A blueprint for evaluating climate risk in real estate

Cutting emissions in the built environment is critical for reaching the goals of the Paris Agreement. It’s also crucial for reducing physical and transition risks in real estate portfolios. But it’s not all risk and no return – investment opportunities also abound. Robeco’s SDP model is designed to uncover the real estate companies that are the most exposed to risk but also those best positioned to profit from the net-zero transition. To do this the model focuses on four key areas:

• Measuring the alignment of company emissions intensities pathways with science-backed benchmarks

• Testing the viability and credibility of companies’ planned emission reduction commitments

• Estimating the costs and future financial impact of ‘green and clean’ capex investments

• Evaluating the shape, speed and impact of regulatory policies and other market forces
  

Buildings generate nearly 26% of all global GHG operational emissions, making it one of the most emissions-intensive economic sectors.^1,2 To reach Paris-aligned climate goals, emissions must plummet (see Figure 1) from current levels. This will be a challenge given the energy inefficiencies and fossil-fuel dependencies of the existing built environment. What’s more, the total floor area is expected to increase by 20% globally in the next decade – more than the existing floor area of North America. Without abatements, emissions will also expand, potentially derailing net-zero efforts to combat climate change.

More importantly, failure to curb energy use and emissions is intensifying the sector’s exposure to transition risks and even stranded assets as regulatory policies and tenant preferences make emission-intensive properties unattractive. Physical risks are also increasing with the frequency and severity of heat waves, wildfires, and damaging floods in summer and freezing cold snaps in winter that are overwhelming energy grids and building systems. Despite tenant discomfort, the brunt of the damage will be borne by property owners, operators and their insurers.

The model is focused on listed companies which own or manage real estate assets. It measures company emission performance based on gaps in its alignment with science-backed sector benchmarks. To simplify its application to investment portfolios, we have designed a single decarbonization score for each real estate company assessed. The score, which ranges from 1 to 100 (worst to best), is the culmination of several streams of analyses that measure a company’s past, present and future emissions intensities against internationally accepted and science-backed sector standards (see Figure 3 for an illustrative company example).³

A high decarbonization score could reflect smaller gaps between emission intensity levels and the industry benchmarks and helps identify early leaders with strong decarbonization momentum.

High scores can also mean that companies (even those with high current emissions intensities) realize the work ahead and have committed to reducing those emissions to required levels. Although scores are principally used to compare the decarbonization performance of companies in the real estate sector, they are designed to be comparable across sectors and investment universes.

Although company emission pledges account for more than half of its decarbonization score, announcements don’t equal execution. And committed capex is ultimately what counts. The IEA estimates over USD 570 billion in energy-efficiency investments are needed annually through 2030 to align with net-zero climate scenarios.

We therefore use a company’s capital expenditures on decarbonization technologies to measure the credibility of its pledges as well as to estimate the potential impact of ‘green upgrades’ on the bottom line. In order to simplify technology cost calculations and apply the model on a global scale, we assume all buildings will, to some extent, undergo deep energy retrofits⁴ which include:

• Re-insulation of the exterior walls, foundations, roofs, windows, and doors

• Replacement of fossil-fuel HVAC systems with all-electric models

• Sensor-based lighting and appliances to reduce energy use

• Installation of energy-efficient water heating

We estimate the magnitude of upgrade investments needed based on a company’s current energy intensity - if it is far above benchmark, larger retrofits will be needed.⁵ Larger upgrade costs could negatively impact a company’s future cash flows and stock price performance. Moreover, when estimates for retrofits don’t match the company’s planned capex for property upgrades, it signals a red flag, which casts doubt on the company’s capacity to achieve its decarbonization goals.

EU countries are farthest along in regulatory planning – frameworks range from building energy codes and minimum performance standards to stipulations on solar energy installations. But regulations in both the EU and in jurisdictions globally are spread too thinly over different mechanisms to have an appreciable impact. And policy variations between municipalities also complicate the analysis. We therefore do not calculate policy costs in the model.

While the push from regulators will intensify as countries honor their net zero commitments, the pull to decarbonize is presently stronger from tenants. This should push property owners towards deep retrofit upgrades in the short- to mid-term. First, demand for certified sustainable space, which is not only less polluting but also more energy- and cost-efficient to operate, is picking up. Second, greener structures enable commercial tenants and building owners to meet their own operational emission targets. Property owners are increasingly forced to renovate simply to attract and retain more lucrative occupants. For this reason, our analysis considers capex costs for green retrofits as more financially material for real estate companies than the impact of regulations or fines at present.

Opportunities don’t stop with customers; renewable energy generated onsite not only lowers a property’s energy costs, but also provides profit opportunities as excess solar power is sold back to the utility. Moreover, over the medium- to long-term, a bigger risk is looming. As sustainable buildings become the new normal, buildings which have not been upgraded to meet sustainability standards are likely to become stranded or impaired assets – generating zero to negative value.

Finally, there is too much data variation and too little transparency in many areas. This means generalized assumptions were applied to make analyses efficient and the model scalable across real estate companies globally. Those assumptions will be refined as more data becomes available. In the meantime, estimates should still provide insights that inform investment teams of the material risks associated with decarbonization and the net zero transition in the real estate sector.