Chapter 3: Understanding Climate Risk: Physical and Transition Risks Explained

 Climate risk is usually divided into two broad categories: physical risk and transition risk. Physical risks arise from the physical climate (and weather) impacts that result from the changing climate, whereas transition risks arise from the economic transformation and any dislocation needed to drastically reduce, and eventually eliminate, net greenhouse gas emissions to reach net-zero emissions—a goal that many countries have set for themselves to reach by 2050.

Physical risks result from hazards that are usually subdivided into acute and chronic hazards. The former includes weather-related or weather-exacerbated events, whose incidence are increasing with climate change, such as floods, hurricanes, and wildfires. The latter includes gradual, long-term trends such as rising average temperatures and sea levels. 

The equivalent drivers of transition risk include factors such as tighter government policies to reduce emissions (e.g., through carbon taxes), technological changes (e.g., cheaper renewables making fossil fuel–based power generation less economical by comparison), and bottom-up consumer pressures for sustainable products. But for both kinds of risk to manifest, hazards (or driving factors) are not enough alone. In the face of these hazards and factors, different kinds of assets and companies will have differing levels of exposure and vulnerability. Exposure, here, is used in the classic financial sense of assets or firms that are in a vulnerable place or setting. A factory or warehouse in a low-lying coastal area would be exposed to sea level rise, and consequently so would the firm that owns the factory. A high-emissions facility, such as a coal-fired power plant or a steel plant, would be exposed to tighter climate policy, such as a higher carbon price.

Vulnerability—a concept linked to notions of resilience, flexibility, and adaptation—is less of a focus in traditional financial risk, but it is integral to considerations of climate risk, especially physical climate risk. It refers to the propensity or predisposition of the asset (or firm) to suffer adversely from its exposure to hazards. At the facility level, vulnerability to physical climate risk typically depends on physical infrastructure: for example, of two neighboring factories in a flood zone, only one may have flood pumps installed. Vulnerability can also be discussed at the facility level for transition risk, referring to the ease of reducing or eliminating emissions—for instance, through conversion to hydrogen-based production—as opposed to having to pre-maturely close a facility, thus stranding it. At the corporate level, vulnerability can refer to the lack of preparation for such issues as climate change mitigation and adaptation planning, or it can apply to a lack of financial resilience, such as through insurance-based mechanisms. Overall, the interaction between hazards or drivers, exposures, and vulnerability then produces the overall effect of climate risk (see Figure)

In essence,  Climate risk =  Hazard x Exposure x Vulnerability