Schroders Capital on building climate risk into real estate investment decisions

This article is sponsored by Schroders Capital.

This has been a year in which the consequences of climate change have become more evident than ever before, as extreme weather events including heatwaves, wildfires and flooding have impacted people and property around the globe. And while most institutional real estate investors have grasped the costs of mitigating carbon emissions on asset values, they are still struggling to integrate physical climate risk into their strategies and valuations, says Craig Morey, climate lead for real estate at Schroders Capital.

“A significant shift is needed to fully understand our exposure and vulnerability to climate risks,” he argues. “We need to look beyond the asset-level, and incorporate city and regional level resilience, societal shifts and market exposures, to protect and deliver consistent value for investors.”

Why is climate-related risk a critical issue for the real estate sector?

Essentially, climate risk is financial risk. The real estate industry, and financial sector, has typically addressed climate risk by focusing on mitigation of climate change and associated transition risk through energy efficiency and carbon emissions reduction. Attention is now turning to actual physical risk.

Supported by the latest science, insurers and investors are waking up to the impending risk of physical impacts caused by climate change. There is a real threat to entire markets from shutdowns of core infrastructure, asset damage and supply chain disruption, with the WEF predicting that the coming decades will be defined by “ex-cities and climate migrants.”

According to the EU, Europe has seen more than €145 billion of losses from climate events in the last decade, and C40 Cities estimated the cost to cities of sea-level rise and associated inland flooding could reach $1 trillion by 2050. That risk is compounded by the lack of action toward climate resilience, with UNEP suggesting climate adaptation finance is currently declining.

We are potentially looking at a global temperature rise of 2.5 to 2.8 degrees, which will have an enormous impact on ecosystems and generate huge climate migration.

What does the landscape for climate frameworks and regulation look like? Is there enough focus on physical risk?

Climate disclosure frameworks have tended to focus on mitigation, supported by considerable climate reporting guidance for carbon measurement and management. Those don’t exist to the same extent for physical risk quantification and valuation. TCFD goes some way to enabling this but is limited in setting strict parameters.

The absence of a reporting structure means that investors are unable to consistently understand the actual risk embedded in their portfolio and take action to mitigate where possible.

The challenge for the real estate sector is to create a risk framework that is consistent and replicable. The ULI C-Change framework provides guidance for incorporating transition risk into financial reporting and cashflows and an equivalent should be developed for physical risk. The enhanced disclosure criteria in the forthcoming IFRS S2 and CSRD standards should generate progress toward this.

At present, a climate value-at-risk calculation is relatively easy to consistently calculate for carbon. A similar calculation for physical risk involves measuring the likelihood that a climate-related event like a flood or storm would affect a building, and determining replacement costs. But what is more difficult to calculate is the level of damage, the effect on usability, the social impact and the effect on insurance costs and/or future insurability.

What makes city-level risk and resilience so important for understanding real estate exposure to physical climate hazards?

Physical risks will present themselves very differently in different cities, including flooding, drought, wildfires, storms, rising sea levels and subsidence. We are facing both increased extremes in weather and shifting boundaries of extreme events into previously unaffected areas, and investment in making an individual asset resilient can be undermined if it is in a vulnerable city that has not planned for the future.

Assessing resilience and vulnerability of a building or city is one part of the challenge. We must also assess how disruptions to supply chains, energy, transport and residential regions outside the city can affect market functioning.

Efforts to rank sustainable cities typically look at climate risk exposure and the existence of climate policies and adaptation strategies. Often though, they are not examining the adequacy of those policies. Are they being implemented quickly enough? Are they focusing on the right issues? Are they creating financial incentives for businesses to build resilience?

While we know that there will likely be up to 6.3 billion people living in urban centers by 2050, some as a result of climate migration, we don’t yet understand how the needs of a city’s population will have changed due to a difference in climate.

It is not all about the risks, though. We believe that entire new markets could open up for investment because climate-driven changes in occupier or consumer preferences make them more attractive. Resilient assets could see a better-quality tenant base emerge with higher rental expectations and values. Cities that are beginning to invest heavily in climate resilience and nature-based solutions might capture new market share and could present significant opportunities.

How will climate change risks impact cities differently and how may resilience be affected? 

We know that there is a high likelihood that the US sunbelt is going to be quite dramatically hit by shifting boundaries of extreme heat and storm events. Important cities in Asia are going to be more at risk of cyclones, heat stress and coastal inundation. Without appropriate solutions, it may be difficult to operate safe and insurable buildings in these locations.

An added layer of complexity is that some efforts to mitigate climate change can actually amplify the risk to an asset from physical impacts. As an example, in an effort to comply with decarbonization regulation in office assets in northern Europe, owners may look to deliver heavily insulated, airtight buildings. However, that can reduce the ability to adequately ventilate those properties as temperatures rise, not to mention significantly increase the demand for air conditioning.

In Mediterranean or Middle Eastern climates where people already deal with extreme heat, there might be less vulnerability to temperature increases, because buildings are already designed for it, and people have already adapted by working at cooler times of the day. A challenge for European markets is that around 80 percent of our existing buildings will still be in use in 2050 and might have to significantly adapt both to mitigate and to deal with the consequences of climate change, whereas emerging markets will have a higher proportion of new-build properties.

How can data and technology help managers evolve their assessment of climate risk and resilience?

Modeling tools will need to give asset managers the ability to aggregate risk data with asset and market level information – building age, occupancy type, surrounding logistics networks, the dominant types of economic activity within that city. All those things play into determining the risk and vulnerability level of an asset.

Thankfully, physical risk tools are becoming increasingly granular in their risk identification and are allowing for more flexibility in approaches to data aggregation. This level of detail is important; for example, the impact of flood risk can vary within a few meters. We are also seeing the implementation of AI and machine learning to enable climate risk analysis to deal with many different overlapping information layers and simplify accordingly.

The next step will be to further utilize AI and digital twin models. For instance, we will be able to see what the increase in cooling load would be if the external air temperature rises by a certain amount, and then analyze how a building’s systems and operation will respond in various occupancy scenarios.

Where does engagement and collaboration need to improve?

We need greater collaboration between businesses, public and sector-level bodies, and government, to build awareness of what is happening outside of the realm of our individual assets, so that investors can see the full influence sphere and mitigate acquisition risk or adapt assets in the most effective way.

So far, decision-making on climate risk has been led mostly by sustainability teams. We need to work together more closely with asset management and property management teams to understand asset-level risk vulnerability and resilience measures in a more complex environment of potentially conflicting regulations and desired outcomes.

International co-operation to benchmark best practices will be essential. A lot of the technology and adaptation initiatives we will need in the coming years could already be in vogue in places already dealing with specific risks and/or in the course of being implemented. For example, the US already designs buildings to withstand higher wind speeds, which could become very useful in the European market.

What are the next steps for ensuring climate risk and resilience is factored into decision-making?

Any framework for climate risk investment decision-making must have financial risk and impact assessments standing behind it, so that we can build that into cashflow models. Then that information needs to be utilized by insurance and valuation teams.

Once we can begin to determine the effect of physical climate risk on valuation and business plans, then the market can start to move toward creating more resilient assets and adapting exposed assets to become more resilient. While it may be too early to put accurate costs to climate impacts in our portfolios, it is already too late not to act.

We have enough information to include climate risk exposure in our decision-making. It should be part of our investment strategies, due diligence, hold or sell decisions, net-zero and biodiversity strategies. By assessing resilience, well-prepared managers that incorporate information on the physical, economic and social consequences of climate change will ultimately produce the best returns for their investors.

What contradictions exist with regard to climate risk and market reaction?

If we consider the impact of climate risk events like rising sea levels and flooding in the Miami region, for example, there is evidence of residential property values increasing in some of the worst-affected areas where insurance cover has become more expensive, or even inaccessible. We believe that contradiction might be caused by an imbalance between supply and demand, and a lack of awareness to risks on future events.

That raises the question of whether it is possible to have a resilient property in a vulnerable location. The answer to that is currently, probably yes. Property values rebound within three to five years of a major weather event, and the value of assets that prove to be most resilient to those events rebounds more quickly.

However, if an event repeats itself, the market and valuation impact is much more severe and longer lived. Multiple events will lead to assets being uninsurable. As result, in the medium to long term, without adequate city-level resilience and significant investment into adapting infrastructure systems, entire markets will become vulnerable, leaving even the most resilient asset stranded.