We’re kicking off 2022 with Logan Soya, Aquicore’s Founder and Executive Chairman. In his most recent Medium article, Logan introduces carbon discounts and premiums and discusses the implications for real estate.
In 2022, carbon performance data, climate finance, and net-zero commitments from the capital markets will culminate in a tipping point that will begin to affect asset valuations.
Real estate investors are at risk of seeing asset valuations affected earlier than other asset classes, however, they have an opportunity to create plans now to align their investments with capital market expectations and outperform slower moving competitors.
This is the first of a two-part post to dive into what carbon discounting is and how it might work. In the first post, I’ll introduce carbon discounts and premiums and why they make sense. In the second post, I will provide a framework that investors can use to think about how they can apply this risk to their underwriting.
Let’s dive in.
What are carbon discounts?
Put simply, a carbon discount is a discount on the valuation of an asset that is underperforming against a carbon reduction target. Conversely, a carbon premium is a valuation premium for an asset that is over-performing against said target. Throughout this piece, I will occasionally refer to these price adjustments generically as “carbon valuation adjustments”.
I’ve often wondered how and when investors will incorporate the risks of achieving carbon reduction goals into the investment valuation process. Throughout my career, I have taken part in the evolving ESG narrative, and even founded a company for financially minded real estate investors centered on ESG data collection and analysis. COP26 and 2021 marked a turning point where this topic became essential for financial investors worldwide. Top insurers like Lloyds and governing bodies like the International Renewable Energy Agency estimate that between $10 trillion to $40 trillion worth of assets are at risk of becoming economically stranded over the next 30 years as the world transitions to a low-carbon economy.
All of this has led investors and analysts to ask: how do we incorporate these risks into our financial valuations for investments we are making today?
Today’s missing link between ESG and carbon reduction
In 2021, the capital markets were abuzz with ESG as the latest Wall Street investment craze. Private equity, asset managers, ratings agencies and many more have all jumped into the fray, looking for ways to understand how climate data can be collected, synthesized, and monetized into reporting so that equity investors can show the inclusion of climate risk into their investments. However, as a former physics student, I’ve always found these scores a little shallow when it comes to reporting “science-based progress” towards climate change prevention.
It would probably surprise the casual observer to learn that, in most cases, ESG scores today mostly do not factor in a company’s progress towards decarbonization. As a recent landmark report by Bloomberg points out:
“most ESG reporting systems flip the notion of sustainability. Instead of measuring the risk that companies pose on the world, these ratings grade the risk the world poses on the company (and its profits).”
While the details of ESG indices warrant their own post entirely, the basic idea is that ESG scoring today measures the resiliency of an asset against a physical climate risk (e.g. sea level or forest fires), and not the progress an asset makes to decarbonize. Thus, if an investor sold a property in Miami to acquire one in New England, their portfolio ESG score would increase because the new asset possesses less physical risk from rising sea levels. This means the score may improve even if New England property has a bigger carbon footprint. This is an oversimplification — and only one of many issues with ESG reporting today — but you get the idea. (Bloomberg’s article above goes into excellent detail for those interested in learning more).
The move to carbon performance investing
I expect and hope that more investigative reporting will press ESG and financial disclosure to tie more closely to science-based measures of climate performance instead of profit protection. While there’s still much work to do, I can thankfully say that 2021 marked a major shift: investors are now actively seeking more direct reporting capabilities of carbon emissions.
The most notable example of increased investor focus on climate performance reporting is the adoption of the Net Zero Asset Managers initiative (NZAMi). With over 220 signatories, including titans of industry like BlackRock, Brookfield, Invesco, Vanguard, and many more, signatories publicly commit to driving decarbonization goals within their investment portfolios. In total, asset managers have committed over $57 trillion, representing over 50% of the total AUM in the global capital markets.
To join, asset managers and corporations must publicly declare science-based carbon reduction targets that are aligned with the Paris Agreement’s goal of keeping global temperatures below 1.5 degC. To provide a trustworthy commitment to carbon reduction targets, the Net Zero Asset Managers initiative relates closely to the Science-Based Targets initiative (SBTi). SBTi provides a comprehensive framework for both Asset Managers and Corporations on how to set a carbon reduction target. By making these public commitments, capital market participants are effectively signing up to price good and bad performers against these goals.
In the scramble to define what ESG investing is, it is often easy to forget that the emergency in climate comes down to a single number, the concentration of carbon in our atmosphere. The investment community is wise to move quickly to adopt carbon performance into its underwriting.
Why carbon valuation adjustments for the real estate industry first?
Equity investors, lenders, and insurers across all asset classes are beginning the journey of learning how to incorporate the price of carbon performance. However, one industry that I believe will see adoption earlier than others is real estate (and sure enough, we have already seen early examples in late 2021 starting in Europe). I believe real estate will be subjected to carbon valuation adjustments earlier than other asset classes for a few key reasons:
- Real estate requires large capital investments to decarbonize.
As an industry, real estate is responsible for approximately 40% of global emissions, and it is estimated that the total cost to decarbonize the industry may reach $50 trillion. How much of that enormous investment is from the building that you are about to buy? Is that risk or opportunity included in the seller’s underwriting? Future investment in decarbonization needs to be incorporated into real estate asset valuations.
- Real estate is a cost-of-capital business
Real estate investing often boils down to a cost-of-capital calculation, which is why real estate is a financial asset. Last year, capital markets sent a clear signal they would reward environmentally progressive companies and penalize non-progressive ones — so it’s only a matter of time before this translates into financial underwriting. Without this as the next step, capital markets risk investigative reporting, or face discounts relative to competitors with profiles that are better positioned to benefit from these requirements.
- Real estate environmental data is easier to report
To be fair, this is a bit of a loaded statement, and I am sure that there are passionate ESG professionals reeling in their chairs from me calling ESG data collection “easy” in any context. But before pulling out the war paint, hear me out. Roughly 80% to 90% of a real estate asset’s yearly operating emissions can be captured and reported within direct on-site emissions and indirect emissions from utility purchases (this is known as Scope 1 and Scope 2 emissions by the GHG Protocol, the global standard for carbon accounting). This is a big deal. Real Estate operations avoid major data wrangling costs and assumptions that many other industries are grappling with today. It is not uncommon for corporate operators to find 60% or even 80% of total emissions needing to be traced through complex corporate supply chains (e.g. try calculating the carbon emissions of coffee beans harvested in Brazil versus those harvested in Vietnam!)
Before moving on, I want to acknowledge the hundreds (if not thousands) of individuals who I have personally spoken to and worked with ESG data collection across my 10+ years in this space. It’s their efforts that have allowed data reporting and risk analysis to get to a place where we can even have this discussion!
What risks are being accounted for in a carbon discount?
As investors assess the future enterprise value of a real estate asset, what financial risks does a carbon premium or discount account for?
- The cost to decarbonize: As noted earlier, it is estimated that fully decarbonizing real estate globally will cost up to $50 trillion. While the exact cost of decarbonizing an individual asset will be difficult to know perfectly at the time of investment, every property will require both operational and capital investments to reach its optimally decarbonized state over the next 20 years.
- Counterparty risk: Capital market investors depend on each other to make a successful investment. If poor carbon performance results in higher rates from lenders and insurers, or worse, refusal to take part in a potential investment based on their own underwriting procedures.
- Leasing risk: Properties seeking to earn lease revenue from Fortune 2000 corporations need to demonstrate that their assets are on track with the decarbonization goals of any anchor tenants. As large multinational corporations and tech companies accelerate their own net zero goals, the spaces they occupy will constitute a significant part of their carbon supply chains that they will seek to manage. Landlords be forewarned: your prime Class A real estate in the heart of the city may no longer be eligible to be rented by that star anchor tenant if you aren’t able to meet their new corporate standards.
- Regulatory risk: As investors evaluate a purchase, there are real risks that new liabilities will be introduced over the lifetime of an investment due to the passage of new carbon taxes or other regulations. One such example is New York’s Local Law 97, which came into effect in 2019 and is estimated to cost New York landlords almost $4 billion, effectively eliminating between $60 billion to $70 billion in real estate value from the New York market (assuming a conservative 6% cap rate). With municipalities around the country in various stages of adopting similar measures, and the SEC preparing to announce a single carbon disclosure requirement in Q1 of 2022, it is a sure bet that real estate will be exposed to these risks in the months and years ahead.
- Reputational risk: Organizations not showing credible progress towards net zero face increased scrutiny and reputational harm from the capital markets, tenants, and the general public. Capital market investors don’t want to run the risk of a PR flap. For many large organizations, Brookfield’s 2021 “greenwashing” stumble has served as a sobering cautionary tale.
- Carbon debt reporting: Carbon finance and accounting is one of the hottest topics of 2021 (and one of the most widely discussed items at COP26). We witnessed major breakthroughs in the past year to move us closer to a global price on carbon and carbon accounting standards. Once we reach consensus in these areas, it’s easy to envision the carbon emissions of any asset rapidly becoming a new liability on the balance sheets of major emitters. While this process won’t happen overnight, investors should expect new rules in carbon finance and carbon accounting to reach maturity within the lifecycle of the real estate investments being made today.
Closing thoughts: turn the stick into a carrot
The points covered above create the perfect storm for all assets to be subject to carbon valuation adjustments from equity investors, debt lenders, and insurance companies alike, and hint at a future environment where buildings risk becoming economically stranded before they become physically stranded.
However, 2022 is a year of opportunity. Investors have the opportunity to make plans now that align their assets with upcoming capital market expectations. In fact, many of these required investments will involve retrofitting buildings with newer technology that actually will yield higher long-term cash flows.
In my next post, I will provide a framework for how investors can think about making a valuation adjustment to based on an individual assets carbon performance. Welcome to the new year. Please share your thoughts or comments!