Since Mark Carney first raised ‘stranded assets’ in 2015 when he was Governor, Bank of England, investors and asset managers have been turning their attention to climate risk – and the financial impact of climate change and climate politics on their investments. At the same time, the Task Force on Climate-related Financial Disclosures (TCFD), set up in 2015, has been making disclosure recommendations to increase market transparency and stability. The TCFD aims to provide a standardised framework for companies to disclose relevant information so that investors can assess climate-related financial risks and make informed capital allocations. In his new role as UN Special Envoy for Climate Action and Finance, Mark Carney talked about ‘fear and greed’ at Davos, in January this year.
Under the guidance of TCFD, here at the Blockchain & Climate Institute (BCI), we have focused on measuring climate risks in the real estate industry, which accounts for close to 40% of energy consumption and 30% of all greenhouse gas (GHG) emissions in the EU. In general, climate risks comprise two components; physical and transitional. In the past, investors such as insurance companies have concentrated on the physical risks, for example, flooding, droughts and other extreme weather events. This article explores the prospect of transition risk and the effort required to measure the impact of policy and technology changes or the reputational risk associated with climate politics.
In the real estate industry, transition risk includes the failure of properties to meet future market expectations or regulatory requirements relating to energy consumption and greenhouse gas emissions. Some properties face potential value depreciation, cost inflation or premature obsolescence. Assets subject to such risks are known as stranded assets. The UK CCC 2020 report on Buildings included that from 2028, no dwellings can be sold unless it meets the minimum EPC level C.
To measure the climate transition risk of UK real estate, we leveraged a tool from a recently completed EU-funded research project called CRREM (Carbon Risk Real Estate Monitor). The CRREM tool has several advantages over other risk analytics providers, such as MSCI. Firstly, CRREM focuses solely on climate transition risk – a new field of research for other institutions. Secondly, it takes a very detailed approach, accounting for regional and sectoral differences (as demonstrated below). And thirdly, CRREM is an open-source tool, and we can leverage the capability of our vast network of volunteers to improve it.
The following diagram shows the key output of this model:
The green line is the decarbonisation pathway; derived from the breakdown of the global anthropogenic GHG emissions budget that is consistent with the Paris Climate Agreement, the commercial real estate sector, property types and individual assets. In other words, this target pathway is unique per country and property type. In addition, it is adjustable to different future climate scenarios (limiting global warming to 2°C or 1.5°C).The black line represents a property’s baseline and future carbon performance of GHG intensity and represents the amount of annual greenhouse gas emissions per building floor area. Emission figures include those directly generated through the on-site combustion of fossil fuels for heating and indirectly generated through district heating and electricity consumption. Retrofitting the property with things like insulation can significantly improve carbon performance. CRREM also considers two additional effects on the GHG performance of a property:
- Potential climate change effects: The number of days that require heating/cooling (HDD/CDD) in a year changes over time. While global warming will likely reduce the demand for heating, the energy requirements of cooling systems are increasing in return.
- Electricity grid decarbonisation: The increasing share of electricity generated from renewable sources implies that the average amount of GHG emitted per consumed kWh will continue to decrease over time.
The red circle highlights the year in which the property becomes stranded (asset exposed to write-downs as they exceed carbon emission target). Upon further analysis, we can quantify climate transition risk by calculating the Climate Value at Risk for each property. A three-step estimation process:
- Calculate the total excess emission from the current year to 2050.
- Calculate carbon costs of excess emissions by multiplying total excess emission by the projected carbon price.
- Calculate climate value at risk by dividing the carbon costs by the property’s price. The more negative this metric is, the more climate risk the property faces.
Here is an example of carbon costs for a UK property:
BCI has successfully enhanced the model’s capability by automating the Excel-based model in Python and moved all raw data needed onto an AWS database to enable big data analytics. We have also created a web API to retrieve the CRREM output by specifying an address as input, covering over 18 million EPC UK addresses.
To adapt CRREM to the UK property portfolio, we used the Energy Performance Certificates (EPC) as input data. EPCs are publicly available reports for around 64% of properties in England (BCI Research Division I). And provide valuable data points on carbon performance and various energy-related specifications. We then adjusted the model to make it compatible with EPC input without sacrificing the overall effectiveness of the model.
Our next steps will be to improve the model by verifying assumptions and apply the model to property sectors outside the UK. Through our work, we hope to establish standards for measuring the climate transition risks of real estate and raise awareness of the financial impacts to investors, regulators and the general public.