What is climate risk? Physical vs transition risk, explained
Climate risk has two faces. One is the weather itself: floods, heat, drought. The other is the shift to a low-carbon economy. Here is how the main frameworks define both.
What is climate risk? The definition
In climate science, risk is not the same as the extreme event. In the IPCC's Sixth Assessment Report framing, as presented by Climate-ADAPT, climate risk means the potential adverse consequences for human or ecological systems. It comes from the interaction of three factors:
- Hazard: a possible physical event or trend that can cause harm, such as drought, a heatwave or sea-level rise.
- Exposure: anything of value located where it could be harmed: people, livelihoods, ecosystems, infrastructure.
- Vulnerability: how prone a system is to harm, meaning its sensitivity and its limited ability to cope and adapt.
Climate-ADAPT's example is drought damage to farming. The drought is the hazard, the fields are the exposure, and dependence on rain is the vulnerability. Change any one of the three, and the risk changes.
Physical climate risk: acute and chronic
In finance, climate risk is split into two families. The split is set out in the 2017 recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), which the US Environmental Protection Agency (EPA) reproduces.
Physical risk comes from the physical impacts of climate change and takes two forms:
- Acute: event-driven, such as more severe storms, floods and heat or cold waves. A Greek example is the storm of September 2023, which according to NASA's Earth Observatory brought record rainfall to Thessaly on 5 September.
- Chronic: driven by longer-term shifts, such as higher average temperatures, sea-level rise and changing rainfall.
The Bank for International Settlements (BIS) gives the same picture: acute risk comes from more frequent or severe extreme events, chronic risk from long-term changes in climate.
Transition risk: policy, technology, market, reputation
Transition risk has nothing to do with the weather. It is the financial risk from the shift to a low-carbon economy, arising from changes in policy, technology, market sentiment or customer behaviour. The TCFD, via the EPA, splits it into four categories:
| Category | Examples |
|---|---|
| Policy and legal | Carbon pricing, stricter emissions reporting, rules on existing products, litigation |
| Technology | Products replaced by lower-emission options, failed investments, cost of switching |
| Market | Shifting demand, unclear market signals, higher raw material costs |
| Reputation | Changing customer and public perceptions, stigma attached to a sector |
The same source also lists opportunities: resource efficiency, cleaner energy, new products, new markets and resilience. Climate risk is not only about losses.
Climate risk in finance: TCFD, ISSB, ECB, NGFS
- ISSB: in June 2023 it issued IFRS S2, effective for annual periods beginning on or after 1 January 2024. It integrates and builds on the TCFD recommendations and explicitly covers physical and transition risks.
- ECB: on 27 November 2020 it published its final guide on climate-related and environmental risks, explaining how it expects banks to manage these risks prudently and disclose them transparently.
- NGFS: the Network for Greening the Financial System builds scenarios for central banks and supervisors that, according to the BIS, fall into "orderly" (early policy, lower risks), "disorderly" (delayed or uncoordinated policy, higher transition risk) and "hot house world" (warming not halted, severe physical risk).
The key lesson of the scenarios: the two risks often move in opposite directions. Less action today means lower transition risk now, but higher physical risk later.
Climate risk in the Mediterranean: Greek examples
The first European Climate Risk Assessment (EUCRA) by the European Environment Agency, published on 11 March 2024, identified 36 major climate risks for Europe in five clusters, eight of them particularly urgent. Southern Europe stands out: it is particularly at risk from wildfires and from the effects of heat and water scarcity on farming. Risks from heat and drought to crop production are already at a critical level in the south.
Physical risk quickly becomes economic. Climate-ADAPT reports that olive oil prices in Spain rose by almost 50% in 2022. For Greece, the most relevant physical risks are wildfires, floods and water scarcity. Each business meets them differently: a hotel through water and heat, a farmer through drought, a warehouse through flooding.
How a climate risk assessment works
Methods differ, but most follow the hazard, exposure, vulnerability logic. A simple version, as we read it:
- Inventory: which assets, sites and supply chains you have, and where they are.
- Hazard: which physical hazards each location faces today, for example from official flood maps.
- Scenarios: how physical and transition risks change under different futures, such as the NGFS scenarios.
- Vulnerability and impact: what each scenario would mean for operations and finances.
- Action and monitoring: what adaptation is needed, and which indicators show the picture changing.
A hypothetical example. Take a hotel on an Aegean island. In step 1 it lists its buildings, its water supply and its suppliers. In step 2 it sees that the strip near the stream appears on the 100-year flood map, and that the island has seasonal water scarcity. In step 3 it looks at one scenario with hotter summers and one with stricter energy rules. In step 4 it asks what a week without water at peak season would cost. In step 5 it decides, for example, to save water and track reserves. The example is invented and not based on any real business.
Our business and investment page describes how a digital twin could support steps 2 to 4, and our flood risk page shows one hazard in detail.
What this article is not
This article explains terms. It is not investment, financial or legal advice, and it does not assess any company, security or property. For decisions, speak to a licensed adviser. Kassandra Labs is at concept stage: it has no clients, results or measured accuracy to show.
Frequently asked questions
What is climate risk?
Climate risk is the potential harm that climate change can cause to people, ecosystems, infrastructure or businesses. In the IPCC framing, it comes from three factors: the hazard (such as drought), exposure (what is in harm’s way) and vulnerability (how easily it is damaged). In finance it is usually split into physical risk and transition risk.
What is the difference between physical and transition risk?
Physical risk comes from weather and climate themselves: acute events such as floods and heatwaves, or chronic shifts such as rising temperatures. Transition risk comes from the move to a low-carbon economy: new rules, new technologies, shifting markets and changing reputations. The two often move in opposite directions, which is why scenarios consider both.
What is climate risk in finance?
In finance, climate risk means the ways physical and transition risks can affect the value and stability of companies, banks and investments. Frameworks such as the TCFD recommendations, the ISSB’s IFRS S2 standard and the ECB’s 2020 guide for banks set out how organisations should identify, manage and disclose these risks.
Is this article investment advice?
No. This article explains terms and frameworks using public sources. It is not investment, financial or legal advice, and it does not assess any company, security or property. For decisions, speak to a licensed adviser. Kassandra Labs is at concept stage and does not provide risk assessment services.
Sources
- Climate-ADAPT — Adaptation Support Tool, step 2.1 (IPCC AR6 risk framing)
- US EPA — Climate risks and opportunities defined (after TCFD, 2017)
- BIS Financial Stability Institute — Climate risks: scenario analysis, executive summary, 31 May 2023
- IFRS Foundation — IFRS S2 Climate-related Disclosures
- ECB Banking Supervision — press release on the guide on climate-related and environmental risks, 27 Nov 2020
- European Environment Agency — "Europe is not prepared for rapidly growing climate risks", 11 March 2024
- Climate-ADAPT / European Climate and Health Observatory — Ξηρασία και λειψυδρία (2024)
- NASA Earth Observatory — "A Deluge in Greece", September 2023