The year that’s closing is expected to be the first year in which average surface temperatures will top the 1.5°C goal set during the 2015 Paris Agreement. That’s the point at which irreparable damage is expected to begin setting in and greater physical damage will affect everything, including commercial real estate.
One difficulty has been how to model and integrate climate risk in cash flow analysis and credit risk calculations, says Moody’s. The firm looked at the latest report — Physical Climate Risk Divergence: PCRAM for Investors — from the Institutional Investors Group on Climate Change (IIGCC) for possible answers.
As Moody’s explains it, PCRAM, which stands for Physical Climate Risk Assessment Methodology, has four steps: scoping and data gathering, materiality assessment, resilience building, and economic and financial analysis. The four steps help create a three-part cash flow analysis: a base case, a climate case, and a resilience case. And then, the process integrates the cash flow analysis into a cost/benefit analysis, internal rate of returns calculations, and asset value implications.
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The objective of the first step is to determine whether there is enough data and if it is of sufficient quality to continue with other steps. Some of the tasks include defining the projection, data gathering, and testing for sufficiency. That leads to the initial climate study, critical components, and key performance indicators selection. Then it’s time to decide if the data is good and sufficient enough to proceed.
Materiality assessment means a determination of how vulnerable a property is. The company considers hazard scenarios, impact identification, impact severity, and risk qualification. From this comes a detailed climate study; a list of impacts and severity by component; and a climate case cashflow forecast. Then determine if the physical climate risks are material to the asset in question.
In the third step, resilience building, you identify resilience options. This includes hard options that include structural alterations that involve capital expenses. The soft options are operational and involve systems. The outputs are a repeat materiality assessment, a revised climate study for new elements, and a resilience case cashflow forecast.
The fourth step is the economic and financial analysis. The intent is to address risk management for asset exposure to physical climate risk. That requires a cost/benefit analysis and internal rate of return comparison. Finally, you get recommendations and value implications.
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