Climate Value-at-Risk (CVaR)
Last updated
Last updated
Climate Value-at-Risk (CVaR) is a financial metric that models the potential loss in asset or portfolio value over time based on different climate emission scenarios. It is calculated as the percentage difference between the current NPV and the NPV adjusted based on the increase in OpEx, CapEx and Discount Rate due to climate change. Most CVaR providers apply a fixed numeric value or percentage based purely on the risk exposure of an asset. This ignores the fact that each asset or portfolio has different cashflows and methods of valuation.
At AlphaGeo, we offer a dynamic CVaR calculation framework based on Discounted Cash Flow (DCF). We offer 4 financial metrics that adjust the OpEx, CapEx, and Cap Rates that influence the Net Present Value (NPV) of an asset due to climate change. These are:
Annual rate of insurance increase
Annual rate of utility increase
Additional CapEx for thermal comfort/hazard reinforcement retrofits
Additional Exit Cap Rate (Discount Rate) based on future shifts in climate hazards
By applying these metrics to a DCF model, we can obtain a new, climate risk adjusted NPV of an asset or portfolio. We then calculate the CVaR as the percentage difference between the 'Climate-adjusted NPV' and the 'Baseline NPV'.
We illustrate with two simplified DCF models below.
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.
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 Discount given by the model. In this case, a 0.25% cap rate is added to the exit cap rate to account for future climate related hazards, downtimes, and CapEx beyond the holding period. Generally, a higher emission scenario will lead to a larger climate discount to account for increased volatility.
The final NPV show in the figure reflects the adjusted NPV after factoring the different financial metrics and gives an effective climate VaR of -6.51% compared to the baseline scenario.
This method of Climate VaR calculation is context specific to the current cash flow of the asset and would change based on the projected income, holding period and climate pathway.
Currently, the four financial metrics are shown on the platform under Financial Impact Analytics.
Related to this, our cash flow calculator function allows users to input relevant values of a DCF model and obtain the expected Climate VaR directly.
