Use Case: AlphaGeo for Climate-adjusted Valuation
How analysts can use Climate Financial Impact Metrics to forecast climate-adjusted cashflows
Last updated
How analysts can use Climate Financial Impact Metrics to forecast climate-adjusted cashflows
Last updated
At AlphaGeo, we offer Climate Financial Impact analytics that are easily incorporated into standard financial frameworks, including Discounted Cash Flow models for climate-adjusted valuation. 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, analysts can forecast the climate-adjusted NPV of an asset or portfolio. We then calculate the Climate Financial Impact 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 Financial Impact of -6.51% compared to the baseline scenario.
