Now is the time to integrate climate risk for real estate investors

The United Nations Climate Change Conference (COP26), recently held in Glasgow, has highlighted once again the need to drastically reduce greenhouse gas (GHG) emissions. In order to maintain the global temperature increase well below 2.0˚Celsius, emissions will have to be reduced by 55% by 2030, compared to levels in the 1990s, and reach net zero by 2050.¹

As many industries pledge to do their part in the climate transition, the built environment will need to make significant efforts to reach the targets set by the Paris Agreement. The GHG reduction efforts undertaken so far are not enough. The real estate sector remains one of the largest contributors to global GHG emissions.

Decarbonization targets and strategies to reduce buildings’ related emissions have become a key priority for many real estate companies. Besides increasing social responsibility awareness, this is also driven by increasingly stricter regulations and imposed carbon taxes, which are expected to increase materially in the coming years.

Nevertheless, the slow decarbonization progress and the risks stemming from not meeting carbon neutrality targets raise the question of the potential financial consequences for the real estate sector, if it fails to decarbonize fast enough. It also raises the question of what ways the sector could reduce its carbon emissions.

According to the International Energy Agency (IEA), the built environment represents over 38% (13.4 billion metric tons of CO²) of total energy-related emissions annually. Building operations including heating, cooling and lighting are responsible for 28% of global emissions, while building materials and construction, typically referred to as embodied carbon, are responsible for an additional 11%.

In order to achieve the set targets, the real estate sector needs to decrease emissions with a decarbonization rate of 6% annually (85% by 2050). This challenge requires large investments in retrofitting programs; potentially more than USD 20 trillion (see Figure 1). This represents the only alternative to incurring even higher costs in the form of potential carbon taxes or the risk of stranded assets.

By not reaching the required decarbonization targets, the real estate sector faces a potentially significant financial impact. Considering the total value of real estate globally (around USD 250 trillion²), our simulations show the cumulative costs may account for between 7% and 19% of the global real estate market value, or between USD 19 and USD 48 trillion.

Ever since humans began to build with concrete and steel, the embodied carbon emissions from construction activities have been a significant contributor to the total emissions of the built environment. However, operational carbon emissions still represent the main source of emissions during the typical lifespan of a building.

So, while progress is being made to quantify and reduce embodied carbon, operational carbon emissions remain a priority for the real estate sector. Technologies to retrofit buildings to reduce the carbon footprint are already available in the market, while renewable energy and efficient designs can offset the operational carbon of a building.

Based on publicly available disclosures from 200 companies in the listed real estate sector and their decarbonization strategies, our research shows that the sector is expected to cut its carbon emissions intensity by 43% by 2030. Although this reduction falls below the required levels under COP21, this pathway would considerably reduce the financial impact from potential carbon taxes.

At the current levels of carbon emissions, the cost of taxes on operational carbon alone could easily be equal to 4% of the market capitalization of the listed real estate sector. Furthermore, our research also shows that these potential costs are clearly not equally distributed across the sector, but quite the opposite.

These costs range from insignificant, for some segments, to more than 10% of market capitalization for the worst performing segments. This leads to the conclusion that some segments are clearly more at risk than others. Therefore, investors in the listed real estate sector should already incorporate decarbonization strategies into their valuation framework and investment decisions.

Footnotes

¹ Estimate based on the targets set in the European Union, as part of the European Green Deal.
² Source: Savills World Research (2021): The total value of global real estate.