Braving the Energy Transition: Understanding and Managing Transition Risks for a Sustainable Future

The rise of ESG

The integration of environmental, social and governance (ESG) principles into business strategies is becoming more widespread, reshaping traditional practices and operations standards.

Faced with the climbing frequency of climate disasters and their spiralling costs, the growing complexities of social issues in supply chains and louder calls for transparent governance, organisations are increasingly embracing ESG initiatives. This shift towards ESG-focused strategies isn’t just market-driven; it’s an essential response to emerging global challenges.

As ESG gains global momentum, it’s crucial to also address other important, less-discussed aspects of the conversation. Specifically, components closely tied to climate-related events and the shift towards a low-carbon economy – such as transition risk, transition opportunity and physical risk – deserve thorough consideration.

To assess these, we turn to the framework developed by the Task Force on Climate-related Financial Disclosures (TCFD), which aims to help companies improve their disclosures concerning climate-related risks and opportunities. Although the TCFD has been disbanded following the release of climate-related disclosures by the International Financial Reporting Standards (IFRS), its framework continues to be a crucial resource. This tool is helpful for various stakeholders, including investors, lenders, suppliers and consultants, in gauging a company’s and an industry’s position in the transition towards cleaner energy.

Understanding the importance of transition risk, transition opportunity and physical risk

Organisations may grapple with financial and reputational risks amid the upheaval of a lower-carbon economy – a threat known as transition risk. This risk can emerge from policy, legal, technological and market changes. It can expose organisations to a spectrum of risks, the severity of which is dictated by the pace and type of these changes.

Conversely, transition opportunities empower organisations to adapt and foster innovation amid the shift to a lower carbon economy. This adaptability is vital for their growth and resilience, particularly against adversities like climate change.

Yet another potential hazard, physical risk, looms over organisations because of acute or long-term climate changes. These could wreak havoc on their assets, disrupt supply chains and induce operational setbacks, potentially jeopardising their financial wellbeing.

Government policies are one of the main engines behind transition risk

Apart from factors like changing market forces, consumer preferences and technological innovation, government policies are one of the primary catalysts in the shift towards sustainable practices. For instance, since 2015, countries have united under the Paris Agreement to limit global warming to 1.5°C. To achieve this target, greenhouse gas (GHG) emissions must hit their peak by 2025, and then plummet by 43.0% by 2030. Nations like Australia are enacting policies to reduce emissions and aim for net-zero by 2050. 

Government policies and measures significantly shape business operations, requiring companies to adapt to new regulations. This shift often involves transition risks – a potential downside associated with the economic shift towards decreased reliance on carbon-intense resources. To manage these risks effectively, businesses need to implement key adaptation and mitigation strategies.

Mandatory climate reporting and the battle against greenwashing

A prime example is the upcoming mandatory climate reporting that is set to commence in July 2024. Under the proposed climate reporting requirements, businesses that meet thresholds related to employee count, gross assets and annual revenue must incorporate climate disclosures into their annual reports.

These changes, anticipated to roll out over the next few years, are set to impact over 6,000 entities, reflecting the broad reach of the new disclosure requirements. Transition risk is further amplified by the Australian Securities and Investments Commission (ASIC)’s efforts to curb greenwashing.

Recognising the harm greenwashing can inflict on consumer trust, market integrity and the overall energy transition, ASIC will maintain its focus on combating these deceptive practices in 2024. Under the 2024-25 budget, the corporate watchdog will receive a funding boost of $10 million, spread over four years starting from 2024-25, underscoring the government’s commitment to battling greenwashing. The failure to meet sustainability disclosure requirements amplifies the risk of litigation and reputation damage, which can instigate a flow-on impact affecting stakeholder trust, market standing and overall business sustainability.

Who is particularly impacted by transition risk?

Financial services sector

The transition to a low-carbon economy would bring about changes like stricter regulations on carbon emissions, advancements in green technology, shifts in investor preferences towards sustainability and changes in consumer demands. Although the financial sector isn’t directly a substantial contributor to carbon emissions, it holds significant ties with many carbon-intensive industries via funding channels.

Banks and other financial institutions may find their balance sheets at risk because of their associations with high-emitting sectors or industries heavily dependent on fossil fuels. Increased obligations for emissions reporting and the transition to cleaner energy, for example, could lead to asset devaluation and even result in stranded assets as scrutiny of high-emitting sectors intensifies. This could have sweeping implications on the financial viability of these institutions, affecting their valuation, costs, capital availability and overall profitability.

ASIC’s crackdown on greenwashing poses an additional threat. The regulatory body has notably targeted companies and funds that misrepresented or exaggerated their environmental credentials. A recent win against Vanguard Investments Australia showcases this commitment; the Federal Court ruled that Vanguard had contravened the law by disseminating misleading information about ESG screenings applied to their investments. ASIC’s legal triumph underscores its steadfast commitment to battling deceptive marketing practices and greenwashing.

While the financial services sector is crucial in enabling the energy transition via funding sustainable technologies and initiatives, it faces substantial transition risks because of its exposure to high-emitting industries and changing government regulations.

Strategies for success

• Emphasise comprehensive risk analysis: Carrying out risk evaluations, like scenario analysis per TCFD guidelines, can help financial institutions gauge their susceptibility to regulatory and transition risk. This enables them to measure their exposure to high-emitting sectors and adapt their investment and lending practices accordingly. Risk assessments can equip financial institutions with the necessary insight to strategically channel their investments towards industries that align with Australia’s decarbonisation objectives, which helps future-proof their portfolios against transition risks.
• Exercise activist influence: As significant shareholders or lenders, financial institutions can actively push for improved environmental and sustainability practices within their investee companies, leveraging their influence to drive industry-wide change towards sustainability. For instance, the Commonwealth Bank has restricted project financing for particular infrastructure related to new oil and gas (O&G) extraction initiatives. The bank expects some O&G companies that meet certain thresholds to have verifiable, Paris-aligned transition plans encompassing Scope 1, 2 and 3 emissions by 2025.
• Enhance scrutiny of investment claims: In the fight against greenwashing, financial institutions must elevate their due diligence processes around environmental claims. The method includes rigorous investigation and verification of prospective investees’ green credentials and sustainability practices. This thorough vetting is essential in ensuring an accurate representation of environmental impact. It also helps safeguard the financial institution against reputational damage and potential regulatory repercussions from associating with entities misrepresenting their carbon footprint or sustainable practices.

Mining

As Australia accelerates its path to net-zero, the mining sector, especially coal mining and O&G extraction, will grapple with transition risks like more rigid carbon pricing and the shift from traditional non-renewable sources towards cleaner, alternative energy options.

The upcoming mandatory climate reporting and stricter carbon pricing through the reformed Safeguard Mechanism are escalating pressure on mining companies to reduce their carbon footprint. More importantly, the transition to renewables will substantially impact coal miners and O&G extraction operations.

The Future Made in Australia plan revealed in the 2024-25 budget, alongside Australia’s Green Bond Framework, demonstrates the Australian government’s determination to redirect funding towards projects that contribute to the nation’s journey towards net-zero emissions.

Many initiatives, including the Hydrogen Headstart program and the creation of the Net Zero Economy Authority, will hasten the shift towards an economy sustained by clean energy, reducing reliance on non-renewable fuels. If mining businesses heavily reliant on fossil fuel extraction do not successfully adapt to these changes, they may suffer from stranded assets, reduced capital availability and profitability.

Additionally, the social pressure and reputational risk associated with contributing to climate change can challenge their long-term sustainability. These challenges could be exacerbated by constraints in capital availability for fossil fuel-related businesses as investments and sponsors pivot towards sustainable alternatives.

Strategies for success

• Embrace green solutions: Mining companies can invest in green solutions such as sourcing renewable energy for operations and transitioning their vehicle fleets to hybrid or electric models. This proactive approach can help curb carbon emissions, align with regulatory guidelines and demonstrate their commitment to sustainability. Lowering emissions could result in mining companies needing to purchase fewer Australian Carbon Credit Units (ACCUs) under the reformed Safeguard Mechanism. This strategy can help mitigate transition risks, as the companies would be better prepared to meet tightening regulations and less likely to face financial penalties for non-compliance. It also aligns mining companies with the broader energy transition towards a low-carbon economy.
• Incorporate carbon pricing in decision-making: Mining companies should consider carbon pricing scenarios when making capital and operational decisions. By factoring in the potential costs of carbon emissions, they can make more informed choices about investments, operational efficiency and long-term strategic planning, helping them better manage climate-related risks and opportunities. This approach complements the adoption of green solutions by driving them to implement sustainable practices and technologies to curtail their carbon emissions.
• Diversification of operations: Coal miners and O&G operators should explore diversification strategies, shifting their focus from non-renewable resources to include initiatives in the renewable energy sector or projects contributing to the energy transition. For instance, coal miners can invest in renewable energy initiatives or minerals catering to clean technology. Crafting a sustainable strategy to wean off reliance on fossil fuels can effectively assist in managing transition risks. This approach is particularly crucial in the context of Australia’s pledge to achieve net-zero emissions, which will include significant shifts in policy, regulations and market demand that is set to impact the traditional fossil fuel industry.

Manufacturing

The transition towards a low-carbon economy presents several risks for the manufacturing sector. Regulation changes, such as stricter environmental policies and increased carbon pricing, can lead to higher operating costs.

The reformed Safeguard Mechanism’s requirement of a 4.9% yearly reduction in GHG emissions until 2030 and a 3.285% reduction thereafter is a transition risk for some manufacturers who must curb their carbon footprint, buy ACCUs or face potential penalties – all representing a cost hike.

Numerous manufacturing industries that rely heavily on fossil fuels for high-temperature heat processes, including steel and iron manufacturing, cement and lime manufacturing and alumina production, fall into the hard-to-abate category, making the transition to lower emissions even more challenging because of the inherent difficulties in reducing their carbon footprint.

The proposed mandatory climate disclosures are also particularly challenging for the manufacturing companies that meet the reporting thresholds, as they must account for and disclose Scope 3 emissions from the second reporting year. This shift from primarily qualitative to quantitative climate scenario analysis necessitates these industries to measure, manage and mitigate their entire carbon footprint, adding complexity to their transition to sustainable practices.

Strategies for success

• Embrace emerging technologies: Manufacturers should consider exploring technologies such as Carbon Capture, Use and Storage (CCUS). CCUS captures carbon dioxide emissions from industrial processes, using them for other purposes like enhanced oil recovery or storage underground, which can be particularly beneficial for hard-to-abate manufacturing sectors by enabling them to limit GHG emissions while maintaining their production levels. Adopting nascent technologies like CCUS can help manufacturers reduce their carbon footprint, enhance operational efficiency and comply with environmental regulations.
• Implement financial mitigation strategies: Given the potentially high cost of implementing technologies that help in the energy transition, manufacturers could consider several strategies. These could include building partnerships with technology providers, participating in industrial consortiums to share costs, implementing an incremental approach to new technologies to spread out expenses over time and leveraging government incentives, grants or subsidies (like the Emissions Reduction Fund) that are geared towards enhancing energy efficiency and reducing emissions. Such strategies can help make the transition more financially viable and lessen the monetary impact of the transition.
• Allocate resources to renewable energy sources and augment energy efficiency: Manufacturers should consider investing in renewable energy sources. Transitioning the energy supply from fossil fuels to renewable resources reduces carbon footprint. Implementations could include installing solar panels and wind turbines or purchasing green power from renewable energy suppliers. Manufacturers can invest in improving the energy efficiency of their facilities and processes, which includes upgrading to energy-efficient machinery and equipment, optimising production processes, or improving their buildings’ insulation and energy management. By implementing these strategies, manufacturers can secure long-term cost savings and stay ahead of stricter emissions regulations, bolstering their competitiveness and resilience in a low-carbon economy.