In the realm of ESG, a fourth concept is emerging as organizations consider the implications of climate change on their businesses. It’s a concept that cuts across organizational units and is usually evaluated along with risk. We’re talking, of course, about resilience.
While the letter “R” has yet to establish itself as fully as “E”, “S,” and “G,” resilience remains an urgent topic within the environmental category. In the past year, it has gained significant traction with organizations across all sectors, though real estate stands out in particular: physical assets face some of the most significant risks when it comes to a changing climate. All of this has contributed to the rise of a new expression: “ESG+R”.
To date, the world has largely focused on climate mitigation rather than climate adaptation or resilience. The majority of efforts revolve around reducing carbon emissions to halt or arrest climate change, rather than preparing for and managing its inevitable effects. But in our post-COVID world, where society has been forced to adapt to the economic and social shocks associated with a global pandemic, “resilience” as a concept is more important than ever before.
Defining Climate Risk and Resilience in Commercial Real Estate
In theory, the more you manage your organization’s climate risk, the more “resilient” it becomes. It sounds simple enough. But what does climate risk really mean?
The Task Force on Climate-Related Financial Disclosures (TCFD) is a good place to start. Its industry-leading climate risk disclosure framework defines two types of risks associated with climate change that organizations must manage: physical risks and transition risks.
- Physical risks are hazards caused by a changing climate. They include both acute events, like floods, fires, and storms; and chronic environmental conditions, like rising sea levels and temperatures. Since real estate is the business of owning and operating buildings, the specific threats here are quite tangible, making real estate one of the most vulnerable sectors to climate-related risk.
- Transition risks encompass the human and societal responses to climate change, including economic and regulatory shifts and changing consumer behaviors and technologies. In real estate, examples include enhanced emissions reporting and energy benchmarking net-zero building requirements and caps, such as New York’s Local Law 97. These risks require real estate players to constantly look ahead to regulatory, economic, and social changes that could impact assets.
When it comes to real estate, both physical risks and transition risks can touch almost every aspect of a building’s operations and value. When considered in aggregate, they can help paint the picture of a portfolio’s cumulative climate risk, which is crucial to understand when making long-term strategic and investment decisions.
How to Evaluate and Measure Climate Risk
In commercial real estate, there are three primary scenarios in which it makes sense to evaluate and measure a building’s climate risk:
- Asset Acquisition: During the due diligence phase of the acquisition process, there is a unique opportunity for potential buyers to assess the value and climate risk of individual assets prior to purchase and to inform an eventual decision.
- Day-to-Day Property Management: The potential hazards and risks from climate change vary by asset and geographic market and may be specific to individual building conditions and surroundings, including floors, equipment below grade, and historical climate events and impacts. Assessing the specific hazards and risks at an individual building during the course of normal operations is key to identifying the right mitigation measures to put in place.
- Overall Portfolio Management: The cumulative impact of individual asset climate risks equates to a portfolio’s overall climate risk. It is important to evaluate the entire portfolio’s risk, as this can inform strategic business and investment decisions. For example: if a company’s portfolio contains a majority of buildings in high-risk flood zones, the company may consider diversifying its portfolio to include assets in different geographic markets, mitigating climate risk accordingly.
Managing Climate Risk and Resilience
In general, the best way to manage climate risk is to first evaluate and understand it. While every asset is different, there are some tried-and-true recommended steps you can take to assess risk at both the asset and portfolio levels:
- Conduct a science-based climate risk analysis using property and location-based data to map potential exposures
- Identify and prioritize properties that are higher risk
- Quantify portfolio impact by assigning a dollar value to potential risk
- Take action at both the building and portfolio levels (more on this below)
The output from these efforts: critical knowledge to inform your short- and long-term investment decisions. You may decide against acquiring higher-risk assets, and will certainly have a better sense of where you need to invest money to protect overall asset values.
The types of climate risk mitigation activities you engage in may vary significantly depending on the individual asset and portfolio. Here are some best practices to consider at both the asset and portfolio levels as you go through the recommended process outlined above:
- When conducting your climate risk analysis at the asset level, use third-party data and internal tools for mapping and evaluating physical climate risk exposure through science-based climate scenarios
- Develop local and regional disaster response plans across the portfolio
- Consider site-specific mitigation measures such as raising properties out of the base flood elevation, raising the height of dock doors, increasing the thickness of roof materials in hail-prone areas, and utilizing Integrated Rapid Visual Screening (IRVS) tools.
- Consider enhanced flood insurance for higher-risk buildings
- Continue to deliver transparent disclosures to your investors and tenants about how you are proactively managing your climate risks. Use the TCFD’s resources as a guide.
The potential cost of not focusing on adaptation and resilience could result in huge financial implications for any company. However, the real estate real industry is expected to be one of the hardest-hit sectors. In one especially jarring study, the International Renewable Energy Agency estimated that $7.5 trillion in real estate assets could be “stranded” and experience major write-downs in value.
With that in mind, perhaps “R” does deserve a special call-out in the world of ESG for real estate. GRESB, the leading ESG framework for real estate, has already given a nod to the increasing importance of resilience by adding an extra module on this topic in its annual benchmark. All told, strong climate resilience strategies will be key to guarding and future-proofing assets, the real estate industry, and the world at large in the years to come.