The Link Between Physical and Transition Climate Risk

Summary:

The Journal of Portfolio Management, Novel Risks and Sources of Volatility Special Issue, Vol 51, Number 7, May 2025

The authors argue that what is usually referred to as climate transition risk can be more usefully decomposed into an expectation part and a variability around this central value. They show that there is a strong inverse relationship between the expectation component of transition costs and the expectation of physical damages and how this relationship can be estimated.

The results indicate that the uncertainty in transition costs decreases as the abatement policy becomes more aggressive (and physical damage decrease), although uncertainty remains a large portion of the expectation component. The authors also show that, with the definition provided, their transition costs match well with the corresponding quantities from the benchmark IPCC scenarios.

Key Findings:

• From an investor’s perspective, transition risk and physical damages should be considered in a joint manner (because they are imperfectly but inversely related), and this article shows how this can be done. Investment decisions made on the basis of either piece of information in isolation can be misleading.
• The uncertainty in transition costs decreases as the abatement policy becomes more aggressive (and physical damage decrease), but uncertainty remains a large portion of the expectation component.
• The authors embed their treatment in a probabilistic framework that recovers well as a special case with the transition costs estimated (without probabilities) in the IPCC-sponsored SSP-RCP scenario framework. So, this approach is consistent with, but adds (probabilistic) information to, established scenarios.

Article accessible in open access here: https://eprints.pm-research.com/17511/132480/index.html?52826