What it means
Physical risk is the direct kind: flooding, heat, storms, water scarcity and the disruption they cause to sites, staff and suppliers. It splits again into acute risk from single events and chronic risk from slow changes such as rising average temperatures or shifting rainfall.
Transition risk is what happens as policy, technology and customer preference move. Carbon pricing, efficiency rules, cheaper alternatives and buyers who screen their suppliers can all reduce the value of assets and contracts long before any physical damage occurs.
Quantification usually starts with expected annual loss for physical risk: the probability of an event multiplied by the loss it would cause, added up across sites. Transition risk is modelled by applying a carbon price or regulatory cost to current emissions under a small number of stated scenarios.
The output feeds real decisions: where to build, what to insure, how long to depreciate an asset and what to disclose. Lenders and insurers price this in directly, so a site in a flood plain can face higher premiums, shorter loan terms or cover being withdrawn entirely.
The hardest part is the time horizon, since the largest effects sit well outside the three to five year window most planning uses. The practical answer is scenario analysis: modelling a few clearly described futures instead of pretending to a single reliable forecast.
In practice
Real-world examples.
Example
A food processor with two plants in a drought-prone region models water availability under a chronic physical risk scenario. It finds that a 20% cut in water allocation would reduce output by 15%, so it invests $4,000,000 in water recycling rather than face a production ceiling within a decade.
Example
A property investor is refused cover on a coastal retail park after two claims in three years. Without insurance the lender will not refinance, so the asset is written down by $6,500,000 and marketed for sale, an outcome driven entirely by physical risk rather than by tenant demand.
Example
A car components maker supplying diesel engine parts models transition risk and concludes that 35% of its revenue relates to products likely to decline sharply within twelve years. It shortens the depreciation life on two production lines and starts a capital plan to move into electrical assemblies.
Think of it
“Climate risk is the financial danger from climate change-potential losses from a changing climate.
Formula
Calculation
Expected Annual Loss = Probability of Event x Financial Impact
Net Transition Cost = Emissions x Carbon Price x (1 - Pass-Through Rate)
A distribution business owns a warehouse on a flood plain with a 2% chance of serious flooding in any year. A flood would cost $12,000,000 in damage and lost trading.
Expected Annual Loss = 0.02 x $12,000,000 = $240,000
The same business emits 30,000 tonnes of carbon dioxide a year. Under a scenario where a carbon price of $85 a tonne applies, the gross cost is 30,000 x $85 = $2,550,000, and it estimates it could pass 40% of that on in prices.
Net Transition Cost = $2,550,000 x (1 - 0.40) = $1,530,000
Combined annual climate exposure is $240,000 + $1,530,000 = $1,770,000, which against operating profit of $18,000,000 is just under 10% of profit, enough to justify a formal mitigation budget.Case study
Seen in the real world.
Fenwick Marsh Beverages is an illustrative and entirely fictional drinks producer with three bottling plants. Its risk register listed climate as a single line item marked medium, with no numbers attached, and the audit committee asked for it to be quantified properly.
The finance team ran the exercise site by site. One plant sat behind ageing flood defences with an estimated 4% annual flood probability and a $9,000,000 impact, an expected annual loss of $360,000. On the transition side, its 22,000 tonnes of annual emissions exposed it to $1,870,000 a year under an $85 carbon price scenario, of which the commercial team believed only a quarter could be passed on.
The board approved $2,200,000 of flood protection and site drainage work, and an energy efficiency programme targeting a 30% emissions reduction over five years. In this illustrative case the insurer reduced the premium on the affected plant by 18% once the defence work completed, which alone recovered part of the cost within the same planning cycle.
Watch out
Common mistakes.
- Filing climate risk under sustainability rather than finance. The exposures show up in insurance costs, asset values, financing terms and revenue, so they belong in the same process as any other enterprise risk.
- Looking only at your own sites. Most businesses carry more climate exposure through suppliers, logistics routes and customers than through the buildings they own.
- Treating a single scenario as a forecast. Scenario analysis is meant to show how outcomes differ under different assumptions, not to predict which future arrives.
Questions
People also ask.
What is the difference between physical and transition risk?
Physical risk comes from the climate itself, such as floods and heat, while transition risk comes from the response to it, such as carbon pricing, regulation and changing customer demand.
What is a stranded asset?
An asset that loses value well before the end of its expected life because of transition effects, such as a plant that becomes uneconomic once emissions carry a price.
Does climate risk affect the cost of borrowing?
Increasingly yes, since lenders assess exposure when setting terms, and assets that cannot be insured are often difficult to finance at all.
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