Transition Risk

Transition risk refers to the financial risks arising from the process of adjusting towards a low-carbon, environmentally sustainable economy. These risks are increasingly significant for banking and financial systems as governments, markets, and societies respond to climate change through policy reforms, technological shifts, and changing consumer behaviour. In the Indian context, transition risk has gained prominence due to India’s developmental priorities, reliance on carbon-intensive sectors, and commitments towards sustainable growth.
For banks, financial institutions, and the wider economy, transition risk affects asset values, credit quality, investment decisions, and long-term financial stability. Unlike physical climate risks, which arise from extreme weather events, transition risks are largely driven by regulatory, market, technological, and reputational changes associated with climate action.

Concept and Nature of Transition Risk

Transition risk emerges when economic agents face losses due to changes required to move towards a greener economy. These changes may be gradual or sudden, depending on the pace and stringency of climate policies and market responses.
Key sources of transition risk include:

• Policy and legal risks, such as carbon taxes, emission caps, or stricter environmental regulations.
• Technological risks, arising from the replacement of carbon-intensive technologies with cleaner alternatives.
• Market risks, driven by shifts in demand away from fossil fuels and polluting industries.
• Reputational risks, affecting firms and financial institutions perceived as environmentally irresponsible.

In banking and finance, these risks translate into higher credit risk, asset impairment, reduced profitability, and increased volatility in financial markets.

Transition Risk in the Banking Sector

Banks are particularly exposed to transition risk because of their lending and investment portfolios. Loans to carbon-intensive industries such as coal-based power, oil refining, cement, steel, and heavy manufacturing may face higher default risk as these sectors adjust to stricter environmental norms.
Major implications for banks include:

• Stranded assets, where projects lose economic value before the end of their expected life.
• Deterioration in asset quality, affecting non-performing assets (NPAs).
• Capital adequacy pressures, as risk-weighted assets increase.
• Changes in credit allocation, favouring green and sustainable sectors.

In India, public and private sector banks have significant exposure to infrastructure and energy sectors, making transition risk a material concern for balance sheet stability and long-term profitability.

Transition Risk in Financial Markets

Transition risks also affect capital markets, insurance companies, mutual funds, and pension funds. Equity valuations of carbon-intensive firms may decline as investors reassess long-term sustainability and regulatory exposure. Bond markets may face repricing risks, particularly for issuers with high carbon footprints.
Financial market impacts include:

• Repricing of securities due to climate-related disclosures.
• Increased market volatility during policy announcements or regulatory changes.
• Shift in investment flows towards environmental, social, and governance (ESG)-compliant assets.
• Liquidity risks for firms unable to access green finance.

These dynamics influence capital formation and investment efficiency within the broader financial system.

Transition Risk and the Indian Economy

For the Indian economy, transition risk is closely linked to the challenge of balancing economic growth, energy security, and environmental sustainability. India remains dependent on coal for a substantial share of its energy needs, while also committing to expanding renewable energy and reducing emissions intensity.
Transition risks at the macroeconomic level include:

• Employment risks in fossil fuel-dependent regions and industries.
• Fiscal risks, arising from reduced revenues from carbon-intensive sectors.
• Industrial adjustment costs, particularly for small and medium enterprises.
• Competitiveness risks, if domestic industries lag in adopting clean technologies.

At the same time, an unmanaged transition could amplify financial instability and slow economic development.

Regulatory and Policy Dimensions in India

The assessment and management of transition risk in India are increasingly shaped by regulatory guidance and supervisory expectations. The Reserve Bank of India has recognised climate-related financial risks as a source of systemic vulnerability and has encouraged financial institutions to improve climate risk management and disclosures.
Key regulatory approaches include:

• Integration of climate risks into risk management frameworks.
• Stress testing and scenario analysis for climate transition pathways.
• Enhanced disclosure requirements aligned with global standards.
• Encouragement of sustainable and green finance initiatives.

These measures aim to improve the resilience of the Indian financial system while supporting orderly economic transition.

Sectoral Exposure to Transition Risk in India

Transition risk is unevenly distributed across sectors of the Indian economy. Energy, transport, construction, and heavy manufacturing face higher exposure due to their carbon intensity. Conversely, renewable energy, electric mobility, and green infrastructure stand to benefit from the transition.
High-risk sectors typically face:

• Rising compliance and operating costs.
• Reduced access to finance without transition plans.
• Increased scrutiny from regulators and investors.

For banks and investors, understanding sector-specific transition pathways is essential for prudent risk assessment and capital allocation.

Advantages of Managing Transition Risk

Effective management of transition risk offers long-term benefits for banking and finance:

• Improved financial stability and reduced systemic risk.
• Better alignment of portfolios with sustainable growth.
• Enhanced investor confidence and access to global capital.
• Support for innovation and green job creation.

For the Indian economy, proactive transition risk management can facilitate a smoother shift towards sustainable development while minimising economic disruption.

Challenges and Criticism

Despite growing awareness, managing transition risk poses several challenges. Data gaps, uncertainty about policy timelines, and limited expertise hinder accurate risk assessment. Smaller financial institutions may lack the capacity to conduct advanced climate risk analysis.
Critics also argue that:

• Rapid policy shifts could disproportionately affect developing economies.
• Excessive regulatory pressure may restrict credit to traditional sectors.
• Short-term economic costs may outweigh immediate benefits.