Discounting Transition Risk : The Development of a Climate Risk Model for Equity Portfolios

Abstract: To mitigate climate change, the transition to a low-carbon economy is imperative. Even though this transition poses unprecedented economic and social risks, academic research regarding the impacts of such risks on the financial sector is limited. This thesis develops an integrated analytical framework to quantify the transition risks of equity portfolios. The aim is to improve the scientific understanding of transition risk modelling and to enable a forward-looking risk analysis in investment management. Transition risks are analyzed with a scenario-based approach. Three transition scenarios that stretch until 2025 and 2030 are constructed. For each scenario, three risk variables are designed: a global carbon tax, a change in the share of renewables in electricity generation, and a change in fossil fuel production. A transition-adjusted dis-counted cash flow (TA-DCF) model is developed to estimate the financial impacts of those risks. Furthermore, a method to model company-specific transition capacity is applied. The findings of the study suggest limited total transition impacts on the portfolio level until 2030. The analysis of a diversified global equity index discovers losses of -2.95% of the total market value in the most ambitious transi-tion scenario. Transition risks become more apparent on the sector and individual company level. The thesis finds that three sectors, Energy, Utilities and Materials, are highly exposed to transition risks. In addition, the TA-DCF model enables the identification of companies that are expected to lose of most of their value due to transition risks as well as companies that leverage the emerging opportunities. The developed framework can be applied in portfolio management and portfolio construction to incorporate tran-sition risks into decision-making processes in financial risk management. Several use cases, i.e. the development of a low transition risk benchmark, are discussed.