FEBRUARY 2020 European Research Report: Managing & Pricing Climate Risk

HOW TO BEST MANAGE CLIMATE RELATED RISKS? 

As real estate (directly and indirectly) contributes to 36% of greenhouse gas (GHG) emissions globally, a deep understanding of climate change related risks for the commercial real estate sector is starting to develop. Climate change risks include both direct physical and indirect transitional risks. New tools are emerging to help improve this. Among others, Munich Re’s new assessment tool addresses the direct physical impact of sea level rise and other climate related hazards. Also, the new Carbon Risk Real Estate Monitor (CRREM) is a practical tool that measures regulatory transition risk. Non-compliance with EU determined future energy and GHG reduction targets is unlikely to trigger assets to become stranded in the short term, i.e. impossible to sell or requiring costly capital expenditure, but when GHG targets are not met by the specified dates, EU and local governments are likely to become stricter in enforcing their targets and policies. This could increase the financial risk of non-compliance significantly. In the meantime, investors themselves are already implementing better energy efficiency and GHG intensity reduction with the emerging new tools. This report aims to explain these risks and illustrate the potential use of these new tools in order for investors to control them as far as possible.

CURRENT BUILDING CERTIFICATIONS LACK CLIMATE RISK FOCUS

Source: Greenbrook, Munich Re & AEW

EXECUTIVE SUMMARY: NEW TOOLS TO BETTER PRICE CLIMATE RISKS

• As real estate assets face significant climate change related risks, investors are shifting their focus to avoid obsolescence risk.
• In this report, we consider the two main sources of climate related risks for real estate investors:

Physical risks of damage and disruption to buildings as a result of storms, river flooding, sea level rise, heat and droughts could leave some assets stranded. The increased cost of insurance or climate change adaption measures might render buildings impossible to rent or sell;

Transitional risks associated with climate change mitigation, which include regulatory risks such as energy and GHG reduction requirements but also market expectations, technological and reputational changes. Upcoming energy and GHG reduction regulatory targets are likely to result in a shift in focus from current building certifications towards a more climate risk focus approach to be achieved.

• Two acute and five chronic physical climate related hazards are quantified by reinsurer Munich Re using their natural catastrophe risk models calibrated with their historical claims data. Data on a diversified sample portfolio of nearly 20,000 European buildings allows us to show the main results for each specific risk on location-level.
• In the case of the change in daily temperature, we show a consistent northwest to southeast pattern across the sample portfolio. For the precipitation stress index we see a similar pattern with some variation in the Alps. For sea level rise, our sample shows that despite the Netherlands being largely below sea level, sufficient sea level rise protection mitigates the risk significantly.
• Future regulatory change on Energy reduction and GHG intensity play a crucial role in transitional risk. GHG can be measured by the Carbon Risk Real Estate Monitor (CRREM). Current GHG intensity varies widely between EU countries, due to their existing energy mix. As a result, there are different starting points for landlords in different countries and their future requirement to reduce GHG intensity.
• France stands out with a very low current GHG intensity mainly due to its reliance on nuclear energy which represents 70% of the energy produced. This also leaves it with a not very steep GHG reduction pathway. Italy, Spain and CEE have much more to do in this respect due to a low percentage of renewable energy in their current energy mix.
• GHG intensity varies also by property type, with hotels and office among the most intensive sectors and residential and logistics among the least intensive sectors. Based on our analysis, investors in European offices are not (yet) pricing in climate change.
• CRREM has recently been an operational tool that shows the percentage of portfolios that could become non-compliant due to regulatory change alone and the timings of such non-compliance. We note that there is likely to be a significant delay in governments implementing the GHG intensity target in local laws and enforcing them. This delays the impact of non-compliance and also short term risk.
• Non-compliance with EU determined future energy and GHG reduction targets is unlikely to trigger assets to become stranded in the short term, given that current national legislation is delayed and the level of fines is very low, but, when GHG targets are not met at the specified dates in future, EU and local governments are likely to become stricter in enforcing their targets and policies. This could increase the financial risk of non-compliance significantly.
• Policy debates also highlight the possibility for a market-based policy such as a European carbon tax to accelerate the de-carbonisation of commercial real estate. Such a carbon tax could also trigger some energy inefficient and GHG-intense assets to become stranded.