What’s the difference between physical vs. transition climate risk?

Aon recently reported that in 2022, economic losses from natural disasters were estimated at a whopping USD313 billion. Companies need to act on these growing climate risks. But what are physical and transition climate risks, and how is climate change driving increasing exposure to these risks?

Climate risk describes the potential for climate change to present adverse outcomes for global communities and the planet. For companies, climate risk refers to the potential impact of climate change on their financial performance. Exposure to climate-related impacts may have serious financial consequences for organizations.

Climate hazards can bring business and operations at a standstill, from short-term disruptions to large-scale events with negative financial consequences still impacting communities years later. For example, during the 2022 UK heatwave, Transport for London (TfL) estimated that it lost GBP8 million due to five million fewer passengers wanting to travel in 40C heat. With heatwaves becoming more frequent and severe, the TfL has launched a new plan outlining its adaptation strategy. Firms must be informed of their climate risks, so they can take appropriate adaptation measures.

As climate change continues to accelerate, companies face increasing pressure to disclose their climate-related financial risks and opportunities. This includes both physical risks, such as damage to property and infrastructure due to extreme weather events, and transition risks, such as the financial impact of changing regulations and policies aimed at reducing greenhouse gas emissions.

Physical climate risk describes the potential for physical damage and disruption to people, property and productivity as result of the increased exposure to climate hazards driven by climate change, such as damage to property and infrastructure due to extreme weather events such as floods, droughts, and wildfires. This can result in direct financial costs for companies, such as a hurricane damaging infrastructures or buildings resulting in repair and replacement expenses, as well as indirect costs such as supply chain disruptions and business interruptions.

Physical climate risks can be driven by climate shocks, extreme weather or climate events such as hurricanes, or heatwaves. These are often short-lived but can be devastatingly impactful. They are also driven by longer-term climate stresses, such as changing sea levels or a steady rise in average temperatures. Over the longer-term, these can depreciate the value of physical assets, and leave them potentially uninsurable.

Transition risks refer to risks arising from the transition away from fossil fuels and other greenhouse gas (GHG)-emitting activities. Backed by climate scientists, policymakers worldwide have made it clear that decarbonization isn’t a nice-to-have, it’s a must-have for businesses. However, the decarbonization of a firm’s portfolios accrues costs, which exposes firms to transition risks. Organizations that don’t or can’t decarbonize can be impacted by other types of transition risks such as loss of market share or regulatory repercussions.

There are several different types of transition risk. Policy transition risks are associated with climate policies, carbon pricing, and regulations that restrict negative contributors to climate change and encourage climate-resilient changes to business operations. Policy changes are a driving factor behind stranded and depreciating assets. A recent study estimated that stranded assets from the oil and gas industry could exceed USD1 trillion.

Legal risks refer to climate-related litigation. A recent example of legal action relating to climate change is ClientEarth's lawsuit against Shells Board for failure to manage their climate risk. Policy and legal risks are also linked to reputational risk, where negative perceptions of an industry or company in relation to climate change impact its value. Reputational risks can mean it becomes more difficult to access capital both via bank lending and capital markets.

Other types of transition risk include technological risk, where disruption is driven by the development of new technology to support a low-carbon economy. Whereas market risks are driven by economic and social factors influencing the supply and demand of goods and services

Physical and transition risks are inextricably linked. As physical risk increases, so too does transition risk. As the physical risk of extreme heat events rises, so do the costs of either action or inaction – transition risk is inherent in either choice.

Owners of a manufacturing plant at high physical risk of heat waves can either adapt their asset, or continue business as usual. If they choose to adapt, the associated costs of relocating and retrofitting the asset represents a transition risk to the business that must be taken into account. If they choose not to respond to their physical risk, they face loss of revenue arising from reduced workability or operability, and the depreciation of their asset as competitors adapt.

Only by considering both the physical and transition risk to their assets across different time periods and climate scenarios can organizations make fully informed decisions about how best to protect their business from inevitable climate-related risk.

Cervest’s Dr. Helen Beddow explains the use of climate scenarios: “Climate scenarios help business leaders to make informed decisions by considering multiple different future climate possibilities and impacts and allow them to better create strategies to mitigate damage to their assets and adapt.”

Using these climate scenarios to analyse climate risk over short, medium and long time horizons helps organizations to understand their future physical and transition climate risks. Equipped with concrete insights on climate risk, organizations can make enables them to make the climate-informed decisions about their portfolios and supply chains – and act now.

EarthScan™, Cervest’s flagship product, presents a solution to this problem by allowing anyone to analyze climate-related risks at the asset level across a range of climate scenarios. Powered by climate intelligence (CI) — asset-level intelligence on climate risk to inform decision-making — it fuses the latest climate data and machine learning techniques to generate automated, science-backed climate risk insights that can upgrade your climate-related financial disclosure.

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