Why Climate Risk is Too Big To Ignore When Making CRE Investment Decisions

Lukky Ahmed, Co-Founder and CEO of climate analytics and resilience solutions firm Climate X, kicked off the November 5 virtual event, “Real Estate Resilience: How Proactive Adaptation Drives Investment Performance” — which was hosted by Commercial Observer Partner Insights and presented by Climate X — with a clear-eyed assessment of how to approach climate risks in commercial real estate operations. 

“Physical risk is real,” said Ahmed. “We recognize that impaired assets make it increasingly difficult for successful valuations to be met on exit strategies and exit points in the life cycle of assets. But the political environment today has made sustainability a bit of a dirty word in the industry.”

With that, he turned to his guest for the event, Harry Morrison, Partner, Sustainability & Responsibility at Bain & Company, to ask how he approached branding when it came to sustainability. 

Morrison said that one obstacle in discussing climate risk with clients is a certain vagueness around the topic itself.

“You’ve hit me with the big question up front around sustainability,” said Morrison. “It’s hard to argue with the big idea of sustainability, that we want development to meet the needs of the present without compromising future generations. But the concept is quite vague and it covers many different topics. Therefore, it’s difficult to have a specific and practical discussion about it, and I think that’s been an issue for many businesses.”

Morrison also notes that the actual language around sustainability gets caught up in what he refers to as a “hype curve.”

“We just did a study on this,” he said. “We saw that there’s a massive increase in business leaders talking about sustainability through the pandemic period, and then it’s come back down again. It’s still quite high, but it’s more at 2018 or 2019 levels.”

Morrison said that we can take several lessons from this.

“The first lesson is, let’s be specific. Let’s talk about the actual issue,” said Morrison. “So if the issue is water stress, let’s talk about water stress. if the issue is human rights, let’s talk about that. Or if the issue is climate physical risk and the implications for real estate, let’s be specific about that issue, because then we can all agree: what’s the problem, and how are we going to tackle it?”

Morrison then introduced his second lesson by mentioning a recent study, based on input from 35,000 CEOs, demonstrating a recent shift in how CEOs talk about climate risk.

“There’s this real shift from talking about sustainability as a question of purpose and commitment — which maybe was the language four or five years ago — to now, talking about the business imperative, which is talking about value, cost, risk, growth potential, etc,” said Morrison.

Combining more specific language with discussions about tangible concepts like value, cost, and growth allows for more practical and actionable approaches. 

“Physical risks create genuine financial exposures. What are we going to do about it? What’s the cost of adaptation? What’s the impact on asset values?” said Morrison. “That’s a conversation we can all get behind.”

Morrison mentions that climate-related losses are growing around 5 to 7 percent per year, and that insured loss last year totaled around $150 billion globally from catastrophic weather events. 

With temperature levels rising, Morrison emphasizes the need for immediate action on climate risk mitigation, mentioning that goals for keeping average global temperature rise under 2 degrees Celsius are already failing.

“There’s always been talk about the 1.5 degree goal,” Morrison said, “but the latest UN figures say we’re effectively on track for a 2.3 to 2.5 degree world. Of course, a 2.5 degree world brings a lot of physical risk for our property, much more so than a 1.5 degree world. That’s what we now need to start to plan for, and so that increases the urgency for action right now.”

Ahmed raises the issue that some have delayed action due to an over-reliance on the promise of insurance, but that hedge against action is quickly losing its effectiveness.  

“There’s an intensity that’s rising now on trying to correlate physical risk to insurance impacts, because that’s always been seen as the backstop – if you’ve got insurance, then why care about the problem?” said Ahmed. “But what’s happening now is that under the renewals, we’re seeing spikes of three or even 5x coming through in certain states – and that’s if insurance is available at all, as certain insurers are trying to withdraw from certain regions. So the insurance markets are starting to react with ideas of how they might incentivize clients to invest in adaptation and resilience, with the incentive of some sort of credits that might be applied on the insurance premiums.”

One difficulty this presents for clients with climate-risked assets is trying to accurately plan for insurance premiums in the coming years.

“Often, you’re insuring for the next 12 months, but you may be looking to own the asset for five or 10 years. So you’re taking a risk as to, what’s the price of the insurance going to be in years two, three, four and five,” said Morrison.

Ahmed then brought up how physical risk assessments would likely be different for different asset types, adding yet another challenge to the assessment of risk.

Morrison notes that much of our information and data about traditional asset classes is standardized, reducing that challenge, but that determining this data for infrastructure then becomes a greater challenge. 

“While you can understand the physical risk because of the location, you know less as far as available data and quality information about the potential to adapt,” said Morrison. “That tends to become a more bespoke exercise, and require more ground-truthing with the engineers.”

Toward the event’s end, Ahmed mentioned a survey which found that about a third of investors are expecting to reject investment opportunities if there’s no climate resiliency plan in place.

“This is really quite significant,” said Ahmed. “There’s going to be a premium that’s eventually going to be attached, or at least a strong discount, for cases where you can’t prove resilience.”