Climate risk is now a critical component of financial risk management, impacting global markets, regulatory frameworks, and corporate decision-making. The Sustainability and Climate Risk (SCR) Certificate from the Global Association of Risk Professionals (GARP) equips professionals with the knowledge needed to assess and mitigate these risks.
Two key areas covered in the SCR exam—and essential for professionals in risk management—are transition risk and physical risk. These risks shape financial institutions' climate risk assessment strategies and regulatory reporting. Understanding their implications is crucial for passing the SCR exam and excelling in climate risk management.
This article provides an in-depth analysis of transition and physical risks, their impact on financial markets, and their relevance to the GARP SCR exam.
What Are Transition and Physical Risks? GARP SCR Certification , Transition and Physical Risks
Climate-related financial risks are categorized into two broad groups:
Physical Risks – Direct risks from climate change, including extreme weather events, rising sea levels, and biodiversity loss.
Transition Risks – Indirect risks associated with the shift to a low-carbon economy, including regulatory changes, technological advancements, and market shifts.
These risks are interconnected, influencing investment portfolios, credit ratings, corporate strategies, and global financial stability.
Physical Risks: Direct Climate-Related Impacts
1. Defining Physical Risks
Physical risks refer to financial losses resulting from climate-related events. These risks can be further divided into: GARP SCR Certification , Transition and Physical Risks
Acute Physical Risks – Short-term events such as hurricanes, floods, wildfires, and extreme heatwaves.
Chronic Physical Risks – Long-term shifts, including rising sea levels, desertification, and temperature increases.
2. Financial Implications of Physical Risks
Physical risks disrupt economies, supply chains, and financial institutions. The economic impacts include:
Increased insurance claims due to extreme weather damage.
Higher capital costs for rebuilding infrastructure.
Reduced asset values for properties exposed to environmental damage.
Supply chain disruptions, leading to higher commodity prices.
Increased credit risk for companies in climate-exposed industries.
3. Real-World Examples of Physical Risks
Hurricane Katrina (2005): Caused over $125 billion in damages, significantly impacting insurers and reinsurance firms.
California Wildfires (2020-2022): Led to billions in losses, affecting mortgage markets and insurance companies.
European Heatwaves (2022-2023): Reduced agricultural output, driving food price inflation and GDP contractions in several economies.
Understanding these case studies is crucial for answering SCR exam questions on climate risk impacts.
4. How Physical Risks Are Measured
Climate Stress Testing – Used by central banks and financial institutions to evaluate exposure to extreme weather scenarios.
Geospatial Data Analysis – Determines asset vulnerability to climate risks.
Scenario Analysis – Projects long-term risks under different climate models (e.g., IPCC scenarios, Network for Greening the Financial System (NGFS) pathways).
Transition Risks: The Shift to a Low-Carbon Economy
1. Defining Transition Risks
Transition risks arise from economic, regulatory, technological, and market changes associated with the transition to a net-zero economy. These risks are primarily driven by:
Government policies and regulations (e.g., carbon pricing, emissions caps, sustainability mandates).
Technological advancements that disrupt fossil-fuel-based industries.
Market preferences shifting toward sustainable and ESG-compliant investments.
2. Key Financial Implications of Transition Risks
Stranded Assets – Fossil fuel reserves, coal plants, and outdated industrial infrastructure that lose value due to regulatory changes.
Carbon Pricing and Taxes – Increased costs for high-emission industries.
Legal and Compliance Risks – Companies failing to comply with climate policies may face lawsuits and regulatory penalties.
Sectoral Shifts in Capital Allocation – Investors moving away from traditional energy and toward green finance.
3. Real-World Examples of Transition Risks
EU Carbon Border Adjustment Mechanism (CBAM): Industries exporting to the EU must pay carbon tariffs, increasing operational costs for carbon-intensive sectors.
Energy Transition in the U.S.: Government policies phasing out coal-fired power plants in favor of renewables, affecting coal sector employment and investments.
Automobile Industry Shift: Companies like Tesla disrupting traditional car manufacturers, forcing them to invest in electric vehicle technology.
The SCR exam often includes case study-based questions requiring candidates to assess the financial impact of transition risks.
4. How Transition Risks Are Measured
Carbon Footprint Analysis – Evaluates emissions intensity across investment portfolios.
Climate Policy Stress Tests – Models financial exposure under different regulatory scenarios.
Scenario-Based Risk Assessments – Uses frameworks such as the TCFD (Task Force on Climate-Related Financial Disclosures) to model risks under different climate transition pathways.
The Role of Transition and Physical Risks in the GARP SCR Exam
The SCR exam tests candidates' ability to:
Identify and differentiate physical and transition risks.
Evaluate financial implications of climate-related risks.
Understand climate risk measurement tools such as stress testing, scenario analysis, and regulatory compliance frameworks.
Analyze case studies on corporate risk exposure and mitigation strategies.
Key Exam Areas Where These Risks Are Covered:
Climate Risk Measurement and Management (SCR Exam Chapter 6)
Scenario Analysis and Stress Testing (SCR Exam Chapter 7)
Net Zero and Transition Planning (SCR Exam Chapter 8)
Example Exam Question: A multinational energy company is exposed to both transition and physical risks. How should the company integrate these risks into its financial risk management strategy?
To answer this, candidates must consider:
Quantifying transition risk (e.g., carbon pricing exposure, regulatory penalties, stranded assets).
Evaluating physical risks (e.g., damage to infrastructure from hurricanes, wildfire impact on supply chains).
Implementing scenario analysis and stress testing.
Strategizing risk mitigation (e.g., diversifying into renewable energy, adopting sustainability-linked financial instruments).
Why Mastering Transition and Physical Risks is Essential
Climate risk is now a core financial risk category, making the GARP SCR Certificate highly relevant for professionals in risk management, banking, asset management, and regulatory compliance.
By mastering transition and physical risks, SCR candidates can:
Excel in the exam by answering application-based questions effectively.
Enhance their career prospects in climate risk analysis and sustainable finance.
Contribute to financial institutions’ ability to navigate climate-related risks in a rapidly evolving regulatory landscape.
Understanding these risks is not only key to passing the GARP SCR exam but also essential for building a sustainable financial system that is resilient to climate-related challenges.
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