Let’s not get lost in translation with climate risk disclosure
In the fight to contain climate change and its severe consequences, the financial sector increasingly demands that firms disclose information on their respective emissions and climate risks. There are several reasons for this trend. First, from a purely financial perspective, investors are increasingly interested in both the transition- and physical risks of their portfolio firms. Second, clients of financial institutions are increasingly demanding more transparency in terms of climate risk and pollution. Namely, disclosure of, for example, total emissions can be used to hold firms accountable for their actions. Finally, some institutional investors are bound by stewardship codes or mandatory laws to disclose their climate risk exposure. One such example is Article 173 of the Energy Transition for Green Growth Act in France, which requires French institutional investors to disclose the climate risk of their portfolio assets.
A study (link here) recently published in the Review of Financial Studies ran a survey asking institutional investors how important they consider climate risk disclosure compared to other types of firm reporting. Interestingly, the researchers found that approximately half of the respondents in their survey consider reporting by portfolio firms on climate risks equally important compared to reporting on financial information (see Figure 1).
Notes: This figure illustrates how important investors consider reporting by portfolio firms on climate risks compared to financial information.
However, these same respondents indicate that standardized disclosure tools and guidelines are not yet available and that those that exist are uninformative. The difficulty here, especially for climate risk disclosure, is that climate risk models vary in nature and composition. They tend to use various types of base data, from different sources, which are then cleaned and analyzed using various techniques. The most well-known example is how the US flood maps differ between the two most prominent vendors, First Street Foundation and FEMA.
While the paper published in the Review of Financial Studies does not focus on any specific sector, the conclusions are highly relevant to the real estate sector. Namely, in addition to being a big contributor to climate change, the built environment is one of the sectors that will suffer the most from the consequences of climate change. In essence, real estate is both a long-term investment and an immobile one. It's grounded in specific geographic locations, and those locations are increasingly subject to the negative impacts of a changing climate.
Real estate climate risk disclosure lacks standardization
One of the main avenues taken in the real sector to provide information on assets’ and funds’ sustainability level, is by means of certification. Yet, this approach has received a considerable amount of criticism. Matt Ellis, Co-founder & CEO at Measurabl, argues that each certification organization has created different standards for what it means to be a ‘Green’ building. It follows that if different organizations claim to measure the same principle in different ways, then it follows that their criteria of measurement are subjective rather than objective. This makes the current certifications sometimes confusing or uninformative.
A research report by the Urban Land Institute and LaSalle seems to back this claim. The study concludes that institutional investors struggle to translate the complexities and uncertainties, of climate models into real estate decisions-especially given the rapidly evolving nature of climate science and its natural levels of uncertainty. They refer to this as the “science-business translation problem.”
Figure 2 provides a real-life example of how different vendors seem to give completely different climate risk assessments for the same assets. As mentioned previously, the main reason for this is that most of them use proprietary data and methodology to produce their climate risk estimates. This results in a lack of transparency, comparability, and usability of climate risk disclosure.
Standardized disclosure is the way to go
For climate risk to be fully incorporated in the real estate market, and thus have actual impact, standardization is imperative. France took a significant first step by passing Article 173 of the Energy Transition for Green Growth Act, however, more is needed.
Figure 3. A guide to Sustainable Travels
If you still need to be convinced of my arguments, look at Figure 3, which shows the different sustainability levels that Booking.com gives to its listings. The difference between levels 1, 2, and 3 is that the property owner has made either (1) “some,” (2) “considerable,” or (3) “large” efforts to implement impactful sustainability measures. I think that the informational value of these disclosures is close to, if not equal to, zero. The shades of green can be many, but the standard should be one. Let's illuminate our path to sustainability with clear, standardized measures.
Emirhan Ilhan, Philipp Krueger, Zacharias Sautner, Laura T Starks. “Climate Risk Disclosure and Institutional Investors.” The Review of Financial Studies, Volume 36, Issue 7, July 2023, Pages 2617–2650, https://doi.org/10.1093/rfs/hh...
Urban Land Institute, LaSalle. “How to Choose, Use, and Better Understand Climate-Risk Analytics.” Urban Land Institute.https://knowledge.uli.org/-/me...