The complex climate models used to inform policy decisions are becoming increasingly useful to investors and risk managers. Nick Wood, Director of Climate Policy Research, believes it’s high time to harness the data and correct pricing now, and for future property investments.
Imagine this scenario: I am wealthy and middle aged and I am interested in buying, off-plan, a luxury seafront property on Australia’s beautiful east coast. I have two financial objectives in mind: firstly, an investment for a period of 10 – 20 years and secondly, as an option for my retirement living. In considering the purchase however, there is something vital that I don’t know. The question of whether I will be able to get insurance for the property for the next 20 years and beyond, and how much will it cost me, is a mystery. I ask the bank lending me the money, I ask my insurance company, and I ask the property developer. None of them are able to tell me. Talk about three wise monkeys!
What does this lack of information mean? What do the sorts of things I’ve heard about climate change mean in terms of financial risk to this investment? There seems to be a crucial piece of financial information missing in the interaction: an estimate of the long-term insurability of the property.
The issue of risk pricing in domestic insurance has been looked at in detail several times before. The 2013 work on market-based mechanisms for climate change adaptation from the National Climate Change Adaptation Research Facility and The Climate Institute of Australia’s 2014 analysis of insurance costs in relation to natural catastrophes, both provide great analysis of the issues. In this article, I build on this work by asking what the issues mean for financial risk in a wider context through three key questions:
- Why does the current system of interaction between the lender, insurer and developer fail to provide a clear and long term risk / price signal (insurability)?
- How could the emergence of climate related risk translate into systemic risk in the property development sector?
- What can be done to address this problem?
Let us consider the first question. The answer to this lies in the way that the two types of instruments at the heart of the transaction, the mortgage (or home loan) and domestic insurance, are structured over time.
“The coastal risks of storm surge, coastal erosion and gradual sea level rise are excluded by many general insurance policies in Australia.”- Insurance Council of Australia “Living with Climate Change” Report 2010
A home loan is a long-term debt instrument where a substantial loan is made upfront and is repaid in well-defined amounts at planned intervals, usually monthly, over terms of 10 – 25 years. The home itself is used as security for the loan and the homeowner is required to maintain insurance over it for the full term of the loan. However, the homeowner is typically only able to obtain insurance that is renewable on an annual basis. This misalignment in the timeframes of the instruments is a key feature.
As McAneney, J, et al note: “Given that the typical duration of an insurance policy is 12-months, pricing will not reflect any future changes in risk that may arise due to increasing exposure concentration or anthropogenic climate change affects on severe weather. This being the case, the best insurers can do is to provide incentives to reduce vulnerability by sending price signals on an annual basis reflecting the extant risk”.
When it comes to the emergence of risks related to climate change there is evidence that the misalignment is starting to cause problems. Although insurers may be trying to “provide incentives” the current situation seems to be one of more noise than signal. The analysis of the cost and extent of cover offered for natural catastrophes in the report Buyer- Beware published by The Climate Institute of Australia found that it could vary greatly by location, by insurer and over time. In addition, The Insurance Council of Australia noted in their 2010 publication “Living with Climate Change” that: “The coastal risks of storm surge, coastal erosion and gradual sea level rise are excluded by many general insurance policies in Australia. Consumers should ensure they are familiar with their policy and are aware of what risks the policy will not respond to”.
“We have a long-term liability but can only get short term risk hedging.”\
We have a long-term liability but can only get short term risk hedging. Within the dynamics of the financial and property markets we could be in a situation where key metrics such as the asking price for the home, the size of the home loan, the risk management of the lender, the financial planning of the property developer and the financial security of the homebuyer are all currently being determined using price information that may not include this new climate risk information.
What about the second question? How could the emergence of climate related risk translate into systemic risk in the property development sector? The answer to this lies in a consideration of three factors; the total value of new developments that may be exposed to climate related risks and “in harms way”; the level of risk (deficit and future) that they re exposed to; and the power of climate models to provide data on future physical impacts at a localised level. The last factor is often overlooked in the political discussions in climate risk but in terms of a systemic risk it is perhaps the most important. In a similar manner to the way that social media impacted politics and consumer advocacy it is this emergent “ data power” from climate models, this new information available at a town by town scale, that could be the main instrument of change
Until quite recently the technical ability to determine a long-term view of the risks related to climate change was limited by the computational power of the climate models. However, the climate models used to inform policy decisions are becoming increasingly useful. The output of these models has evolved from generic data at a continent and sub-continent scale to detailed projections of multiple climate variables at a regional and sub-regional level (50 -100km grids). The ability also exists to take these variables and downscale them to 20, 10 and even 2km scales over specific regions.
This emergent data power is a game changer. With investment in the right skills and tools, the financial service industry could begin to take longer-term views of climate related risks. In particular, it would allow for interested parties to develop a metric for insurability for home lending. It would be possible to create a screening tool that could inform the lender or purchaser of locations where the future cost or availability of insurance may become an issue. The missing price signal could then emerge in the form of correction in property values.
In summary, the increase in the power of climate models will allow the financial services sector to develop better capabilities to price risks related to a changing climate. This new knowledge could lead to the identification of locations where a price correction is required.
New capabilities for Australian business
Three things have become apparent. The complex climate models used to inform policy decisions, and once the domain of academics only, are becoming increasingly useful to investors, speculators and risk managers. The financial risks associated with a changing climate need to be better understood and managed.
- The objective of long-term economic growth within a changing climate will require new types of financial instruments, risk transfer products and “climate proof” investment opportunities.
To assist Australian business in developing new capabilities in this process, Climate Policy Research P/L is setting up a Masters level research group with the universities within the ARC Centre of Excellence for Climate System Science. (Inter alia UNSW, Monash). The research group will consist of students recruited from Australian and global businesses (banks, mining, insurance, property etc.) that understand the potential of this opportunity and would be prepared to commit one of their staff to the research project. The focus of the research will be to develop applications using the extensive climate data sets that are emerging from the UN models.
This is a large and challenging undertaking but has the potential to produce some very powerful new capabilities for the sponsoring businesses. It is the intention that the group will consist of 10 -12 students and that the research will commence in July 2015.
Typically the Masters level degree delivered by research takes two years. This course is aimed at the future leaders and thinkers in Australian business; people that will be at the helm and able to deal with climate risks as part of their everyday vocabulary.
Climate data can now be used in financial risk management but it will require new skills in order to use it. It is my personal view that, whether they understand it or not, the banks, insurers, mining companies and property developers are now in an arms race to develop the capabilities to manage climate risks. You cannot be a wise monkey forever.
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