Given the long duration of real asset life cycles, intensifying climate hazards are expected to dramatically affect investment performance in the coming years. However, many investors aren't actively protecting their assets and are failing to optimize their portfolios.
Given the projections for increased frequency and severity of climate-related events, it is critical that institutions properly assess climate risk at all stages of an investment — measuring hazard, exposure and vulnerability of their real assets — and then optimize their portfolios for climate resilience through a combination of due diligence, forward-looking design, assertive disruption management and thoughtful divestment of certain assets.
As weather and other climate-related disasters intensify globally, so do the economic effects. According to the National Oceanic and Atmospheric Administration, the number of billion-dollar (inflation-adjusted) climate disaster events in the U.S. alone grew to 91 from 2010 to 2017, from 28 during the 1980s. And the average annual costs rose to $81 billion from 2010 to 2017, from $17 billion in the 1980.
Real assets investors traditionally have relied on insurance to help mitigate climate-related risk. Securing insurance to cover the costs of rebuilding after extreme weather events, for example, has been a prerequisite for investors to consider real asset acquisitions in areas with high climate risk exposure. However, given insurance models are largely based on historical data that might not accurately benchmark future risks, climate risk might be underpriced, premiums might rise and in some cases, assets might become uninsurable. Beyond purchasing insurance, however, not all investors are managing the long-term climate risks associated with their investments. In failing to understand this exposure, they not only ignore growing risk, but also miss out on the potential positive impacts on returns of resilience efforts. These can include cost reductions (lower operating costs and averted damage), revenue growth (increased occupancy rates) and higher asset values.
Assessing climate risk
Investors should adopt a systematic, three-dimensional approach in evaluating real asset climate exposure to mitigate potential risks and maximize investment opportunities.
First, ascertaining the likelihood, timing and potential impact of hazards that a particular market faces as well as how those hazards might change over time will serve as a baseline for the degree of climate risk. Understanding the type of extreme events that can occur and how they are interrelated (e.g., droughts exacerbate wildfires, which in turn can contribute to the frequency and severity of landslides) is equally important and typically not factored into insurance models, which tend to be based primarily on historical patterns and do not account for a changing climate.
Second, with an understanding of the range of potential hazards, investors should evaluate the exposure to expected climate impacts faced by their specific asset. For example, in a market at high risk of flooding from sea level rise, the extent to which a property or infrastructure asset is located inland vs. on the coast and above vs. below sea level will go a long way to identifying the magnitude of climate risk.
The third dimension of climate risk assessment is to ascertain vulnerability of the specific asset to sustain damage or losses in the event of a hazard, looking at factors such as the asset's age and materials composition, the use of storm windows and drains, whether the electrical equipment is located in the basement or rooftop. Such details can make a significant difference to damages and costs from a weather or climate event. For example, a mixed-use project in Boston that incorporated resilience features including elevated mechanical systems, seawalls and saltwater tolerant landscaping reduced its actuarial flood-loss expectancy by 90%, according to the Urban Land Institute.
The lifecycle approach
Following an in-depth risk assessment of climate hazards, exposure and vulnerability, investors can optimize portfolio performance by following a life cycle approach.
A step-by-step approach to managing risks begins with due diligence, which involves evaluating climate threats facing a market and asset, then assessing the ability and costs to enable the asset to withstand those risks.
Investors should then look at design improvements that can boost resilience and consider the costs to retrofit assets to higher standards, including features such as storm-resistant windows, extra insulation or backup generators, the location of electrical and telecommunications systems and availability of backup data centers, and alternative hardware to support continuity of operations. Infrastructure assets such as airport runways, roads and rail transport in regions faced with intensifying heat waves will likely need to be designed to tolerate greater heat. Similarly, bridges and oil and gas pipelines might need modifications to withstand more frequent flooding.
At the same time, investors must establish a plan to manage disruptions if disaster does strike. This means lining up suppliers and contractors to be ready to respond in an emergency and ensuring business continuity plans are in place.
Lastly, investors should continuously evaluate each asset in their portfolios to determine whether projected returns outweigh associated climate risks (including costs of mitigation or asset upgrades) and make an informed hold/divest assessment. Given the speed at which climate hazards appear to be accelerating, real assets investors should thoughtfully consider climate risk and resilience at all stages of an investment in order to mitigate the risks and optimize portfolio performance and returns.
Tony Charles is head of research for Morgan Stanley (MS) Real Assets and Josh Myerberg is managing director, Morgan Stanley Real Estate Investing, based in New York and San Francisco, respectively. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.