If we don’t address climate change and keep anthropogenic warming under the 2°C threshold set out by the Paris Climate Accord, then we will face the wrath of nature through rapidly rising sea levels, increased drought and wildfires, and other trends that will make life on earth more difficult — this is the physical risk of climate change.
If we do address climate change and do keep anthropogenic warming under the 2°C threshold set out by the Paris Climate Accord, then we will face the wrath of economics through rising regulatory activities, the loss of value in substantial assets, and other trends that will make business on earth more difficult — this is the transitional risk of climate change efforts.
Until recently, the concept of ‘stranded assets’ has essentially been a hypothetical and abstract idea for climate-focused economists to apply to future forecast models. It describes assets that suffer from unanticipated or premature write-downs, devaluations, or conversion to liabilities, due to environment-related risks. Think water scarcity making water-intensive coal-fired power plants inoperable or activism preventing energy firms from extracting shale gas in areas where they bought drilling rights.
Today, stranded assets are best known for describing multi-billion dollar fossil fuel resources sitting in the ground and on the books of major oil and gas companies. As we continue to de-carbonize the economy and strive for a greener world, the value of these assets could drop rapidly. Many now claim that the current value of those assets is inaccurate, based on old metrics that do not account for the seemingly inevitable stranding that many of these assets will experience. The energy industry could soon be turned upside down and the buildings industry should take note.
“Environment-related factors are already stranding assets in different sectors of the economy. This trend looks to be accelerating, which could represent a major discontinuity, able to profoundly alter asset values across the global economy,” reads a report by the Smith School of Oxford University, which has taken a leading role in expanding the research on stranded assets beyond fossil fuels.
In the case of real estate, trends are emerging that will rapidly de-value buildings that do not keep up with energy regulation, for example. In the Netherlands, office buildings need to meet the minimum energy performance requirements (label C) by 2023 or they cannot be rented out to any tenant. By 2030, this minimum threshold is intended to be raised to EPC label A. The UK and New York state are introducing similar regulations that would reduce the value of many buildings to “almost zero” overnight.
“In New York, the Netherlands and the UK, policymakers have implemented carbon and energy regulations that threaten the cash flows and valuations of standing real estate investment portfolios. Properties that do not meet these standards could become stranded assets,” says says Rik Recourt, associate at GRESB, an investor-driven organization assessing the sustainability performance of real asset sector portfolios and assets.
Buildings account for 36% of global energy consumption and almost 40% of CO2 emissions, making the real estate sector highly susceptible to energy regulations and other climate change mitigation pressures. Society itself is placing increasing pressure on oil and gas firms to “leave it in the ground” and similar pressures are mounting on buildings, directly and indirectly, to improve their energy performance.
A 2018 survey by the U.S. Green Buildings Council (USGBC) found that 79% of people said they would choose a job in a LEED-certified building over a non-LEED building. “Employees who work in LEED green buildings are happier, healthier and more productive than employees in conventional buildings,” the report added.
This rising pressure from society will increase pressure on buildings to go green so they can attract enterprise-tenants that want to increase productivity while impressing both employees and customers with their green credentials. The growing sense of environmental responsibility across society also drives green regulations like those seen in the Netherlands, UK, and NY. These accelerating trends could soon start turning dumb buildings into stranded assets unless they bring their energy performance level up to the ever-increasing standards demanded of them.
“Understanding climate-change risk in our real estate investments is crucial. Whether it is physical risk or transition risk, it is ultimately linked to the location and characteristics of an individual asset,” says Derk Welling, senior responsible investment and governance specialist at APG Asset Management. Welling echos the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD), which focuses on the resilience strategy of an organisation by taking a wide variety of physical and transitional climate-related scenarios into consideration.
In 2018, an EU-funded research project was established to help investors and managers understand the financial risks to their portfolios in relation to two decarbonisation scenarios. The Carbon Risk Real Estate Monitor (CRREM) developed a ‘multi-step downscaling’ model to assess how real estate portfolios need to decarbonise to align with 1.5°C or 2°C warming scenarios. Supported by three institutional investors, the project is now expanding beyond Europe to include global portfolios of various building types.
“The CRREM methodology is the only science-based methodology we have come across to measure transition risks bottom-up,” says Welling. “Once you can measure it at one asset, it will allow you to aggregate it any level. As the original scope of CRREM was only commercial real estate in Europe, it was obvious for us to team up with peers and take CRREM global and include residential assets.”
Like oil and gas, the real estate assets stranded by the transition to a greener world could create significant economic turmoil as values drop and the market is forced to adjust. And like oil and gas, real estate assets not stranded by the transition to a greener world could create significant environmental turmoil risking billions of lives.
How we balance these two risks, through the severity and timing of regulation is going to be a challenge for government, who themselves are under pressure to follow the will of an increasingly green society.