Physical and Transition Risks

Physical and transition risks have emerged as critical dimensions of financial stability in the context of climate change, with significant implications for banking, finance, and the Indian economy. These risks arise from both the direct impacts of climate-related events and the systemic economic adjustments associated with the transition towards a low-carbon and environmentally sustainable growth model. In India, a climate-vulnerable developing economy with a rapidly expanding financial system, understanding and managing these risks has become increasingly important for policymakers, regulators, and financial institutions.

Conceptual Background of Climate-Related Financial Risks

Climate-related financial risks are broadly classified into physical risks and transition risks. Physical risks stem from the direct consequences of climate change, including extreme weather events and long-term environmental shifts. Transition risks arise from policy, technological, market, and behavioural changes associated with the shift towards a greener economy.
For the financial sector, these risks are not merely environmental concerns but sources of credit, market, operational, and systemic risks. Banks and financial institutions face potential losses due to asset impairment, declining borrower creditworthiness, and disruptions to economic activity.

Physical Risks and Their Economic Dimensions

Physical risks refer to losses caused by climate-related events such as floods, cyclones, droughts, heatwaves, and rising sea levels. India is particularly exposed to such risks due to its geographic diversity, long coastline, dependence on monsoons, and high concentration of population and economic activity in climate-sensitive regions.
In the banking sector, physical risks materialise through increased defaults in climate-sensitive sectors such as agriculture, infrastructure, real estate, and small-scale industries. Damage to physical assets reduces collateral values, while income losses among households and firms weaken repayment capacity. Recurrent extreme weather events also raise insurance claims and increase the cost of risk coverage, affecting both insurers and lenders.
At the macroeconomic level, physical risks can reduce productivity, disrupt supply chains, and impose fiscal pressures through higher public spending on disaster relief and reconstruction. These effects can slow economic growth and indirectly weaken the balance sheets of financial institutions.

Transition Risks and Structural Economic Change

Transition risks arise from the process of adjusting to a low-carbon and environmentally sustainable economy. These risks are driven by changes in climate policies, environmental regulations, technological innovation, energy pricing, and shifting consumer preferences.
For India, transition risks are closely linked to commitments on emissions reduction, renewable energy expansion, and sustainable development. Sectors such as coal-based power generation, fossil fuel extraction, energy-intensive manufacturing, and conventional transport face the risk of asset stranding and declining profitability. Banks with high exposure to such sectors may experience rising non-performing assets and valuation losses.
Financial markets are also affected by transition risks through repricing of assets, increased volatility, and shifts in capital allocation towards green and sustainable investments. The pace and predictability of policy changes play a crucial role in determining the magnitude of these risks.

Implications for the Banking Sector

Banks are central to the transmission and amplification of physical and transition risks. Climate-related shocks can simultaneously affect multiple borrowers, regions, and sectors, increasing the likelihood of systemic stress. Traditional risk assessment models, which rely heavily on historical data, may underestimate climate-related risks due to their forward-looking and uncertain nature.
Indian banks face challenges in integrating climate risk into credit appraisal, stress testing, and capital planning. Exposure to agriculture, micro and small enterprises, and infrastructure projects increases vulnerability to physical risks, while lending to carbon-intensive industries heightens transition risk. Strengthening climate risk management frameworks has therefore become a supervisory priority.
The Reserve Bank of India has recognised climate-related risks as a source of financial instability and has initiated steps to enhance disclosure, risk assessment, and regulatory awareness within the banking system.

Impact on Financial Markets and Institutions

Beyond banks, physical and transition risks affect insurance companies, pension funds, mutual funds, and non-banking financial companies. Insurers face rising claims from climate-related disasters, which can threaten solvency if risks are not adequately priced. Long-term investors are exposed to valuation risks arising from stranded assets and changing return profiles across sectors.
Capital markets play a key role in facilitating the transition by mobilising funds for renewable energy, climate-resilient infrastructure, and green technologies. However, inadequate information and inconsistent disclosure of climate risks can lead to mispricing and sudden market corrections.

Policy and Regulatory Responses in India

Addressing physical and transition risks requires coordinated action by financial regulators, government agencies, and market participants. Regulatory initiatives increasingly emphasise climate risk disclosure, scenario analysis, and stress testing. Aligning financial flows with sustainable development goals is seen as essential for long-term economic stability.
International institutions such as the International Monetary Fund have highlighted the macro-financial implications of climate change for emerging economies, reinforcing the need for proactive risk management. In India, policy measures aimed at promoting renewable energy, sustainable finance, and climate-resilient infrastructure directly influence the risk profile of the financial system.