Climate risk in finance: unveiling transition risk exposure in green vs. brown companies

ABSTRACT

This study delved into transition risk by introducing a novel Climate Transition Score to evaluate the climate-related performance of the most capitalized firms in the stock markets of developed countries. Then we classified these firms into green and brown portfolios. Our analysis demonstrates that high-emission or brown firms bear more risk than their green counterparts do, even if they do not consistently outperform them.

To gauge exposure to transition risk, we employed asset pricing factor models such as CAPM, Fama and French 3-Factor, and Carhart’s (1997) model. However, these models failed to provide a satisfactory explanation for portfolios’ excess returns in their standard formulation. To address this gap, we introduced the Green Minus Brown risk factor. This addition enhanced the explanatory power of the models, emphasizing the heightened exposure of brown companies to transition risk.

KEYWORDS:

• Transition risk
• climate risk
• ESG
• factor models
• sustainable finance

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

2 Robustness test with other parameter values within 0.1 limits have been performed; they provided qualitatively similar results. The results can be obtained from the authors upon request.