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    Facing the implications of net zero for UK housing

    Facing the implications of net zero for UK housing

    14 March 2022 Responsible investment, Fixed income

    UK residential mortgage-backed securities (RMBS) can be an attractive source of potential returns and low risk. While physical environmental risks for UK housing are well known, we believe the transition risks arising from striving to reach the UK’s net zero target need to be addressed. One of the ways that we are helping to highlight and tackle these risks is through our Secured Finance team engaging with mortgage lenders to drive better energy efficiency in UK housing.



    UK mortgage originators, whether banks or alternative lending platforms, have yet to incorporate environmental metrics into their underwriting criteria, largely because it is very difficult to prove a correlation between environmental metrics and credit outcomes.

    However, we believe that on its current trajectory, climate change would have very negative consequences for the UK mortgage market. While physical risks are being addressed to some extent, we believe the risks associated with achieving the UK’s net zero target are material and requires a lot more focus.

    Physical environmental risks to UK housing are being managed but more work is needed

    Physical environmental risks are not new to the UK housing market. For example, Japanese knotweed – a highly invasive, fast-growing plant that can physically damage property and is extremely difficult to eradicate – has impacted 5% of all UK houses, according to one estimate1, leading to house price declines of 20% in properties with no insurance2. Mortgage lenders have been aware of this issue for many years and adjusted their lending practices accordingly.

    With regard to climate change, a rise in global temperatures is highly likely to increase catastrophe risk, including flooding in the UK3. House prices in flood-prone regions could see large price drawdowns, negatively impacting credit outcomes.

    The physical risks from climate change are being addressed by UK mortgage lenders. The first round of Task Force on Climate-Related Financial Disclosures (TCFD) reports from UK banks show that when physical risks such as flooding are considered, especially as part of the underwriting process for lending, there is lower risk exposure for the properties within their lending portfolios versus the UK average.

    While incorporating physical risks into the underwriting framework is a positive first step, we believe more could be done to tackle the impact of climate change by providing innovative products that support homeowners against such catastrophes, like ‘green further advance’ mortgages, which give borrowers access to better lending terms for energy improvement projects.

    The risks from transitioning to net zero carbon emission targets still loom

    UK housing today would miss the government’s climate change goals by a factor of almost 2.5 times. If emissions do not fall dramatically, temperature rises above 2⁰C are conceivable, which would undoubtedly increase physical risks across the UK.

    The £94 billion challenge for UK housing

    The UK economy has set itself on a path towards a greener, less polluting economy. This transition toward a lower-carbon world has many associated risks, which are arguably more impactful to the economy than physical risks alone.

    The UK housing market is far from energy efficient, with an average household energy performance certificate (EPC) rating of D (ratings range from a high of A to a low of G). In 2020, with 27.8 million households in the UK, data from energy providers suggests UK housing emits almost 100 million tonnes of CO2 each year, accounting for 27.9% of the UK’s total 326.1 million tonnes of CO2 emissions in 20204.

    The UK government has set one of the most ambitious climate change targets in the G7, aiming to reduce CO2 emissions in 2035 by 78% from 1990 levels5, meaning the UK would need to emit a total of only 140.1 million tonnes of CO2 emissions6.

    Assuming the housing market continued to account for 27.9% of the total emissions, by 2035 the average UK household would need to have at least an EPC rating of C in order to comply with these government targets.

    The cost to upgrade a home from an EPC rating of D to C alone has been estimated at costing £6,1557. With almost 55% of homes having an EPC rating below C, this would imply a total cost of £94bn. The government has announced plans to support this transition, but more will need to be done8.

    Table 1: Emissions from an average UK home according to its EPC rating

    EPC rating CO2e kg/year CO2e vs A rating
    A 684.52 1x
    B 1,048.17 1.52x
    C (minimum for net zero) 1,775.47 2.59x
    D (UK average) 2,524.17 3.69x
    E 3,272.86 4.78x
    F 3,968.08 5.8x
    G 4,278.25 6.25x

    Source: Insight Investment analysis and Energy Rating.

    How energy efficiency can predict mortgage risk

    A recent study conducted by the Bank of England analysed borrower-level data on mortgage arrears against energy efficiency ratings across 1.8 million homes9.

    There was a quantifiable difference in arrears against energy-efficient properties, typically 0.2% lower versus less energy efficient properties. Prime mortgages in the UK typically see late-stage arrears of around 1%, showing that less energy efficient homes increase credit risk by at least 20%, allowing the study to conclude that energy efficiency is indeed a relevant predictor of mortgage risk.

    Increased engagement to help mitigate the impact of the climate transition

    We believe investors, including Insight, must work alongside originators to help the government achieve its 2050 net zero targets. At the same time, the asset-backed market accounts for only a fraction of total mortgage lending in the UK, so there must be a greater effort by government entities to promote improvement in the energy efficiency of homes.

    Insight’s Secured Finance Team has therefore engaged with a range of issuers to discuss the risks arising from climate change.

    In 2021, we worked with a UK mortgage lender to introduce green incentives, whereby new and current borrowers could access better borrowing rates if they were able to improve the EPC rating of their property by at least one notch. We are striving to continue this engagement process with originators in both public and private transactions to promote awareness and help enact policies which can begin to improve the trajectory for UK housing.

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