Can Today’s Risk Management Programs Deal With Climate Change?

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October 1, 2018
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Can Today’s Risk Management Programs Deal With Climate Change?

This past year has been a tough one in several areas of the country. The devastating impacts of Hurricanes Florence and Michael are still being felt in Florida, Georgia, the Carolinas, and Virginia, with a combined death toll of 75 as of this writing, catastrophic flooding, and thousands of homes destroyed or still without power.

In much of the West from Arizona and California to Montana and Wyoming, this summer’s record fire season has resulted in the destruction of hundreds of square miles of forested land and forced tens of thousands to abandon their homes.

According to the National Oceanic and Atmospheric Administration (NOAA), as of October 9, the U.S. has experienced 11 weather and climate disaster events with losses exceeding $1 billion each. This list does not include losses from Hurricane Michael, which made landfall on October 10.

Unfortunately, such extreme weather events are nothing new and are rapidly become part of the norm in North America and throughout the world. Most scientists agree that these events are the result of rising temperatures and climate change. In fact, July 2018 was the hottest month ever recorded in California.

What does this new reality mean for lenders and commercial real estate lending risk management programs?

A Myopic View of Environmental Risk

Traditional environmental risk assessments are focused wholly on current and known property issues and risks. For instance, most lenders require the borrower to complete an environmental questionnaire and then conduct an environmental screen on the property. If there is any historical evidence of possible contamination, a Phase I is ordered.

This approach has worked well in the past, but it presents challenges in a world of increasing and uncertain risks due to climate change and environmental catastrophes. A property may be judged low-risk for contamination based on its prior or current business use, or the historical record of adjacent properties, but may actually be a higher risk for damage, liability, loss of income, or contamination due to an increase in high-wind, flooding, drought, and fire events.

In addition, insurance companies have lost billions of dollars in recent years from unanticipated catastrophic weather events, and are adjusting their premium rates accordingly. In many cases, they are completely vacating high-risk markets and no longer provide flood, fire, and wind damage coverage in these areas.

Lenders face many types and levels of risk, including direct risk associated with physical damage to collateral, indirect risk from a borrower’s potential loss of assets and income, to significant reputational and liability risks as well. Today, financial institutions need to begin adjusting their environmental risk assessment programs to incorporate a long-term and forward-looking approach, including a clear-eyed view of current and future risks from climate change and catastrophic weather events.

The Time is Now

Environmental risk management faces a new and uncertain world. But some banks and credit unions are beginning the process of reviewing their programs and considering the myriad impacts of extreme weather events, rising sea levels, and other climate-related contingencies.

Ninety-four financial institutions in 37 countries, including major U.S. banks like JP Morgan Chase, Citigroup, and Bank of America, have adopted the Equator Principles, a set of due diligence standards to support responsible risk decision-making in financing major projects that impact the environment.

Lenders must also begin to consider climate risk in their loan pricing and decisions. Geographic and industry-specific risks should be considered when deciding to enter into new lending markets. The availability and cost of specialized liability and collateral insurance coverage must be evaluated as part of the overall underwriting process. Financial institutions should also consider developing a Strategic Environmental Assessment (SEA) as a method of evaluating environmental factors as part of the overall risk versus return equation.

Above all, financial institutions must begin to take a long view of the impacts of climate change on their lending operations. Catastrophic weather events and other climate-related impacts go well beyond the life of a single loan. The climate problem is one we all have to deal with, and it will impact loan portfolios for the foreseeable future.

 

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