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FRM Part I · FRM Exam Part I · Enterprise Risk Management and Future Trends

A bank wants to assess the financial impact of climate-related risks on its loan portfolio. It distinguishes between physical risk and transition risk. Which of the following is the best example of transition risk?

A carbon tax that cuts the profitability of a coal-dependent borrower is transition risk, because it stems from policy and market changes in moving to a low-carbon economy. Hurricane damage, flooding and drought are physical risks caused directly by climate-related weather events.

  1. AA coastal property loan suffers collateral damage from a severe hurricane
  2. BA manufacturing borrower's factory is flooded, interrupting production
  3. CDrought reduces crop yields for an agricultural borrower
  4. DA new carbon tax sharply reduces the profitability of a coal-dependent borrowerCorrect

Explanation

Transition risk arises from the shift to a lower-carbon economy through policy, technology or market preference changes. A carbon tax hitting a coal-dependent borrower is the classic case. Hurricanes, floods and droughts are physical risks arising directly from climate events.

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