Climate risk in finance: unveiling transition risk exposure in green vs. brown companies

Abstract

ABSTRACT This study delved into transition risk by introducing a novel Climate Transition Score to evaluate the climate-related performance of the most capitalized firms in the stock markets of developed countries. Then we classified these firms into green and brown portfolios. Our analysis demonstrates that high-emission or brown firms bear more risk than their green counterparts do, even if they do not consistently outperform them. To gauge exposure to transition risk, we employed asset pricing factor models such as CAPM, Fama and French 3-Factor, and Carhart’s (1997) model. However, these models failed to provide a satisfactory explanation for portfolios’ excess returns in their standard formulation. To address this gap, we introduced the Green Minus Brown risk factor. This addition enhanced the explanatory power of the models, emphasizing the heightened exposure of brown companies to transition risk.