This research paper focuses on the transition towards a low carbon economy and its associated risks. The transition requires companies to adapt in many facets of operations, including changing how energy is used, prices and land use patterns, and will inevitably present serious policy, market, legal and reputational risks for firms.

The report details and seeks to quantify how adaptive capacity can protect companies from transition risk, including the role of dynamic and strategic capabilities and the ability to reconfigure an asset base in response to threats. This ability is commonly estimated in the short-term by equity and credit analysts where models are constructed, and implicitly include assumptions about adaptive capacity often in the terminal growth rate. However, the vast majority of models are short-term focused meaning long-term analysis is neglected, posing a threat to understanding transition risks.

Adaptive capacity requirements are determined by the need to adapt, driven by external factors. These include scale, speed and idiosyncrasy of change. In contrast, the ability to adapt is driven by internal abilities and influenced by factors including corporate culture, strategic capabilities and capital lock-in. Adaptive capacity can be achieved by firms through a range of strategic options, however these often involve changes in business segment or operations.

It details the risk of a “too sudden, too late” scenario, where the transition to a low-carbon economy is triggered in a non-linear, disruptive fashion, and the increased risk exposure of firms with relatively long (or unlimited) product life cycles such as oil and gas. This is demonstrated in the report, with findings that the difference in cash flows between a 2 and 6 degree transition to be $28 trillion over 25 years. Or, a difference in cash flows of 30-50%.

Co Firm, Allianz Global Investors, Allianz Climate Solutions and WWD Germany also include an approach to modelling financial climate transition risk. This includes probable changes in regulations technology and customer segments among others, and modelling a firms ability to adapt.

The paper notes there are several challenges to estimating the ability of companies to maximise long-term adaptive capacity, which can include time horizon of data, time horizon of decision-making, increasing uncertainty and cost challenges. Additionally, sell side equity research is skewed to the short-term and most equity analysts research is being incentivised in the short-term. Importantly, the extensive use of assumptions introduces levels of uncertainty into the analysis.

A range of potential responses to these challenges are detailed within the report. Methods such as the stress test approach and probability-weighted scenario analysis, among others, are explored, along with the pros and cons of each. Importantly, improving adaptive capacity estimates is critical to improving financial asset pricing in financial markets. This would result in better returns for financial institutions and better overall economic growth.

1. Economies are transitioning to a low-carbon economy, and this may occur in a number of scenarios. These include a soft, slow transition, or a more sudden, accelerated transition. These two scenarios and associated risks are described in the paper.
2. There are many risks involved in transitioning to a low-carbon economy. These include policy, market, legal and reputational risks. These risks may be particularly significant if the transition is left too late in a scenario which requires firm changes to be made suddenly. These risks can impact upon cost structure, financial performance and end customer price.
3. Adaptive capacity can protect companies from significant transition risk. Adaptive capacity is driven by the external need for adaption, from the extent to which they pose a challenge through scale of change, speed of change, idiosyncrasy of change and evolution vs. secular design.
4. Internal determinants of adaptive capacity are the internal capabilities of a firm to adapt driven by governance and corporate cultures, strategic capabilities and dynamicism. Examples of this include degree of capital lock-in, balance sheet strength and product diversity among others.
5. Long-term adaptive capacity is often not modelled by financial analysts and this presents a risk to understanding transition risks. The vast majority of financial analysts focus on the need for short-term analysis.
6. Analysts often have a good ability to assess short-term adaptive capacity however, a longer term view is rarely modelled. This is due to a number of reasons including time horizon of financial data and decision making, complexity and the heavy use of assumptions and an unclear cost-benefit analysis.
7. Companies face a range of strategic options around achieving adaptive capacity. These include business segment switch, product switch and supply chain or production process switch.
8. The extent to which firms will be affected by a move towards a low-carbon economy depend on the nature of the markets and constrains of the firm. These include the general level of competition in a market (i.e. can prices be passed onto customers), geographic centrality of the marketplace (geographic exposure to different regulations) and the difference in preparedness of companies.
9. There are a number of potential responses to the challenges of long-term modelling of adaptive capacity. Potential responses to the challenges of long-term modelling of adaptive capacities include methods such as worst case scenario/stress test approaches, historic role models, probability weighted scenarios among others and bottom-up deep dives among others.