The real-life consequences of climate change are getting more visible every year. Extreme weather is causing unprecedented damages to housing and infrastructure, causing suffering amongst communities. This also presents the banking world with serious risks. Climate change-related risks are expected to cost the global economy up to 23 trillion dollars by 2050, unfortunately disproportionally impacting marginalised communities.
Climate change represents a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors and, more importantly, in specific geographical areas. That's why EU and national governments are taking more and more measures, to achieve net zero and mitigate this risk. The GFANZ initiative (Glasgow Financial Alliance for Net Zero) recognizes that, in order to keep alive the goal of limiting global warming to 1.5 degrees Celsius, all companies, including banks, need to adapt their business models and develop and implement credible transition plans. The most vulnerable intermediaries are those that operate with long time horizons and are exposed to the consequences of extreme events, such as insurance companies and banks.
The ECB (European Central Bank) expect banks to ultimately manage Climate-related and Environmental (C&E) risks in the same way as any other material risk they face. That's why the ECB has included climate-related and environmental risks in the ECB Banking Supervision’s supervisory priorities for 2022-24. In this context, the European Commission has put forward a proposal for a legally binding requirement for banks to develop, implement and disclose their transition plans.
In short, from the standpoint of long-term risk mitigation and short-term regulatory compliance, banks are expected to step up their game regarding C&E, part of Environmental, Social and Governance (ESG) compliance. In January, the ECB announced they'd be performing a stress test in Q2 of 2022, to 'identify vulnerabilities, best practices and challenges banks face when managing climate-related risk'. Results are expected to be published in July. However, past year evaluations showed that most European banks are not prepared. Whether they’ll withstand the ECB’s stress test is a huge question mark. How can banks start managing these C&E risks, specifically on their real estate portfolio? What data do they need and where can they find it?
How are banks exposed to C&E risk?
Banks are exposed, as climate change and environmental degradation affect their balance sheets through physical and transition risks. The first is physical risk, in other words the economic impact stemming from the expected increase in the frequency and magnitude of natural hazards.
The second is transition risk, where the potential delayed and abrupt introduction of climate policies to reduce CO2 emissions could have a negative impact on certain carbon-intensive industries. For example, industries that rely heavily on non-renewable or highly polluting resources, such as mining or fossil fuel extraction, could face a sharp fall in profits and higher production costs.
Transition and physical risks are therefore two sides of the same coin: greater policy action may increase the impact of transition risks, but at the same time reduce physical risks in later decades.
In Q2 2022, the ECB will conduct a stress test of the banking system, which investigates how bank liquidity and capital would be affected under a number of severe – but plausible – scenarios of potential future events.
Climate-related and environmental risks in real estate
For their real estate portfolios, institutions will be requested, amongst others, to disclose information on the energy efficiency of the underlying real estate collateral, including the distribution of collateral by EPC label and energy consumption.
The ECB looked at whether institutions already disclose information about EPCs for their financed real estate portfolios, which may be an important indicator of exposure to transition risk. More than 80% of institutions do not do so. Some institutions (around 4%) disclose EPCs only for their residential real estate portfolios and others (around 3%) only for their commercial portfolios. Less than one in ten institutions disclose such information for both their residential and commercial real estate portfolios.
These results need to be included in their lending and monitoring practices as well.
Next to that, banks are expected to mitigate risk in their owned real estate assets. What assets are prone to physical risk? What measures can be taken now to mitigate this possible physical risk in the future and what does that mean for transitory risk (a.k.a. the cost of 'future proofing' the real estate assets)?
Filling the data gaps for C&E risk assessment
While banks have started to include C&E risks in the risk inventory, only a handful have set key risk indicators or concrete risk limits. This means that banks cannot properly control or manage those risks.
While almost half of the banks have integrated C&E risks into their lending policies and client due diligence, most are still lacking a sound risk classification structure or loan pricing framework for C&E risks. In other words, these banks are generally not yet in a position to identify, manage and monitor C&E risks at counterparty level.
Operational risk management, liquidity risk management, reporting and disclosures require the most work. Less than around two-fifths of banks have developed plans that are (broadly) adequate in those areas. Often the plans do not foresee any assessment of how many of their activities are exposed to liability and/or litigation risks driven by C&E factors.
A huge blockers for banks to move forward in C&E compliance, is their lack of data. However, when accurate or complete data are unavailable, the ECB expects banks to at least assess their data needs for sound risk management, and to determine how current and future gaps will be filled. In reality, however, only a few banks have made any effort to take stock of their data needs to start accounting for C&E risks.
Therefore, the ECB emphasises the need for banks to take intermediate steps when data or methodological gaps exist. They should use qualitative metrics, develop proxies with the data sources that are available and adjust their strategies accordingly to enhance their resilience against C&E risks.
What data exactly is needed for assessing C&E risk in real estate?
There are no definite frameworks yet set by the ECB to determine C&E risk, but we're getting more and more indicators about what is necessary, especially since the ECB launched their stress test in January 2022. In this stress test, the ECB formulated 3 modules in which they map the climate risk stress testing framework, look at exposure to carbon intensive industries and look at transition risk and physical risk.
Energy labels & location data
First of all, in their qualitative questionnaire, the ECB wants to gain insight into relevant drivers for the quantification of climate risk. For real estate, this includes energy labels and location data. However, this present a problem for most large real estate portfolios. Energy label data is often supplied in static pdf's, after which aggregating the data and turning this into insights on a large real estate portfolio becomes difficult.
Another challenge is to organize the location data of a property portfolio. Where are the properties located? Are these high risk areas for certain climate-related events? Not only is aggregating this data a challenge, but visualizing it as well.
In order to have a decent overview of energy labels and location risks, a property data management system is indispensable. A system in which it's possible to zoom in on specific properties to asses their risk, but zoom out as well to make large scale analyses on C&E risk.
Severe flood, heat & drought events
Regarding transition and physical risk, the ECB for now limits their stress test to two climate risks of key relevance: severe flood and extreme drought/heatwave. They are now focusing mostly on direct effect of physical risk on credit risk. Second round effects such as losses by insurance companies are for now not weighing in the physical risk assessment.
Severe flood events can cause significant harm to real estate properties in the affected area. This will likely lead to a serious devaluation of the property. On the longer term, the property could lose more value due to the increased risk of more floods. Last but not least, repairing damages puts an extra strain on the borrower's financial capacity, leading to more delinquencies. Banks are expected to asses these risk based on their portfolio's exposure to vulnerable areas.
For heat and drought, a main risk factor is credit risk. Where the likelihood of long-lasting droughts is high, several industries like agriculture, manufacturing and construction could be affected. What businesses are located in areas that are vulnerable for heat and drought? Mapping this data can be a real challenge.
That's where Spotr comes in: 2m savings per year
Spotr is an AI-powered remote property data platform, helping you to gain insights into your biggest real estate challenges. Spotr uses computer vision to analyze a huge, up to date image database in which data about your real estate portfolio from different sources are collected. With this enriched database, you can easily analyze your real estate portfolio.
With Spotr, banks can fill the data gaps they've been struggling with so far to mitigate risks on the real estate market. Spotr offers data on both the physical risk side as transition risk side. When looking at transition risks, Spotr offers data on ECP/energy label, maintenance heavy building objects and opportunities for sustainability improvement like opportunity for placing solar panels.
On the physical risk side, Spotr works with map layers like flood risk, foundational risks and heating and cooling risks that can be placed over the entire real estate portfolio, helping banks get a quick overview of risk heavy areas in their real estate portfolio.
All this can be done completely remote, using our visual databases and image recognition. By not using on-site visits to gather the data needed, we estimate that banks can save 2fte per 50.000 properties at a yearly cost of 100K euros. This accumulates to saving 2m euros per year for a 1m houses real estate portfolio, all while gathering precise data that's needed for the ECB's C&E risk reports.
An added bonus: faster due diligence
When banks implement the use of Spotr, they can immediately extend its use to other departments. One example is using Spotr to accelerate due diligence during an investment process. With Spotr, banks are not only able to finish DD before competing parties (which can be completed within 2 weeks instead of 6), but C&E risk can easily be taken into account at the same time.
The costs of hiring external maintenance experts range from 200 euros to 600 euros per property, while Spotr can deliver this service from 15 to 100 euros. This saves a lot of money and time per property, will lead to a much faster due diligence process and takes C&E risk into account at the same time, making it easier to comply with ECB's regulations.
Interested in discovering how to use Spotr for C&E risk assessment?
We're happy to tell you more. Plan a meeting with Dirk Huibers here:
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