Financial risks related to the transition to a less fossil-dependent economy are called transition risks. The transition risks for a country (or region) arise from all the political, legal, technological and market changes that arise from the transition to an economy with lower greenhouse gas emissions. For example, policy decisions such as increasing carbon tax, subsidising renewable energy or banning the use of petrol cars, which are intended to contribute to reducing the use of fossil fuels, would change competition or other conditions for certain markets. In turn, this could increase the sovereign risk, for example, through increased expenditure or reduced tax revenues from previously profitable markets. The transition may also have consequences for the pricing of securities in the financial markets, such as the stock market, the credit market or the commodities market, which, in turn, may affect investors’ financial risk.
In October 2020, the International Network for Sustainable Financial Policy Insights, Research and Exchange (INSPIRE) presented a report on the link between climate change and sovereign credit risk that identified six transmission channels through which climate-related risks may increase the sovereign risk, including tax revenue, the balance of trade and foreign investment in the country. The analysis shows that higher vulnerability to climate risks leads to significant increases in government borrowing costs. See INSPIRE (2020). Another report from the Basel Committee on Banking Supervision (BCBS) shows that climate-related risk drivers affect banks’ traditional risk categories (credit risk, market risk, liquidity risk, operational risk and reputational risk) rather than giving rise to a new type of risk. See BCBS (2021).