Banks weigh up the climate risks of real estate
Making sense of the latest trends in property and economics from around the globe.
5 minutes to read
Climate exposure
The financial system is exposed to climate change from many angles. If your house floods, it could be underwater from both a physical and financial perspective, creating losses for banks and insurers. Portfolios of 'brown' office buildings may be unsuitable for upgrade or repurposing, creating more losses. Entire industries, let's say sections of the mining industry, may be regulated out of business, leaving companies unable to service their loans.
How much damage all this will do depends on the pace and scope of rising temperatures and the speed at which the industry adapts. The Bank of England conducts stress tests on banks and insurers and in its worst case, published yesterday, losses could amount to £330 billion by 2050. Even in less severe conditions, climate risks will become a persistent drag on profitability, with loss rates cutting into average profits by around 10% and 15% annually - this speech by Sam Woods, head of the Bank’s Prudential Regulation Authority, provides a shorter overview.
The key message from Mr Woods is that how and when the financial sector manages the transition will have a big impact, cutting losses by as much as 30% with a rapid response. "Adjusting late and abruptly to climate risk triggers a messy recession – with rising unemployment as the corporate sector adjusts," he said.
Any response will have implications for real estate and construction. Banks say they envisage boosting lending to the construction sector, particularly as demand for retrofitting and flood defence improvements rises. Life Insurers say they're on the hunt for green assets and want to invest in the decarbonation of real estate, though much depends on "the disclosure of appropriate metrics to distinguish which assets were genuinely green". Life Insurers are also concerned that a surge in green investment will "unduly raise asset prices, potentially reducing the attractiveness of this type of investment."
Green homes
Banks say they are having a hard time working out their exposure to the residential sector, both due to the lack up-to-date EPC ratings for much of the UK’s housing stock and difficulties modelling risks at a granular level over long time horizons.
It is likely, however, that the interplay between energy costs, borrower incomes and the energy efficiency of properties will begin to exert more influence in the mortgage market moving forwards. The BoE recommends lenders begin modelling loan affordability based on the interaction between energy efficiency improvements on the one hand, and potential increases in energy prices on the other. Other suggestions include "revising physical risk vulnerability on an on-going basis: for example, property valuations should be routinely re-assessed after a physical climate risk event."
Progress in retrofitting the UK's stock of existing homes has been severely limited by financial pressures. Despite estimates from the Building Back Britain Commission suggesting that the cost of retrofitting many homes is exceeded by the benefit of higher home value and energy savings, most homeowners balk at the upfront payment involved.
There is some evidence that financial incentives will continue to move in favour of retrofitting as energy prices rise and banks place greater emphasis on energy consumption in their lending decisions. There are already signs of movement - Homeserve results published yesterday revealed a 23.3% increase in searches for tradespeople in the period January to March 2022 with a shift of emphasis from kitchen and bathroom replacements to projects focused on alternative energy sources and cost savings. That included a 61% rise in online searches for tradespeople to fit insulation and a 59% rise in specialists to conduct renewable energy projects.
Growth slows
The UK private sector reported a sharp slowdown in economic activity during May, according to the latest S&P Global / CIPS Flash United Kingdom PMI. The 51.8 reading is down from 58.2 in April and represents the lowest measure since the Covid-19 lockdowns of February 2021.
Input pricing is a decent leading indicator for consumer price inflation (see chart) and May's reading hit an all-time high. Concerns about squeezed margins and weaker order books resulted in a considerable drop in business expectations for the year ahead. The index signalled the lowest private sector growth projections since May 2020.
A separate survey of 56 retailers from the CBI hints at a rapid decline in sentiment, despite a robust set of sales figures for April. The survey found that companies’ investment plans were at their lowest since May 2020. For a more detailed look at the current state of UK retail, I recommend the latest piece from Stephen Springham.
Housing market sentiment
We now have the first signs of ebbing sentiment amongst homeowners.
May’s reading of +64 for future house price expectations was the weakest since December 2021 in the IHS Markit Household Sentiment Index (see chart). Current house price sentiment dropped back to +59 in May from +60 in April. It's worth noting that a score of more than 50 represents strengthening sentiment, and both measures remain significantly above their pre-pandemic position.
We conduct our own survey measuring sentiment on a range of measures, from your plans to buy (or not) and how often you're commuting. If you appreciate receiving these notes, we'd be very grateful if you could take the time to respond. We'll even throw in a Fortnum & Mason hamper for one lucky respondent!
We'll cover the results of the survey in detail over the coming weeks. You can find a link to the survey here.
In other news...
Royal request could bring heat pumps to London's historic buildings (Telegraph), Shaftesbury warns of inflation threat to central London recovery (FT), SEC prepares to crack down on misleading ESG investment claims (FT), UK pay deals hit highest level since 1992 (Reuters), L&G forms US property partnership (Times), more rate hikes in New Zealand (Bloomberg), and finally, removing NYC's last phone booth (Bloomberg).