The distinction between physical and transition risks is the foundational taxonomy of IFRS S2. Understanding each category, and the sub-types within them, is essential for correctly classifying risks and building a comprehensive strategy disclosure.
The Two Categories of Climate Risk
IFRS S2 paragraph 3 establishes two categories of climate-related risk:
- Climate-related physical risks: Risks from the physical effects of climate change
- Climate-related transition risks: Risks from the process of transitioning to a lower-carbon economy
These categories are not mutually exclusive. A single event (for example, a new carbon tax) is a transition risk. But the physical disruption that motivates the policy (for example, rising temperatures) is a physical risk. Companies often face both simultaneously.
Physical Risks: Acute and Chronic
IFRS S2 Appendix A distinguishes two types of physical risk:
Acute physical risks are event-driven, meaning extreme weather events that occur suddenly:
- Tropical storms and hurricanes
- Floods (riverine, coastal, and flash)
- Heatwaves
- Wildfires
- Droughts
- Extreme precipitation events
Chronic physical risks arise from longer-term shifts in climate patterns:
- Rising mean temperatures
- Sea level rise
- Changes in precipitation patterns and frequency
- Biodiversity loss and ecosystem degradation
- Changes in soil productivity and water availability
| Type | Examples | Time Horizon Typical | Asset Impact Example |
|---|---|---|---|
| Acute: storms | Cyclones, hurricanes, tornadoes | Short to medium term | Damage to coastal facilities, supply chain disruption |
| Acute: flooding | River flooding, storm surges | Short to medium term | Damage to riverside factories, data centres |
| Acute: heatwaves | Extended extreme heat events | Short to medium term | Reduced worker productivity, cooling cost increases |
| Chronic: temperature | Rising average temperatures | Medium to long term | Increased cooling demand, reduced crop yields |
| Chronic: sea level rise | Coastal inundation | Long term | Stranded coastal real estate, port infrastructure |
| Chronic: water stress | Reduced freshwater availability | Medium to long term | Production halts for water-intensive manufacturing |
Transition Risks: Five Subcategories
IFRS S2 Appendix A defines transition risks as risks arising from the transition to a lower-carbon economy, across five subcategories:
Policy risks (changes in government regulations and policy):
- Carbon pricing mechanisms (emissions trading schemes, carbon taxes)
- Mandatory energy efficiency standards
- Prohibition of certain technologies or fuels
Legal risks (litigation and regulatory enforcement arising from climate-related obligations):
- Climate liability lawsuits against high-emission companies
- Liability for failure to adapt or disclose climate risks adequately
- Regulatory enforcement actions for non-compliance with emissions standards
Technological risks (disruption from new low-carbon technologies):
- Rapid cost reduction in renewable energy stranding fossil fuel assets
- Electrification of transport affecting internal combustion engine manufacturers
- Carbon capture and storage costs affecting industrial competitiveness
Market risks (changing supply and demand patterns):
- Shifting consumer preferences toward low-carbon products
- Increasing raw material costs from carbon pricing on supply chains
- Changing investor preferences affecting access to capital
Reputational risks (changing perceptions of an entity's role in climate change):
- Consumer boycotts of high-emission companies
- "Greenwashing" accusations
- Difficulty attracting talent or partners
The difference between physical and transition risks is like the difference between weather risk and regulatory risk in a traditional industry analysis. A fishery faces both: a bad storm season (physical risk) can destroy boats and reduce catches; a new fishing quota regulation (transition risk equivalent) can limit operations regardless of weather. In climate, both are real and often interconnected. Governments sometimes introduce regulations precisely because physical risks are worsening.
Climate-Related Opportunities
IFRS S2 also requires disclosure of climate-related opportunities, the potential positive effects from climate change or the transition. These can include:
- Resource efficiency: Reducing operating costs through energy efficiency
- New energy sources: Revenues from renewable energy development
- Products and services: New markets for low-carbon or climate-resilient products
- New markets: Access to green finance, carbon credits, or sustainability-linked markets
- Resilience: Competitive advantage from more resilient supply chains and operations
Time Horizons
Every risk and opportunity must be assigned a time horizon. IFRS S2 paragraph 10(d) requires the entity to define what short, medium, and long term mean for its circumstances, linked to its planning horizons. There is no universal definition, but common approaches include:
| Term | Common Range | Example Basis |
|---|---|---|
| Short term | 0 to 2 years | Annual budget cycle; near-term regulatory effective dates |
| Medium term | 2 to 10 years | Capital investment cycle; 5-year strategy horizon |
| Long term | 10+ years | Asset lifetimes; 2050 climate commitments |
Key Takeaways
- 1Physical risks split into acute (event-driven: storms, floods, heatwaves) and chronic (long-term shifts: rising temperatures, sea level rise, water stress)
- 2Transition risks span five subcategories: policy (carbon pricing), legal (climate litigation), technological (disruption from renewables), market (shifting demand), and reputational (greenwashing accusations)
- 3Climate-related opportunities must also be disclosed, covering resource efficiency, new energy sources, low-carbon products, green finance, and supply chain resilience
- 4Physical and transition risks are not mutually exclusive - a single business context often involves both simultaneously, and policy responses may be motivated by worsening physical risks
- 5Every risk and opportunity must be assigned an entity-defined time horizon linked to the entity's specific planning cycles, not a generic industry standard