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Climate Change Impact on Commercial Real Estate Finance — What the Industry Needs to Know Today

June 06, 2019

It can be difficult for business leaders to assess how climate change will impact commercial real estate finance. The sheer volume of climate information in the public domain is beset with politically charged debate, conflicting reports and complex meteorological jargon.

Climate change impact on commercial real estate

The confusion has left decision-makers at banks, debt funds, insurance companies and real estate developers with hard choices – from predicting how climate change could affect real estate prices to deciding how to finance certain property – and what changes, if any, to make to their businesses going forward.

In an effort to bring some non-partisan business clarity to the conversation and prepare interested parties across the industry for what lies ahead, we identify, summarize and analyze the impact of climate change on commercial real estate finance and developments that warrant attention from industry participants.

Davos: Extreme Weather a Serious Economic Threat

Impact of tornadoes and extreme weather on commercial real estate

Earlier this year, at the forum’s annual conference in Davos, Switzerland, many were surprised when climate change was identified as the number one threat to the world economy. In past years, the themes of this elite gathering held at a luxury ski resort in the Alps focused on more traditional economic issues like trade barriers, globalization and public-private cooperation.

But this year, leaders from the private sector, government and academia concluded that the greatest danger to the health of the global economic system was the increasing frequency and intensity of extreme weather events. Second among the gravest risks to economic growth was a related concern: the failure of public officials to limit the effects of climate change.  The annual report published by the World Economic Form ahead of this year’s event described this sentiment: “Of all risks, it is in relation to the environment that the world is most clearly sleepwalking into catastrophe."
 

The guest list for this annual summit was a true who’s-who of powerful and influential men and women who shape our economy.  Included among the 3,000 participants from over 100 nations were the CEOs of JP Morgan, Goldman Sachs, Morgan Stanley and Barclays, the political leaders of Germany, Japan, Canada and Brazil, executives from Zurich Insurance Group, McKinsey and Walmart, the UN Secretary General and the International Monetary Fund chief. George Soros and Bill Gates were also in attendance.

Critics of Davos frequently dismiss this gathering as nothing more than an exclusive cocktail party for the rich and famous, including rock stars and royalty.  However, to dismiss the discussions out of Davos this year would be a mistake.

With major banks, governments and businesses agreeing that climate change must be addressed in some material way soon, it seems clear that change is likely to follow for all sectors of our economy, including real estate development and finance.  Maybe not tomorrow, but soon as the direction that the arrow is pointing is clear.

The sentiment in Davos is a continuation of both the global cooperation which produced the Paris Agreement on Climate Change and, in a different but equally clear way, the thousands of students holding climate strikes around the world earlier this year.  The United Nations will continue this momentum in September 2019 when it holds a yet another climate change summit aimed at solving the problem with a global solution.

   

New York: The Climate Mobilization Act

New York City, the financial capital of the world, is one place where the message from Davos was heard loud and clear. In April 2019, the New City Council passed legislation called the Climate Mobilization Act.  The overarching goal of this ambitious new law is to reduce fossil fuel emissions and improve energy efficiency among certain high-rise buildings. There are over 1 million buildings in New York City, and combined, these skyscrapers account for roughly 75% of all citywide greenhouse gas emissions.

The new law requires that buildings exceeding 25,000 gross square feet must reduce their greenhouse gas footprint starting in 2022 and each year thereafter so as to meet an established sliding scale of emission limits. The result will be that by 2050, citywide emissions will be 80% lower than they were in 2005.

A new city agency called the Office of Building Energy Performance will enforce these rules and require annual reporting (with filing fees) by building owners to provide evidence of compliance starting in May 2023. Failure to comply with the guidelines will result in civil penalties based on the building’s gross floor area. Fines will also be imposed on developers who make materially false statements in their emissions reporting. The new law requires energy audits to be performed by registered design professionals to assist the agency’s enforcement efforts.

Additionally, the Climate Mobilization Act authorizes an exploratory study to be performed on the utility of carbon trading systems.  “Cap and trade” programs for carbon are not new and are currently in place in cities like Tokyo where property owners can meet regulated emissions caps through a marketplace where fossil fuel burning capacity is bought and sold among real estate developers. Over the next few years, New York City will evaluate whether instituting such a market can accelerate its goal of reducing emissions by 80% by 2050.

To sum up this landmark legislation, NYC Mayor Bill de Blasio was quoted as saying, “To say the least, we would like our national government to focus more on how to stop global warming, but in the meantime, the City of New York is doing all we can.”

For real estate developers in the Big Apple, and the banks who finance them and the insurance companies who insure them, it should be clear that considerable capital will need to be spent to install energy conservation improvements, to make day-to-day property management changes and to buy renewable energy in order to comply with New York City’s version of the “Green New Deal.”

   

The Bank of England: Climate Change Risks and Bank Stress Tests

England’s central bank, the Bank of England, is flashing very clear warning signs to UK lenders and insurance companies that climate change is a risk they need to start planning for now as part of their everyday businesses.

In December 2018, the Bank of England announced that they were considering adding climate change risks to their bank stress tests starting in 2019. These balance sheet tests evaluate whether financial institutions have enough capital to survive extreme economic shocks without needing a government bailout. Never before has climate change been part of the equation.

England’s central bank indeed is worried about it, as a 2018 survey conducted by the Bank of England concluded that only 10% of banks were adequately factoring in climate-related risks, like extreme flooding, and moving away from fossil fuel investment and transitioning to a low-carbon economy.

Second, in April of this year, Mark Carney, one of the England central bank governors, penned an open letter to the financial industry warning about the threat climate changes poses to the global economy. The letter was co-signed by Villeroy de Galhau, governor of France’s central bank, and by Network for Greening the Financial System (NGFS), a climate change group made up of over 30 central banks and regulators.

The message was clear. The financial industry must adapt to climate change immediately to avoid economic disaster. The authors of the letter asked for more banks to consider undergoing climate change stress tests and called for more global collaboration to solve the problem.

The letter reads in part, “Climate change is a global problem, which requires global solutions, in which the whole financials sector has a central role to play,” and that the actual solutions are “unprecedented, urgent and analytically difficult.”

The NGFS report which accompanied the letter identified three key risks:

  • extreme weather physical risks like massive flooding and droughts
  • transition risks of moving from fossil fuel investments to greener technologies, which require huge amounts of capital reallocation and might result in huge write-downs
  • liability risks which may overwhelm insurers when losses are suffered because of the above-noted physical and transition risks

In a speech made on April 15 of this year, by another Bank of England official, Sarah Breeden, it was announced that the UK insurance industry will be asked as part of the 2019 stress test to evaluate how they would be affected by the physical, transition and liability risks of climate change.  According to Breeden, the Bank of England became the first regulator on the planet to publish guidelines for banks and insurance companies to develop best practices to manage the financial risks posed by climate change. 

   

Federal Reserve: Preparing Financial Institutions for “Severe Weather Events”

Federal Reserve plans for climate change

Back at home, the Chairman of the Federal Reserve, Jerome Powell, indicated in an April letter to Congress that the Federal Reserve is also working to ensure resilience of the financial system from extreme weather related to climate change.

“Although addressing climate change is a responsibility that Congress has entrusted to other agencies, the Federal Reserve does use its authorities and tools to prepare financial institutions for severe weather events,” he wrote.

The Chairman’s comments came in response to a January 25 letter from Senator Brian Schatz of Hawaii emphasizing the need for the Fed to manage the risks from unexpected weather conditions and to prepare banks to do the same. As Senator Schatz noted in his letter, such climate-change risks include potential loan losses at financial institutions from business interruption caused by storms, wildfires, hurricanes and other acute weather events.
 

In testimony before Congress in February of this year, Chairman Powell also focused on climate-change risks as a matter of supervising banks rather than as a matter of monetary policy. This is because extreme weather events are a shock to the financial system where the Fed and most financial institutions have needed to be reactive rather than proactive. Such weather events are also difficult to predict and cannot be easily factored into economic projections.

However, other regional leaders, including Philadelphia Fed leader Patrick Harker, have pushed for recognition that climate change is also relevant for longer-term monetary policy and could lead to issues such as elevated credit spreads. Worse, powerful storms are now being viewed as a significant risk to creating a financial crisis stemming from infrastructure and agricultural damage and disruptions to supply chains.

It seems that the U.S. central bank and its regional branches are still trying to determine how to quantify and incorporate climate-change risks into short-term and long-term economic evaluations, but recognizing the need to do so is one positive step in the direction of matching our British counterparts across the Atlantic.

It remains to be seen whether the Federal Reserve proposes a stress test for U.S. financial institutions under its supervision.

   

Resilience Programs: Mitigating Losses from Environmental Disasters

In contrast to the efforts to predict the effects of climate change on the financial system, many cities have moved towards adaptation to climate change through the development of resilience programs.

During the past two years, there were 30 extreme weather events in the U.S. These disasters, including floods, hurricanes, heat waves, and droughts, caused roughly $400 billion in economic losses, mostly to residential and commercial real estate. As recently as March of this year, floods in the Midwest caused more than $1.5 billion in estimated losses and damages to more than 2,000 homes in one week.

And the long-term effects of climate change will not be limited to individual assets, but rather entire geographical regions.  According to a recent report from Urban Land Institute (ULI) and Heitman, a real estate investment management firm, more than $130 billion of U.S. institutional real estate is located in cities that are in the top 10% for exposure to rising sea levels. While real estate investors are also trying to incorporate climate risk into the investment decision-making process, the focus has shifted to mapping physical risks and exploring physical adaptation and mitigation measures for at-risk locations, including local resilience strategies.

Interviewees for the ULI/Heitman report noted that a local government’s willingness to make necessary mitigation investments related to climate change was equally important as evaluating the vulnerability of that area. For example, Miami is investing $200 million into a resilience program that includes installing pump stations and upgrading infrastructure and Miami Beach is spending almost double that under a resilience program entitled Rising Above to raise sidewalks and seawalls using funds from higher property taxes.

Experts have found that it is cheaper to build hazard-resistant structures than it is to follow the minimum building codes and repair damage after extreme weather events.  Miami-Dade County also entered into the Southeast Florida Regional Climate Change Compact with three other Florida counties, which has committed funds to address emissions, rising sea levels, storm water management and flood control. These types of regional compacts may become more prevalent in other low-lying, at-risk locations to promote sustainability and resilience.

On the other coast, the City and County of San Francisco recently adopted a strategic plan for resilience. A new Office of Resilience and Capital Planning in the San Francisco City Administrator’s Office was established to manage several programs, including:

  • The Resilient SF – Stronger Today, Stronger Tomorrow strategic plan. Under the strategic plan, in addition to adaptation planning for rising sea levels, some of the more interesting goals include launching a regional resilience design challenge and developing more mobile infrastructure to handle disaster recovery from healthcare to sewer management.
  • The Earthquake Safety Implementation Program to address San Francisco’s vulnerabilities to earthquakes, including developing standards in the building code for post-disaster usage and occupancy and encouraging retrofitting of seismically dangerous buildings.
  • The Lifelines Council focused on post-disaster recovery.

The City also expanded its Property Assessed Clean Energy (PACE) Program to create a new financing initiative to help property owners make seismic and environmentally conscious building improvements.  Recent extreme weather events from flooding to hurricanes to wildfires have all demonstrated that focus on property-level climate change risks is no longer sufficient.  There is no question that local resilience programs will play a large part in the evaluation of real estate investment going forward.

   

Climate Change Funds: Investing in Innovation

Renewable energy and climate change funds

Out of the uncertainty on how to handle climate-change risks to the financial system, new investment opportunities have thrived. Several climate-change funds have been established to invest in companies that combat climate change and its effects – including investments in renewable energy sources as well as projects for adaptation to global warming.

In 2018, investment managers had $3 trillion in assets invested with a focus on climate change according to the US SIF: the Forum for Sustainable and Responsible Investment. These funds, however, do not face any less of a challenge than the Fed in determining how climate change threatens the profitability of its portfolio of assets.
 

The Hartford Environmental Opportunities Fund formed a research partnership with the Woods Hole Research Center, a non-profit climate change program, to identify metrics important for such investments. The correlation between droughts and migration has been an early focus of the partnership and the asset manager for the Hartford portfolio suggested that the conclusion may be that movable assets are more valuable than permanent assets.  For example, investment in farm equipment may become more important than farmland itself.

Other climate change-funds have moved away from solely investing in renewable energy projects and towards stock in non-traditional farming, waste management and clean water delivery systems.

There is no market standard or measuring stick as to what constitutes a green investment.  A freight company that outpaces its competitors by relying on trains rather than over-the-road trucking may be considered a green investment, as may be a carbon-efficient salmon farm compared to a cattle ranch producing methane gas. There seems to be a consensus that climate change does not need to be the mission of every green fund.  Rather, like any investment fund, what is needed to be successful is sustainable business practices and long-term growth and that necessitates fund managers incorporating climate change into its investment strategy.  

   

Summary

Commercial real estate properties impacted by climate change

Climate change is real and it is happening today. Public sentiment is growing on both sides of the aisle that the climate crisis is truly that – a crisis – and must be solved by our elected officials and business leaders. Seventy-three percent of registered voters in the U.S. believe climate change is a real problem, an 11% jump since 2013.  And perhaps the most compelling evidence is Mother Nature. By turning on The Weather Channel on any given day, we see proof that our environment is changing in ways which are causing increasingly severe damage to property, communities and economies, large and small.

Political screaming matches on cable TV and doomsday threats about the end of humanity are not helpful to people running real estate companies and commercial real estate lending operations. They are not useful components of the commercial judgment rule being used by executives who must answer to boards, shareholders, clients and employees.

But one thing is clear. Like all movements which have altered the course of history, climate change is gaining velocity as a social, moral and economic issue at all levels of society. Causes on this scale sooner or later ultimately lead to government regulation at local, state and federal levels.  New laws will be enacted which will require all businesses to spend large sums of capital to adapt. As this article has shown, climate change is already impacting the commercial real estate finance industry, and more impacts are certainly on the way in the not too distant future.
 

More Background on Climate Change

Climate change has quickly become one of the most dominant news stories in today’s society both in the U.S. and around the globe. On a daily basis, the news includes stories of unprecedented flooding, rain bombs, wildfires, melting glaciers and polar vortexes, each accompanied by stunning video footage. All of these extreme weather events point to climate change as the culprit. Beyond the weather, media outlets are also documenting how animal extinctions, food shortages, refugee caravans and the spreading of viruses are the results of the climate crisis.

However, not everyone agrees, partly because climate change is now a political issue.

Advocates for climate change are demanding loudly that their governments take action to pass regulations to cause companies to reduce, and eventually stop, all fossil fuel emissions. The Paris Agreement adopted in 2015 is perhaps the most famous example.

The ever-increasing public support for addressing climate change is backstopped by scientific data. It is now common knowledge that at least 97% of the climate experts who study this phenomenon in peer-reviewed journals conclude that mankind’s burning of fossil fuels is warming our planet at a dangerous rate. According to NASA, 18 of the 19 hottest years of our planet’s recorded history have all occurred since 2001.  And the 5 hottest years on Earth were the last 5 years – 2018, 2017, 2016, 2015 and 2014.  2018 was the hottest year on record in 29 countries and Antarctica.

In the other corner of this incendiary debate is the fossil fuel industry. For the most part, the oil and gas sector, their well-funded political lobby and the “climate denial” community push back on the science as misleading and inconclusive. To them, climate change is confusing and unconvincing.  They claim that the Earth’s climate history is too complicated to understand, and that perhaps the Earth is actually cooling or that it is naïve to believe people can actually influence the global climate.