Although more managers are mapping the physical risk of climate change in their real estate portfolios, it is still rare for these factors to have a material impact on investment decisions, said panellists on a webinar hosted by the Urban Land Institute Europe last week.
The risks from rising global temperatures – both acute in the form of extreme weather events, and chronic in the form of changing climate patterns – are increasingly understood by an industry confronted with spiking insurance costs and hard-hitting disaster headlines in recent years. Yet physical risk is still only assessed as part of the routine due diligence process, the panel found.
The industry will need to develop new skill sets and solutions for physical climate risk management, similar to what has already been done for transition risk and decarbonisation, said Meghan Johnson, ESG director at Houston-headquartered manager Hines.
“It’s one thing to do a screening of assets for a fund, for investor reporting – there are plenty of tools on the market for that now – but it’s another thing entirely to take that information and start to incorporate it into investment decisions, design decisions and capex decisions,” she added.
Craig Morey, climate lead for real estate at London-based manager Schroders Capital, said his firm has been integrating physical risk analysis into its due diligence and portfolio reviews “for some time”, but is now trying to turn that information into financial metrics in order to make it “tangible and useful for our asset management teams and business decision-making”.
Currently, Morey said, the chances of physical risk influencing an investment committee’s final decision on an asset are “relatively slim”, owing to a lack of clear financial metrics linked specifically to physical risk.
“We can outlay that there are clear risks to the portfolio or the asset, and we can outlay that we know that there is an adaptive capacity in that building,” he explained. However, without being “extremely confident” in the financial metrics used to inform a cost-benefit analysis, “it’s harder to get that message across as an investment decision”.
He said the industry needs a framework similar to the ULI’s C Change, which helps quantify the financial impact of transition risk: “[Physical risk] might be an influence, but I don’t think it will be a clear decision factor until that exists.”
A complex picture
Indeed, Morey emphasised that climate resilience is another key reason why physical risk is yet to be fully integrated into investment decisions. With heat, for example, a building with air conditioning will be significantly more resilient to climate risk than one without. However, where many buildings in the UK and Northern Europe carry planning conditions to increase their thermal insulation in order to reduce heating-related energy consumption, this makes them less adaptable in the case of overheating, he noted.
With this in mind, Morey also pointed out that any assessment of physical risk in an investment decision will be heavily influenced by the type of investment proposed. With a value-add investment, any inherent physical risk to a building would need to be assessed in the context of its adaptive capacity, whereas the value proposition would be “quite the converse” for a core asset.
“There’s so much complexity there before we get to black-and-white, yes-or-no decision-making. We need something more complex before we get to that.”
Johnson agreed, adding that as Hines continues to conduct net-zero carbon audits across its European portfolio and starts retrofitting assets, “it seems silly to me to miss the opportunity to also be looking at opportunities to improve resilience”.
A question of resource
With financial value frameworks for physical risk yet to be developed, software that models this particular type of climate risk is in high demand.
Johnson said Hines is currently reviewing a number of different climate risk data providers to systematise how the firm assesses and manages physical risk. She explained the goal was to choose a preferred provider for Hines worldwide rather than having local teams and funds decide on their own. However, she added, this process yields “a lot of variation” in risk results on the same assets across different third-party providers.
The industry therefore has some way to go to develop the solutions and services that managers need in this area, she said, adding it is difficult to find providers that can assess every type of physical risk, from flooding to wildfires and heat stress.
As managers grapple with how to approach physical risk in both their existing assets and new investments, however, their dilemma is as much a question of ESG resource allocation as it is the dearth of data and frameworks on the matter. As Morey pointed out, “capex and opex are all competing to be used for different needs”.