The transition to a low-carbon economy risks creating stranded assets and mis-priced share valuations, which could lead to financial instability. These risks are known as transition risks.

Transition risks are primarily focussed around fossil-fuel energy exposed companies. Such companies may be overvalued due to the failure to factor in transition risks appropriately, potentially causing financial stability issues and sharp share price downward revaluations.

The efficient market theory (EMT) may not apply due to market failure in respect to inaccurately factoring in longer-term transition risks. Current financial models may simply be just too simplistic to deal with these risks. Many models assume normal distributions whereas in the real world this is often not the case. Transition risks are potentially exposed to skewed and fat tail distributions. In addition, current models may be subject to behavioural biases, and it is also difficult to model cash flows in relation to transition risk accurately.

Many market models assume that risk as equally distributed across an investment time horizon and thus a single discount rate is often used. In reality, risks are often unevenly spread and investors tend to have a bias towards short-term decision making; that is the short-term market is relatively efficient but the longer-term investment horizon is inefficient. Often, investors will merely extrapolate shorter-term trends into the future. Models may also be informationally inefficient, with insufficient data on future transition costs and general externalities. In terms of transitional externalities, there is also often little distinction between inter-temporal externalities (how this will affect people in the future) and geographical externalities (how a company’s actions may affect people in different geographical locales). This raises the issues of both inter-generational and inter-geographical neutrality, that is, a one world approach.

In terms of investment management these long-term transition risks are more immediately apparent. This is because fund managers are rewarded for performance on a relatively short-term basis; they are not rewarded for considering longer-term risks. This is reflected in the models fund managers use. Models are also often path dependent, based on assumptions from the past and not sufficiently forward looking.

The paper promotes the creation of better and smart risk models and the need to address the agency problem (for example that professional investor’s motives may not be aligned to the need to consider longer-term transition risks). It also suggests that longer-term models should be applied and that tail risks be incorporated more systematically. However, the paper admits there is uncertainty regarding the extent to which such risks are integrated into models and whether transition risks are better handled by stress testing models.

The authors also make clear they are not providing any evidence as to the scale or materiality of transition risks. Rather, they seek to highlight that, if these risks do indeed exist, that they could be particularly damaging in terms of the misallocation of capital and potential increased costs of a transition to a low-carbon economy. It also suggests that regulation may be necessary to impose longer-term risk considerations.

1. Mispriced transition risks could cause a bubble in fossil-fuel exposed companies, leading to sharp share price drawdowns.
2. Current financial models are often over simplistic.
3. Modelling transition risks may be subject to behavioural biases.
4. Transition risks may not be normally distributed thus more sophisticated models may be required.
5. The market may not know what it doesn’t know and is constrained by bounded rationality.
6. Investors tend to have a shorter-term bias where transition risks are longer-term in nature.
7. Regulation may be required to impose longer-term risk considerations.
8. Efficient Market Theory (EMT) may not apply to transition risks.