Decarbonizing real estate: How to price the net zero transition to avoid a 'carbon bubble'

Real estate is the largest asset class in the world and it’s also one of the most significant contributors to global carbon emissions. As recognition of the existential threat of climate change grows, actions to decarbonize the sector have also gained momentum, however the speed of change must exponentially accelerate to meet key climate targets.

One of the greatest challenges lies in transitioning the existing building stock, 80% of which will still exist in 2050. Renovation rates hover around 1-2% per year, however, and the percentage of those that are green retrofits is likely much smaller.

Furthering this challenge is the absence of broad market recognition of both the cost to transition these buildings and the cost of delaying, or failing to.

The Urban Land Institute Europe (ULI), a global network of cross-disciplinary real estate and land use experts, recently stated that “European property owners, investors and valuers have failed to account for the cost of transitioning to net zero, resulting in a widespread overvaluation of offices, shops and residential property… if transition risk costs are not factored in now by owners, then the industry could face a major crisis.”

The ULI warns of a possible ‘carbon bubble’ where the continued lack of pricing this transition risk keeps asset values artificially high and further perpetuates the chance that they ultimately become too costly to retrofit, resulting in widespread stranding of assets.

A stranded asset is one that has prematurely lost its value, often immediately, due to certain factors such as regulation changes or changes in demand. In this context, it is directly related to emissions.

The risk of this occurring is not a distant future possibility, but rather an imminent reality of this decade. According to recent research from JLL, the 2022 GRESB (Global ESG benchmark for real estate related financial products) results show that the average Carbon Risk Real Estate Monitor (CCREM) stranding year of GRESB-submitted buildings is 2025.

Further driving the increasing price disparity between green and brown – often referred to as the brown discount – are both demand side drivers and regulation, according to JLL.

Many governments are either already doing so or planning to financially penalize owners that do not meet certain emissions standards adding to the cost of inaction.

Demand for green buildings is also growing, especially from large corporations pursuing their own climate targets and continued research demonstrates that many commercial occupiers are willing to pay a premium for extremely efficient buildings.

Many investors do price climate risks, including the cost to transition assets to become more efficient and meet certain standards set by government bodies, and those required by their investment partners.

But they do so in a proprietary way, bespoke to their own organization and investment thesis, and rarely share the results with broader stakeholders.

The lack of a standard approach for assessment and disclosure means buildings will often continue to trade at current market values because there are still buyers willing to acquire them that may not be factoring in these costs fully, or lack the sophistication and awareness to do so.

According to ULI’s Transition Risk Assessment, the following carbon bubble risks can be modelled currently and can be added to standard analyses in order to better reflect actual costs:

There are additional transition risks cited by ULI such as reputational risk, insurance and the access to debt capital that are not yet possible to model, but the industry should nonetheless be mindful of and eventually factor in as they become more quantifiable.

Properly accounting for both the potential costs of decarbonization and inherent value in doing so, along with the cost of inaction, is essential to any industry and real estate is no exception, especially given the value of global real estate and the impact of buildings on public and planetary wellbeing.