The (long) road to net zero for the real estate sector

A couple of weeks ago, I gave a talk for a group of executives at Blackrock, on the topic of “the road to net zero” for commercial real estate (slides here). The long road, that is, because the real estate sector is a large consumer of electricity, which is to a large extent produced by gas (and coal)-fired power plants.

While the presentation touches upon many drivers of and barriers on the road to net zero, economists would argue that simply putting a price on carbon, thereby increasing the cost of electricity, goes a long way toward reducing the energy intensity of the real estate sector. Alas, if only life were that simple, and if only policymakers would listen to economists… Current policies mostly focus on subsidies, on decreasing information asymmetry, and on hitting the inefficient part of the real estate market with a stick (e.g. making it unlawful to rent out or sell office buildings that are inefficient, in the Netherlands and the UK).

But recently, vital signs of carbon pricing for real estate have emerged. The city of New York is leading the way here, with Local Law 97 (check this blog by CodeGreen for a detailed description). Under that law, buildings are required to meet carbon emission intensity standards set by the local government, with an initial period from 2024-2029 and the second period (with much lower carbon intensity levels) from 2030-2034. Buildings that have carbon emissions above the threshold will pay $268 per metric ton of CO2. That sounds low, but could run into millions of dollars for large buildings. There is no easy way out for landlords, given that “green” electricity can only be sourced locally, and there is no way there is sufficient generation of fossil-free electricity in the state of New York. Watch this space, as many high-profile landlords will be affected, and opposition is loud.

More recently, the European Commission announced that it will introduce a “mini-ETS” for cars and buildings. The European Union already has an emission trading scheme (ETS), but that only affects heavy industry (and the price of the emission rights remains too low). In the new scheme, slated to be introduced on July 14 this year, CO2 cap-and-trade would apply directly to buildings, putting an additional price on the cost of running a building, thereby incentivizing landlords and tenants to invest in energy efficiency measures. More details to follow (knowing the EU, don’t hold your breath).

Both examples are bringing the real estate sector closer to a world where carbon emissions are becoming a carbon liability, and where inefficient buildings are facing a significant “transition risk” (that is, either a significant capital outlay to reduce emissions, or the risk of a large carbon liability). CRREM, the Carbon Risk in Real Estate Monitor, has developed “carbon pathways” for specific property types in specific countries. Conceptually, these pathways look like this:

Graph 12

Where the black line represents the carbon pathway (or: carbon intensity) of the asset, over time. The carbon intensity may increase following hot weather (more cooling needed) or may decrease as the grid decarbonizes (more renewables, fewer coal and gas-fired power plants). Comparable assets are on the downward-sloping red line, and assuming that the sector as a whole becomes less carbon-intensive over time, there comes a point when the asset is above the threshold or benchmark (similar to Local Law 97 in New York). At that point, the delta between the asset and the threshold becomes the carbon liability, which translates into fines or costly offsets. As an alternative, and assuming efficient markets, landlords will start to invest in the energy efficiency of their buildings, which is of course the desirable outcome.

While carrots and sticks are still the preferred policy measures today, the energy efficiency of the commercial real estate sector is slated to become an even “hotter” topic in the years to come, as carbon pricing and related mechanisms emerge. Buyer beware: the pricing of commercial real estate will increasingly be affected by the extent of its carbon liability.