Climate-related stranded assets in real estate part 4: Who pays for change?

We know that the potential exposure to stranding is something faced by all forms of real estate asset. But whereas a lot of residential real estate is predominantly owner-occupied, rented or social housing, commercial property is more heterogenous. Do the impacts therefore also differ – and is finding a solution to stranding risk more difficult?

Kevin Muldoon-Smith: There aren’t many different types of house ownership out there. But in commercial property, it is more varied in terms of ownership and tenancy. The value is typically higher and that makes it controversial and expensive to negotiate who pays for the burden of building improvement – who deals with the stranded asset issue? Is it the tenant, landlord or investor? Who pays upfront and then how is it going to be passed on, for example, in rent?

Paul Greenhalgh: If you look at the typical measures by which you might improve the EPC rating of your home, you can have better insulation. But how might you tackle that in a multistorey building with commercial retail on the ground floor and offices above? When you mix residential and commercial together in the same block it can be complicated. In a cold climate like the UK, how do you improve thermal insulation, how would you improve water heating, how would you replace glazing, install draft proofing, and improve heat loss from a high-rise building?

Martin Haran: I think there’s challenges for the residential sector in terms of affordability, and there’s challenges the commercial sector by virtue of the ownership dynamics. In the residential sector, we are running a project looking at how you produce carbon neutral homes. One of the obvious things is that it costs more money than a conventional build, so the developer will pass that through to the prospective buyer. I think the bigger challenge is how to incentivise the green retrofitting of homes for homeowners. There’s no doubt that financial incentives are a key way forward for residential, whether that’s reduced interest rates on mortgages or some sort of lump sum incentive at the outset of the mortgage. There are various products on the market already that are actively encouraging the purchase of net zero homes and retrofit of existing homes.

When thinking about stranded assets in real estate on a global scale, the circumstances between different countries are very different. What does this mean for taking action about stranding risk: is the risk the same, and how do the solutions differ?

KMS: This is where a lot of our research [1] touches upon. If you talk about the built environment in the western world, fossil fuel exploitation has been deeply integrated into our system for many years. But an awful lot of other countries haven’t had the same opportunity to exploit fossil fuels in the same way. There’s a big equity issue between nations across the world. The opportunity that brings is to avoid a lot of mistakes, to build buildings and infrastructure that are not dependant on fossil fuels, and to develop markets that aren’t locked into practices that ultimately lead to stranding risk. The challenge in the western world is how to divest, whereas in other countries it’s about investment. However, it’s a double-edged sword. A lot of nations have not had the chance to take part in this exploitation, and that needs to be recognised.

PG: One of the things that always comes to mind when we’re talking about this lock in is being off grid. Most urban areas in developed countries tend to be on a gas grid, an electricity grid. We spend a lot of time and energy maintaining that grid, whereas future renewable energy systems can be more localised and off grid.  

Every country will also have slightly different tenure systems and ways of owning land and property. Some of the relationships we’re talking about – split incentives – might not be relevant, but others will. We need that deeper, more nuanced understanding of how these trends might play out in different countries with different cultures and practices.

MH: When we talk about developed economies a lot of the challenges lies around retrofitting existing stock, but for a lot of other countries, the challenge will be the initiation and inception of new builds that are carbon neutral from the outset.

If the built environment sector is to get to grips with stranding exposure, what would you say are the priority actions?

MH: What we’re seeing is specialist investors and operators in the market that are investing in assets to undertake retrofit. I think there is a skills related problem. It’s about upscaling those companies and having the financial framework and investment model to facilitate green retrofitting. If you’re a company with a portfolio of property, your asset managers are used to traditional or convention refurbishments. It doesn’t necessarily mean they are best placed to undertake a green retrofit. There are huge issues, not just around competencies and skills for asset managers and letting agents, but also around how to collaborate and how to structure joint venture arrangements for the financial delivery of retrofitting solutions. It’s also about how government can incentivise the 75% of companies or individuals in the industry who may not either have the appetite, financial capacity, or skills and knowledge to change.

KMS: We’re always looking at western world practices, but a huge amount of the solution is elsewhere in the world. We need to capitalise on that as much as possible. We need to seek to understand relative and emerging skills – there’s a big skills gap. We’re also not yet in a position where we have everything in place in the supply chain to adapt properties at the moment, so that is also a challenge.

We need to develop better and more integrated data sets. For example, in the UK, you could unite energy performance certificates with national valuation data sets. Once you connect these data sets, you have a value against properties with an EPC rating and you have an opportunity to recognise the interrelationships between efficiency and value. You need property reference numbers to link data sets together, and you need consistent baselines and codes of information to measure the performance of the property. Unfortunately, these data sets lack comparative consistency which makes connecting the data sets difficult in any meaningful way. A guideline relating to consistency and transferability in built environment data produced by government would be very useful. This could be repeated around large parts of the world, as lots of countries collect property tax information and are starting to record building performance data.

PG: This problem exists because the systems are built from the bottom up. You’ve got two different groups of people looking at the same individual property units for different purposes. You can’t even get the addresses and the units that make up an occupied building to match up. It should be within the gift of government and powerful computing to overcome this.

MH: Data harmonisation is essential. There has to be greater integration of energy performance data and data about financial performance from the commercial real estate sectors. There’s a complete disconnect between energy performance and financial performance. As part of the CRREM [2] project we looked at getting key data providers together, but issues around commercial interests and sensitivity are preventing data sharing. A lot of real estate investors will be providing data to companies such as GRESB who monitor and analyse their energy performance, and to MSCI who look at financial performance and investment characteristics for the same properties and assets. I think the whole debate would be shifted if you could showcase the associated financial benefits of improved energy performance.

[1] https://www.sciencedirect.com/science/article/pii/S2214629618309599

[2] https://www.crrem.eu/