How you measure transition risk matters: Comparing and evaluating climate transition riskmetrics

A fundamental and seemingly easy question in climate finance remains unanswered: how to best measure companies’ climate transition risk. Most authors do not critically discuss this first order question, however, as we show in this paper, choosing different transition risk metrics can lead to significantly different results. We employ a new dataset containing for the first-time reported EU taxonomy alignment of both capex and revenues as a proxy for companies transition risk. We compare taxonomy alignment to commonly used CO2 emission data and E scores from Refinitiv and MSCI. We also utilize TRBC codes as a granular sector/technology classification as well as text-based approaches to measure transition risk. We find a strong divergence in transition risk metrics for similar companies. Next, we also evaluate the different transition risk proxies. Our empirical approach uses the return sensitivity of 9 transition risk metric based Brown Minus Green portfolios against news indices which track unexpected shocks to transition risk. Thereby, we are able to show which transition risk metric is more/less sensitive to transition risk shocks and therefore better suited to measure climate transition risk of firms. We find that green taxonomy, text based and TRBC based portfolios react strongest to climate transition risk shocks. Popular emission or MSCI E-score based portfolios do not react significantly to climate transition risk shocks, indicating that they are no valid transition risk measures. Interestingly, no chosen risk metric is able to create a brown portfolio, which is significantly related to transition risk shocks. Our findings are relevant for all stakeholders on global financial markets who want to accurately measure the brown- and greenness of their portfolios.