Physical and Transition Risks

Context

Climate change is one of our generation’s most pressing challenges, with myriad negative implications for financial systems as well. Though these implications are immensely broad, they can be clubbed distinctly into two distinct categories. The first category includes potential losses due to direct physical damage, which are called physical risks. The second category includes losses that indirectly arise due to human responses to mitigate these risks.¹

Figure 1: Physical and transition risks to the financial system and their respective transmission channels

Source: NGFS (2020)²

What are physical and transition risks? 

Physical risks are those that emanate from the physical impacts of climate change such as sudden changes in weather or catastrophic events. These risks could stem from acute/seasonal phenomena such as heat waves and floods or through chronic events such as droughts and rise in sea levels. They cause direct physical losses to households, corporations, and financial institutions, which can manifest in different ways, including damage to assets, e.g., real estate, decrease in productivity, or loss of livelihoods.

Transition risks are those that emanate from human responses to climate change. These risks can be broadly categorised into three sub-categories. First, policy risks, i.e., changes in policies and/or laws. Second, technology risks, i.e., the emergence of new technologies that replace existing ones, which may make them obsolete in the long run. Third, belief systems risks, i.e., changes in the beliefs and preferences of people.

An illustrative example would be that of a region where climate change–induced catastrophic events such as cyclones have seen a rise in incidence, thus harming people and commercial activity alike. The negative implications of this rise in catastrophe is an example of a physical risk. However, as a result, the government may change land use and/or business regulations in the said region, which may further affect the population. This in turn is an example of a transition risk.

On a positive note, the Reserve Bank of India (RBI) has taken some measures to tackle these risks.³ It first acknowledged climate-related financial risks as a systemic risk in its annual report in 2020. Then, in 2021, it joined the NGFS, a coalition of central banks that aims to address climate risks to the financial system. In the same year, the RBI established a sustainable finance group within its regulatory department. The following year, it published two key reports in this context. First, a report on the findings of a survey it conducted, titled “Report of the Survey on Climate Risk and Sustainable Finance”, and second, a paper on sustainable finance titled “Discussion Paper on Climate Risk and Sustainable Finance”. Further, in 2023, it auctioned the first sovereign green bonds in India in two tranches of INR 8000 crore as well as introduced a framework for green deposits. Finally, in 2024, it published the “Draft Disclosure Framework on Climate-related Financial Risks”, which aims to institutionalise the measurement, monitoring, and management of climate-related financial risks to the Indian banking system.

Who should care?

• Banks and financial institutions 
• Insurers
• Asset management companies
• Investors
• Central bank and other regulators