Climate change is introducing an evolving series of systemic risks that threatens the resilience of a wide range of assets and their investment value over the long term. The nature of modern capital markets requires risks to an investment be identified, valued, accounted for and managed in the present.

For some real estate investors with long-term mandates, particularly pension funds, the impacts are now either materialising, or are forecast to materialise, over the typical holding period of an investment building and certainly over the life-cycle of a new asset or development. Mitigating and managing these risks is therefore an increasingly important consideration.

What are the risks?

On 15 January 2020, the World Economic Forum published their annual Global Risks Report.

For the first time in the survey’s history, all top five risks in terms of likelihood are simultaneously occupied by climate change and environment-related issues being extreme weather, climate action failure, natural disasters, biodiversity loss, and human-made environmental disasters.

In terms of the global economic impact, climate action failure surpassed weapons of mass destruction, taking the top risk impact position with biodiversity loss and extreme weather occupying impact position three and four respectively.

The building and construction sector is a substantial contributor to these risks through its heavy consumption of energy and high emissions. The International Energy Agency (IEA) estimates that the sector is responsible for approximately 36% of global energy consumption and 39% of CO2 emissions.

The IEA have also indicated that the real estate sector could be 40% more energy efficient by 2040, although achieving this opportunity will require a large alteration of existing infrastructure, energy use patterns and technological capacity. These, in turn, will all require significant levels of investment.

Stranded assets

The nature of the real estate sector necessitates long-term thinking, as real assets are both fixed and longstanding in nature. Physical assets must be able to provide tenants with sustainable and resilient utility of space to ensure the asset, and hence the investment, remains profitable in the long term.

Failing to respond adequately to both physical and transitional asset-level risk will increasingly expose investments to the risk of early economic obsolescence. When an asset is able to meet market expectations of what it should be able to do – it becomes ‘stranded’.

What is a stranded asset?

The term ‘stranded assets’ refers to assets at risk of losing their value, in this case due to climate change.

Until fairly recently, the concept of a stranded asset in the commercial real estate sector has been largely hypothetical. However, trends are emerging that are changing this.

For example, the European Union (EU) adopts one of the most comprehensive approaches to regulating assets globally, through the use of Energy Performance Certificates (EPCs). Following the 2010 EU Energy Performance of Building Directive, it became mandatory for all European properties to hold an EPC and to monitor heating and air conditioning.

EPCs are a key enabler of building improvement, as they have potential to influence investment decision-making. They also provide the opportunity for governments to enforce minimum energy standards, and are an important information tool for building owners, occupiers and stakeholders.

In the Netherlands, office buildings need to meet minimum energy performance requirements (EPC Label C) by 2023, or they cannot be leased. By 2030, the minimum is expected to be raised to EPC Label A.

Policymakers across the world are following, notably in the UK and New York, and have implemented carbon and energy regulations that will similarly impact assets, and threaten the cash flow and valuation of those that do not comply.

How to avoid stranding

For physical assets to maintain their present utility, and hence value, into the future, asset managers must increasingly consider climate risk issues alongside regular capital and operational expenditure to inform ongoing asset improvements and avoid the risk of asset stranding.

This includes not only the mere direct physical impact of extreme weather events, but also includes other impacts including shifts in consumer preferences for low-carbon products, sustainable buildings, increasing insurance premiums, growing risk of litigation and other increased operational costs.

The International Renewable Energy Agency (IRENA) have identified that US$11.8 trillion of current assets could be stranded by 2050 based off today’s rate of global emission reductions.

The risk of asset stranding is therefore of increasing significance for fund managers and in January this year, BlackRock, Inc., the world’s largest asset manager representing US$7 trillion of investment, declared it will now make climate change central to its investment considerations.

In his annual letter to CEOs, BlackRock CEO, Larry Fink stated that ‘the evidence on climate risk is compelling investors to reassess core assumptions about modern finance... We believe that all investors, along with regulators, insurers, and the public, need a clearer picture of how companies are managing sustainability-related questions.’