Capital Ideas: Transition Risk in Transition

As host of a podcast on sustainability, I’ve heard a sentiment repeated by a number of guests lately. That is, regardless of the constraints President Trump imposes on existing federal environmental regulations and legislation, states and cities will continue to drive toward decarbonization and cleaner buildings through new regulations and codes.

Well, last week Trump signed an executive order indicating that non-federal efforts to mitigate climate change and encourage the transition to cleaner energy are not beyond his grasp. The E.O. titled “Protecting American Energy from State Overreach” would stop any regulation that stood in the way of “unleashing American energy.”  

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The executive order’s main objective is to protect domestic energy producers facing “illegitimate impediments” at the state and local level, but it promises to go much further when it states:

“The Attorney General shall prioritize the identification of any such State laws purporting to address ‘climate change’ or involving ‘environmental, social, and governance’ initiatives, ‘environmental justice,’ carbon or ‘greenhouse gas’ emissions, and funds to collect carbon penalties or carbon taxes.”

The president cited New York retroactively fining energy companies for past greenhouse gas emissions and California “punishing” businesses for carbon emissions as examples of states that “regulate energy beyond their constitutional or statutory authorities.”

This is certainly another post-inauguration blow for the climate-conscious, but what’s the impact for commercial real estate investment and finance? Two words: Transition risk. As many of you are already aware, that’s the financial, legal and reputational risk investors and lenders associate with the transition to a low-carbon future.

Rising insurance costs in the face of mounting natural disasters is part of that transition risk factor, as is compliance with new state and local mandates. And transition risk varies state to state, local market to local market and property to property.

“These risks,” according to the GRESB website, “are interconnected and often top of mind for investors as they attempt to navigate an increasingly aggressive low-carbon agenda that can create capital and operational consequences to their assets.”

Transition risk for lenders

Not surprisingly, the United States lags European Union and Asia-Pacific lenders in considering the environmental factors in lending practices, according to a recent paper by MSCI. But the general direction is, since transition risk impacts the performance of the asset, lenders will be factoring it into their underwriting.

Meanwhile, helping property owners finance compliance with state and local climate regulations has been seen by lenders as an opportunity with a long runway.

But how do you calculate compliance costs and other transition risk factors when the transition to a low-carbon future is now in question at every level? CRE executives have been looking forward to some regulatory relief under Trump on the federal level, but they didn’t expect a potential change in direction at the state and local level.

The questions about transition risk are not the only extra layer of uncertainty. Tariffs, taxes and 10-year Treasury rates are also big question marks. Combined, these factors are likely to slow down transactions in a year that looked like it guaranteed a reset.