The ESG Interview: How Green Is Your Property Portfolio?

Jana Hock, Senior Research Officer for Climate Change at ShareAction, warns investors may carry the cost as regulators ramp up pressure for change in real estate.

Real estate does not always sit high on the list of sectors targeted by asset managers and owners for engagement around climate-change risks. But that’s likely to change as it becomes more widely known that buildings account for significant levels of carbon emissions across their lifecycle, from the drawing board to the wrecking ball and all stages in between.

Whether it’s ‘embedded’ carbon – the sources of emissions stemming largely from materials and construction – or the ‘operational’ carbon that arises from how a building is used, targets are being set and regulators are exerting pressure for change.

It’s time investors found out more about how to reduce their exposures, suggests Jana Hock, Senior Research Officer for Climate Change at ShareAction, and author of a new report, ‘Decarbonising Real Estate – Foundations for Success’.

“It’s such a massive sector that it’s too big to ignore. It makes up so much of our emissions. The stats speak for themselves,” she says.

Estimates by the World Resources Institute suggest energy use in buildings contributes around 17.5% of global greenhouse gas emissions, while their construction drives demand for cement and steel, collectively accounting for more than 10%.

According to the World Green Building Council (WGBC), alignment with the Paris Climate Agreement means new buildings must have net-zero operational emissions by 2030, with net-zero embedded carbon by 2050, including a 40% reduction from today’s levels by 2030. Retrofitting existing stock to improve energy efficiency should take place at a rate of 5% per annum.

Decarbonisation across the lifecycle

Buildings’ embedded carbon emissions start with design and construction, particularly involving the constituent materials and construction process, but also include those generated by renovations and maintenance over time. The ‘operational carbon’ that typically receives most attention is a function of the energy needs of residents and users of the buildings, with emissions determined by power source and demand levels. At the end of its lifecycle, the demolition process and disposal of remaining materials can also add to a building’s emissions.

Hock sees it as necessary for the real estate sector to pursue decarbonisation across the full lifecycle of buildings and says it is important that the future challenge of reducing embodied carbon is not seen as secondary to cutting operational carbon, much of which can be addressed now. As well as use of renewable energy sources, this means reducing demand through changes to how buildings are heated, cooled and insulated, including use of double-glazing and reflective surfaces.

Across these elements, Hock says, no one aspect is contributing significantly more emissions than any other. And although the overall ratio of embedded to operational carbon averages at 50:50, it varies by type and location. Nevertheless, the order of priorities for firms in the real estate sector and their investors are driven by the possible. We can drive down emissions today by changing energy sources and certain materials and processes now, while anticipating future breakthroughs in low-carbon cement and steel for example.

“Some of that technology isn’t there yet,” says Hock. “For embodied carbon to be net zero, all the input materials to buildings need to be net zero, and that is heavily reliant on sectors like steel and cement.”

There are positive developments in these areas, with collaborative initiatives making headway on new production processes which will eventually reduce embedded carbon. But, as Hock notes, they “definitely have a bit further to go”.

“We have a lot of solutions that are ready for operational carbon to come down to zero,” she says. “We already have infrastructure to make sure we only use renewable energy, as well as solutions such as heat pumps, which use far less energy and are much more efficient, and therefore environmentally friendly.”

Regulators ratcheting up the pressure

Hock argues that regulators and policy-makers are already taking many of the necessary steps to incentivise the real estate industry and its suppliers to make an orderly transition toward net-zero emissions by 2050. Further, she sees a gradual tightening up, which will oblige firms to adapt over time, both through industry-specific regulation and broader frameworks such as the EU Taxonomy Regulation, designed to govern the constituents of green investment solutions.

“We already see a lot happening on the regulatory front. This sector needs to get down to net zero by 2050 and regulators are aware of that. This is why we are currently seeing a wave of new and also tightened regulation coming in,” says Hock.

In terms of regulatory pressure to reduce operational carbon, Hock cites the potential for the EU Emissions Trading Scheme (ETS) to be extended to include more emissions from building operations. Currently, the EU ETS covers 30% of buildings’ heating and cooling emissions, but an imminent review is expected to price in more buildings-related emissions. Also imminent is a tightening of energy performance standards for buildings, as well as a wave of EU policy aimed at renovating and improving the energy efficiency of existing buildings.

The Buildings Directive requires all new buildings to be ‘nearly zero-energy buildings’ (NZEBs), with all stock required to meet Paris-aligned energy efficiency targets. In recognition that the vast majority of European housing stock will still be standing in 2050, the European Commission has launched a ‘renovation wave’, which provides financial incentives aimed at doubling the prevailing rate of energy renovations over the next decade, for residential and non-residential buildings.

“We see a host of regulation coming in on operational carbon. That doesn’t mean embodied carbon is completely being left behind, although it’s certainly a bit of a laggard,” says Hock. The current emphasis will evolve, in part due to the EU Construction Products Regulation, due for revision in 2023, which will gradually reduce carbon levels in building materials to zero.

The likely introduction of carbon pricing will also have an impact, with developers gravitating toward designers and contractors who build using cheaper, low-to-no carbon materials. “We will probably see a quite natural, market-led change in the cost competitiveness of traditional materials that have not decarbonised,” suggests Hock.

In addition, the voluntary EU ‘Levels’ framework, which sets sustainability and decarbonisation standards for buildings throughout their lifecycle, could become compulsory.

Regulatory drivers of emission reductions in the UK are less advanced, partly explained by the time required to develop domestic alternatives to European initiatives. In addition, successive governments have been reluctant to make low-carbon targets for buildings compulsory, and incentives such as the Green Homes Grant have faced implementation challenges. This is unlikely to continue as the UK looks to coordinate global efforts on several fronts in the run-up to COP26, which it is scheduled to host in November.

“Regulators are slowly, but surely getting on top of decarbonising buildings, and that that is obviously critical to investors as well,” she says. “For example, under the EU Taxonomy, a building has to be around 20% more efficient [from an energy use perspective] than currently required under the highest net-zero building standards to count as a green investment. We really have regulation coming in from all sides, some even targeted at investors directly.”

The costs of delay

The International Energy Agency (IEA) has put the case for immediate action from firms in the real estate sector in terms of savings versus delayed response.

“Waiting another ten years to act on high-performance buildings construction and renovations would result in more than two gigatonnes of additional CO2 emissions from 3,500 million tonnes of oil equivalent of unnecessary energy demand to 2050, increasing global spending on heating and cooling by US$2.5 trillion,” according to a 2019 report by the agency.

“Decarbonisation poses a really significant risk to investors within the real estate space,” adds Hock, warning of potentially severe downside risks from reduced resale values and rental revenues, resulting in stranded assets.

“If these things don’t happen, we will most likely see decreasing resale value for property that does not align with new decarbonisation standards, which obviously will have massive effects on real estate portfolios.”

And retrofitting once might not be enough, warns the ShareAction report, noting that upgrade projects “might be needed sequentially to meet increasingly stringent standards over time”.

“It is not completely out of the question that incoming regulation that is likely to be tightened over the years in order to achieve net zero would put limitations on the renting out of real estate assets if they are not met,” adds Hock.

Although the report’s recommendations are focused on investors’ equity exposures to real estate, Hock says they could also be adapted for use by investors with direct or indirect exposures, e.g. through engagement with managers of real estate investment trusts.

“Real estate is a big term for a lot of underlying assets,” she acknowledges. “Decarbonising an office building is going to be significantly different from decarbonising a residential building. So, any investor’s strategy is going to depend on the areas they’re involved in across construction, development or demolition company.”

Engagement priorities

In some respects, investors already know the drill when it comes to assessing the past record and future pathways of real estate firms as they transition toward net-zero emissions.

According to the ShareAction report, asset owners should insist on investee companies and firms all along the value chain setting quantifiable interim targets, as part of an overall emissions-reduction strategy baked into their overall business plans, with transparency on governance, incentives, advocacy and expenditure, as well as reductions achieved.

Disclosure is fundamental, but this should mean not only reporting in line with universal frameworks such as the recommendations of the Task Force on Climate-related Financial Disclosures. Property labelling via the EU’s Levels guidelines or similar best practice standards is also encouraged.

In addition, says ShareAction, investors should look for adherence to both mandatory regulation and voluntary guidance, as well as involvement in corporate initiatives aimed at specific low-carbon objectives, such as those overseen by the Climate Group.

These include RE100 and EP100, which represent a wide range of firms focused on increasing their use of renewable power and improving the energy productivity of buildings, while Steel Zero is a demand-side coalition dedicated to using net-zero steel by 2050.

The report also recommends use of lifecycle assessments of inputs and environmental product declarations, which allow designers to compare product specifications with a view to identifying and using the lowest carbon materials and setting overall targets.

The list of areas for investors to consider when engaging real estate companies may seem exhausting, even though it is not exhaustive. Regulatory change should, over time, help to supply investors with more relevant data through improvement of disclosures.

No matter how complex and multi-faceted the challenge of decarbonising the real estate sector, it is just one element of a much bigger picture, notes Hock.

“When we’re talking about decarbonising real estate, we’re also talking about the demand signal that the sector is sending upstream, particularly where it buys its construction components. It’s super important for property development companies and similar to have a strategy for decarbonising their assets, but it’s just as important for them to be sending signals to steel, cement and aluminium manufacturers in order to speed the whole value chain to reach net zero in time.”

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