Use Case: Climate-adjusted Valuation

How analysts can use Financial Impact Analytics to forecast climate-adjusted cashflows

Use Case: AlphaGeo for Climate-adjusted Valuation

Overview

At AlphaGeo, our Financial Impact Analytics suite provides 9 bottom-up metrics covering insurance, OpEx, income, and CapEx impacts. All of these metrics can be easily incorporated into standard financial frameworks, including Discounted Cash Flow (DCF) models, to determine a climate-adjusted valuation.

To illustrate how this works in practice, the simplified use case below demonstrates applying a subset of these features to a DCF model:

1. Annual rate of Insurance Premiums increase

2. Annual rate of Utility Demand increase

3. Additional Retrofit Costs for thermal comfort/hazard reinforcement retrofits

4. Additional Exit Cap Rate (Climate Risk Discount) based on future shifts in climate hazards

While a complete analysis on our platform also factors in Maintenance Costs, Operational Efficiency, Operational Downtime, Workforce Productivity, and Insurability Risk, we have omitted them here for simplicity.

By applying these forecasted changes to a DCF model, analysts can forecast the climate-adjusted NPV of an asset or portfolio. We then calculate the Financial Impact Analytics as the percentage difference between the 'Climate-adjusted NPV' and the 'Baseline NPV'.

Financial Impact Analytics in DCF Modelling

We illustrate with two simplified DCF models below.

Step 1: Build Baseline Scenario

In the baseline scenario, we model the NPV of the asset based on the assumptions illustrated in the table above. The cash flow assumptions do not take climate change induced hazards and retrofits into consideration. The assumed Discount Rate is 8% and the Exit Cap Rate, which influences the Terminal Value, is assumed at 5%. The Terminal Value is calculated as Next Year NOI/Exit Cap Rate.

Step 2: Develop Climate-adjusted Scenario Using AlphaGeo's Financial Impact Analytics

In this climate-adjusted scenario, due to climate change, insurance premiums and utility costs are expected to increase at a rate higher than gross income. For this asset, flood insurance is expected to have a YoY increase of 3%, fire insurance an increase of 2%, and utilities an increase of 2%. This increase is applied yearly to the baseline value as "Baseline value * (1 + %increase)".

In addition, climate change might also induce necessary CapEx, mostly in the form of thermal retrofits and on-site reinforcements against acute risks (such as flooding). In the baseline scenario, we have set a side 4% of gross income as CapEx. Based on the climate risk profile of this location, we recommend adding another 2% to CapEx to account for the additional retrofits, giving the new CapEx as 6% of gross income.

Lastly, the long-term effect of climate change on a location should be accounted for during the exit transaction. This can be factored in using the Climate Risk Discount given by the model. In this location, the Climate Risk Discount is 0.25% as calculated based on the methodology in the previous page. We add the 0.25% Climate Risk Discount to the existing exit cap rate of 5% giving a climate-adjusted exit cap rate of 5.25%. This adjusted exit cap rate accounts for future climate related hazards, downtimes, and CapEx beyond the holding period.

The final NPV in the figure factors in the different financial metrics and yields an effective Climate-adjusted impact on NPV of -6.51% compared to the baseline scenario.

In our platform, this final figure (calculated over a standard 10-year period with all available metrics) is exactly what is presented as the 10-Year NPV Loss (CVaR) metric. If we average this value over the holding period, we arrive at the Average Annual Loss (AAL). This demonstrates how the bottom-up climate adjustments feed directly into the top-level valuation metrics.