The green premium is an elusive concept. Laurence Monnier reviews the academic literature and crunches some numbers to try and quantify the extra pricing power afforded by more sustainable commercial properties.
Institutional investors are increasingly focused on delivering a positive impact1 on society through their investment strategies. As of March 2021, asset managers representing $37 trillion of assets, or one third of global AUM, have committed to be carbon neutral by 2050 or before – many have interim targets before that date. In January, we committed to reach net-zero emissions’ across our real assets platform by 2040.2
The increased investor focus reflects a deepening concern of the climate urgency that pervades society3, particularly millennials. As younger generations gain in wealth and corporate influence, the ESG focus will likely intensify.
Regulatory pressure to measure and report the climate impact of investment portfolios is increasing too. Although carbon disclosure initiatives like the Task Force on Climate-related Financial Disclosures started as voluntary, the direction of travel is towards mandatory disclosure and reporting, as is the case for UK pension funds. This trend is part of the global momentum for stronger ESG disclosure, exemplified by the recent Sustainable Finance Disclosure Regulation in Europe.
Understanding climate impact is critical to valuing buildings
Reducing the carbon footprint of the built environment – both residential and commercial property as well as physical infrastructure4 - is at the core of the challenges to reach net zero.5 But how does it translate into asset value?
A review of academic literature on green premia – i.e. the higher pricing power of more sustainable buildings – shows that it has existed in real estate for much longer than the relatively recent surge in ESG demand and commitments to net zero. Although the studies are not comparable in their scope or method, they all confirm the existence of a green premium, which varies from five to 30 per cent.
A European study conducted in 2013 provided more granular analysis and showed a 0.45 per cent improvement of value for every one per cent improvement in energy consumption.6
Figure 1: Sales premiums (per cent)
Source: Andrea Chegut, et al., 2014; Norm G Miller, et al., 2008; Franz Fuerst, et al., 2009; Wiley Benefield, et al., 2010; Tunbosun B. Oyedokun, 2017; Maya Papinaeu, 2017; Macro Del Giudice, et al., 2020
In large part, this reflects the higher rents paid by tenants for more energy efficient properties. The correlation between more energy efficient buildings and higher rents has also been found to exist across different continents. Figure 2 aggregates the findings of some key literature and shows an impact of similar magnitude.
Figure 2: Rental premiums (per cent)
Source: Andrea Chegut, et al., 2014; Alexander Reichardt, et al., 2012; Franz Fuerst, et al., 2009; Wiley Benefield, et al., 2010; Erin A. Hopkins, 2016; Stefanie Lena Heinzle, et al., 2012; Prashant Das, et al., 2013; Franz Fuerst, et al., 2015; Maya Papinaeu, 2017
Although few valuation reports contain detailed analysis of environmental factors, the above studies point to a significant impact on asset values.
Studies often compare the price of assets with different certification standards
The studies often compare the price of assets with different certification standards (for example BREEAM or LEED vs. uncertified), rather than purely measuring the impact of CO2 emissions or water usage. The premium measured is therefore wider than what could be reasonably explained by the costs of future carbon emissions alone. The measured green premia are likely to include:
- Energy cost savings reflecting the potential for higher rent charges.
- Building quality: Buildings with higher standards are generally more modern, better equipped, and to attract a premium beyond the strict environmental impact.
- Branding impact for the owner and tenant of owning/occupying a building with better environmental performance.
- Carbon price/offset impact: As more investors commit to net zero and disclose their portfolio alignment, the carbon impact of real asset investments will become visible. For assets that are harder to decarbonise, buying carbon offsets may be necessary. Offset costs, whether actual expenses or used in internal decision making, could increasingly feature in asset valuations.
These impacts are illustrated in Figure 3. Critically, the value of most of these factors is expected to rise. In the post COVID-19 world7, tenants are likely to be more demanding on the quality of the office experience for their employees. This will favour newer buildings, with greener credentials and natural ventilation. The carbon offset factor should also grow as demand rises; the market is still embryonic, and it is difficult to forecast its evolution. While there is huge variation in forecasts on the price of carbon, all point to significant increases. Therefore, the green premium could increase further.
Figure 3: The impacts of green premium
Source: Aviva Investors, July 2021
Green premium appears to exceed future price of carbon
To understand the observed green premium, we tried to calculate the potential “obsolescence” or loss of value of an asset over the next ten years that is directly linked to its carbon emission and energy consumption – assuming no building improvement.
We tried to calculate the potential obsolescence
To do this, we compared the expected trajectory of an average asset in terms of carbon intensity (tonNE CO2/sqm/year) and energy efficiency (KWh/sqm/year) to the trajectory required to reach net zero by 2050, using the CRREM risk assessment tool. Figure 4 shows how the carbon intensity of assets is projected to decrease as the power sector decarbonises, but unfortunately it will not be enough to reach the required market transition.
Figure 4: UK real assets carbon intensity versus market pathway (tCO2e / sqm)
The observed difference between the market trajectory and the net-zero pathway is multiplied by the cost of carbon8 (for the carbon difference) and the cost of energy (for the energy efficiency difference). We then add the net present value of the excess cost of carbon and energy over the next 30 years. By doing the same calculation ten years in the future, you can observe the difference between these two figures, which represents the estimated obsolescence for the sector. Put plainly, this is the loss of value linked to the energy and carbon footprint of an average asset over the next ten years.
The carbon transition obsolescence risk equates to between three and ten per cent of the average asset value
These calculations show that the carbon transition obsolescence risk equates to between three and ten per cent of the average asset value over the next ten years if no capital expenditure (capex) is made to improve it. The range is quite wide, so it could be considerably higher for some assets. While industrial assets are typically less energy intensive than offices, the obsolescence risk is higher for this asset class due to the lower price per sqm of the assets.
This estimated range of values only includes the direct cost of energy and carbon offset. It does not consider other qualitative aspects which contribute to the five to 30 per cent green premium discussed above.
Figure 5: Obsolescence linked to energy and carbon efficiency (per cent)
Source: Aviva Investors, June 2021
Implications for real estate investors
The implications of the observed green premium are clear. Analysing and valuing the carbon impact of buildings will be fundamental to both real estate investment and asset management strategies.
Portfolios could face growing obsolescence risk
Failing to recognise and act on this could mean portfolios face growing obsolescence risk.
For active asset managers, incorporating the carbon impact should be considered at every stage of the investment process:
- At the investment and divestment stage, underwriters should:
- Consider current energy performance, aligning future investments to align to a net-zero pathway, and divest from assets most at risk.
- Assess long-term physical climate risk (e.g. storms or flooding).
- Asset and development managers should:
- Consider environmental impacts in their asset and business planning, notably how much embodied carbon9 already exists within a building, but also the cost and timing of the required capex to align the assets to net zero.
- Building valuations should:
- Wherever possible, explicitly incorporate this dimension when valuing a building.
The cost of transition to net zero will also vary by sector and location. Rental and investment values are likely to be more resilient in some sectors, like industrial properties.10
In addition, countries where the power sector is quicker to decarbonise will see the benefit of cleaner energy flow through buildings. Different building regulations may also influence the quality of the original buildings and the pace of future decarbonisation required. Understanding this dynamic is critical when allocating to multi-sector real asset portfolios.
Opportunities for lenders
Real estate lenders, while less directly exposed, should also be mindful of the carbon footprint of the assets they lend to. As most commercial mortgage loans bear refinancing risk at maturity, reducing obsolescence risk is critical for the asset class.
On the positive side, sustainable lending also offers the opportunity for lenders to generate positive environmental impact.11 Sustainable loans can include covenants that incentivise the borrower (for example via a margin reduction) to improve their environmental impact. To qualify as a sustainability-linked loan, such improvements should be ambitious and go beyond business as usual”improvements a professional asset manager would undertake anyway. Furthermore, to qualify as impact investing, a loan must demonstrate additional contribution to the asset’s improvement of ESG factors and set targets that are ambitious and material.
The objective of these loans is to deliver impact and future-proof assets to ESG obsolescence and transition risks. Forward-looking sustainability performance of the collateral will therefore be an increasingly important feature in this analysis. Key ESG performance indicators in the loans need to be appropriately aligned to best-practice industry standards (e.g. science-based targets initiatives for net-zero targets), while ESG targets should be assessed by external providers to ensure alignment towards the Loan Market Association's (LMA) sustainability loan principles.
Sustainable loans can be attractive for borrowers
Sustainable loans can be attractive for borrowers, both from a franchise standpoint, and because the costs of the improvements they have to make (for example, installing solar panels) can be offset by operational and financial cost savings.
Lenders have also been attracted to sustainable lending, but some investors query the justification for lower margins.
For lenders, sustainable lending not only creates impact, it also reduces the obsolescence risk of their security, and improves the loan-to-value (LTV) ratio once the retrofit is implemented. LTVs are one of the key risk measures used by real estate lenders, and lower LTV loans typically command a lower margin.
Based on the City of London Business School study of lending terms in the UK, a one per cent decrease in the LTV has reduced the margin in the prime property sector by between three and 15 basis points depending on the riskiness of the investment, as shown in Figure 6.
Figure 6: Impact of one per cent lower LTV on margins (in bp)
Source: City of London Business School study of lending terms in the UK
Based on the data in Figure 6 and an assumed value improvement of 0.45 per cent from a one per cent energy efficiency gain12, a five-to-seven per cent energy efficiency improvement would justify a five basis points reduction of margin – even when ignoring the wider societal benefit of the strategy.
There is mounting evidence to show greener, more energy efficient buildings command a higher premium. The make-up of this premium is complex, and it includes much more than the direct cost savings induced. As more investors focus on the green transition, and the price of carbon becomes more visible, we expect the green premium to be more evident and rise further. For real estate equity investors, the implications are clear. Portfolios that are better aligned with the green transition are expected to maintain a higher value than their peers.
Sustainable lending reduces the obsolescence risk of their security and improves LTV
For real estate lenders, sustainable loans are an opportunity to not only to positively impact the environment, but also reduce risk. They preserve the value of collateral throughout the transaction, which can justify the reduced margin offered.
As progress towards net zero accelerates, keeping assets ahead of the curve in terms of emission intensity will play an important part in future-proofing real estate portfolios. This is true for both lenders and equity investors.