Is the Reduction of Carbon Emissions a Pipe Dream?

Despite Another Disappointing COP Meeting, the Real Estate Sector Continues Its Journey to Net Zero

You’d be forgiven to have forgotten about the recent COP summit in Egypt (in case you didn’t miss it altogether). The goal of this annual jamboree is for countries to discuss how to reduce global carbon emissions, such that the world stays below 2 degrees of global warming -- a scenario in which climate change would be kept “under control.” This year’s talking-fest yielded depressingly little progress. But, optimists behold, the real estate sector is still making progress:

- Some leading developers have recently committed to and are working on reducing carbon emissions from the construction of the real estate, an important source of emissions;

- A plethora of real estate investors have formally declared net-zero targets for their existing real estate portfolio, making strides to improve the energy efficiency of assets in the current stock;

- At the top of the food chain, an ever-growing number of pension funds and other asset owners are screening investments in REITs and private equity funds on anything ranging from ESG commitment to actual carbon reductions;

- Comparable to their equity-providing peers, lenders to real estate are increasingly asking for either a minimum energy performance level for assets to be financed, or require a business plan for the energy efficiency of assets to be improved;

- Policymakers around the globe are targeting the real estate sector, either requiring minimum energy efficiency standards for existing buildings (stick), or connecting taxation to energy efficiency levels (carrot).

When the COP-21 meetings took place in Paris, in 2015, most developed countries committed to reducing carbon emissions such that global warming would stay below 2 degrees Celsius. The terms of the agreement were (and are) broad, but come down to substantial reductions in national carbon emissions, with global carbon neutrality as the goal for 2050. Replacing coal- and gas-fired power plants with renewable energy, such as solar and wind, is an important element of the plan that each country has committed to developing. But reducing energy consumption in the most intensive sectors, including transport, manufacturing, and buildings, is the second main pillar.

Indeed, buildings are a significant carbon culprit, directly and indirectly, responsible for 37% of global carbon emissions in 2021, a small uptick from the COVID years, and even above 2019 levels. That’s not new news, and pressure has been put on the property sector to reduce carbon emissions for at least a decade now. That pressure comes from governments, asset owners, lenders, as well as those companies and individuals residing in buildings. The recent, war-induced energy crisis in Europe has exacerbated the relevance of energy efficiency for anybody active in real estate, most acutely those paying the bills, i.e. the residents and tenants.

Even though the recent COP meeting in Sharm el-Sheikh was a waste of resources (and carbon emissions), at least to the outside observer, the private sector has embarked on a glide path to reducing carbon emissions. And once the business is on a path, it will stay the course, for (hopefully) a safe landing, with destination net-zero carbon, in 2050. Indeed, there are many indications that the real estate sector is moving towards decarbonization. Here are some highlights:

- An often-overlooked source of carbon emissions comes from the construction of buildings. The production of concrete, steel, and other carbon-intensive materials, as well as their transport from construction to the building site, make up a big chunk of the sector’s carbon impact. Some leading European developers, most notably Edge Technologies, have committed to net-zero carbon construction by 2050 while reducing the total carbon footprint of new construction by at least 50% as of today. Add to this the rise of mass-timber construction (such as the poshy The William in London, and the impressive mixed-use development Arboretum in Paris), and the future footprint of new construction may be reduced substantially.

- Energy efficiency in existing buildings is a harder nut to crack, not least because tenants typically pay for energy while owners pay for investments in energy efficiency. There’s a rising tide of regulation to nudge, if not force, building owners to improve the energy efficiency of buildings they own and operate. Most bluntly, the UK has banned transaction activity on offices with energy performance certificates (EPCs) of F or G on a scale from A-G, while Holland goes even further, banning transaction activity for offices with an EPC of D or lower (on a similar scale). New York takes a somewhat more market-based approach, setting a carbon cap for each building (exceeding 25,000 sqft) in the city, with a fine for building owners that fail to reduce carbon emissions sufficiently (40% by 2030 and 80% by 2050). Governments doling out carrots are hard to find, but as pointed out by the Economist, Belgium has taken an interesting approach, allowing for rent increases in energy-efficient rental homes only.

- Private equity real estate firms and REITs, who jointly represent the vast chunk of institutionally-owned real estate, are out-competing each other in the race to net zero. At least when it comes to net-zero commitments. The Science-Based Targets Initiative currently counts 194 real estate investors amongst its ranks, with clear, publicly communicated targets. At the most aggregated level, GRESB reports that carbon emissions decreased by -0.5% in 2021, after a massive 8.2% drop in 2020 (due to much of the real estate sector being closed following COVID).

- Lenders, not known for being the most progressive stakeholders, are increasingly joining the carbon-reduction chorus. Corporate green bonds and sustainability-linked bonds are frequently used by real estate investors (although current interest rates have somewhat reduced the appeal of debt financing), and some commercial and residential mortgage lenders are also incorporating energy efficiency requirements or clauses into their terms – this is often on the back of local government regulation, which makes non-efficient assets more risky collateral for lenders.

Of course, this is mostly a “developed world” view of what happens in construction and in the existing stock. Given that the largest share of construction takes place in Asia and Africa, the real carbon impact, or carbon emissions to be avoided, is not in the Netherlands or New York, but in Bangalore or Beijing. This is similar to coal being phased out in developed markets while coal-fired power plants are still developed en masse in China and India.

Perhaps this is where COP comes back in – after all, a bottom-up improvement in the energy efficiency of buildings needs to be supported by top-down coordination on energy generation. Otherwise, we may well hit our 2050 target in terms of reducing on-site consumption but still fail miserably with the remainder of building energy consumption coming from “dirty” sources. Let’s hope that next year’s meeting in the United Emirates (another shining star in sustainability) leads to better, and more tangible outcomes, nudging and helping emerging economies to transition to clean energy and low-carbon construction.

In the meantime, the real estate sector should stay the course. The technology, business case, and capital are all there -- let’s keep on moving buildings from “brown” to “green.”