TL;DR
- European banks struggle with collecting climate risk data, impacting accurate CRE collateral valuations and lending practices.
- Physical climate risks increasingly affect CRE values, requiring more cautious lending practices and collateral assessments.
- Inadequate consideration of energy efficiency investments may lead to underestimating future risks in CRE lending.
- European banks should integrate climate risk factors into property valuations by using comprehensive data and adjusting for long-term climate-related impacts.
As climate change continues to reshape the global economy, European banks face significant challenges in managing property valuations, particularly concerning commercial real estate (CRE) assets.
The European Central Bank (ECB) has highlighted several key issues that banks operating in Europe must address to mitigate the risks posed by climate change.
These challenges include insufficient data collection on climate risks and energy efficiency for CRE assets and the inadequate inclusion of capital expenditures needed to improve energy efficiency to an acceptable standard.
This article explores the ECB's perspective on these challenges and ways to address them; then drawing from the latter, examines how banks could improve their physical risk data and modelling approaches more effectively in their lending practices and collateral valuations.
A Perspective from the ECB
The ECB has identified key weaknesses in European banks' credit risk management frameworks, notably the lack of thorough data on climate risks and energy efficiency for commercial real estate assets.
Banks often fail to gather essential information such as energy performance certificates, carbon emissions, and potential physical risks like flooding or wildfires, hindering their ability to accurately assess CRE risks.
For example, the ECB's 2022 climate stress test results reveal that banks were unable to assign 13% of their reported collateral into an EPC bucket (see chart below).
The limits in gathering climate-relevant data hindered banks' ability to perform crucial materiality assessments on their CRE portfolios, leading to the widespread use of proxies for collecting scope emissions and EPC data, with approximately 65-90% of banks relying on these proxies.
Additionally, the ECB note that banks frequently overlook the capital expenditures required to meet acceptable energy efficiency standards.
As sustainability becomes increasingly important, properties lacking high energy efficiency are expected to lose value over time. Many banks do not factor in the costs of necessary upgrades, leading to an underestimation of financial risks.
The failure to include these capital expenditures in risk assessments can create significant financial vulnerabilities. With stricter regulations and evolving market demands pushing for greener properties, banks not accounting for these costs may face higher default risks and diminished collateral values as the market adapts to new environmental standards.
The European supervisor recommends that lenders assure valuers gather data on environmental factors, energy performance certificates (EPC), pollution, and climate physical risks, as specified in the International Valuation Standards (IVS - 104 Appendix A10).
The lack of thorough data and consideration of necessary upgrades means that banks may misjudge the true value and risk associated with CRE assets. Without accurate and comprehensive environmental data, banks are at risk of overvaluing properties, miscalculating potential losses, and failing to account for future financial impacts related to climate change and sustainability regulations.
By ensuring that valuers gather detailed data on environmental factors and adhere to standards like the IVS, banks can improve their risk assessments, make more informed lending decisions, and better align their portfolios with evolving market and regulatory demands.
It is also worth reminding that the ECB is expecting EU-operating banks to fully integrate climate-related and environmental risks into their business practices by the end of this year, and is ready to impose penalties on those that fall behind.
This also signals that addressing climate-related data limitations for property valuation is crucial to ensuring that banks can effectively manage their credit risk, and safeguard their financial stability in the face of growing physical climate risks affecting the CRE market.
Approach to Lending Practices and Collateral Valuations
To effectively manage the risks associated with climate change, European banks must enhance their data collection efforts and integrate climate risk considerations into their lending practices and collateral valuations.
Comprehensive Data Collection
A best-in-class comprehensive database for climate risk usually requires advanced models that many banks don’t have at this stage.
For instance, the Basel Committee for Banking Supervision (BCBS) argued last year that a great number of institutions are still facing considerable data and methodological challenges, especially in providing granular data for physical risk assessment.
Precisely, the absence of data on specific at-risk locations is the most commonly reported. This also adds up to the highly-uncertain nature of acute physical events such as coastal flooding emerging from anticipated Sea Level Rise (SLR).
Banks must therefore bring the proper expertise to the table and develop sophisticated models capable to gather detailed but relevant data on extreme weather events, at-risk locations and energy efficiency for CRE assets.
This is essential to support the evaluation of property vulnerability to physical climate risks, and anticipating more precisely future impacts.
A comprehensive database will enhance banks’ ability to assess property risks and make better-informed lending decisions.
Incorporating Capital Expenditures in Risk Assessments
Banks need to account for the capital expenditures (CapEx) required to enhance energy efficiency in their risk assessments.
This includes assessing the costs of retrofitting buildings to meet higher energy standards and incorporating these costs into loan terms and conditions. Doing so will help banks avoid overvaluing properties and better align their loan portfolios with the evolving market conditions.
In this respect, Climate X’s solution Adapt provides the best available service. As incorporating CapEx for energy efficiency in climate-related risk assessment can be daunting, Adapt facilitates the identification of climate adaptation needs, improving decision-making efficiency and reducing dependence on third-party evaluations.
Enhanced Valuation Practices
The ECB has emphasised the need for accurate and prudent property valuations to manage climate-related risks.
Considering this, banks must adjust their valuation methodologies to account for both current and future climate impacts, including physical risks and energy efficiency improvements.
This involves updating valuation inputs to reflect the latest market conditions and carefully using automated valuation models (AVMs), ensuring they are regularly updated to align with market and regulatory changes.
AVMs utilise statistical modelling and comprehensive property data to estimate real estate values, requiring regular updates to align with current market conditions and climate-related risks, such as physical hazards and energy efficiency improvements, as highlighted by the ECB.
Regular Review and Adjustment of Valuation Models
Due to the evolving nature of climate risks, banks need to frequently update their valuation models to align with current market conditions.
This involves revising inputs on construction costs, energy efficiency standards, and potential physical risks. Additionally, banks should perform sensitivity analyses to assess how fluctuations in these factors might affect property values and loan outcomes.
By adopting adaptable and responsive valuation practices, banks can more effectively manage risks in their CRE portfolios.
Collaboration with External Experts
Banks should collaborate with external experts, including climate risk and environmental consultants and property valuers, to deepen their understanding of climate risks and enhance valuation practices.
Experts can offer insights into energy efficiency trends, regulatory changes, and physical climate risks. Furthermore, partnering with data providers like Climate X can enhance this approach by offering crucial data on climate risk adaptation.
Such collaboration can ensure property valuations are transparent and objective, reducing the risk of overvaluation and enabling more informed decision-making.
Conclusion
Echoing the ECB, European banks must double down on proactive steps to manage the climate risks affecting their CRE portfolios.
By addressing the challenges identified by the ECB, banks can enhance their resilience to climate-related shocks.
Through comprehensive data collection, prudent valuation practices, and a strong focus on sustainability, banks can better manage the risks associated with their CRE assets and contribute to a more sustainable and resilient financial system.
Physical Risk Data
Climate risk data is crucial to assess the long-term effects of climate change and enable stakeholders to develop informed adaptation strategies. These strategies could include enhancing building resilience or revising insurance policies, which help maintain property values and contribute to the overall stability of the property market.
You can estimate the asset-specific financial losses from both acute and chronic physical hazards with Spectra, the climate risk platform developed by Climate X. Plus, the innovative Adapt module allows you to determine the ROI of taking pre-emptive climate adaptation action based on a range of 22 different interventions.