Press Release

DBRS Morningstar’s Takeaways from SFVegas 2021: Measuring Climate Risk in Securitizations Is a Critical but Complicated Task

October 07, 2021

As part of its takeaways series, DBRS Morningstar is publishing the below write-up about the key ideas discussed at one of the many Environmental, Social, and Governance (ESG) panels at the SFVegas conference that the Structured Finance Association (SFA) hosts. Moderated by DBRS Morningstar’s Chuck Weilamann, the panel gathered analytics providers, lawyers, and investors to discuss climate risk in securitized transactions. One of the panelists, David Sobul, is a member of the SFA’s task force dedicated to coming up with ESG standards and recommendations for disclosures. “I think that there is the perception out there that the task force is going to come up with a stamp to put on different products and say that these are ESG or sustainable products… That’s not the expectation at all,” clarified Sobul, Structured Finance & FICC ESG Legal Advisory Counsel at the Bank of America.

Ultimately, climate risk falls into two categories, according to Neil Hohmann, Managing Director, Head of Structured Products at Brown Brothers Hariman. The first is physical risk, which is tied to events (e.g., wind storms and flooding) and chronic risk (e.g., sea levels rising). The second is transition risk, which includes regulatory components and macroeconomic components as well as legal, policy, and technology changes. Of the two, Hohmann believes transition risk will have the biggest impact on issuers and collateral pools. Timing is also a factor, and risks can be broken down into the near term, medium term, and long term.

Assessing climate risk for securitizations presents challenges that the industry will need to address. One major hurdle is the gap in information between what the issuers provide and what investors and others want to know. According to Eknath Belbase at Andrew Davidson & Co., climate science firms want to get down to specific property-level information. They don’t just want to know the location but also whether the building on the property is raised, if it has been reinforced for fire risk, the type of terrain the property sits on, etc. “The bulk of the work is that the climate risk scoring firms are at one place and our industry, in terms of credit risk, speaks a different language,” said Belbase, “And those models basically need to talk to each other. That’s where we’re focused at least for the next year.”

Weilamann agreed, saying that Sustainalytics, which is an affiliate of DBRS Morningstar and under the Morningstar, Inc. umbrella, is trying to design and offer a common language so the market can benefit from improved clarity and more uniform taxonomy.

Hohmann mentioned that one key metric issuers could provide is their greenhouse gas emissions footprint. These types of emissions come into three scopes. According to the Environmental Protection Agency, Scope 1 is direct greenhouse gas emissions associated with company-owned or -controlled sources. Scope 2 is indirect greenhouse gas emissions through the organization purchasing utilities like electricity, steam, heat, or cooling. Finally, Scope 3 is indirect greenhouse gas emissions not in Scope 2—those that are the result of activities not owned or controlled by the reporting company but that affect its value chain.

He also offered up exposures (such as geographic) and how sensitive these exposures are. The latter relates to how much the physical risk and transition risk affect individual collateral types. Other metrics include land usage, energy usage, and waste management.

Despite the challenges, structured finance issuers have a real advantage over corporate debt issuers from a climate risk assessment standpoint. Per Hohmann, there is detailed accounting of the underlying collateral, particularly geographical, and the information availability is greater than for most corporate issuers. In addition, the core principal of structured finance is to protect the investor from any associated corporate risk.

Public policy can also play a role in addressing climate risk. For example, the Federal Emergency Management Agency (FEMA) has changed the pricing of its National Flood Insurance Program (NFIP) to account for climate change risk. The program provides about $1.3 trillion in coverage to approximately 5 million people. Sobul believes change is necessary—as the original program was unsustainable. “Unlike many other forms of insurance, the National Flood Insurance Program doesn’t require reserves to be held for extraordinary events… if there are extraordinary events like a Hurricane Katrina that blow up the pricing model for the NFIP, they’re allowed to borrow from the Treasury. That borrowing has now increased on a steady pace as we’ve gone through more and more inland flooding cycles, and it actually reached a peak of over $30 billion in 2017.” Sobul thinks it’s most likely Congress will want to address the repeat claimants; about 1% of the properties in the NFIP’s insured portfolio account for 25% to 30% of all claims.

Increasing premiums is one way to provide the necessary funds. However, Belbase mentioned these rising costs could further make homeownership more unaffordable. Also, it still keeps in place a system that allows building and rebuilding in areas where storms and flooding are more likely to cause repeated damage.

Of all the structured finance asset types, Hohmann identified single-asset/single-borrower commercial mortgage-backed securities as the one with the biggest exposure in the near term (zero to five years). Again, insurability really comes into play for these assets. Flooding concerns question if an asset can even qualify for insurance. For the long term, he believes transition risk will significantly affect the major auto manufacturers, questioning if these issuers are going to be in the same economic shape five to 10 years from now as the world transitions to electric vehicles.

We are still in the early days of assessing climate risk in securitizations, and no set standards are in place yet. But though it won’t be easy, it’s important for the industry to endeavor to evolve.

Written by Caitlin Veno

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