In his previous Medium article, Logan Soya, Aquicore’s Founder and Executive Chairman, covered why carbon valuation adjustments are coming to the capital markets sooner than people realize. This article offers a simple 5-step approach to performing a valuation adjustment based on the carbon emissions.
These are early days in the rapidly evolving landscape of climate finance and carbon performance pricing. While doing research on this topic, I found both overly simplistic anecdotes and hyper-complex models that require excel acrobatics — but nothing in between. I hope this article can give readers a practical starting point for carbon performance pricing in any valuation process.
I find the adoption of a valuation method usually occurs when it is “simple but not simplistic” — that is, when investors and operators can easily remember a framework during their daily thinking, but holistic in how it approaches a problem.
This valuation method builds upon the work of the Science Based Target initiative (SBTi), the emerging global standard for corporations and asset managers to perform science-based carbon emissions reporting. This valuation method comprises five parts. Parts 1–3 are largely borrowed from the standard process for creating an approved SBTi target, where steps 4 and 5 offer insight into how an investor can use this as a baseline for valuations:
- Know your Emissions Coverage
- Set a Base Year
- Set a Target Emissions Pathway (using the GMAT!)
- Report Carbon Performance
- Apply a Carbon Multiple
By taking these five steps, investors and asset owners can get a basic idea of what a carbon valuation adjustment might look like for a particular investment. Below, I will summarize each step, provide a quick example, and conclude with final thoughts and caveats.
1. Know your Emissions Coverage
For the uninitiated, carbon emissions are a measure of volume (kgCO2e). I won’t cover how to calculate emissions in this article, but know there are credible methodologies to do this based on your given business activities. The total emissions of an asset for a period is called its absolute emissions.
In addition to absolute emissions, assets need to report carbon intensity. When comparing different asset types, this is measured in kgCO2e per dollar of revenue (kgCO2e/revenue). For industry-specific comparables, the real estate world has adopted the measure of carbon intensity as kgCO2e/sqft (or kgCO2e/m2 in Europe).
As an investor, you need to know that the reported emissions of an asset covers at least 95% of the total emissions of a prospective investment. GHG Protocol breaks out emissions into three Scopes: direct on-site emissions like those created by a natural gas boiler (Scope 1), indirect emissions from utility consumption (Scope 2), and indirect emissions from corporate value chain activities such as the carbon embedded in purchased materials (Scope 3). In my formulas, I will use a subscript of either (S12) for Scope 1 and 2 or (S123) for all 3 scopes.
For real estate, most of the emissions from annual operations are captured via Scope 1 and Scope 2 emissions. Ambitious investment groups can push to include Scope 3 at the cost of additional data wrangling and some baked assumptions. This could be appropriate when major capital upgrades occurred within the asset or to capture the carbon of purchasing materials during operations like replaced carpet or ceiling tiles. For ground up development, Scope 3 is required, given that most emissions will come from the carbon embodied within materials used in development.
2. Set a Base Year
Similar to tracking revenue growth, investors need to set a base year to track yearly reduced emissions. Given the pace of adoption of SBTi standards and the Net Zero Asset Managers initiative by asset managers and corporations, I expect most companies across most industries will establish a base year between 2015 and 2025.
In order for an asset to set an SBTi-qualified base year, it requires verifiable Scope 1 and Scope 2 data. If Scope 3 data comprises over 40% of asset emissions, then Scope 3 is also required. Given market trends within real estate, I expect most institutions will set a base year between 2016 and 2022 with scope 1 and 2 coverage. Investors should look for SBTi-certified reporting to ensure that there is a qualified base year with sufficient coverage.
I will add a “B2018” in the subscript of my formula so that both the base year and the coverage are known for a calculation:
3. Set a Target Emissions Pathway (using the GMAT!)
To comply with the 1.5 degC global target, assets must achieve a minimum rate of CO2 reduction per year. Luckily, the SBTi makes this simple. SBTi defines the global minimum ambition threshold (GMAT) to be a linear annual reduction of 4.2% per year to maintain 1.5 degC rise.
This global emissions pathway becomes the anchor-point for valuation analysis. Assets doing better than the GMAT would trade at a premium, while assets doing worse than the GMAT would trade at a discount.
With a GMAT and the base year, investors and operators can calculate a target emissions pathway, which is a series of carbon intensity targets for each year following the base year. This creates a downward slope of year-over-year emissions reductions for the asset.
For example, let’s assume an asset you are evaluating has a carbon intensity of 5.0 kgCO2e/sqft for an SBTi approved base year of 2018. Then the target carbon intensity for 2020 is calculated as follows:
Repeat this for every year following the base year to create a target emissions pathway that looks like this:
4. Calculate the Carbon Performance
With a target emissions pathway, evaluation looks a lot more like traditional financial analysis. Operators or investors can calculate the asset’s carbon performance by comparing actual carbon intensity vs. target carbon intensity for any year. We multiply the calculation by -1 because values above the GMAT are bad and would be discounted, while values below the GMAT are good and would receive a premium.
For actual performance, I recommend at least 1 year of actual decarbonization performance, demonstrating an asset’s ability to plan and execute decarbonization projects that track to its target emissions pathway. Note that seasonality can play a major factor in emissions of an asset over time, so less than a year creates normalization issues. Top real estate asset owners can provide this now, while I expect that most asset owners will provide this by 2023.
Benchmarks are very early in this space, but based on experience, it would not surprise me to see an asset’s carbon performance (i.e. their target vs actual carbon intensity) vary widely between 5% and 40% today. These wide ranges represent the reality that we are very early in this game.
For forward-looking projections, thoughtful seller and buyers will want to see an ESG project plan — an itemized inventory of initiatives and budgets necessary to achieve the building’s target emissions pathway. In investment underwriting, it is common to require a third-party reviewed Quality of Earnings report (QE) which itemizes and verifies that the underlying client contracts sum up to the advertised revenue of an investment. Similarly, investors should strive for an audited “Quality of Emissions Pathway” (QEP) report that shows a credible path to decarbonization. Sellers can use this report to give the buyer confidence that the asset has a clear and budgeted plan to achieve its Target Emissions Pathway.
Apply a Carbon Multiple
Cap rates, revenue multiples, P/E Ratios and EBITDA multiples all serve the same purpose for investors — enabling us to represent the future risk or opportunity in the valuation of an investment versus its current financial performance. It’s a quick way for investors to do ballpark math over coffee and build mental conviction that a valuation makes sense.
As I mentioned in my first post, this multiple represents forward-looking risks for an asset and includes risks during the investment period, such as:
- Unexpected capital requirements to decarbonize
- Unknown liabilities introduced by new taxes or legislation
- Counter-party risks with partnered lenders and insurers
- Reputation or brand risk
- Other undeclared “carbon debts” that may surface with new carbon accounting and financing regulations.
Applying a carbon multiple against the carbon performance creates the following final formula to determine a carbon valuation adjustment (CVA). Negative carbon performance creates a carbon discount, while a positive carbon performance creates a carbon premium.
This is where the rubber meets the road. With limited benchmarks, most investors have unknowingly set their carbon multiple to 0. As investor conviction grows around the economic risks cited above, and deeper studies piece together a weighted risk analysis, carbon multiples will appear — and sooner than you think. Earlier this week, the RICS (the world’s leading body for property valuation guidance) released new guidance advising that property valuations include sustainability.
I expect multiples to be in the 0.5x — 1x range at first, which is conservative compared to some early reports of carbon valuation adjustments in the 10% to 30% range in Europe. As reporting becomes more regulated by the SEC in 2022 and time marches forward towards critical global climate deadlines, I suspect this multiple will trend up (i.e. the price of carbon will rise as the costs of inaction increases).
A quick example
Let’s take a simple example. It’s 2022 and we are thinking about buying a building with the following basic assumptions:
- Coverage: The building has been calculating and disclosing Scope 1 and Scope 2 emissions since 2020 using SBTi and GHG Protocol standards.
- Base Year: The building reported an SBTi base year of 2020 with absolute carbon emissions of 550K kgCO2e. Carbon intensity is easily calculated by dividing absolute emissions and gross sqft:
- Target Emissions Pathway: Using the GMAT target of a -4.2% linear YoY reduction, we project the Target Carbon Intensity for each future year:
- Calculate Carbon Performance: Using the buildings 2021–2023 actual and projected carbon intensity, we can chart the yearly carbon performance below (it looks like our example building has been lagging the global minimum ambition threshold):
- Apply a Carbon Multiple: last, we need to price in the weighted risk of this building’s carbon performance. Given that past and forward-looking performance doesn’t look too rosy, as a buyer, I would probably expect a higher multiple to represent the higher risks of buying this asset (e.g. 1x instead of a 0.5x). The seller provided no QEP (Quality of Emissions Pathway) report to show that decarbonizing was in their plan, so we can assume the forward projection is not including these costs. I will need to do the work as the buyer to bring in experts and technology to invest in a credible decarbonization plan and assume the execution risks.
Wrapping up: All-in, this example building valuation might have originally priced at $200M before introducing carbon performance pricing. With a 9.95% CVA discount applied, the final sale price comes out to be $180M. A price variation like this is nothing to sneeze at! This discount prices in the future penalties and risks of carbon underperformance which is not being accounted for in the NOI calculations of an asset as yet.
Before wrapping up, I wanted to share a few caveats and considerations as we go beyond a basic example to manifest in the real world. We are in a time of transition where early adoption will occur in select areas before mass adoption. Here are a few market signals for forward-thinking participants to look out for:
- Incentivized Data Collection and Reporting — Capital Market investors should demand for the adoption of science-based carbon emissions reporting within their portfolio. Asset Managers earn credit for adopting this by enrolling in SBTi’s Portfolio Coverage Methodology. This measures the total %AUM covered by an approved SBTi standard. It is one commitment that Asset Managers can make to join the Net Zero Asset Managers initiative. Data collection and reporting can be solved today with well-understood technologies and operational best practices.
- Enforced Carbon Accounting — The Greenhouse Gas Protocol is the internationally accepted framework for carbon accounting and has become widely accepted. The SEC will announce in Q1 2022 required emissions reporting standards and early movers recognize it will take time to establish this level of verifiability behind such reporting.
- Sector-Specific Comparables — One of the biggest breakthroughs will be the establishment of market comparables by asset type, vintage, geography and sector. Once carbon intensity and carbon multiple comparables become more widely known across the investment community, investors will reduce their mental models to 3 simple pieces of information: (1) What’s the current carbon intensity of the asset, (2) What’s the forward-looking carbon performance, and (3) What’s the carbon multiple that the market will pay. This will make Carbon Valuation Adjustments a mass-adoptable practice across all investment asset types.
- Global Price on Carbon — The final nail in the coffin to complete this transition of pricing carbon emissions would be a global price on carbon. The global climate finance community has made significant progress on this topic in 2021 and I think this could be 12–24 months away.
I hope this offers readers a simple mental framework to draw the link between carbon performance and valuation. While not intended to be the perfect underwriting method for all companies, I think this is a solid approach to get started. I’ve been around this topic for many years, but this is the first time that there is enough data and investor sentiment to lend credence to incorporating calculations like this into investment return analysis and price discovery. For those interested, I’ve appended several useful resources and white papers available to those who are interested in digging deeper into this topic.
Note: This blog represents thoughts and opinions that are my own and does not constitute investment advice. Please conduct your own research before making investment decisions. If you enjoyed reading and talking about this topic and would like to hear more from me about this and other areas of climate finance, please follow and share this post.
Here are a few key white papers and resources for those interested in learning more: