How Will Lenders Factor Climate Risks into Underwriting?

Lenders and investors are beginning to identify climate change impact as an emerging risk that has the potential to profoundly impact not only their physical assets, but also entire financial systems due to climate change related events. Climate change can result in “direct financial risks, prompting a reassessment of asset values, changing the cost or availability of credit, or affecting the timing or reliability of cash flows,” as noted in “Climate Change and Financial Stability”, published by the Federal Reserve Board of Governors in March 2021. And just today, Chairman Jerome Powell suggested that the Fed will probably require banks to conduct stress testing for climate vulnerability at some point in the future.

Physical risks–manifestations of a changing climate and the associated costs–are top of mind for most financial institutions, as they could directly impact asset value and borrower solvency. Physical risks are varied and include chronic risks like extreme heat, drought, and water access as well as acute risks like wildfires, hurricanes, and flooding. Due to increasing frequency and severity of acute events, it is therefore vital for lenders to begin to understand how climate change may impact properties and approach risk management systemically. Lenders are grappling with how to address this. Few lenders want to be out front making tough decisions based on climate risks, so for now, they can at least begin to collect data about their assets to start understanding future risks. Even if climate risks are not factoring into financial decisions, understanding the risks now will have long-term benefits.

This article specifically addresses physical risk and asset level assessments; however, climate risk management is a complex and multifaceted emerging issue that has the potential to impact financial institutions systematically with reach far beyond real estate. Other risk areas include operational risk, reputational risk, compliance risk, and transitional risk or the risk resulting as societies decarbonize and transition to a low carbon economy and how this transition could affect a company’s long-term profitability.

Identifying Asset Level Climate Risks

There are two main factors when it comes to evaluating asset level climate risks –understanding the regional climate risks and evaluating property-specific data for resiliency (i.e. a property’s ability to withstand the impacts of climate change). The first is more of a “desktop” approach and involves an analysis of the historical data and regional climate data for the property’s location to identify risks from climate change, natural disasters, and man-made impacts. This approach, sometimes called a climate risk assessment or screening, provides levels or grades for a range of climate related risks on a scale (low to high risk), and indicates the expected degree of change in climate scenarios such as floods, heat stress, hurricanes, sea level rise, water stress, and wildfires. It should be noted that not all climate data is created equal. Lenders should be aware that modeling methods vary greatly, and care should be taken to identify data providers that have an up-to-date approach to climate modeling.

While various climate risk assessments are available for financial institutions to utilize, these tools do not take into consideration property-specific data, which requires an on the ground assessment of the property’s conditions to identify vulnerabilities and estimates of potential damages. An asset-level resiliency assessment evaluates the property’s specific vulnerabilities and ability to withstand future stressors (climate change and natural disasters) and whether risk mitigation measures will be necessary to avoid property downtime or costly equipment replacements.

For example, if heat stress is identified as an elevated risk for a property, the evaluation of the efficacy of HVAC systems, backup generators and cooling capability would provide salient information applicable to underwriting decisions. Similarly, if hurricanes are an elevated risk but the on-site evaluation reveals building features that mitigate that risk (ex. impact resistant windows and a properly strapped roof), this could provide the lender greater confidence in the asset’s future performance. The same methodology could be applied across physical risk categories.

Standardizing the Process

There is currently no standard methodology either for how these risk evaluations are done, or for incorporating physical climate risks into the credit risk and underwriting process – but that is changing. As for the scopes of evaluation: an ASTM task group has been formed to create an ASTM Guide regarding the assessment of climate risk and resilience of commercial buildings. Three of the Partner Energy team are members on the task group helping to form the guidance. The Guide will outline various levels of property evaluation from desktop reviews, to site-specific evaluations, to incorporating mitigation strategies to make the building more resilient.

What level of evaluation is appropriate for a lender to use in underwriting? Again, there is no standard approach yet. Lenders will undoubtedly be mindful of costs and staying competitive, so a tiered approach may be best. Fortunately, a framework already exists in the tiered approach that banks currently take in environmental risk management. This matrix-methodology (“if this, then that”) helps banks determine how much due diligence to do based on factors like loan size, property type/risk, and loan type (origination, refi, foreclosure, etc.). Using this framework, a climate risk methodology might look something like this:

  • Small loan amount and low risk region – no climate risk screening
  • Large loan amount or high risk region – do a desktop screening
  • Large loan amount and high risk region – do property-specific evaluation
  • Foreclosure or bank-owned facility – do a property-specific evaluation with mitigation strategies identified

This is not a recommendation but merely a concept for how lenders could form a policy around managing climate risks in underwriting.

What Will Lenders Do with Climate Risk Information?

The approach to climate risk is evolving as fast as the regulations surrounding it; however, there may be a time in the  future where asset level assessments impact credit and underwriting decisions in tangible ways such as higher interest rates for at risk properties, escrow holdbacks for future improvements in the event of damages due to physical risks, and possibly requirements for mitigation of identified building risks prior to closing.

As financial institutions continue to build out capabilities for managing risks associated with climate change, they should be systematic in approach, as climate change has potential widespread impact across the bank’s risk management functions. Asset level assessments are not only an easily achievable starting point, but a vehicle to collect salient property data that could potentially be used in larger scale portfolio stress testing down the road.

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