Investors grapple with physical climate risks, long-term impacts

Investors are stepping up efforts to understand and better manage the impact of climate change on their physical investments in real assets, including private equity, from farmlands to urban office buildings. It is an increasingly urgent mission as the transition to a net-zero economy ramps up.

"Physical climate-risk scenario analysis is particularly important for real asset investors as portfolios are more likely to be materially affected by increased risk of physical impacts and damage as a result of flooding, coastal inundation, sea level risk and extreme heat," said Shuen Chan, head of ESG for LGIM Real Assets in London. Her firm's analysis of extreme physical climate risk has stepped up in the last 18 months, including more forward-looking scenario analysis of that risk, with the idea "to build more resilient portfolios," she said.

In the U.S., the $267.8 billion New York State Common Retirement Fund, Albany, and Impax Asset Management Group PLC have joined forces to ask S&P 500 companies to identify the location of key facilities and buildings where climate change events could negatively affect operations and in turn, financial results.

"Where a company operates key facilities is a major factor in its exposure to physical risks," said New York State Comptroller Thomas P. DiNapoli, the fund's trustee. "Investors need much more precise physical location data from companies to help make sound long-term financial decisions."

Based on the responses so far, New York State Common and Impax are learning that companies are not seriously considering, let alone planning for, the physical risks of climate change, and investors are dealing with a lot of unpriced value risk, according to a report by Julie Gorte, Impax senior vice president for sustainable investing.

According to an S&P Global Inc. report, an estimated 60% of S&P 500 index companies' physical facilities and buildings face high risk of climate-related losses, representing a total market capitalization of $18 trillion in the U.S. alone.

Along with more dramatic risks to buildings, owners and investors in real assets need to consider the longer-term impact of climate change from greenhouse gas emissions and carbon footprints, sources said. The built environment also contributes more than 40% of global greenhouse gas emissions, according to the World Business Council for Sustainable Development. That ramps up the pressure on private and public decarbonization efforts to achieve global net-zero carbon goals. The International Energy Agency projects that to reach interim goals by 2030, all new buildings would need to be on track to be net-zero carbon ready by 2040, and 50% of existing buildings would need to be retrofitted.

A report by BlackRock Alternative Investors and U.K. banking firm NatWest Group PLC to find out how the net-zero transition will impact the U.K. real estate sector and investors there highlights how much more there is to know.

Emerging technologies to decrease real estate's carbon footprint, such as advanced data monitoring, energy efficiency measures and renewable energy sources, will help as more companies, governments, lenders and investors commit to a more sustainable transition, but it will take industrywide collaboration, said the London-based co-authors of the report, Simon Durkin, head of European real assets research and strategy for BlackRock, and Charlotte Foster, managing director of real estate finance, large corporate, for NatWest.

Real estate investors will also benefit from advances in data monitoring and collection, but the challenges are not insignificant, the authors said. Any delay in retrofitting commercial buildings could make decarbonization increasingly impossible, they warned. Pressure from U.K. and European regulators and investors to make real estate cleaner could also mean more expensive debt.

"Action needs to be taken immediately to prevent these assets from becoming stranded" if improving real estate becomes financially unviable, the authors warn. Increasing the share of renewable power available to building users will be key, along with better information on buildings' energy profiles and more uniform industry standards, the authors said.

KKR & Co. Inc. has an education program for its portfolio companies to help them understand and manage climate risk, including measuring greenhouse gas emissions and considering carbon offsets.

KKR recently joined the Initiative Climat International, a global community of investors seeking to understand and manage climate risks, and helps to run the private equity working group at climate advocacy group Ceres that is helping general and limited partners address the impacts, risks and opportunities of climate change in alignment with the goals of the Paris Agreement.

Physical climate risk has been a KKR priority for more than a decade, said Ken Mehlman, partner, global head of public affairs and co-head of KKR Global Impact, a fund investing in climate action and other sustainable themes. "If you are investing in oceanfront property, it's important, but it's also important if you are investing in other places that could be impacted by supply chain issues. Managing exposures to extreme weather is increasingly important. We hear this from our LPs and our public investors," he said.

"More broadly, climate risk and opportunity is something we intend to continue increasing our focus on across all the investments we make," Mr. Mehlman said.

When it comes to addressing physical climate risk, "we do see more movement on the private (investment) side," said the Rev. Kirsten Snow Spalding, senior program director of the Ceres Investor Network in Berkeley, Calif. "They are looking at their own portfolio construction, and what information they need," she said.

Initiatives like the ESG Data Convergence Project, led by the $493 billion California Public Employees' Retirement System, Sacramento, and The Carlyle Group, to create a standardized set of ESG metrics and a system for comparative private equity reporting, will be critical to managing physical climate risk, Ms. Spalding said. The project will help private equity general partners track, gather and report on ESG data from their portfolio companies based on six metrics: Scopes 1 and 2 greenhouse gas emissions, renewable energy, board diversity, work-related injuries, net new hires and employee engagement. The data will be shared with limited partners and aggregated into a benchmark overseen by Boston Consulting Group.

Other institutional investors, including the Albany-based $148.1 billion New York State Teachers' Retirement System in late December, increasingly have announced plans to review their private equity investments for climate-related risks and opportunities.

Investors are also expanding low-carbon investments to their private asset classes. Last March, sustainable investing officials with the $319.9 billion California State Teachers' Retirement System, West Sacramento, announced that over the next few years, they anticipate investing up to $2 billion into private markets, initially focusing on affordable housing opportunities and then low-carbon solutions relating to energy, technology-enabled resource efficiency, water and waste management, land and agriculture management and food security. The plan for the first two years is to focus on leveraging existing CalSTRS relationships to invest up to $150 million with private equity managers in low-carbon solutions and between $200 million and $500 million with real estate managers in affordable housing investments.