Climate Risks in Focus for Real Asset Portfolios

 

Assessing and managing physical and transitory climate risks

 

For investors and asset managers with a focus on real assets, climate is often at the center of their ESG risk and opportunity assessment. Real assets are among the few economic activities that are equally affected by both dimensions of climate-related risks, physical and transitory risks.   

Especially for investors in assets with a long-term investment horizon, the trade-off between higher transitory or higher physical risks plays a major role. This approach is based on two fundamental scenarios for dealing with climate change:

• The "Giant Leap" approach describes a path with disruptive measures, far-reaching climate protection policies, changing consumption patterns, and technological adaptation.
• The "Too Little Too Late" scenario, on the other hand, represents a transformation that is too slow, entailing the risks of physical climate damage and the associated adaptation measures in the medium to long term.

"Giant Leap" or "Too little, too late" – both pose risks for real asset investors

 

Physical Climate Risks

Physical climate risks are more tangible for real estate and infrastructure than for almost any other asset class. Climate-related natural disasters have been increasing worldwide for years (source: MunichRe). At the same time, this sector belongs to the economic activities with particularly high exposure to changing climate conditions (source: S&P Global).

It is particularly crucial for investors in this sector to identify physical climate risks and incorporate them into portfolio management. A sound risk assessment helps prevent losses in value and protect investments over the long term. It is becoming apparent that assets with high risk exposure will be valued lower in the future – or will only be financed to a limited extent. Many asset owners, such as insurers or pension funds, have recognized the importance of physical climate risks and are demanding corresponding analyses from asset managers. This is no longer just a reporting exercise, but rather a matter of developing resilient business strategies.  

Database-supported tools already exist for such analyses, which, based on geodata and asset valuations, also provide information on the financial consequences of climate risks. For example, CLIMADA Technologies, a fors.earth partner, draws on the climate research expertise of ETH Zurich and is thus able to model scientifically sound risk assessments across various climate scenarios for individual assets and across entire portfolios. This helps identify both opportunities and risks and leads to a holistic portfolio strategy.

Example portfolio under RCP 2.6 scenario in 2050, Climada Technologies

Example portfolio under RCP 4.5 scenario in 2050, Climada Technologies

Example portfolio under RCP 8.5 scenario in 2050, Climada Technologies

 

Transitory Climate Risks 

The fact that transitory climate risks, in addition to physical risks, are particularly relevant for investors in real assets is primarily due to the central role that real estate plays in the global emissions balance.

37 % of global emissions were attributable to real estate activities in 2022 (source: UNEP). This means that, apart from the energy sector, hardly any other economic sector is as much in the focus of climate protection efforts as the real estate sector. However, unlike the energy sector, the real estate sector is currently not on track to achieve national and international decarbonization targets. CO₂ emissions from building operations in 2022 were a full 40 % above the target of 7.0 Gt CO₂ per year. To return to the target trajectory, an annual emissions reduction of approximately 10 % until 2030 is required starting in 2023. This implies that more radical cuts and greater regulation are needed, not only in new construction.

Real estate sector worldwide not on course for decarbonization (Source: UN Environment Programme)

However, national policies in many countries are also taking action. For example, the EU Building Directive (EPBD) requires zero emissions for new buildings from 2030 and a ban on fossil-fuel boilers by 2040. Local laws, such as Local Law 97 in New York, also stipulate strict emission limits for buildings. And emerging markets are following suit. Since April 2022, the "General Code for Building Energy Efficiency and Renewable Energy Utilization" has been in force in China, requiring energy-efficient planning for all new buildings, extensions, or renovations.

The modernization of existing buildings is also a hot topic. In Germany, the modernization rate would have to increase from the current 1 % to around 3 % to achieve decarbonization targets (source: Federal Environment Agency).

Investors should also consider these global considerations at the portfolio level. A first step is to examine one's own portfolio for compatibility with relevant decarbonization pathways, for example with the help of the Carbon Risk Real Estate Monitor (CRREM).

The CRREM Risk Assessment Tool is suitable for starting the assessment of transitory risks in the portfolio

Such an initial assessment allows for a more precise risk assessment, and potential stranded assets can be identified and actively managed early on. The analysis described is also an opportunity for investors, enabling them to identify areas where investment needs and increased demand for financing exist. Energy-related renovations in Germany alone are expected to cost approximately €4 to €5 trillion by 2045 (source: German Federal Parliament Research Service).

 

You can find our services for real asset investors here.

Interested? Contact us for a free initial consultation.

Hendrik Leue

Director

Phone: +49 151 74270767
E-mail: hendrik.leue@fors.earth