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11 Oct 2022 - Decarbonise real estate or be left behind
By: abrdn

Decarbonise real estate or be left behind

abrdn

August 2022


Market sentiment on China has become especially fragile of late amid fears over near-term growth. However,

We are in one of the most significant periods of change for real estate. Seismic shifts are taking place as we respond to climate change and decarbonise assets. It is clear the changes will be dramatic and they will be apparent well before some market participants currently assume. The conflict in Ukraine and the resulting higher costs for fossil fuels have sharpened the focus on decarbonisation. At this stage, adopting an agile response and taking steps to prepare for the effects of the transition to net zero are vital. This will allow investors to mitigate the impact on valuations, returns, investment activity, and the future investibility of their assets.

The momentum is building

There is increasing pressure on asset managers to reduce the emissions from the assets they manage. Extreme global environmental changes combined with pressure from governments, investors, regulators, occupiers and employees are forcing change. With the built environment accounting for around 40% of global carbon emissions, the commercial real estate investment sector is in the spotlight. Real estate has a large part to play in limiting global warming to the 1.5 degrees threshold.

While the target of net-zero emissions for buildings is necessary, how to get there is still not clear. Government policies at a global level lag well behind what is required. As a result, the gap has been filled with a proliferation of voluntary standards, such as the Better Building Partnership, the World Resources Institute, and the World Green Building Council. While these are well-intentioned, they are often contradictory. And in the absence of a common definition of what 'net-zero carbon' means, they can cause significant confusion.

A clear trend is emerging where real estate assets with a higher sustainability specification can command a premium, while those that don't are vulnerable to a 'brown' discount.

More sustainable assets are commanding a premium

A clear trend is emerging where real estate assets with a higher sustainability specification can command a premium, while those that don't are vulnerable to a 'brown' discount. Ramping up sustainability performance standards is certainly increasing obsolescence (no longer fit-for-purpose) in buildings. But measuring rental premiums, lower void periods and higher valuations for more sustainable assets is likely to remain challenging, given there is limited data and evidence on which to base assumptions.

Regulatory confusion isn't helping

The current reliance on Energy Performance Certificates (EPCs) across Europe illustrates some of the issues with the existing regulatory regime. EPCs can be helpful in providing information about a property's theoretical energy use, but they tell us nothing about the actual energy used in practice. The key European Union (EU) sustainable finance regulations rely heavily on EPCs. But how these concepts are implemented by each member state renders cross-border comparison nearly impossible. At present, the same building will be efficient or inefficient (under the Sustainable Finance Disclosure Regulations), or it will be sustainable or unsustainable (under the EU taxonomy classification of sustainable activities), based purely on the country in which the building is located.

Estimating the future impact of decarbonisation on assets.

What is the expected cost of decarbonising real estate? No one really knows. The heterogeneity of the asset class and the uncertainty associated with the recommended path to net zero make it difficult to quantify. Numerous factors will have a sizeable impact on the cost. For example, the age of the asset, plant and machinery; the complexity of the layout; the geographic location of the asset; or the costs of construction in the country concerned.

Furthermore, the decarbonisation or otherwise of the electricity grid in a particular country where there is a high level of green energy (nuclear energy, for example) will reduce the overall decarbonisation costs. The degree of global warming in the country concerned will also affect the decarbonisation start and end points. Countries that are more susceptible to global warming will have a greater need to decarbonise quickly.

So how do investors begin to put a cost on decarbonisation? Estimating a decarbonisation cost for the average asset in a particular sector, within a specific country, and taking account of the sustainability of the grid, gives a benchmark starting point. Investors can then collaborate with expert consultants, such as JLL, Verco, and Evora, to analyse assets on a bottom-up basis. This provides the key data that can be used to refine the broad averages.

We take a multi-pronged approach

The key challenge at the moment is finding a consistent pathway to net zero. It needs to take account of different sectors, countries, future climate change, and the sustainability of energy sources in each country. The science-based energy emissions guidance from CRREM (Carbon Risk Real Estate Monitor) is our starting point. This is then combined with the extensive bottom-up data that we have collected from external analysis of our assets. We then take a view on the most appropriate numbers based on our country or sector views. We expect our guidance to evolve as we build up a more precise database of expected and actual costs.   

So what does this mean?

Given the undeniable impact of global warming, along with the ever-tightening and more onerous sustainability regulations, the real estate industry is under pressure to change. Investors are becoming much more aware of the need to tackle excess emissions in their assets.

We are at the early stages of investors pricing in the likely costs associated with 'good' and 'bad' sustainable assets. But given the level of scrutiny in this area of real estate, the pace of change is gathering significant momentum.

Some investors will be left with assets that require too much capital investment to be viable. These assets may not attract tenants or they may not generate a cashflow in the future. Indeed, they may even become obsolete, where the only course of action will be to knock them down. We are taking significant steps now, to avoid such extreme measures in the future.

Author: Simon Kinnie, Head Of Real Estate Forecasting and
Ruairi Revell, Head Of Real Estate Esg (Core, Plus And Value-Add Funds)


Funds operated by this manager:

Aberdeen Standard Actively Hedged International Equities FundAberdeen Standard Asian Opportunities FundAberdeen Standard Australian Small Companies FundAberdeen Standard Emerging Opportunities FundAberdeen Standard Ex-20 Australian Equities Fund (Class A)Aberdeen Standard Focused Sustainable Australian Equity FundAberdeen Standard Fully Hedged International Equities FundAberdeen Standard Global Absolute Return Strategies FundAberdeen Standard Global Corporate Bond FundAberdeen Standard International Equity Fund Aberdeen Standard Life Absolute Return Global Bond Strategies FundAberdeen Standard Multi Asset Real Return FundAberdeen Standard Multi-Asset Income Fund

 

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