Understanding the Difference Between Physical and Transition Climate Risks

Who should read this?

CEOs

Business Leaders

CSOs

Compliance Officers

Climate risk is not just one problem—it is an umbrella term that covers different kinds of risks businesses face because of climate change. Some risks come directly from physical changes in the environment, such as extreme weather events, rising sea levels, or long-term shifts in temperature and rainfall. Others come from the way governments, markets, and society are responding to climate change, through new policies, technologies, and customer expectations. These two categories are commonly known as physical risks and transition risks. Understanding the difference between them is crucial, because both can disrupt operations, affect financial performance, and shape long-term business competitiveness.

Physical vs. Transition Climate Risks: A Side-by-Side View

While physical and transition risks are often discussed together under the umbrella of climate risk, the two differ in how they emerge, the way they impact businesses, and how they can be managed. Looking at them side by side makes these differences clearer.

1. Source of Risk

• Physical risks originate from the natural environment. They are driven by climate change itself, such as rising sea levels, stronger storms, prolonged droughts, or increasing global temperatures. For instance, a coastal factory in Florida may face recurring flooding because hurricanes are becoming more intense due to warming oceans. These risks are environmental in nature and occur regardless of government actions or business decisions.
• Transition risks, however, are created by human responses to climate change. They come from policy changes, evolving technology, or shifts in consumer expectations. A coal power plant in Germany may operate without physical issues but still face decline as stricter EU emissions rules make coal energy less competitive. In this case, the environment is not the direct threat — society’s effort to reduce carbon emissions is.

2. Type of Impact

• Physical risks cause direct and often visible damage to assets and operations. A storm can destroy warehouses, a wildfire can damage power lines, or a drought can lower agricultural yields. For example, when Hurricane Harvey hit Texas in 2017, oil refineries had to shut down, leading to billions in losses and widespread energy supply disruptions. The effect of physical risks is immediate and often measured in damaged property, halted production, or repair costs.
• Transition risks reshape businesses more indirectly, but the consequences can be just as significant. Instead of breaking buildings or machinery, they challenge the viability of current business models. For instance, traditional automakers relying heavily on petrol and diesel cars have had to invest billions in electric vehicle production to meet changing consumer demand and regulatory pressure. Companies that fail to adjust to these new expectations risk losing relevance in their markets.

3. Timeframe and Predictability

• Physical risks can occur suddenly, like flash floods or wildfires, or gradually, like desertification and sea-level rise. Sudden events are hard to predict and often leave businesses with little time to react. Chronic risks, while easier to anticipate, create long-term pressure that can erode asset values or make certain regions unviable for business. For example, properties in Miami are already losing investor confidence due to the steady increase in flood risks.
• Transition risks tend to follow more predictable paths, often tied to regulatory timelines or market signals. Governments usually announce new climate policies years in advance, and technology adoption often shows early trends before it accelerates. For example, when the UK announced its plan to ban the sale of new petrol and diesel cars by 2030, carmakers had more than a decade to prepare. Those who ignored the trend, however, risked being overtaken by competitors who adapted earlier.

4. Financial Consequences

• Physical risks usually result in immediate financial costs. Businesses may face expenses for repairing facilities, replacing inventory, or paying higher insurance premiums. In 2024, for instance, heavy rains flooded small businesses in New York, costing shop owners thousands of dollars in both sales losses and property repairs. For SMEs in particular, repeated disruptions like these can create financial strain that is hard to recover from.
• Transition risks tend to affect financial health over time rather than overnight. A company with high carbon emissions may find it increasingly difficult to secure loans as banks adopt stricter lending criteria linked to sustainability. Investors are also shifting their portfolios toward low-carbon industries, reducing access to capital for businesses that lag in adopting green practices. Over time, this can lower a company’s market valuation and make it difficult to compete for investment.

5. Management Approach

• Physical risks are usually managed through adaptation strategies. Companies may choose to strengthen their infrastructure, relocate vulnerable assets, or diversify their supply chains to reduce exposure to climate hazards. In practice, this could mean moving critical equipment to safer locations, designing facilities to withstand floods or storms, or spreading operations across regions to avoid over-reliance on one high-risk area. Similarly, in agriculture, businesses often adapt by introducing more resilient crop varieties and adopting smarter irrigation systems to cope with recurring droughts.
• Transition risks require a more strategic transformation of the business itself. This might mean adopting cleaner technologies, changing product lines, or restructuring business models to align with a low-carbon economy. Energy companies like BP and Shell are already shifting their investments toward renewable energy and electric vehicle infrastructure to prepare for future market demands. Organizations that embrace this shift proactively can turn what looks like a risk into an opportunity for long-term growth.

Why Businesses Must Address Both Physical and Transition Climate Risks

Physical risks threaten where and how businesses operate by causing direct environmental damage, such as floods, storms, or heatwaves that disrupt infrastructure and supply chains. Transition risks, in contrast, affect what and why businesses operate by reshaping markets, policies, technologies, and customer expectations. Both types of risks are highly disruptive, and they often overlap. For example, a severe flood may not only damage business assets directly but also lead governments to introduce stricter building codes, increasing compliance costs. Similarly, a new carbon tax might push companies to relocate operations, which could place them in regions that are more exposed to natural disasters, adding new physical risks on top of the transition challenges. Preparing for both risk types is no longer optional; it is a core part of building resilience, protecting competitiveness, and ensuring long-term business survival in an economy where climate change is shaping the rules of the game.