Climate change is underway, but is it priced in?

In a recent interview, PGIM’s head of thematic research expanded on some of the aspects of that company’s recent report on climate change. The report emphasized that climate change is a fact, not a hypothesis, and that since the associated risks are only imperfectly reflected in the price of assets, this fact creates investment opportunities. The research head Shehriyar Antia, spoke specifically of the value (and mispricing) of real assets, which includes land, homes, water, and infrastructure and the resulting opportunities. “Real estate offers opportunities for capital investment in climate resilience: investments that can harden properties in the face of extreme weather events,” he said. The hardening can be straightforward: a landlord or the lessor of a commercial property can simply elevate electrical wiring a foot off the ground. This can allow the properties to survive and continue functioning through weather events that would otherwise knock them out, and in the process preserve the steady stream of rental income. Unfortunately, such simple hardening measures don’t yet produce benefits for the property owner in the context of insurance. But that is likely to change in the years to come: perhaps gradually, perhaps in one big leap (a “Minsky moment.”) The phrase “Minsky moment” is named for Hyman Minsky (1919-1996), an economist who wrote in the Reagan era about how an accumulation of private debt can push an economy toward crisis, the build-up to the crisis will be gradual but its onset will seem sudden. Minsky’s thinking has been applied in recent years to our understanding of the events of 2007-09. Antia uses the term, not to suggest that there is going to be one single global Minsky moment on climate, but simply to outline some scenarios in which certain prices will shift drastically. Residential mortgages With that thought in mind, consider residential mortgages. Real estate prices along the coasts, where storm surges, and even more broadly a global threat of higher ocean levels, threaten livability do seem to reflect the climate risks. But it doesn’t follow that the mortgages do. The report tells us that “[c]oastal states such as Florida, Virginia, and Maryland -- with some of the highest climate risk -- also have among the lowest average mortgage rates.” Do flood insurance premiums reflect the increased risk efficiently? No. The PGIM report says that outdated flood maps have helped keep the re-pricing inefficient. For example: the number of homes in the U.S. that are now at risk from a 100-year flood are roughly twice what the maps suggest.” Although as noted government policies get credit for helping with the obsolescence of coal, they get the blame for the over-valuation of shoreline residential debt. Fannie Mae and Freddie Mac help preserve inefficiencies. Banks can offload their mortgage risk to these GSEs. That means that they don’t have to hang on to the 30-year mortgages they underwrite. This means in turn that the originating banks don’t have to account for flood risk in mortgage pricing or push for better maps. An inefficiency continues, and anyone in a position to look past short-term fluctuations can take an investing position on the side of the underlying realities. From such facts, PGIM infers that “climate change is a slow-burning issue with indiscernible impacts on a year-to-year basis but potential for exponential growth once tipping points are reached.” When the tipping point does come, even realty hardenings that seem modest now could pay off handsomely. Information and intelligence Relatedly, Antia said, “A revolution is underway: a data revolution that, together with AI, creates real opportunities.” Typically, analysis of threats from, say, storm surges would proceed at the postal code level. But in this situation "all properties can get painted by the same brush," he said, and this undervalues some. The new tech can allow for analysis "block by block and even property by property." This brought us back to the issue of property and casualty insurance mentioned above. Many of the weaker players have exited in recent years. The fittest have survived, and as changes in the climate become more obvious, it stands to reason demand for their service will increase. Further, the fittest are those in the best position to make good use of big data. Chubb, Liberty Mutual, and other strong players will leverage innovations in risk-sharing and in high tech, which will allow for more effective weather modeling and will capture new opportunities. What the insurers can leverage, realty investors can likewise leverage. The PGIM report includes an “illustrative” dashboard of a sort that may become typical for the screens in such investors’ office. An investment manager could call up a property, say “11 Fillmore Street” and discover in a glance not only that 11 Fillmore, somewhere in the southwestern U.S., is an office building, and has produced a steady rental stream, but that it is not at risk from sea level rise or hurricane/typhoons, that it is only somewhat at risk from heat stress, and that it is at high risk from earthquakes or water stress. For agricultural properties, likewise, sensors, GPS, and variable rate technology can enable the managers of land to adjust the supply of water, fertilizers, and pesticides to adjust for weather variability and its impact on soil, pest populations, and so forth. 'And not a drop to drink' The question for much of the PGIM paper then is: Are markets factoring climate risks into the price of assets? If the answer is, “generally, yes,” then the next question is “are they doing so efficiently or inefficiently?” Inefficient pricing always spells someone’s investment, or at least someone’s trading, opportunity. In this connection, in our interview Antia spoke of water infrastructure as an investment. “Water filtration facilities or storage at the municipal level are underappreciated opportunities for a debt investor, he said. In global terms, “investors need to be on the ball” because “markets without a straightforward regulatory landscape or strong property rights” can be a trap here. Projects in the southwestern United States or in Australia, where those protections are present, are promising.

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Climate change is underway, but is it priced in?

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Christopher Faille

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