon technologies, such as renewable energy sources, energy storage systems, and sustainable transportation. All these require substantial investments from the public and private sectors to raise technological risk in shifting to a carbon-neutral economy.

2. Market Risk

Market risk has a more apparent impact on businesses and organisations. In today's era, the marketplace dynamics behave in the same way as the technological factors. Markets are continuously changing in a complex manner and are at high risk of being affected by climate change. As the supply and demand of diverse products and services change during the decarbonisation phase, it will significantly influence relevant costs and prices. As a result, the highly resilient market players who adapt to this dynamic and complex market circumstance will not only navigate the transition more successfully but will also be able to sustain their existence during the transition phase. While others who do not comprehend the nature of these changes may not be able to outlast [7].

• Potential Impacts of Market Risks

Market risks corresponding to low-carbon transition are specified as the financial insecurities faced by organisations from changes in market preferences and asset values. These risks include changes in consumer behaviour, regulatory impacts, and competitive pressures, thereby leading to financial losses and reduced market share. Market risks related to low-carbon transition may cause the following potential financial and economic impacts on society [7], [9]:

• Changing Consumer Behaviour: A shift in consumer preferences will reduce the demand for goods and services delivered by an organisation. For example, the trend towards electric vehicles (EVs) is increasing nowadays due to eco-friendly and cost-effective options. Therefore, the market for internal combustion engine (ICE) vehicles faces a decrease in demand and presents a potential market risk for their manufacturers.

• Rise In Cost of Production: Uncertainty regarding price and availability of raw materials presents a serious market risk for businesses. The increase in raw material price will raise production costs, thus raising the overall price of the final product and service. Moreover, other factors involved in the production process, like changing input prices (e.g., energy, water) and output requirements (e.g., waste treatment), will intensify market risks.

• Labour Market Impact: Low-carbon transition will significantly impact the labour market under macroeconomic challenges. The net impact of the transition on the labour market scenario may have a positive impact on employment levels; however, in practical terms, there is no guarantee that new jobs created in the renewable energy sectors will replace all old jobs in the fossil fuel production industry.

3. Policy & Legal Risks

The approach to climate change policies is constantly changing. Generally, these policies aimed to either restrict actions that contribute to climate change or encourage adaptation to it. The financial impact and risk associated with policy changes depend on the type and timing of the policy change. Moreover, as the costs incurred by hazards of climate change increase, the litigation risk will likely grow. Reasons for such legal actions include organisations' inadequacy to mitigate and adapt to the impacts of climate change or inadequate disclosure of financial risks [7].

• Potential Impacts of Policy & Legal Risks

Policy risk happens when a company is vulnerable to the impact undertaken by policies to drive the low-carbon transition. Litigation risk is related to legal actions that are taken against companies that fail to mitigate and adapt to climate change issues. Policy and legal risks related to low-carbon transition may cause the following potential financial and economic impacts on society [5], [8], [10]:

• Energy Systems Strains: The socio-economic structure is heavily influenced by energy systems; hence, the transition to low-carbon energy may significantly influence the social and political landscape. The swift transition of the global energy system away from fossil fuels to renewable resources is highly dependent on well-defined policies and legal systems. The International Energy Agency (IEA), in its report ‘Power Systems in Transition,’ warns that “the challenge for policymakers and system planners is to update policies, regulations, and market design features to ensure that power systems remain secure.”

• Distributional Issues: The Paris Agreement binds all signatory countries to reduce GHG emissions by building resilience to adapt to climate change hazards. Therefore, every country is taking actions directed towards the global low-carbon transition goal. However, within countries, this transition may have distributional effects, which, if mishandled, may get a political backlash from the affected communities. For example, those people who belong to the lower-income population are probably to be disproportionately affected by the transition due to higher energy prices.

4. Reputation Risk

There is a possibility that climate change could negatively impact an organisation's image since it can influence consumers and stakeholders who see the company's role in the transition to a lower-carbon economy. Today’s customers are now more aware of using eco-friendly products and prefer to buy from companies that implement sustainable strategies in all stages of their product’s life cycle analysis. Reputation risk pertains to the customer's perceptions regarding businesses for taking transition policies and actions based on frequent re-evaluation [7].

• Potential Impacts of Reputation Risks

There is a growing trend observed considering low-carbon transition actions and responsible climate conduct expected from stakeholders, including investors, lenders and consumers. Governments and organisations are taking collaborative actions to devise various transition risk management strategies. Nevertheless, reputation risk persists, which can create a loss of trust and confidence in businesses. Reputational risks related to low-carbon transition may cause the following potential financial and economic impacts on society [11], [12]:

• Shifts In Consumer Preferences: Customer preferences can drive fluctuations in demand and prices. Technology and market dynamics play an important role in building consumer preferences; as more people use technology, network effects may accelerate further shifting in preferences. Organisations may find a decrease in revenue from certain products and services, such as the rise in the trend of eco-friendly packaging for products, which will reduce sales of goods containing unsustainable packaging such as plastic or non-recyclable packaging.

• Stigmatisation of Sector: Reputation risks can stigmatise any particular sector and assign negative perceptions in the minds of consumers related to climate transition. For example, in the United States, there seems to be massive public opposition to nuclear energy, along with its high capital costs, hindering its future development, which is a learning story for other newly established technologies.

Recommendations For Effective Management of Low-Carbon Transition Risks

The transition risk management framework covers a wide range of issues and efforts to establish effective governing principles and priorities that are still in the early development phases. The following section briefly presents a set of listed recommendations given by the International Risk Governance Center (IRGC) policy brief based on a multi-stakeholder expert workshop held in September 2020. It includes opinions and insights given by multiple stakeholders that should be further explored and developed by academic scholars, industry professionals, non-governmental organisations, and policymakers for pragmatic implementation [5]:

1. Risk Identification And Evaluation

• Develop A Transition Risk Map: The four main drivers of transition risks, which were extensively explained in the previous section, are the building blocks for more detailed risk assessment or risk mapping exercises. More work is required to develop a comprehensive transition risk map. Moreover, further attention is needed on the interdependencies and possible cascades between different risk categories.

• Use Forecasting Tools: Due to the complexity involved in the risk identification and mapping process, it is imperative to utilise advanced forecasting techniques, such as doing a 'scenario analysis’ as per TCFD recommendations, which helps to build a reasonable picture of possible future scenarios [6], [13].

• Evaluate Target Benefits And Co-benefits: Transition risks are interconnected with other climate-related parameters. The policymaker’s challenge is to weigh both the target benefits and the subsequent consequences by offsetting risks and co-benefits together. Moreover, appropriate identification and management of transition risks will assist in swift progress towards a low-carbon economy [14].

2. Inclusion And Consultation

• Identify And Engage Stakeholders: Stakeholder involvement is vital for effective climate transition strategies. Transitioning to a low-carbon economy affects multiple stakeholders across a wider scale. Identifying these stakeholders is the first critical step for successful decision-making. Afterwards, stakeholder engagement will minimise the gaps between those who are making transition-related decisions and those who are affected by them [15].

• Think Beyond Economic Interests: When managing transition risks, policymakers should think beyond narrow economic costs and benefits. Climate transition policies, specifically related to the energy sector, might raise challenges of identity, community, culture, and place, which are not accountable to quantitative cost-benefit analysis [16].

• Map Distributional Issues: Further extending the risk mapping activity, sustainability experts should pay serious attention to distributional issues. These issues arise due to the gap in transition policies between those making decisions and those affected by them.

3. Policy Development and Implementation

• Build On Existing Mitigation Policies: The shift to low-carbon energy sources is currently in the development phase, and policies are being formulated to address certain transition risks. If these strategies prove effective, they should be implemented and expanded further.

• Learn From Other Transitions: Governments and businesses can gain valuable risk governance insights from past transitions, like previous shifts in energy sources and other significant societal changes such as globalisation and digitalisation.

4. Innovation in governance

• Balance Centralised And Decentralised Authority: Centralised and decentralised authorities can work together to build resilience. Serious coordination is usually required among stakeholders to address wide-ranging difficulties. Decentralisation, including participatory and discussion approaches, can help formulate successful policies in complex systems.

• Explore Private-Sector Solutions: Businesses need to contribute to the shift towards a low-carbon economy by playing three critical roles: (i) complying with environmental regulatory requirements, (ii) building market-based soft law mechanisms, and (iii) developing innovative environmentally friendly products and services.

5. Contingency Planning

• Prepare For Disruption And Improve Resilience: The history of climate policy is marked by numerous missed targets; thus, it is important to be cautious about the potential for success in managing transition risks and maximising co-benefits. One key insight from IRGC's research on risk and resilience is the significance of being prepared in advance for disruptions, accidents, and crises.

Conclusion

To address the continuous rise in global warming, there is an urgent need to tackle climate change challenges that require the development of low-carbon transition policies in most countries. Besides taking climate mitigation and adaptation measures, policymakers and stakeholders should also focus on the potential risks and negative consequences associated with these transitions. The importance of addressing transition risks ought to be a key part of ensuring the success of climate policies. By anticipating and managing transition risks, decision-makers can facilitate a smoother low-carbon transition and minimise the risk of failure. The concept of transition risk is extensive and relatively new. This article consolidates various ongoing efforts related to transition risk and recommends accelerating further research and action in this area. Additionally, the article attempts to grab the attention of decision-makers in different policy areas by contributing to the successful low-carbon transition and ultimately minimising the risks associated with climate change.

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References

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