How can climate change risks and adaptation costs be accounted for in real estate investments, especially given the indeterminate nature of the timing of climate change events?

Climate change is the leading environmental issue of our time, one that likely will be around for decades to come. Increasingly, the urban development and real estate industries will be directly affected by the climate problem—and play a key role in achieving solutions.

Much has been written about the importance of green building design and operations in reducing or mitigating the emissions that cause climate change. However, measures are also needed to reduce the physical risks of climate change to buildings and infrastructure so that the built environment will be more resilient—or able to adapt—to anticipated impacts.

Cities and other local or regional governments around the world are taking the lead in climate change adaptation. Their plans often envision changes in building codes to make buildings and common infrastructure more resilient to events such as heat waves and flooding, and changes in zoning to address increased susceptibility to climate change risk in such places as floodplains and low-lying coastal areas. These plans might also include strengthening or expanding ecosystems, such as wetlands and mangroves that shelter coasts from storms, construction of seawalls, and creation of emergency preparedness plans.

Uncertainty about the timing and severity of climate change impacts makes adaptation planning more difficult. The impacts of greenhouse gas emissions may not be fully felt for decades, a lag that distorts the price signals necessary for appropriate financial responses now.

The magnitude of future climate change depends in large part on an unknown—how quickly global economies can reduce greenhouse gas emissions. Certain scientific relationships are not well known, such as aspects of how ice sheets melt. Climate change models usually state future impacts as averages over large regions. Taken together, these deficiencies lead to a great deal of uncertainty as to when and where impacts will occur and how severe they will be. For example, forecasts of higher sea levels by the end of this century range from more than a foot to a few meters if rapid ice melt occurs. It is understandable that investors are wary of spending money today to address a risk only likely to become serious several decades in the future, and with the exact timing not known. However, preventative measures taken today are needed to mitigate the risks of catastrophic damages in the future.

Adaptation planning is underway in New York City, San Francisco, Miami, Massachusetts, Seattle (King County), Chicago, London, Paris, and several cities in the Netherlands, among others. City planners and adaptation experts from New York City, London, Rotterdam, and Jakarta recently held a workshop titled Connecting Delta Cities to share climate change adaptation plans and experiences of coastal cities on deltas or estuaries. The International Council for Local Environmental Initiatives (ICLEI), an organization of more than 1,000 local governments committed to sustainable development, and the World Mayors Council on Climate Change this year sponsored the First World Conference on Cities and Adaptation to Climate Change, held in Bonn, Germany, in May.

The building-related adaptation measures adopted by cities and other entities are likely to lead to changes in real estate investment criteria. Developers and investors should be aware of how this might reshape building practices, zoning, insurance, and investment calculations.

A panel at the ULI 2009 Fall Meeting in San Francisco discussed the management and evaluation challenges of real estate investments in view of the physical risks of climate change. The panel, which focused on new investment practices and project requirements resulting from adaptation considerations, included a broad spectrum of real estate market participants— institutional investment managers, green building investment advisers, private equity fund managers, and corporate real estate and sustainability directors.

While interest in sustainability, the greening of corporations, and awareness of climate change have become more common in the past few years, adaptation in response to climate change risks is not on the radar screen for most real estate investors, especially those in the United States.

Uncertainty as to the timing and magnitude of climate change impacts makes it more difficult for investors to respond. Models currently used for real estate investment analysis do not factor in events in the medium to long term, when most of the impacts are expected. The concerns of real estate investors today center on getting good, stable rents and having an exit strategy over a shorter time horizon. Likewise, insurance policies generally are written yearly, so premiums do not capture risks far into the future either. For example, flood and storm insurance policies are written on a year-to-year basis, and private insurance premiums are set annually and based on historical data on loss.

Though the private sector can act more efficiently than the government in most instances, in the case of incorporating climate change risk into real estate investment decisions, it may be necessary for the government to intervene. The government, for example, could act by changing building standards in anticipation of increased future risks.

Despite the general lack of response by investors, a few real estate developers in Europe are constructing new buildings that accommodate anticipated higher sea levels, and government entities all over the world—mainly in cities— are starting to plan to protect their buildings and infrastructure from future climate change impacts.

One school of thought advocates delaying adaptation measures rather than incurring associated costs during an economic downturn. However, the momentum for action will continue because city planners and other officials and government entities are worried about risk. For example, according to a report by the World Wildlife Fund and insurance giant Allianz, a rise in global sea levels in the range of 20 to 26 inches (51 to 66 cm) could jeopardize assets in major U.S. coastal cities valued at $7.4 trillion.

How can climate change risks and adaptation costs be accounted for in real estate investments, especially given the indeterminate timing of climate change events? One approach would be to change the investment evaluation framework—for example, by using a longer-term investment evaluation—and modifying evaluation models accordingly. A second approach would be to rely on government-mandated adaptation and resiliency requirements or expectations of such measures, which likely will start to appear before climate change impacts are fully felt. Investors should keep up with the adaptation activities of cities and other government entities and get involved to ensure that investor interests are represented.

The insurance industry is also showing an interest in adaptation. The Munich Climate Insurance Initiative, launched by German reinsurance company MunichRe, recently asked stakeholders to use risk management and insurance to help vulnerable developing countries with adaptation. In the United States, as well as abroad, insurance companies are discussing ways to incorporate climate risk in underwriting practices and to promote resilience in coastal areas.

The U.S. insurance industry is regulated in such a way that premiums for the following year’s policies cannot easily be raised according to risks anticipated further in the future. However, the industry can immediately help evaluate climate risk using catastrophe models and provide other risk-assessment expertise. The output of climate models needs to be refined and integrated with other analysis, such as for hurricane activity and storm surge, to forecast impacts in the nearer term and for smaller geographic regions. The insurance industry can support government research and adaptation efforts, investigate public/private partnerships, and educate customers.

Insurance regulators in the United States seek to protect consumers while maintaining the financial health of private insurance companies. This means setting premiums at an actuarially sound, risk-based level. The Florida insurance pool and the National Flood Insurance Program are examples of programs that have been underfunded because they have not set rates at a level that reflects risk. This is done in the name of affordable insurance, but it leads to the encouragement of development in high-risk areas. A recent paper by the Institute for Policy Integrity at New York University Law School examines how the National Flood Insurance Program is clashing with climate change adaptation goals while running a $20 billion deficit.

Changes in real estate investment evaluation regarding climate change might be driven in the near term by government-mandated adaptation measures, or the expectation of them, rather than delayed until more severe climate change impacts are felt. Growing climate change risks will prod governments, the insurance industry, or both to take nearer-term actions to make buildings more resilient and/or to alter planning considerations and underwriting techniques. Real estate investors would be well-advised to share their expertise and perspective in local dialogues and to learn more about these risks, both physical and regulatory, in order to take them into account now in their investment decisions.