A new challenge: pricing climate risks
In recent remarks, financial regulators across the globe have stressed the importance of understanding the effect of climate risks on the financial system. In a statement released on November 9, 2020, Governor Lael Brainard of the U.S. Federal Reserve stressed the importance of lenders’ abilities to identify and measure the risks posed by climate change. In particular, she emphasizes the importance of moving “from the recognition that climate change poses significant financial stability risks to the stage where the quantitative implications of those risks are appropriately assessed and addressed.” Likewise, the Bank of England expects its regulated financial institutions to understand, assess, and take a sufficiently long-term view with respect to the financial risks linked to climate change. Therefore, understanding how the credit market responds to climate-related risk is a question of first-order importance.
Our empirical study
Our recent work examines whether and to what extent lenders incorporate climate-related risk exposure in the residential mortgage markets. In particular, we investigate whether the pricing of mortgage loans depends on the exposure of properties to rising sea levels. Using a sample of more than one million mortgage loans originated across the United States, we find that the interest rate for mortgages in a ZIP code where all properties are exposed to sea level rise (SLR) risk is approximately 13 basis points higher than the interest rate for mortgages in a ZIP code where none of the properties are exposed to SLR risk. For the average borrower in our sample, this increase in interest rate translates into an approximately $14,000 increase in financing cost. This evidence is consistent with the view that banks account for the increased likelihood of flooding posed by rising sea levels as a long-term tail risk.
Identifying the effect of sea-level exposure on mortgage prices is challenging, as banks take many variables into account when making their loan pricing decisions. Most importantly, homebuyers in areas with a greater exposure to sea-level risk could have a different level of credit risk compared to homebuyers in other areas. For example, wealthier individuals may obtain a mortgage to purchase properties closer to the coast, and banks may take into account the wealth of these borrowers to determine their mortgage rates.
Our empirical approach controls for these variables in two ways. First, we restrict our sample to properties within 30 kilometers of the coast, such that the properties in our sample are more likely to have similar characteristics even with variation in their exposure to increased flood risk. Second, we employ a tight estimation model that compares mortgages that are originated in the same year and in the same county, for properties with similar characteristics (i.e., distance to the coast, elevation above sea level, property type, and property appraisal value), and for borrowers with similar risk profiles (i.e., FICO scores and loan-to-value ratios).
Through additional analyses, we shed light on two fundamental features underlying the sea level risk premium. First, our evidence strongly suggests that lenders view rising sea levels as a long-run climate change risk. Lenders demand a risk premium even from borrowers whose properties will not be inundated until sea levels rise by six feet—a development not expected for many years. In line with this view, we find no significant relation between the property’s exposure to sea-level rise and the interest rate on short-term mortgages with a duration of less than 30 years. We also do not find the exposure to these risks to be correlated with borrowers’ default rates or creditworthiness.
Second, our overall results suggest that lenders are not equally equipped to incorporate climate risks into mortgage prices and that there are several barriers preventing lenders from pricing in this risk. Specifically, we find that the risk premium is more salient in areas with a greater exposure to extreme weather events, such as floods, hurricanes, or tropical storms. In addition, the effect is stronger after the occurrences of deadly hurricanes and after important climate change events have been covered in the news media e.g., after Copenhagen Climate Change Conference in December 2009 or the Paris Agreement in April 2015. We also find that the risk premium is more prevalent in neighborhoods in which local residents are more likely to believe that climate change is happening. Our overall results suggest that it is the belief in climate change, reinforced by a greater exposure to natural disaster events, that drives the risk premium.
Our study presents new evidence about how financial institutions respond to climate change risk. Given the size and importance of the residential mortgage and the increasing association between climate risk and extreme weather events, understanding how mortgage lenders incorporate climate risk into their lending decisions is a priority for borrowers, lenders, and policymakers alike.
Additionally, our study also contributes to a better understanding of the effect of climate change on the overall financial markets. Existing studies have found that stock market investors in general tend to underreact to the effects of climate change; more sophisticated institutional investors, consider climate change risks to already be present and consequential. Our study shows that banks, which are also sophisticated investors, do take climate change risk into account in their investment decisions. Nonetheless, our study also documents obstacles that may prevent banks from recognizing and pricing this very important risk, including exposure to high-profile disasters and public beliefs in climate change. Finally, our study also highlights how climate change can influence the total cost of homeownership. While previous studies find that prices of residential properties are lower in areas exposed to flooding, this reduction in prices is partially offset by the increased costs of mortgage credit.