Climate change is a major source of risk affecting physical property
This is the third installment of a three-part series on physical, climate-related financial risk assessments. In parts one and two, we dove deeper into the qualities that provide for a reliable peril risk models, as well as the intersection of peril risk models and climate models.
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It’s probably no shock that the Federal Emergency Management Agency (FEMA) and the U.S. Department of the Treasury are both active in the discussion surrounding climate-related financial risk. But why are the U.S. Department of Agriculture (USDA) and the Commodity Futures Trading Commission (CFTC) getting involved?
In short, climate change affects everything.
In the first quarter of 2024, numerous federal government agencies took actions to address the variety of climate-related financial risk affecting our nation’s economy.
These actions span a wide range of topics — investor disclosures, building resiliency, homeowner’s insurance, and scenario analyses, to name a few — and each one will greatly affect the way housing and mortgage industries manage the physical risks stemming from a changing climate.
Physical climate risks are manifesting for municipalities, state governments, and financial institutions via traditionally understood financial risk pathways of credit risk, liquidity risk, and market risk.
As a result, federal regulators have their hands full overseeing risk management activities, identifying and addressing insurance gaps, promoting adaptation and resiliency efforts, and uplifting vulnerable and disadvantaged communities, in addition to their other priorities.
However, fully understanding the scope of physical climate risk and the resulting categories of physical property risk is anything but straightforward. To delve into the nuanced discussion required to identify and quantify these risks while also outlining potential solutions to address them, researchers at CoreLogic investigated how physical climate risk affect traditional risk pathways in this third installment of a three-part white paper series.
How Physical Risk Impacts Other Risk Categories
Credit Risk
- Municipalities
Municipalities accumulate credit risk through the issuance of municipal bonds, securities, and other financial vehicles that act as funding mechanisms for local infrastructure projects, including housing developments, transportation systems, and communications networks. However, studies have found that “as extreme storms and other climate change impacts become more frequent and more intense, state and local governments are facing mounting infrastructure-related mitigation, adaption, and resiliency planning costs.”
- State Governments
Like municipalities, state governments can issue bonds, securities, and other financial vehicles to fund infrastructure projects that are paid for through subsequent tax collections or other revenue streams. Public pension funds are another source of credit risk for state governments, and research has shown that “climate-related financial risks can affect retirement savings to the extent they may affect the downgrade and/or default risk of an issuer, a risk that currently exists in the market as rating agencies increasingly factor climate risk into their rating assessments.”
- Financial Institutions
Financial institutions accumulate credit risk via the loans they provide to borrowers. Since physical climate risks most often manifest via material damage to the collateral underlying a loan, a financial institution’s credit risk is therefore affected as soon as these physical climate risks “have a negative effect on a borrower’s ability to repay and to service debt or on a bank’s ability to fully recover the value of a loan in the event of default because the value of any pledged collateral or recoverable value has been reduced,” according to the Basel Committee on Banking Supervision.
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Liquidity Risk
- Municipalities
Liquidity risks arise from a municipality’s inability (whether real or perceived) to meet its cash and contractual obligations without incurring unacceptable losses. These risks can manifest in the aftermath of climate-driven natural hazard events which can lead to unanticipated emergency response costs, infrastructure repair costs, loss of revenue, and increased costs of adaptive strategies.
- State Governments
In the aftermath of a natural disaster event, state governments are called upon to furnish funds to rebuild critical public infrastructure. While one-off events may be easily covered, the increase in frequency and severity of natural hazard events due to climate change creates liquidity pressures on state governments that must provide for their citizens.
- Financial Institutions
Physical climate risks can directly affect financial institutions’ loan portfolios, especially those invested heavily in sectors that are more vulnerable to effects of climate change, such as agriculture and tourism. These institutions can face increased defaults and losses after natural hazard events, and research has indicated that this reduction in assets “can result in a decrease in the bank’s liquidity, making it more difficult for the bank to meet its short-term obligations.”
Market Risk
- Municipalities
This type of risk encompasses the risk of financial loss resulting from movements in market prices. For municipalities, there tend to be disproportionate effects as they often have less flexibility and fewer resources to respond to significant market shifts, which may occur more frequently due to natural hazard events driven by climate change.
- State Governments
State governments are also exposed to many of the same market risks affecting municipalities, including interest rate changes, impacts to GDP growth, unemployment levels, commodity price variations, exchange rate fluctuations, and the dynamic prices of stock investments. However, these risks can be amplified for state governments due to their larger budgets and the additional responsibilities like the management of pension funds.
- Financial Institutions
As our understanding of climate science continues to advance, financial institutions are beginning to incorporate physical climate risks into asset pricing. While this is a necessary step toward solving the overall climate crisis, the Basel Committee on Banking Supervision stated this can also result in “downward price shocks and an increase in market volatility in traded assets” for regional, national, and international financial institutions.
To learn more about how climate-related financial risk impacts traditional risk pathways considered by municipalities, state governments, and financial institutions, as well as see how the use of proper data analytics for real estate can provide potential solutions for federal regulators, read the full white paper.
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