Article 2 - content
It has become commonplace for all sorts of institutions, from governments to corporates and non-profit organizations, to make commitments to reduce carbon emissions.1 In large part, society has accepted the need to transition to a lower carbon economy.
For investors, this societal shift can present both ‘transition’ risks and opportunities. Transition risk refers to the potential financial costs associated with reducing carbon intensity or the potential hit to asset values of not doing so. The opportunities are those benefits that may accrue to owners of assets that could experience increased demand, revenue and hence value.
Whether it is regulators forcing building owners to internalize costs to curb emissions, tenants shunning inefficient properties powered by polluting energy sources, or investors keen to hold cleaner portfolios, the pressure to address climate risks is ubiquitous.
Investors worldwide and across asset classes have, in recent years, been increasingly looking at their portfolios through a climate risk lens.2 Many are voluntarily embracing targets to reach net zero emissions on their assets, regardless of the regulatory landscape, and are now formulating their plans to achieve this.
This sentiment is also true of real estate investing, but before one can price the risk associated with transition one needs to know the starting point from which one is transitioning! Understanding a portfolio’s current carbon intensity may seem straightforward but rarely is – even in listed markets with high levels of disclosure. In private markets like real estate, accessing such data in a consistent and coherent way is easier said than done.
It Takes Data Collection
Detailed modelling of physical risk from climate change - its potential impact on weather patterns and the incidence and intensity of natural disasters - is in no way a trivial task. Layering on the financial implications of these potential changes only adds to the complexity. But from an investor’s perspective, the portfolio data requirements are fairly straightforward. Such models only require the geographical location of properties and their capital values from their owners, which are generally easily accessible.
But to most accurately assess the transition risk of a private real estate portfolio generally takes more effort from the owner or manager to collect as much detailed data as possible about the emissions of every property in the portfolio.
It is one thing to get energy use details from a shopping mall operator, for instance. But to gather the data points for all the different tenants – those that leave lights on overnight and those that use energy efficient light bulbs; those that crank up the air conditioner, operating over long hours and those that are already paying a premium for clean energy – that is a laborious task.
Even where a concerted effort is made to collect such information, it is not always possible to ensure full portfolio coverage. Where the information falls short, an analytical model capable of filling in the gaps can give a holistic view of the portfolio.
Real Estate contributes to global emissions
Real estate contributes around 30% of global emissions, according to the International Energy Agency, half of which comes from commercial properties.3 With such a significant contribution, the sector has a key role to play as governments, and society at large, plot a trajectory to net zero emissions. So, all this effort is justified from an ethical or impact investing perspective but is there any evidence that such modelled risks are hitting the returns of investments today?
Future Risks Can Manifest Today
Equities can provide an example of how climate impacts are being priced in the market today. In this market, where information about a company’s carbon intensity is more widely accessible and managers can more easily screen their portfolios based on such data, managers have been factoring these dynamics into their investment processes for some time already.
Recent MSCI research computed Low Carbon Transition Scores across companies and found clear evidence of a financial impact on valuation levels, stock price and earnings of companies.4 The impact was found mainly in the tails of the distribution with the ‘greenest’ companies – those providing low carbon products and services - having performed better than the ‘brownest’ companies - those with the potential to experience "stranding" of physical or natural assets due to regulatory, market and technological forces arising from "low- carbon" transition.
This impact on stock prices has clearly intensified since 2015, when the Paris Agreement to limit global carbon emissions was signed; seemingly more so for European companies than those in the US and Asia Pacific given the relative intensity of regulatory pressure there.
It remains to be seen whether and how transition risks may permeate through supply chains and pricing dynamics to affect the entire universe of companies in MSCI’s benchmark beyond the most positively and negatively exposed companies highlighted in the study. It also remains to be seen whether the relative strength of impact seen in European companies spreads around the world. President Joe Biden will host a Climate Leaders’ Summit on April 22, Earth Day, and is expected to affirm the U.S.’s resolve to curb emissions and reach carbon neutrality within three decades. If regulatory pressure is indeed a key transmission channel for climate risk, this step change in U.S. policy could be significant.
Practical Steps For Real Estate
While no direct link can be made between empirical results from equity markets to private real estate, theoretically, similar transmission channels could be expected. Greater transparency and frequency of data points in equity markets allow us to see an example of the first signs of climate transition risk impacting the prices of investments today.
Some private real estate investors may choose to do their part, from an ethical or impact investing perspective, to help solve the global climate crisis by allocating capital to reduce carbon emissions. Others may look to the pricing impacts already being felt in equity markets and seek to position their portfolios differently in the face of similar potential risks to real estate assets. Whatever the motivation, the good news is that a sophisticated model is available to help investors understand the potential financial impacts of these somewhat abstract and long-dated climate risks on today’s real estate asset values. Understanding this exposure is a key step in determining appropriate portfolio management action.
For more on incorporate climate risk into your portfolio read our blog.
1E.g. World Resources Institute: https://www.wri.org/blog/2019/09/what-does-net-zero-emissions-mean-6-common-questions-answered
2EY, Climate change the investment perspective: https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/banking-and-capital-markets/ey-climate-change-and-investment.pdf
3International Energy Agency: https://www.iea.org/topics/buildings
4MSCI, Foundations of Climate Investing: https://www.msci.com/www/research-paper/foundations-of-climate/02346584750