Hurricanes, floods, wildfires are the climate shocks that make headlines with harrowing stories of human tragedy.
Slower moving impacts of climate change – think water stress and creeping desertification – will also upend lives and livelihoods in the decades to come.
These ‘slow onset events,’ also known as chronic risks, are a growing concern among investors in real assets, whose investment horizons are long enough to see such risks start to manifest.
The new Physical Climate Risk Assessment Methodology is helping institutional investors assess climate hazards and weave resilience into their lending and investment processes.
The framework – PCRAM for short – is designed to help investors and other stakeholders make sense of the physical risks to real assets and identify potential resilience options. And rather than just focus on the costs, it identifies the benefits of resilience, including enhanced credit quality and more predictable cash flows.
Slow-onset events can sap the returns of long-term investments over time, and deter major institutions from plowing capital into much-needed infrastructure. Pension funds, for example, are evaluating investments in US power plants that are contending with lower generation, higher demand, and more wear and tear as temperatures rise. Insurers are looking at how to finance water treatment and desalination plants in the Middle East that may be threatened by rising seas.
“It might be that certain types of investors and certain types of assets in certain places are likely to be more vulnerable,” says Mahesh Roy of the Institutional Investors Group on Climate Change, a membership group of 400 investors overseeing $65 trillion in assets that is shepherding the further development of PCRAM. “All investors need to look at how all assets respond to slow onset events.”
Step by step
The institutional investors group published “PCRAM in Practice” this month to share an overview of the methodology along with case studies of its application to a hydropower facility and a coastal wind farm.
The methodology standardizes and simplifies a process that could otherwise overwhelm untutored entities. “The reality is that investors aren’t going to be able to afford, or have the time to do, an in-depth, bespoke assessment on all of their existing assets or new assets they’re looking at,” says Roy. “We want to look at a way of integrating this process into existing investor and lender risk management and due diligence processes.”
The step-by-step process helps investors pinpoint an investment’s physical climate risks and improve its resilience to them, from scoping and data-gathering through materiality assessment, resilience building, and economic and financial analysis.
First, assemble the climate, financial, and physical data needed to determine a project’s “base case,” or initial exposure to physical risks. Next, identify the vulnerabilities to specific risks like sea-level rise, drought, or persistent elevated temperatures.
Things get interesting in the “resilience building” step: Bringing specialist teams together to find ways to build resilience against material risks. Options should be screened for cost, alignment with the project timeline, and other consequences, like environmental impacts. Given the complexity of such engineering challenges, investors may want to tap external expertise.
In the case of the hydropower facility, for example, the team identified nine resilience measures, from digging a new access to manage sediment and remove debris, to installing corrosion-resistant turbine blades. Hydropower facilities across the globe have already been impacted by low water levels; there is no insurance for a lack of generation from drought.
Everything comes together in the fourth and final step, “economic and financial analysis.” The resilience and de-risking measures go into a revamped cost/benefit analysis and an updated estimate of the internal rate of return. The process reveals the “true” long-term value of a project.
“It’s good practice for asset management,” says Dominika Nowosinska, head of asset management at Mott MacDonald Group, the London-based engineering and design consultancy. “Yes, there’s a lot of work. But you have to start somewhere – with your key risks, your key hazards, and your key assets first.”
Time horizon
One obvious challenge is convincing investors to quantify physical risks and corresponding resilience measures in the first place, given that their typical holding periods are rarely denominated in decades.
“We need to be very clear around the fact that these are changes that will happen gradually, possibly over decades,” says Juan Hoffmaister of the Environmental Defense Fund, who helped develop the framework. “That already detracts a lot of interest from the private sector.”
One way to normalize the multiple time horizons is by calculating a project’s net present value. A central tenet of PCRAM is that physical climate risk and resilience assessments should be folded into existing investment practices, including cash flow modeling practices. If future cash flows do not account for physical risks, both acute and slow-onset events, a project’s net present value could be mispriced.
Another issue is creating a level playing field. An investor using PCRAM to arrive at the net-present value of a project could discount its prospects compared to a second investor that ignored physical risks to come up with a higher value. The latter would likely outbid the former on financing – possibly to the winner’s detriment. They would have invested at a valuation that doesn’t account for physical risk exposure and a lack of resilience, and would therefore suffer greater financial downside if these risks crystallized.
Even with their eyes open, many investors may not want to pay more for a climate-proofed asset, as the benefits would wash out over a long holding period.
Like many climate-related investor initiatives, the methodology’s prospects hinge on mass adoption by influential institutions, with portfolios of sufficient heft to move the market at large.
Resilient investments
PCRAM was born out of a collaboration between Mott MacDonald and the Coalition for Climate Resilient Investment, which disbanded last year after transferring PCRAM to the Institutional Investors Group on Climate Change. Nearly three dozen institutions pitched into the initial development process, including banks, asset managers,and climate risk data providers. Roy says 50 organizations are currently involved in the PCRAM working group.
The methodology offers an alternative to complex “value-at-risk” models used by investors that operate according to opaque methodologies and are inconsistent across vendors.
It also helps “expand the focus from just managing risk to uncovering opportunities,” Roy said. “ It provides a clearer framework for evaluation and highlights the value that comes with investing in resilience.”
Big insurers and other institutional investors are increasingly interested in climate-resilient infrastructure.
The Insurance Development Forum in April tapped the asset management giant BlackRock to implement a climate-resilience “blueprint” and create a pipeline of infrastructure projects that met insurers needs, likely in the form of a dedicated infrastructure fund.
IDF members, which include Axa, Swiss Re, Allianz, AIG and Zurich Insurance, pledged to invest $500 million in blueprint-approved projects, according to AXA’s Paul Flavier at the United Nations’ Bonn Climate Conference.
“If it’s the start of a series of funds, it’s a reasonable number to start with,” Flavier said, as reported by Climate Proof. “It’s also a reasonable number compared to the pipeline of bankable, available projects.”
What will spur more investors to assess infrastructure projects through the lens of climate resilience?
Flavier had a simple answer: “Compelling returns.”
