Modelling of Transition Risk

Abstract

Climate change poses a significant global challenge, with increasing impacts on the economy and financial markets. Despite its relevance, there is still limited research on how climate-related risks can be systematically incorporated into financial analysis and risk assessment. This thesis proposes an empirical approach to assessing risk associated with the transition to a low-carbon economy by constructing a climate risk factor based on firm-level carbon intensity and environmental performance. The factor is integrated into an extended CAPM framework to estimate sectoral exposure to transition dynamics in equity markets. The analysis shows that exposure to the climate risk factor varies significantly across sectors. Emission-intensive industries typically display highly negative sensitivity to transition risk, while sectors with more sustainable business practices exhibit lower or even positive exposure. Furthermore, about one-third of the companies exhibited significant exposure to the climate risk factor, suggesting that transition risk is not yet fully priced in the market. To evaluate the macro-financial implications of climate policy, a Bayesian VAR model with sign restrictions is used to identify the structural effect of a positive carbon price shock based on the future carbon prices formulated by Network for Greening the Financial System (NGFS). Results show that such shocks lead to persistent increases in inflation and affect equity returns, with firms that are less carbon-intensive tending to outperform those with higher emissions, particularly under scenarios with ambitious climate policies. Scenario-based return projections reveal that the effect of transition risk on expected sector performance is sensitive to both policy timing and intensity. Sectors with positive exposure to the climate factor are projected to benefit from ambitious climate action, while emission-intensive sectors perform better under scenarios with weak policies. These findings highlight the value of incorporating transition risk into asset pricing models and support the use of climate scenarios as tools for forward-looking financial risk assessment.