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A Bank Evaluates the Impact of Physical Climate Risk to its Mortgages

A Bank Evaluates the Impact of Physical Climate Risk to its Mortgages

Real estate investments are uniquely vulnerable to climate change. The impacts of rising seas and storms alone could cost coastal cities $1tr U.S. each year by 2050, according to the Global Commission on Adaptation.1 Financial institutions are starting to recognize climate risk as an important issue that needs to be considered in their investment and lending strategies. There are two types of climate risk:

  • Physical risks refer to chronic climate hazards, which include increased flooding, storm surges and wind damage from hurricanes, etc.
  • Transition risks refer to the costs associated with the market, technological, policy, legal and reputational risks associated with adapting to climate change and transitioning to a low-carbon economy.

The mortgage team at this large bank was working closely with its credit risk colleagues to understand potential weaknesses within the bank’s U.S.-based mortgage portfolio. It was clear to both teams that physical climate risks should be taken into account given the alarming increase in the number of extreme weather events in recent years. This would require the expertise of specialists who had developed proven methodologies to project the impact of such hazards on key portfolios over time to identify the most at-risk assets.

Pain Points

The mortgage and credit risk teams lacked access to the relevant data, analytical tools and expertise needed to assess climate-related risks to the bank’s large U.S. portfolio, which consisted of approximately one million mortgages. The teams wanted to work with a qualified third party that could help:

  • Identify a range of physical risks in different locations throughout the U.S. that could materialize over the typical 30-year lifetime of a mortgage.
  • Evaluate how these risks could increase operational costs for single- and multi-family residential dwellings (e.g., increased cooling expenses with higher temperatures), or result in damages that would require expenditures for repair.
  • Similarly, evaluate how these risks could cause damage or loss of revenue to different types of commercial assets.
  • Review actions that regional governments might take to help protect residents and business owners from these risks.

A member of the mortgage team was familiar with work done by The Climate Service (“TCS”) and knew that the firm had recently been acquired by S&P Global and was now part of the company’s Sustainable1 division. Sustainable1 brings together S&P Global's extensive environmental, social and governance (ESG) resources to provide clients with a 360-degree view to help achieve their sustainability goals. The team contacted TCS to learn more about its capabilities.

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The Solution

TCS described how the group works with banks to identify climate-related risks and quantify their resulting financial impacts on mortgage portfolios. At the center of these engagements is TCS’s Climanomics® platform that measures physical and transition risks and opportunities in financial terms under different climate-warming scenarios.

Members of the mortgage and credit risk teams explained that they wanted to focus the initial analysis on physical risks only for the bank’s U.S.-based mortgage portfolio, and TCS described its methodology. The assessment would start with the teams providing three details on each mortgage: (1) the specific type of asset (e.g., single- or multi-family, condominium or kind of commercial facility), (2) the location, and (3) the value of the property. TCS would then run the Real Asset component within the Climanomics platform to evaluate the impact of major hazards on each asset, including extreme temperatures, drought, coastal flooding, fluvial flooding, water stress, tropical cyclones and wildfires. This would be done in conjunction with a sophisticated analysis of each asset’s unique vulnerabilities to each hazard. For example, geographical coordinates are reviewed, as elevation is one factor that will determine exposure to flooding – in this case, a higher altitude assumes less risk.

To quantify the financial risk, it is important to determine how a hazard will affect an asset in a way that is financially material. For example, how will an increase in temperature impact cooling costs or a flood impact clean-up and repair costs? Of course, this will depend on the type of asset and if it is highly vulnerable or not.

All hazards and assessments of vulnerabilities are considered for each asset to model the average annual loss, which calculates the cost of damage and/or lost revenue for the owner over time as a percentage of the asset’s value. At some point, this loss of income could be a tipping point for the owner, increasing the likelihood of default on the mortgage. The total average annual loss is the sum of the financial impact of all hazards. This can be disaggregated by type of hazard and, within each hazard, by type of expense. The loss data is provided for each decade out to 2100 and four greenhouse gas (GHG) concentration scenarios.

Naturally, different municipalities are taking steps to minimize climate-related risks. For example, Miami is investing significant funds in water pumps and infrastructure upgrades given the city’s exposure to severe storms and sea level rise. Looking at such actions can provide an additional lens when assessing risks. TCS’s Market View provides information on the adaptation of municipalities to physical hazards and transition risks, and the impacts risk-reduction actions can have on property values and insurability.

In summary, TCS explained how these capabilities would provide the mortgage team with:

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Key Benefits

The bank was eager to be seen as a leader in climate-related analysis and embed it in mortgage portfolio analysis ahead of the rest of the industry. Both the mortgage and credit risk teams saw many benefits to the TCS solution and decided to proceed with an assessment of physical risks. In particular, the teams saw tremendous value in having:

  • Access to renowned leaders in the climate arena, with offerings powered by a transparent methodology and rigorous science.
  • An understanding of physical risks in financial terms to support a climate-adjusted view of credit risk.
  • A bottom up approach, starting at the asset level and aggregating to the company and portfolio level, for multiple GHG concentration scenarios and time horizons.
  • An additive layer of analysis with Market View to account for possible preventative measures that could help mitigate certain risks.
  • A technology platform hosted on secure, scalable, enterprise-grade AWS cloud infrastructure.

1 "Change Course", UNEP Finance Initiative, November, 2019, www.unepfi.org/wordpress/wp-content/uploads/2019/11/TCFD-Real-Estate-Web_final_28112019.pdf.