24 / 09 / 20 - 5 minute read
The 'new normal' hides a risky future
Back in January, before COVID-19 seized the globe’s attention, BlackRock shook the investment world by announcing that it was making climate change and sustainability a key pillar of its investment strategy and joined the Climate Action 100+ investor initiative. As the world’s largest asset manager, this announcement was a key signal that the existing investment world order had truly shifted.
It should not have come as a surprise; the 2020 World Economic Forum Global Risk Landscape listed extreme weather and failure of climate change mitigation and adaptation as the risks with the highest impact and likelihood, and had included these risks for over ten years. And in the real estate sector, no one would challenge that sustainability and ESG have been a part of industry discussion for years too; a 2018 UN Environment Program Finance Initiative survey of 44 global real estate investors and fund and asset managers showed that the vast majority (90%) include ESG criteria in investment decisions.
And yet, climate change risks weren’t necessarily top of mind for real estate investors at the start of 2020, thanks to distractions like Brexit. And then, as we all now know, the investment world was mightily shaken once again, this time by the unforeseen impact of the COVID-19 pandemic. While the immediate shock has dissipated, there is now a massive push to manage the disruption to business and investment activity.
"Insurance mitigates some risks in the short term, but premiums will continue to rise as the frequency and intensity of extreme weather increases dramatically."
Although the pandemic will continue to press on the sector and the global economy in the medium-term and uncertainty over longer-term effects will linger, one fact is certain: the impacts of climate change will continue to mount.
19% of retail and 16% of offices in Europe exposed to floods
Insurance mitigates some risks in the short term, but premiums will continue to rise as the frequency and intensity of extreme weather has increased dramatically in the past three decades; insurers are openly warning of the financial impacts. Moreover, insurance cannot mitigate the risk of devaluation or loss of liquidity due to climate change impacts, so it’s critical that we assess and manage these complex risks effectively.
And what exactly are the risks? They are typically divided into two groups: physical and transitional. Physical risks are those that directly affect buildings, like extreme weather events, changes in weather patterns and sea level rise.
In this group, flooding tops the list according to research from risk analytics firm Four Twenty Seven, which revealed that 19% of retail spaces and 16% of offices in Europe are exposed to floods and/or sea level rise. Among the most vulnerable European cities are Copenhagen, with 81% of its offices exposed to coastal flooding; Belfast, UK (73%) and Gothenburg (43%).
In the residential sector, flooding risk is especially apparent in the UK, where The Guardian reports that since 2013 one in 10 of all new homes in England have been built on land at the highest risk of flooding.
Another immediate risk is that as temperatures rise, heat stress will also be a serious issue, creating not only increased operational costs but also indirect impacts in terms of consumer and investor behavior.
“Stranded” real estate assets
Transitional risks are those resulting from a shift to a lower-carbon economy and using alternative sources of energy. A 2019 Urban Land Institute and Heitman report cites regulatory changes, economic shifts, and the changing availability and price of resources as the specific risks associated with this transition, all of which can drive increased costs for operations, adaptation and compliance.
As the real estate sector contributes to 30% of global annual greenhouse gas emissions and consumes around 40% of the world’s energy according to the UN, it has become a prime target for legislation aimed at complying with the Paris Agreement adopted in 2015. The target is a 77% reduction in total CO2 emissions in the sector by 2050.
This means that carbon and energy regulations may affect the valuations of real estate assets and portfolios. Millions of buildings are powered, heated and cooled with fossil fuels, and policies aimed at reducing carbon emissions will require these buildings to undergo major retrofitting. Those that don’t comply will be rendered unsaleable.
All these risks create the issue of “stranded assets,” a term generally applied to the fossil fuel industry but which in this context refers to properties that will be impossible to rent or sell due to the effects of climate change or inability to meet regulatory standards. It is therefore essential for investors to properly assess and price climate risks into asset acquisitions.
Real estate investors are underestimating the impact of climate change
Yet, according to a 2019 RICS survey of nearly 4000 real estate professionals around the world, almost half (46%) think that climate risk factors have “no importance” or are “irrelevant” in making investment decisions. Whether it is because the scale and complexity of the risks seem insurmountable, the long-term perspective is lacking or because other seemingly more pressing issues like Coronavirus simply take up investors’ attention is unclear.
"The real estate sector contributes 30% of global annual greenhouse gas emissions and consumes 40% of the world’s energy, so has become a target for legislation."
To address the first instance, in Europe the Carbon Risk Real Estate Monitor (CRREM) has developed a tool that assesses the risk of assets becoming stranded “due to the expected increase in stringent building codes, regulation, and carbon prices.” It enables investors to better assess their assets and plan the actions required to adapt to future climate conditions and comply with regulatory demands.
Globally, the UNEPFI has developed a framework for real estate investors to identify and integrate ESG and climate change risks into their investment decision making processes. With the overwhelming evidence that climate change risks are real and pressing, and with clear pathways to assessing and addressing these risks, there should be no distraction for investors.