Understanding Physical Climate Risk: Insights from ICE Climate’s New Tool

Hi and welcome to the shift.

I'm your host Jeff Gitterman.

We're live on the floor of the New York Stock Exchange on FinTech TV, and I'm joined today by Evan K Cora.

Evan is the head of research at ICE Climate.

Evan, thanks for joining me today.

Good to be here.

Thanks for having me.

So I love the conversations that we get to have about all things climate, but you guys have a new physical risk tool that you're unveiling.

Can you tell us a little bit about it?

Sure.

Um, so this is something our team has been building for the last 3 or so years.

It builds on something that we had built in a sort of prior incorporation as a startup.

It looks at physical climate risk to global debt markets, so that includes sovereign debt, corporate debt, and then we also have had a long standing specialization with US debt products, so mortgage debt, the mortgage bond universe, and US municipal bonds.

So those are things we've been doing for quite a while.

Um, this new product unifies all of that. um, and what it's what we mean when we say physical climate risk, it looks at things like wildfires, hurricanes, floods, uh, extreme heat events.

Uh, those things that put pressure on asset values one way or another.

We also inject climate change into those models, so not only looking at statistical risk now but also in the future and how that maps to different maturities for different debt instruments.

So this is all actually an extension of how the catastrophe modeling industry that serves the insurance market works, but extend extended and tailored for. debt markets and so what we're doing is essentially giving the same types of products but but you know tailoring those for how a credit analyst would think about where does credit risk come in for the debt markets.

So historically what everyone was talking about for the last two decades was really transition risk and what impact that could have on the debt markets, and there were, you know, significant risks that people thought we were. to on that front, what we've been covering on this show for the past 4 or 5 years is that physical risks can be as dramatic to the debt market as transition risk can be.

But can you tell us a little bit about the evolution, about what are the conversations that you're having with people in the debt markets?

Are the debt markets open to really understanding this risk because ICE is really one of the leading companies in trying to get Credit facilities and different banks to understand that risk that's on the table and talk a little bit maybe about the evolution of that conversation over the past year or two with some of these major physical risk events that have occurred.

Sure.

So interestingly enough, from my point of view, physical risk has always been there.

It's it's coming in one way or another. transition risk is sort of more a political and economic choice to some extent.

There are exceptions to that.

Over the last couple of years with the sort of the shift in politics, especially, a lot of the clients and stakeholders we work with have become more sort of cognizant that physical risk is coming no matter what, and it's already here in a lot of places.

So for the debt markets, this is still a nascent topic again, in looking at the capital markets more broadly, insurance has been dealing with this for a long time.

Um, but there's this idea of an insurance gap that's been created over the last few decades where insurers have gotten smarter and smarter about where to insure risk and where not to and how to, and one of the sort of byproducts of that is a gap has been created wherein the majority of climate risks are uninsured around the world.

And so the problem with that is eventually that that that risk has to fall somewhere.

So we basically sort of follow the money, so to speak.

Um, and in the debt markets which are very dependent ultimately and implicitly maybe on the stability and growth of real estate values, climate can completely upend that.

So by the end of the century.

We're looking at right now 3 °C changed from pre-industrial levels temperature-wise.

3 degrees doesn't sound like much, but it is when you look at the extremes.

I think one thing that's important to emphasize there is it's not like we're going to wake up at the end of the century and all of a sudden this is going to have happened.

This is a transient phenomenon that's going to take place and it's going to accelerate.

According to climate models, if we were to believe them and in broad strokes we have good reason to believe them based on their ability to produce the statistics of climate that we're seeing today.

It's interesting because it's across that whole debt cycle because you've got risk to real estate and then you've got the mortgage risk that layers behind that.

And then if people aren't living in areas anymore, there's climate migration occurring, then there's municipal bond risk that gets layered on top of that.

And then Have you looked into the fact that we're hearing from this current administration that there could be a big drop off of FEMA covering post-natural disasters, not just in disaster kind of people being on the ground to help people, but actual coverage of damages and what impact that could then have on the credit markets.

We are starting to look into that.

It's potentially the biggest systemic risk that We could see related to climate in the US market in particular.

You know, in conversations over many years that we've had with different stakeholders in the US capital markets and especially in municipal debt, um.

There is a there's a well a well grounded assumption that FEMA usually comes in and provides disaster relief for something that could otherwise potentially spur a major default, um.

There's lots of reason to believe that that's a shaky assumption at this point.

Um, and so some of the fundamental underpinnings of how the municipal bond market in the US works we should be questioning and be very thoughtful in considering whether states who are so the purported idea is that states should be dealing with this more on their own.

A lot of states don't have that in their coffers to do so, and so we should all be watching very carefully this hurricane season and frankly wildfire season to see how things go.

So we're talking about the credit risk side.

Talk to me a little bit as an investor, and I'm looking at this data and how can I potentially incorporate this into some investment decisions that I might be making?

Sure.

So right now, as far as most research has shown, climate risk is a component of credit risk, but it's not really factored into how things are priced yet.

People are still grappling with how to do that, and then there's other sort of systems and incentive based reasons why that hasn't happened yet.

If I'm an investor right now, simply put, if I'm comparing two securities A versus B, all else held equal, they're priced the same.

Um, but one has significantly higher climate risk in some form.

Why, you know, why not pick the one with lower climate risk?

We haven't seen any reasons at a sort of data analysis level of how the markets are functioning to suggest that that's happening at scale yet, but that's one very simple sort of intuitive apples versus oranges way of looking at things.

Um, in addition, we're working on things that let asset managers beyond just looking at sort of the statistical risks, which is one way to look at things, just grapple with how to deal with a disaster as it's happening.

So we have a product called Hazard Watch.

If a hurricanes hitting to the extent that we can rely on those forecasts, we can say something about how your portfolio is impacted.

So if you're working and trading, you could potentially exit out of a bond that's in a place that's affected by a disaster, for example.

Um, from an impact investing perspective, there are plenty of countries and communities that need more capital to actually deal with climate.

So if you're thinking of the sovereign space and emerging markets, a lot of those countries don't even have enough capital to deal with basic needs, let alone climate adaptation.

That might seem like it's only their problem, but in the long term, when you think of things like necessary migration once climate gets worse and worse, it's going to be everybody's problem.

It's interesting, you know, we have First Street now that has come out with all of this data on what is your flood risk, your heat risk, your rain risk around your property, and now you can basically look at any property in the US and find the impacts of climate change on or the potential impacts of climate change on that property.

What I've heard is that they're starting to see like in areas that are prone to climate change like a Charleston or Miami, that higher elevation properties are already selling for about 6% more than lower elevation properties and it just seems like it's the very beginning of understanding that the data is out there and putting that data into the day to day buying decisions or investment decisions that you make.

I mean, I look at like Moody's and S&P.

They've been doing value at risk or VAR data reporting and reporting for probably 5 or 6 years now, but at the same time that is not impacting the credit risk of the bonds that they're rating.

Um, it seems like a somewhat of a disconnect.

How do you crok that disconnect in the marketplace?

Yeah, it's a really interesting disconnect.

I think it's the most important disconnect.

I mean, obviously the credit rating agencies have the biggest lever in terms of how people, um, how people in asset management shops deal with with risk.

For example, if you have a shop that's that only deals with investment grade credits.

That by definition is responsive to what the credit rating agencies say because they're the ones that decide what's investment grade and what is not.

Um, frankly speaking, I'm still sort of learning the ins and outs of how this works outside the US municipal bond space, but generally speaking, um, you know, the credit rating agencies are walking a tricky line where they're, they're working with both issuers, so cities in that case or countries if you're thinking of the sovereign space, but they're also working with investors and so they're sort of Um, and the way that they look at credit risk is only out a few years at least in the municipal space, and there's, you know, from the sort of claims that there's so much uncertainty that it's hard to actually deal with pricing climate in and I can't actually blame them for that.

It's an incredibly complicated thing to do to figure out how do you actually like integrate this into a formula that makes sense from a from a credit rating perspective.

Um, so we've got this at once we've got this bottom up thing and look when I'm looking on Zillow for fun, I always look at what the flood factor is and those kinds of things.

So we know that that bottom up thing is starting to happen, but the capital markets are not as quickly responsive as, say, an individual consumer who just doesn't want their house flooded.

So we're going to see that gap for a while potentially, um, and I think that the buy side in the market is going to have to be the first one that starts making decisions that sort of go in the opposite direction.

I think that's really hard to do in certain spaces where as most asset managers are really competing on, on, you know, low fees and getting as much assets, you know, under their umbrella as possible, and when you're doing that, you sort of have to buy stuff that's maybe higher risk, but if the credit rating agencies aren't saying they're higher risk yet.

Then you have no reason not to buy it from a sort of asset.

So it's it's an interesting problem with incentives.

It's it's, it's unclear when that's going to change.

We'll see.

It'll change when FEMA doesn't come in after the first major hurricane that hits a US city and we see the cost post storm of those damages.

I want to just end on a really Really drive home the point that you made that there are these kind of data sets or even scores on value at risk of a bond issue, whether that's a mortgage or municipal bond or credit issue, and you can have a choice as an investor to buy two A rated bonds.

And one can have a really high value at risk to climate change, and one can have a really low value at risk to climate change, and currently that is not priced into the market.

So basically as an investor you could buy almost free insurance in a way in your portfolio.

You could do the same thing in real estate, I would imagine too in a REI that has exposures you could look through those reeds that are available to you.

It could be similar yields and yet much more risk in one portfolio than another.

To, so to me we're at the early days, we're in the very, very early days of like you could call it climate fintech if you want to, right?

So a CRE fund that's very climate aware to my knowledge doesn't really exist yet, um, for example.

I think those who it is sort of like the early adopter advantage to your point.

If you're now is a good time for the investor side right to do portfolio cleansing if you can, again, just keeping in mind all those asset under management dynamics that still exists as well, so it can be some tension there.

I think even more sort of important from a human social you know city and countryside, it's like right now is a good time to so.

In the sovereign in the US, it's sort of in government finance.

One good great use case of these markets is actually if you're in the position to do so to borrow the capital to invest in resilience to physical risk before it gets priced in.

So if you're a city with high climate risk and you're paying the same to borrow money as a city with low climate risk.

Now is a great time to be thinking about building sea walls or whatever the case may be that your your sort of city or because the borrowing cost isn't impacted yet.

That's right.

You can go out there and borrow money for this work and the interesting thing is, on the other side of that.

There's a good chance, I think that there's going to be a recognition for these resilience and adaptation investments that are made.

So you can borrow the money right now without a problem where if the rating agencies get wind and start changing the ratings, you're not going to be able to get that capital and getting that capital now at a lower cost could actually benefit.

That your ratings post the rating is catching on.

There's a great example.

Virginia Beach did this a couple of years ago.

They passed a referendum to borrow about $5 billion to defend, to defend the city from flooding from climate change.

That was backed by a cost benefit analysis done by a university, and it showed very clearly we did some sort of meta work on top of that showing this in a broader sense that.

The if resilience is done right, the cost, the capital costs of doing it far outweigh the sort of risks of not doing it.

Awesome, Evan.

It's always great to have you on the show.

Please come back.

Not hopefully post a major storm that changes everything.

Hopefully we'll have you on before that.

OK, thanks so much.

Thanks.

That's it for the shift.

Looking at investing for our future.

I'm your host Jeff Gitterman.

Until next time.