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MEASURING ENERGY TRANSITION (ET) RISK FOR INVESTORS: DEVELOPING AN ENERGY TRANSITION ASSESSMENT FRAMEWORK FOR EQUITIES AND BONDS

Periodic Reporting for period 2 - ET RISK (MEASURING ENERGY TRANSITION (ET) RISK FOR INVESTORS: DEVELOPING AN ENERGY TRANSITION ASSESSMENT FRAMEWORK FOR EQUITIES AND BONDS)

Reporting period: 2017-05-01 to 2018-07-31

Capital investments and assets in the real economy may be subject to economic shocks if companies misread trends in demand and prices associated with the transition to a low-carbon economy. This impacts financial assets if financial market actors equally misread these trends, either through original analysis or by the use of incorrect assumptions from investees. There is a range of theoretical and empirical evidence that current risk assessment frameworks in financial markets by companies are likely to mis-read these trends, given short-termism in financial markets, behavioural biases, and more fundamentally a missing infrastructure of analytical building blocks for assessing energy transition risks i.e. risks associated with the transition to a low-carbon economy.

The ET Risk consortium, funded by the European Commission, developed the key analytical building blocks needed for Energy Transition risk assessment to contribute to capital allocation decisions that better price transition risks and integrate climate goals into their assessment framework. These analytical blocks consisted of three key pieces.

1. TRANSITION SCENARIOS

The consortium developed and released two transition risk scenarios, the first representing a ‘soft’ transition extending current and planned policies and technological trends (e.g. an IEA NPS trajectory), and the second representing an ambitious scenario that expands on the data from the IEA 450S /2DS, the project’s asset level data work (see Number 2), and relevant third-party literature.

2. COMPANY & FINANCIAL DATA

Oxford Smith School and 2° Investing Initiative jointly consolidated and analyzed asset level information across six energy-relevant sectors (power, automotive, steel, cement, aircraft, shipping), including an assessment of committed emissions and the ability to potentially ‘unlock’ such emissions (e.g. reducing load factors).

3. VALUATION AND RISK MODELS

a) ClimateXcellence Model – The CO-Firm. This company risk model comprises detailed modeling steps to assess how risk factors impact margins and capital expenditure viability at the company level.
b) Valuation models – Kepler Cheuvreux. The above impact on climate- and energy-related changes to company margins and cash flows was used to feed discounted cash flow and other valuation models of financial analysts.
d) Credit risk rating models – S&P Global. S&P Global used the project outputs to determine if there is a material impact on a company’s creditworthiness.
The following work has been carried out towards the achievement of the objectives of the project:
• An ET Risk concept paper was published as a final report in December 2016, outlining the drivers of financial risks and the ‘toolbox’ for risk assessment (Data, scenarios, models).
• 4 concept papers were published on challenges around modelling adaptive capacity, the management of litigation risks, options for transition risk monitoring by financial supervisory authorities and governments, and on the link between the market failure literature and transition risk. The market failure report was published in the Journal of Sustainable
Finance & Investment (Gold Access, July 2016). The adaptive capacity paper and the monitoring report was published in August 2017. The litigation risk report was published in September 2017.
• A physical asset-level data database on Cumulative committed carbon emissions (CCCE) was developed (Assets@Risk database) as well as a database on reductions in CCCE (RCCCE) potentials. The databases covering 6 industries, the car manufacturing, airlines, airports, shipping, cement, steel, power & heat utilities.
• A final report was published outlining all the CCCE methodologies and findings;
• The scenario report (Transition Risk-O-Meter) road-testing was finalized, feedback received integrated and the paper published.
• An excel version of the Transition Risk-O-Meter was published in the project website with the aim to provide the data points developed as part of the publication through a user-friendly format.
• Company climate-risk related models for utilities, steel, automotive, and cement finalized.
• ET Risk net margin impact tool finalized, including visualization and IT-strategy, the investor roadshow was completed, and the tool was launched.
• 5 reports on scenario analysis were published; one providing general guidance on scenario analysis, three sector applications for the electric utilities, automotive, and steel sector, and a summary report providing key results from the company and sectoral analysis.
• A report on scenario analysis for the cement sector was published “Cement's financial performance under 2°C and 2.7°C – A how to guide for the sector, and three companies across six countries”.
• A paper on transition risk and credit quality was drafted. It is expected to be launched in late September.
• Three different demand profiles were prepared based on interpretation of International Energy Agency (IEA) modelling; carbon-constrained 2ºC and 1.75ºC scenarios that assume further climate action and a 2.7ºC. The results were published in March 2018 in a report entitled “Mind the Gap: the $1.6 trillion energy transition risk”.
• Two reports focusing on the current European policy debate on disclosure of climate and broader ESG considerations providing food for thought to the organisations involved in the development and drafting process of policy texts and policy recommendations were drafted and published.
• An ET Risk reporting template for companies was developed.

In terms of outreach and dissemination, the results of the project were presented at 78 workshops and conferences and 3 webinars, a total of 5000 interactions were achieved through those dissemination channels. In addition, project partners disseminated the research outputs through a total of 14 newsletters and press releases, a total of 12250 interactions were achieved.
The project represents progress beyond the state of the art across all core analytical building blocks of financial analysis as it relates to sustainable energy, energy efficiency and the transition to a low-carbon economy:

• The project represents the first attempt to provide a comprehensive mapping and availability to asset level data that quantifies – bottom-up – the locked-in GHG emissions of core sustainable energy and energy efficiency and the economic costs and opportunities associated with unlocking them, potentially revolutionizing the quality and scope of climate data available to financial actors. To date, this data is largely backward-looking and aggregated at company level, making comparisons with climate scenarios impossible
• The project provides the first transition scenarios specifically tailored for financial analysis, responding directly to the recommendations from the Financial Stability Board Task Force on Climate-Related Financial Disclosures for the creation of such scenarios. In this, it anticipated the need over two years before the Task Force flagged this market shortcoming and at time of publication was able to directly respond to this shortcoming.
• The project provides the first collaborative partnership on transition risk modelling across asset classes and linked to company scenario analysis, elevating the quality and availability of models available to both credit and equity investors, as well as companies themselves.
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