Transition Risk under Uncertain Climate Policy

Abstract

This paper analyzes the economic and financial implications of climate transition risk under policy uncertainty, with a particular emphasis on the energy sector. A stochastic modeling framework is developed to capture the dynamic evolution of climate policy regimes, calibrated on NGFS transition scenarios. The model incorporates both the probability of regime shifts and their financial consequences, highlighting how regulatory adjustments respond to the accumulation of physical climate stress and transmit shocks across energy sub-sectors. By employing Monte Carlo simulations, we estimate the likelihood of different transitions and derive climate-adjusted risk indicators., including Climate Value at Risk (VaR) and Climate Expected Shortfall (ES), for both fossil fuel and renewable energy sectors. Results show a clear structural division.: Once ambitious policy regimes come into play, transition trajectories find stability, leading to a reduction in transition probabilities as climate signals are mitigated.. The fossil-based electricity sector appears as highly vulnerable to adverse financial shocks, while renewable energy sector proves relative resilience, even in extreme scenarios. These findings highlight the crucial importance of considering policy uncertainty when making strategic investment decisions and managing financial risks. The proposed framework offers a practical tool, beneficial for both investors and policymakers, to execute forward-looking stress tests and to reallocate assets in response to emerging climate commitments.