How you measure transition risk matters: comparing and evaluating climate transition risk metrics

Abstract

I investigate how to best measure firms' climate transition risk. Therefore, I gather a new dataset of firm-level climate transition risk metrics including reported EU taxonomy alignments of capex and revenues as well as emission intensities, E-scores from Refinitiv and MSCI, The Refinitiv Business Classification (TRBC), and text-based metrics. I find a strong divergence in transition risk metrics for companies. Thus, depending on the transition risk metric – a portfolio's transition risk profile will differ substantially. To evaluate the transition risk metrics, I measure the return sensitivity of nine brown and green portfolios– each constructed using a specific firm-level transition risk metric – to market-wide news indices that track transition risk shocks: the higher the sensitivity, the more effective the transition risk proxy. For green portfolios, I find that taxonomy and TRBC portfolios react most strongly to climate transition risk shocks. Forward-looking metrics seem to be particularly useful. For brown portfolios, only the MSCI E-score portfolio reacts significantly negative to transition risk shocks. The findings are robust across different world regions, different weighting and sampling methodologies and in an event-study setting. I conclude that markets currently price the upside risk for green firms stronger than the downside risk for brown firms.