Transition Risk vs Physical Risk (Climate)

Side-by-side comparison

Decision rule: Assess transition risk to understand how decarbonisation policy and market shifts affect the entity's business model. Assess physical risk to understand how climate hazards affect the entity's assets and operations.

When the distinction matters on an engagement

The two risk categories require different evidence and different expertise. A sustainability assurance provider evaluating the entity's climate risk disclosures under ESRS E1-9 must verify that both categories were assessed independently, because the scenarios, time horizons, and data sources differ. Entities that run only a transition risk assessment (common in sectors with high carbon exposure but low physical hazard exposure) leave the physical risk section undisclosed. ESRS E1 paragraph 64 requires the entity to disclose anticipated financial effects from both material physical and material transition risks.

The inverse problem also occurs. Real estate and agriculture entities sometimes focus exclusively on physical risk (flooding, drought) without assessing transition risk from tightening building energy regulations or changing land-use policy. When the assurance provider finds that one category is missing, the double materiality assessment must be revisited to confirm whether the omitted category was genuinely not material or simply not assessed.

Worked example: Bonetti Costruzioni S.r.l.

Client: Italian infrastructure company, FY2026, revenue EUR 48M, IFRS reporter, first-time CSRD reporter. Bonetti builds and maintains road bridges and water treatment plants across northern Italy. Climate change was assessed as material under both impact and financial perspectives.

Transition risk assessment

Step 1 — Identify transition risk drivers

Bonetti's sustainability team identifies two material transition risk drivers. EU carbon border adjustment mechanism (CBAM) affects the cost of imported steel (approximately 35% of construction materials by value). National building energy regulations (Italian Legislative Decree 48/2020, implementing the EU Energy Performance of Buildings Directive) require upgraded energy specifications for new water treatment infrastructure.

Documentation note: record each transition risk driver, the regulatory source, the affected cost line or revenue stream, and the time horizon (short-term for CBAM phase-in through 2026, medium-term for building energy regulations through 2030).

Step 2 — Quantify anticipated financial effects of transition risks

CBAM-related steel cost increases are estimated at EUR 1.8M per year from 2027 (based on a projected carbon price of EUR 90 per tonne applied to embedded emissions in 12,000 tonnes of annual steel procurement). Compliance with upgraded building energy specifications adds approximately EUR 2.4M in design and material costs across five active contracts.

Documentation note: record the carbon price assumption, the tonnage, the calculation, and the source of the projected carbon price (EU ETS forward curve as of Q4 2025). Cross-reference to ESRS E1-9 transition risk disclosure.

Physical risk assessment

Step 3 — Identify physical risk exposures

Bonetti maps its 14 active project sites against climate hazard data (ISPRA flood maps for northern Italy, Copernicus Climate Change Service heat stress projections). Four bridge sites in the Po Valley are exposed to acute flood risk (return period reduced from 1-in-100 years to 1-in-50 years under RCP 8.5 by 2050). Two water treatment plants face chronic heat stress affecting concrete curing schedules during summer months.

Documentation note: record the climate hazard source, the scenario used (RCP 8.5 for physical risk, aligned with ESRS E1-9 application guidance), the asset locations, and the hazard classification (acute vs chronic).

Step 4 — Quantify anticipated financial effects of physical risks

Flood damage to the four Po Valley bridge sites is estimated at EUR 3.6M over the medium term (10-year exposure window), based on expected repair costs and project delay penalties. Heat-related productivity loss at the two water treatment sites is estimated at EUR 0.4M per year in extended construction timelines.

Documentation note: record the financial effect per asset or site, the estimation methodology, and whether the figure represents gross risk (before adaptation) or net risk (after adaptation measures such as revised construction scheduling or flood barriers). The EFRAG November 2025 draft ESRS E1 introduces gross-versus-net risk guidance; document which basis the entity applied.

Conclusion: Bonetti's disclosure reports EUR 4.2M in annual transition risk exposure (CBAM plus building regulations) and EUR 4.0M in medium-term physical risk exposure (flood damage plus heat stress). If the practitioner had combined both categories into a single undifferentiated climate risk figure, the ESRS disclosure would fail to meet the separate-reporting requirement of E1-9, and the assurance provider would lack the information needed to evaluate each category against its specific scenario basis.

Why it matters in practice

Entities frequently disclose a single blended "climate risk" figure without separating transition risk from physical risk. ESRS E1 Disclosure Requirement E1-9 paragraphs 64–68 require anticipated financial effects from material physical risks and material transition risks to be disclosed as distinct items. A blended figure prevents the assurance provider from evaluating whether each category was assessed against appropriate scenarios.

Physical risk assessments often rely on outdated or overly broad hazard data (national averages rather than site-level projections). The ESRS E1 application guidance and the EFRAG November 2025 draft emphasise that physical risk assessment should use location-specific climate hazard data over short-, medium-, and long-term horizons. National averages mask the concentration of risk at individual sites.

Related terms

Frequently asked questions