Ecological transition and its effects on companies

One of the biggest, and perhaps least understood, risks that organizations are facing today is climate change. Many companies mistakenly see the implications of climate change as something projected over the long term, but the potential impacts are not only physical, nor will they all materialize far in the future. The mitigation process for climate change calls for rapid decarbonization of the economy, if we hope to avoid catastrophic consequences such as the collapse of the polar ice caps or the tropical rain forests.  

• In 2019, CO2 concentrations in the air hit the highest levels ever in the last two million years; and methane and nitrous oxide levels are the highest they’ve ever been in the last 800,000 years.  
• Since 1970, the Earth’s surface temperature has been climbing faster than in any other 50-year period in the last 2,000 years. On a scale of centuries, we would have to go back 6,500 years to find a decade-long period with temperatures hotter than those recorded from 2010 to 2020. Greenhouse gas emissions from human activity are responsible for this upsurge, which scientists estimate is on track to reach 1.5° C.  
• The average sea level around the globe has risen faster since 1900 than it has in any previous century over the past 3,000 years. 

Decarbonization of the economy can no longer wait, and the process will involve deep structural changes. In this scenario, the challenge of the new millennium is to provide financial support targeted to promote initiatives dedicated to sustainable development.  So the EU has drawn up a global strategy for sustainable finance, intending to bolster the role of the financial industry in facilitating the transition toward a low-carbon economy which is resource efficient and sustainable. 

And yet there is a gap in the academic literature on climate change specifically with regard to the risk of transition for companies and the possible impact on their economic and financial variables. In this study, we attempted to explore relevant questions that are still not common topics of discussion. In doing so, we came up with a critical evaluation of the ecological transition risk assessment model for the financial industry developed by CRIF (a global company specializing in credit bureau and business information, and credit solutions) based on an analysis of the variables utilized by other competitors and regulatory indications. 

Climate change risks can directly influence core business activity, value chains, market opportunities, reputations and legal proceedings. By facing these risks, companies can make their production more efficient and become more competitive. But failing to take action can stunt their ability to grow. Risk factors associated with the transition process generate financial fallout, altering prices and skewing market supply and demand toward low-carbon goods and services, both in the short and the long term. Expectations focused on the medium/long term can generate short-term risks, so the key drivers to leverage are: 

• climate change mitigation policy; 
• technological transformation; 
• changes in consumer preferences. 

Climate risks are serious both for companies and financial actors. The former can come up against risks that impact how they do business, which means they must set the transition process in motion, moving toward a more resilient and sustainable business model. Financial actors, on the other hand, could find themselves facing both physical risks for their customers and assets, and transition risks when they operate in greener industries, beyond the possibility of seeing returns on certain investments shrink.  

This is why the priority lies in reporting the impact that climate change can have on a company (not just the impact that the company has on the climate). The dual objective here is to: 

• raise awareness on the issue of climate change, encouraging companies to embark on the path to decarbonization; 
• inform stakeholders about the efforts that the company is making to join in the fight against climate change. 

If we take three different climate scenarios (Disorderly Transition, Hot House World, Orderly Transition), another driver to consider is an evaluation of the extent to which the process of ecological transition can affect the likelihood of default for companies. From this perspective, the KPIs to take into account are connected to profitability, liquidity, and financial stability. 

Companies will have to bake decarbonization and sustainability targets into their strategies, in such a way that is consistent and achievable with respect to their business plan. Specifically, deploying decarbonization and transition strategies will mean allocating financial resources that will have to be considered a necessary investment that serves to strengthen the competitiveness, reputation, and resilience of the company. 

The issue of access to financing and fresh capital will become a critical one in terms of current developments around decarbonization processes because companies that are virtuous in this sense will be more attractive and resilient in the eyes of markets and investors. The central theme will be investments both in innovating infrastructure and materials for electrification (power plants, transmission and logistics), and in alternative energy sources such as wind, hydrogen, and biomethane. In light of all this, sizeable sources of capital will be needed, be they in the form of debt or equity, to support companies in managing environmental risks (physical risk and transition risk). 

As for the metrics, the priority for companies will be to adopt the international and European standards of measurement to more objectively assess their business activities, moving toward more homogeneous data, more readily disseminated and shared. All this while working on specific decarbonization indicators and KPIs. 

The transition process must be seen as a driver not only for companies that operate in the energy industry, but also for manufacturers, in the production of intermediate goods, mass market goods, and services. Corporate finance must take the lead and become the champion of ecological transition.