Perspectives: is this what transition risk looks like

Or how things can be fine, until they are not (and you lose)

“The market can stay irrational longer than you can stay solvent.” John Maynard Keynes

We often read about transition risk and stranded assets, but what does this really mean, and how does it get reflected in the financial statements and value of companies? The short answer is - often much more slowly than you may think. And Thames Water (and other cases) illustrates this rather neatly.

Sustainability transition risk is very real. And it can hit suddenly and hard. You might think that if Thames Water had been a publicly listed company, the stock market investors would have seen this coming. And maybe the company would have had more incentive to restructure sooner. But, I wouldn't rely on this.

Transition risk and the threat of stranded assets are often talked about as reasons why investors should 'avoid' certain assets or companies. But, if the impact on profits and share prices is slow, their effectiveness as a sustainability finance tool is much reduced.

So why might investors continue to own the equity and debt of companies when it's clear, at some point, they will 'hit the buffers'.

Recency bias - or I think things will just keep ticking over

One lesson I learnt in my years as an investor (sometimes the hard way) is that even knowledge that seems to be known does not get 'priced in'. I have not yet found any research that properly explains this, but my working explanation is that investors get fooled by a form of recency bias. Put simply, they over emphasise what they are seeing now and ignore what might happen in the future.

Many investors see sustainability transition risk, and the challenge of potentially stranded assets, in this way. They know that it will probably happen, but they comfort themselves with the notion that 'nothing has happened yet, and it may not happen for a long time, and so in the meantime, the companies make a good investment (at least financially)'. Until of course, something happens that makes this belief untenable. But by then it's too late.

Even if the risk of stranded assets is real, it can take some time, often many years, before the financial markets properly price it in. And even then it can take an external shock to make it real.

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It happens in the financial world all the time

The FT reported last week that shares in the French food retailer Casino fell as much as 37% after the company announced that they were planning to undertake a debt for equity swap. The plan is to convert up to E1.5bn of secured debt into equity, a move that would massively dilute shareholders. This comes on top of the E3.6bn of unsecured debt the company had already announced would be swapped for equity. The rating agency Moody's downgraded Casino debt in May last year, citing "weak liquidity and an unsustainable capital structure".

If this is the case then maybe the risk of stranded assets is not enough to get many investors to change their behavior. Investors in Casino and in Thames Water could see the problem, it sat in plain sight. But they didn’t act, until an external action made the risk obvious. But then of course, it was too late.

We want to explore how we can make the transition risk seem more real. Telling investors about something they already now exists is clearly not enough.