What is the difference between transition risk and physical risk in climate finance?

Climate risk in finance splits into two fundamental categories: transition risk (the economic impact of moving to a low-carbon economy) and physical risk (the direct impact of climate change on assets and operations). They operate through different channels, affect different sectors, and dominate over different time horizons.

Transition Risk

Transition risk arises from the process of adjusting to a low-carbon economy. It is driven by:

1. Policy and legal: Carbon taxes, emissions trading schemes, fossil fuel subsidy removal, litigation against high emitters
2. Technology: Disruption from renewables, EVs, battery storage making incumbent technologies obsolete
3. Market: Shifting consumer preferences, stranded asset repricing, cost of capital divergence
4. Reputation: Stigmatization of fossil fuel investments, ESG screening by asset managers

Example impact on a bank:

Redford Commercial Bank has $3 billion in loans to coal mining companies. A government carbon tax of $75/ton makes many mines uneconomical. PD for these borrowers jumps from 3% to 18%. Expected losses increase by $270 million.

Physical Risk

Physical risk comes from the direct effects of climate change:

1. Acute: Hurricanes, floods, wildfires, heatwaves — sudden, catastrophic events
2. Chronic: Sea level rise, average temperature increase, water stress, changing precipitation patterns — gradual, persistent changes

Example impact on a bank:

Redford also has $5 billion in commercial real estate loans in coastal Florida. Updated NOAA flood maps show that 30% of collateral properties are in newly designated high-risk flood zones. LGD increases because collateral values decline, and insurance costs make properties less viable.

Comparing the Two

The Fundamental Paradox:

Aggressive climate transition (strict carbon pricing, rapid renewable adoption) increases transition risk in the short term but reduces physical risk in the long term. Conversely, inaction on climate policy minimizes transition risk today but locks in catastrophic physical risk for future decades.

For scenario analysis, banks typically model:

• Orderly transition (1.5°C): High transition risk, low physical risk
• Disorderly transition (2°C): Very high transition risk (sudden policy), moderate physical risk
• Hot house (3°C+): Low transition risk, very high physical risk

Exam Tip: The FRM exam may give you a portfolio and ask which climate risk type is more relevant. For a fossil fuel-heavy portfolio, transition risk dominates. For a coastal real estate portfolio, physical risk dominates. For a diversified bank, both matter.

Explore our FRM Part II climate risk materials for more scenario analysis practice.