Green mortgages should be climate resilient as well as energy efficient
In December 2017, the Vice President of the European Commission announced that the Commission is considering loosening financial regulation for sustainable financial products with the aim of boosting green investment. VP Valdis Dombrovskis singled out energy-efficient mortgages in particular as one of the first sectors that could benefit from this type of preferential regulatory treatment.
There are a number of concerns about the idea of a ‘green supporting factor’ since green assets, including green mortgages, are not necessarily lower risk.
Discussions on ‘green mortgages’ usually focus on energy efficiency. But regardless of the property’s energy efficiency, if it is vulnerable to damages from the impacts of climate change, it will be a riskier investment for a mortgage-lender.
Before making policy decisions, we need a better and more complete picture of the climate risks facing the property market.
A ‘green’ property should be not only energy efficient, but also climate resilient
There is no universal definition of a green mortgage, but it is often taken to mean an energy-efficient home. The reasoning is that homeowners who spend less on their electricity bills are less likely to default on their mortgage payments due to having more disposable income. As discussed in more detail in yesterday’s commentary, ‘What are green mortgage and do they work’, more evidence is needed before we can make this link.
Lenders might also need to rethink their definition of ‘green’ to include not only energy efficiency but also resilience to climate risks. Encouraging the retrofitting of homes for energy efficiency is great, but banks need to take more than energy efficiency into account when making a mortgage contract: double-glazing won’t stop a flood.
The European Environment Agency reports that economic losses from weather and climate-related extremes in EEA member countries averaged EUR 13.3 billion annually from 2010-2015. Estimating future losses is difficult, but temperature extremes, heavy precipitation and droughts are projected to increase under climate change, and the European Commission notes that 30% of the EU’s total GDP is generated by communities within 50 km of the coast.
The prospect of climate damages may be beginning to affect decisions about where to build and buy homes, but the damages could be greater than expected and more difficult to predict. Besides the direct damages from climate change (flooding for instance), homes may lose value or face higher insurance premiums as geophysical modelling becomes more sophisticated, better identifying risks and vulnerabilities.
Does insurance protect mortgagors and their banks from the risks of extreme weather events?
From the perspective of the bank lending to a home buyer, it might be tempting to assume that the damages from climate change can be absorbed by the homeowners’ insurance. But not all mortgage providers across the EU require insurance, and insurers may decide to stop providing cover if extreme weather events become too frequent.
In the UK, mortgage lenders routinely require flood risk insurance, but there is a mismatch between the term of the mortgage and the insurance contract. A mortgage often lasts 10-30 years, while insurance contracts are yearly. Theoretically, a homeowner could take out an insurance contract and find out five years from now that the premiums are going to increase significantly, or that the insurance provider will no longer insure homes in the area at all. This could leave some mortgage holders uninsured against flood risk.
In the UK, this problem has led to the creation of the reinsurance scheme FloodRE, which is meant as a backstop to prevent insurance premiums from rising too much. However, there are questions about this scheme’s effectiveness. The scheme has not reduced or eradicated the risks of flood, merely shifted the ultimate responsibility for the damages from the homeowner to the government. Such an approach arguably doesn’t do enough to incentivize flood risk management and prevention.
Flood RE also does not cover commercial properties or homes built after 2009. The intention is that this will incentivize property developers and home buyers to consider flood risk themselves rather than assuming the Government will pick up the tab in case of losses. However it is not clear this is doing enough: analysis by the Committee on Climate Change found that housebuilding on flood plains is almost twice as high as elsewhere.
The insurance schemes in other countries vary. In the Netherlands, for example, flood damage is typically excluded under Dutch insurance policies. In Ireland, insurance providers will not provide flood insurance after a home has been flooded, leaving many households uninsured.
We need to understand the risks before we can address them
A truly green mortgage should not only be energy-efficient but also climate resilient. This will require a comprehensive look at the impacts of climate change on the property market, and also additional research into understanding which actors are facing the greatest risks, and who will be left paying the bill.
Financial regulators in the UK and the EU need to understand the risks climate change poses to property investments, and who will ultimately bear the cost of damages – the bank, the homeowner, the insurer, or the government – which may vary across countries. Understanding the risk is a necessary first step before changing financial regulation to address it.
In order to identify the best policy interventions, incentives also need to match the planned outcomes. By promoting green mortgages as being lower risk for banks while assuming that climate damages will be borne by the insurance companies or the government, financial regulation could inadvertently encourage risky investment. The Dutch National Bank and the Bank of England are already investigating possible losses to banks and insurance companies from climate change damages – other European supervisory authorities should follow their lead, and this discussion on risk should be married with other discussions on green mortgages and bonds.
Real estate bubbles have historically preceded a number of financial crises – without appropriate regulatory oversight and pricing the possibility of damages into the housing market, could losses from extreme weather events precipitate another one?