Climate risk to financial assets comes in two flavours. Physical risk is the cost of climate change actually happening: floods, droughts, heatwaves, sea-level rise, agricultural collapse. Transition risk is the cost of the world moving to a lower-emissions economy: stranded fossil-fuel reserves, carbon taxes, technology displacement, consumer behaviour change. Both are real; both bite assets in different ways and on different timescales.
Physical risk: acute vs chronic
- Acute physical risk: discrete events. Hurricanes, floods, wildfires, droughts. Tend to be insurable (in theory). Increasing in frequency and intensity since the 1980s; the 2024 hurricane season was the costliest on record in the Atlantic.
- Chronic physical risk: gradual shifts. Sea-level rise, average temperature increase, changes in precipitation patterns, ocean acidification. Affect long-lived assets (real estate, infrastructure, agriculture) over decades. Insurance markets struggle here.
Transition risk: four channels
- Policy: carbon taxes, cap-and-trade prices, fossil-fuel subsidy removal, vehicle electrification mandates. EU ETS allowance was €5 in 2017 and €85+ in 2024.
- Technology: solar and battery cost declines have collapsed coal plant economics. Internal combustion engine market share is in structural decline. The risk is being on the wrong side of the technology shift.
- Market: consumer preference shifts. Bank shareholder pressure to divest from coal. Pension-fund mandate restrictions.
- Litigation: climate-attribution lawsuits. Held v. Montana (2023) established standing for climate harm in US courts; similar cases ongoing in the UK, Australia, the Netherlands.
The risk tension
Aggressive policy action reduces physical risk but raises transition risk. Slow policy action keeps transition risk low but raises long-run physical risk. The NGFS (Network for Greening the Financial System) scenarios — used by central banks for stress tests — embed exactly this tension: an orderly transition has high transition cost but low physical cost; a disorderly transition has both; a hot-house world has low transition cost but extreme physical cost.
How both feed a model
For credit analysis: physical risk affects collateral values (coastal real estate, drought-exposed agriculture). Transition risk affects probability of default for emissions-intensive borrowers (mining, oil and gas, conventional auto). Both belong in the PD and LGD assumptions, not in a separate ESG sidebar.
For equity DCF: physical risk shows up in cash-flow volatility and terminal-value haircuts. Transition risk shows up in capex assumptions, market-share trajectories, and beta. For high-emissions sectors, a transition-aware DCF often has a terminal value 30-60% below the standard model. That gap is the climate risk, made financial.
Geography matters
Africa faces the highest physical risk in the world but the lowest transition risk (because emissions are low). Europe faces moderate physical risk and high transition risk (because the policy response is fastest). The US sits between. The geographical asymmetry has financing implications: capital is needed in Africa for adaptation; in Europe and the US for transition.
Exercise
Pick an emissions-intensive listed company (oil major, cement, steel, conventional auto). Identify three transition-risk channels relevant to them. Then identify one physical risk that could affect operations. How might you adjust a standard DCF or credit model to account for these? Be specific about which assumptions you'd flex.