Built to last? Measuring and mitigating the physical risks of climate change
In the latest IPCC Climate Change Synthesis report, the findings show that current implemented policies are projected to increase global warming to 3.2°C above pre-industrial levels by 2100. There is clearly much to be done to keep global warming within the bounds of the small remaining carbon budgets, meet the 1.5°C target and minimize catastrophic climate impacts.
Allee Zhang discusses the physical risks of climate change and the resulting consequences for real assets.
Despite some progress made on accelerating decarbonization of high-emitting industry sectors, significant warming is already locked in due to historical emissions.1 This level of warming, along with every increment of temperature rise since, is driving impacts of climate change, making extreme weather events more frequent, severe and unpredictable.
Research conducted by the University of Oxford and JBA scientists found that extreme river floods occur more frequently in regions with distinct temperature variances across the seasons; a 50-year flood is now happening every 21 years, and a 20-year flood every eight.2 Furthermore, recurrence of extreme floods may not follow a predictable pattern.
In these uncertain times, assets will face rising insurance premiums or even become uninsurable as insurance companies look to protect the downside and reduce uncertainty. According to the European Insurance and Occupational Pensions Authority (EIOPA), in 2023 only about a quarter of the economic losses caused by extreme weather events in Europe were insured,3 resulting in a large insurance protection gap.
In real asset investing, understanding physical risks is imperative to understanding the vulnerability of an asset or the resiliency of a building to withstand certain climate hazards. This means considering potential physical damage along with the loss of income, to assess, manage, mitigate and adapt where possible to strengthen resilience and protect the value of assets and investment portfolios.
Physical climate risks, alongside transition risks and other sustainability factors, should therefore be integrated into the initial investment analysis and throughout the asset’s lifecycle. During the due diligence phase, outcomes of early screening can establish if any further climate-related investigation needs to be undertaken and how they can be appropriately managed to mitigate impacts or to drive positive outcomes. Once acquired and during the active management phase of the investment, physical climate risks are measured and assessed at the asset level for adaptive capacity. Where necessary, mitigation plans are put in place, considering the investment’s financial models and the cost of mitigating the identified physical climate risk.
Methodology and approach4
Methodology and approach4
To evaluate physical climate risk, a comprehensive methodology is needed, focusing on the likelihood and magnitude of hazards, exposure and vulnerability at the asset level. Subsequently, these exposures are aggregated at the portfolio level based on portfolio weighting.
The first step is to select the physical climate hazards that are relevant for the type of asset for the assessment. For example, lightning provides a good indicator of possible storms, but it is not necessarily a material hazard that needs to be analyzed for real estate assets as the physical damage is likely to be attributable to the storm that occurs rather than the lightning. For infrastructure5, a top-down approach by sector is generally taken by examining the physical climate hazards that would be most severe for the assets and value chain of a specific sector. For example, flooding has a high likelihood to impact digital infrastructure assets severely, requiring capital expenditure (capex) to repair damage and possibly resulting in fines due to disruptions in service provisions.
We begin our assessments by examining the current level of natural hazard risks of a specific asset in a given location. The relevant emissions scenarios are selected, which consider models of the increasing GHG in the atmosphere and resulting changes in temperature. A realistic near-term scenario, 2030 RCP4.56 is selected to represent a conservative and “more likely” emissions scenario, and 2050 RCP8.6 is selected to represent a more pessimistic and long term “stress” scenario. The medium-term time horizon of 2040 is also taken for observation to compare how the scenarios change over time. Upon analysis under each emissions scenario, we determine the hazard exposures.
The hazards are rated from “very low” to “very high” based on the likelihood of occurrence and the potential magnitude of the damage, e.g., varying wind speed levels of a tropical cyclone. The risk bands help keep the underlying relativeness of the various hazards and improve comparability between the risk categories. The hazards are then classified into “direct” and “indirect” hazards based on the level of impact to the asset type.
An overall risk rating of the asset is derived from these hazards, combined with the gross asset value exposures, providing the focal point of the vulnerability analysis.
When looking at the vulnerability of assets, we break down its definition into three components. First is the exposure of assets to the identified climate hazards, including the area impacted and the severity and frequency of these hazards. Here we conduct the analysis in a projected extreme scenario where the identified hazards could potentially occur simultaneously, to understand the maximum impact of asset exposures. Next, we look at the sensitivity of assets to be impacted by these hazards based on their condition and capacity and the likely consequences of these hazards to people and organizations. Finally, the adaptive capacity is assessed in terms of the asset, using information such as building typology, structure, technical specifications and surrounding topography to respond to consequences. With regard to infrastructure, assets, facilities, operations, supply chains and resources to adjust to the climate event are also assessed.
Having assessed the asset-level exposure, sensitivity and adaptive capacity, additional steps must then be taken to conduct a deep-dive analysis to understand how adaptation and/or mitigation efforts may reduce the overall risk exposure. For real estate assets, this is performed by gathering very specific risk elements, such as the floor height of the building, which could determine the level of damage of the flood along with historic and modelled flood inundation data. Asset managers coordinate and drive this data collection process for each asset, engaging directly with property managers and managing agents on specific building-level information. Data gathered is then interpretated and a (potentially lowered) residual risk exposure rating is derived given an acceptable level of high resiliency. For assets above the risk threshold, mitigation plans including prospective costs and timelines are developed and incorporated in the capex and asset management business plan.
In real estate, some climate adaptation outcomes are best achieved through joint effort and collaboration between landlords and tenants. It is important to note that many of these measures, especially those designed to address acute physical climate events such as flooding, should be supported by wider processes too. This includes business continuity plans (BCPs) and emergency continuity plans (ECPs) to ensure that roles and responsibilities in the form of standard operating procedures (SOPs) are clear in operating and maximizing the effectiveness of the measures themselves.
For infrastructure, resiliency needs to be built up for specific sites or assets due to their known vulnerability to withstand the potential projected climate hazards in the near, medium and long term. Here, prioritized adaptation solution development is integrated with cost-benefit analysis and aligned in the ongoing capex program
How to value physical climate risk?
Alongside identifying the physical risks at the asset level, it is important to identify the potential financial impact of these risks materializing when no action is taken under various emissions scenarios and time horizons.
In the case of real estate, the effect on cash flow could be due to loss of rent due to damages to the asset, reduced rent from falling demand for a vulnerable asset in a high-risk zone and increased insurance premiums (or even inability to get any insurance) to reflect higher physical climate risks. This approach is a pure estimation of the cost of “doing nothing” without forecasting wider socio-economic impacts of physical climate risk. For infrastructure assets, financial materiality of damages from climate-driven hazards can be estimated by looking at forecasted growth and the sum of the damage factors by each hazard, as well as the proportion of damaged assets with production capacity that have an impact on revenues.
To put a full value on climate risk impacts beyond pure physical damages, further work would be needed to understand the extent and severity of climate change impacts on the less tangible social-economic systems of the assets and surrounding locations. This could ultimately be the largest driver of valuation change over the longer term.
References
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