Among the many challenges mortgage lenders face, tackling the climate change risk posed by the housing market is one of the toughest.
Millions of UK households are living in energy inefficient homes that are rated D to G but that’s not the full picture.
According to the Climate Change Committee, of the 29 million homes in the UK 19 million have an EPC rating lower than C. It’s a staggering number. Worryingly it could be much higher.
Quantifying the energy efficiency risk for lenders
Around half the homes sitting in lenders’ back books have never been rated. Homes that were bought decades ago, pre-dating the Energy Performance Certificate (EPC) rating regime, are lurking on lenders’ balance sheets.
Then there’s the expiration of EPC ratings to contend with. With a shelf life of ten years, thousands of ratings will be out of date.
To achieve net zero emissions by 2050, the government has the housing market firmly in its sights.
UK homes are responsible for producing 20% of the UK’s carbon emissions and mortgage lenders have been called on to play a major role in cutting that number.
Long-term climate risk strategy for lenders
The PRA and FCA want lenders to think strategically about future climate change risks and come up with ways to mitigate them.
But how can lenders quantify their exposure to energy inefficient homes and help improve their portfolio’s efficiency unless they know the full picture?
One way is to use an AVM-type tool to fill in the gaps. Our preliminary solution is under development and estimates the EPC of a property that has never been assessed.
Much like the way an AVM assesses the value of similar houses near to the security property, it could assess the EPC ratings of nearby homes of a similar age and type.
Filling in the gaps in lenders’ portfolios
Being able to rank a property greater or lesser than C or D, for example, would allow lenders to fill
significant gaps in their portfolios.
Having a fuller set of climate change risk data isn’t just a win for accurate reporting to the regulator. It can help lenders make strategic decisions about the new lending they want to do.
A lender may decide to reduce their exposure to the lowest rated properties on the market, for example.
Low-rated properties are a risk because they could lose value over time as they become less desirable on the open market.
If regulations become stricter, they could even become unmortgageable creating mortgage prisoners. And if the homeowner can’t afford to upgrade the property, a cash buyer demanding a big discount could be their only market.
Targeted energy-efficient lending campaigns
Having a complete picture also presents firms with a lending opportunity. It’s not yet known how government will incentivise homeowners to upgrade their homes to an EPC C rating. Or what role lenders will be asked to play.
But it’s certain to be a huge challenge.
The government has estimated that to decarbonise the housing sector between £35 billion to £65 billion of investment is needed by 2035.
By being able to identify all the homes that need upgrading in their own portfolio lenders could launch a targeted further advance campaign to finance borrowers’ improvements.
A campaign like this offers multiple wins.
Almost 750,000 owner occupied homes, or 4.9%, are rated F/G. Knowing that, lenders can write to their customers to make them aware of their rating and the problems it could cause if no action is taken.
Estimating the cost of energy efficiency upgrades
But the campaign could be made even more bespoke.
We’ve been undertaking analysis on the estimated minimum cost of improving a home so it can reach its required grade.
EPCs offer a potential rating and a list of the work that can be done to achieve it. Double glazing, a new boiler, wall and loft insulation are common recommendations.
But the potential rating is sometimes unnecessarily high and in fact only two of five recommendations, for example, may be needed to meet the minimum C grade.
Our study is aimed at estimating that minimum spend. With that knowledge, when developing campaigns lenders know how much needs to be spent, whether they are prepared to lend that amount and if the borrower can afford it.
It will also be clear to see if the spend is proportionate to the value of the home, a factor that would influence a borrower’s willingness to take out a loan.
Giving energy support and transparency to homeowners
And by supporting homeowners who want to upgrade their homes it will reduce the number of properties becoming unmortgageable. This will shrink lending opportunities in the future.
Once the development of the gap filling solution and cost estimates is complete, it’s a straightforward process to provide the additional data alongside our climate change and energy rating pack.
But let’s set the business opportunities aside for a moment.
Engaging with borrowers to share information gathered on their property and explaining the risks they could face is transparent and fair. Goals all lenders strive to meet.
So the case for building a complete picture of energy efficiency is strong.
But a comprehensive climate change risk management system is only possible if back book gaps are
plugged with meaningful and practical data. The challenge is set.
Find out more about our climate change risk products.