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

Dr Helen Beddow, Climate and Content lead at Cervest explains what the difference is between physical and transition climate risks for organisations.

Billions of people globally are already experiencing extreme weather events such as droughts, cold snaps, storms, floods, and heat waves. As the climate crisis persists, the impact of these events on communities around the world is likely to intensify. Climate scientists are predicting that escalating climate change coupled with the return of the El nino climate phenomenon later this year is likely to push global temperatures ‘off the chart’.

Companies are already feeling the impacts of climate change. A Cervest survey found that out of 800 business decision-makers in the UK and US, 9 out of 10 respondents said their company’s physical assets had been impacted by at least one extreme weather event in the last five years.

To encourage companies to become more climate resilient, the UK government has introduced The UK Climate Disclosure Law. The law requires certain UK organizations to publish detailed information about the impact of climate change on their business in line with recommendations from the Task Force on Climate-Related Financial Disclosures (TCFD). This presents a significant challenge for companies that are often unfamiliar with climate-related data and analysis, and have potentially not previously considered potential climate-related risks. So where do organisations start?

What is climate risk?

Simply put, climate risk describes the potential for climate change to create adverse outcomes for people and the planet. This might include consequences to lives, public health, ecosystems, buildings, infrastructures, and the economy. For organisations, climate risk can be described as exposure to climate-related impacts that may have fiscal repercussions or decrease revenues. These impacts can vary from short-term disruptions, to larger-scale events that can wipe out an asset’s entire value or shutdown operations. Larger-scale events can still create financial impacts for communities for years after an event.

Under current policies, the total cost of climate change damages to the UK are projected to increase from 1.1% of GDP at present to 3.3% by 2050 and 7.4% by 2100. Climate disruption poses a very real threat to the UK built environment. How serious the consequences depend on our understanding of this risk and our actions – in short, the adaptation measures we take.

Screening your assets for climate risk is a critical starting place for both addressing the potential financial impact of climate hazards and for climate-related reporting. Climate risk drives physical and financial impacts on company assets through two main channels – physical and transition risk. Through these two channels it creates a wide range of different impacts at different scales. Physical risks for example include damage to property and infrastructure due to extreme weather events, while transition risks lead to financial impacts through things like changing regulations and policies aimed at reducing greenhouse gas emissions.” So what is the difference between physical climate risk and transition climate risk?

What is physical climate risk?

Physical climate risk describes the potential for physical damage and financial losses because of increased exposure to climate hazards. The direct physical effects of climate change can create significant financial costs for companies, such as a hurricane damaging infrastructure or buildings resulting in repair and replacement expenses. They can also create financial losses through the disruption they cause to businesses, such as supply chain disruptions and operational shutdowns.

Physical climate risks come in two forms – shocks and stresses.  Shocks are extreme weather events such as hurricanes, or heatwaves. These are often short-lived but can be devastatingly impactful. Stresses, on the other hand, have slower onsets and happen over longer time periods – for example, 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.  

A recent example of physical climate risk close to home is last year’s extreme heatwave in the UK. The UK saw temperatures reach over 40°C for the first time. The heatwave caused extensive damage to buildings, infrastructures, and supply chains, led to a surge in fires, and disrupted transport networks by buckling train tracks and melting trains airport runways melted. Transport for London (TfL) is stepping up its plans to make its operations more resilient to the effects of climate change after losing over £10 million in revenue due to extreme weather incidents.

What is transition climate risk?

Climate risks can also arise from the actions we take to mitigate climate change. Decarbonization is critical for long-term climate stability – and this transition away from fossil fuels and other greenhouse gas (GHG)-emitting activities drives transition risks for businesses. One example of a sector that will be hit hard by transition climate risk is the energy sector, as it is estimated that around 80% of global energy use is produced by fossil fuels.

There are several types of risks resulting from the transition away from fossil fuels:

  • Policy & legal risks are associated with climate policies, carbon pricing, and regulations that restrict negative contributors to climate change. Policy changes may lead to the increased pricing of GHG emissions or new regulations that restrict activities. The financial impacts of these might be the write-offs and early retirement of existing assets, increased operational costs, or legal liability costs as a result of failure to comply with regulatory requirements.
  • Technology risks are driven by the development of new technology to support a low-carbon economy. Transitioning to lower emissions technologies can reduce revenue for existing businesses, changing the competitive landscape by creating margin pressure or making products obsolete.
  • Market risks are driven by economic and social changes that impact supply and demand, such as changing consumer preferences around supporting fossil fuels. Shifting customer preferences can reduce demand, increase production costs and lead to the repricing of assets.
  • Reputational risk refers to the impact of negative public perceptions of high emissions sectors such as fossil fuels. Negative perceptions can lead to reduced revenue, difficulty accessing capital, and rising labor costs.

How are physical and transition risks linked?

Physical and transition risks are connected. As climate change accelerates, and extreme weather events intensify, the need to take action becomes more urgent, impacting the scale and pace of transition risk. The earlier we take action to limit emissions, the less extreme transition risks have to be. The more we delay action on emissions, the more drastic future policy action will have to be in the future.

To maximize climate resilience for built assets, organisations need to consider physical and transition risks in tandem. There are also opportunities to integrate adaptation and mitigation actions, which can provide additional benefits and a competitive advantage for businesses. 

Acting on climate risk

Acting now on climate-related risks and opportunities is a strategic opportunity. In times of uncertainty, UK organisations differentiate themselves with the decisions they make – and will see returns further down the line. That is why it is essential to have access to science-backed, decision-useful climate intelligence (CI). It is only by getting climate intelligence across their entire portfolio and supply chain that UK organisations can truly see what climate risks might impact them and implement the appropriate adaptation measures.

Actions that we take today matter, and CI enables them. To discover how climate intelligence can provide the foundations for a sustainable built environment, download Cervest’s free ebook.

UKGBC’s guidance for acting on climate risk

In February 2022, UKGBC released our ‘Framework for measuring and reporting physical climate risk.’ This guidance outlines the steps asset owners can take to understand and measure the physical climate risk their assets may face, and then report them in line with the TCFD recommendations. Learn more here.

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