Physical and transition risk are the two halves of climate risk, and they behave very differently. Understanding the contrast is essential, because an asset that looks safe on one dimension can be highly exposed on the other.
Physical Risk in One Sentence
Physical risk is the financial impact of climate hazards - floods, wildfires, heat, storms, sea-level rise - directly damaging or disrupting physical assets and operations. It is highest for asset-heavy, location-specific businesses such as real estate, infrastructure, and manufacturing.
Transition Risk in One Sentence
Transition risk is the financial impact of the shift to a low-carbon economy - carbon pricing, policy change, technology disruption, and shifting demand. It is highest for carbon-intensive businesses such as fossil energy, heavy industry, and high-emitting transport.
The Key Differences
Physical and transition risk differ across almost every dimension:
- •Driver: physical risk is driven by the climate itself; transition risk by society's response to it.
- •Direction of warming: more warming increases physical risk but can reduce transition risk, and vice versa.
- •Time profile: some physical risk is already here; transition risk depends on the speed of policy and technology change.
- •Who is most exposed: asset-heavy, location-specific firms for physical; carbon-intensive firms for transition.
Why You Need to Measure Both
Because the two risks respond oppositely to warming, measuring only one gives a dangerously incomplete picture. A rapid, orderly transition lowers physical risk but raises transition risk; a failed transition does the reverse. A credible assessment quantifies both under the same set of climate scenarios so the trade-off is visible.
How They Interact
Physical and transition risk are linked through the warming pathway. Scenario frameworks such as NGFS make this explicit: an orderly Net Zero 2050 pathway carries high transition risk but limits physical risk, while a Hot House World pathway carries low transition risk but severe long-run physical risk. Floodlight models both physical and transition risk across these scenarios and expresses each as Climate Value-at-Risk, so the interaction is quantified rather than assumed.