TEN TRENDS FOR A ZERO CARBON WORLD
05. Retrofit revolution
Much of the innovation required to deliver a net zero carbon real estate industry by 2050 focusses on how to construct buildings that are more sustainable. The real challenge, however, is what to do with the vast stock of existing buildings that need to remain in use for many decades to come.
If governments are to have any chance of meeting the targets that they are setting themselves, they will need to find ways to encourage an upgrading of the existing building stock. To fulfil the terms of the Paris Agreement, direct emissions from buildings need to halve by 20301 and the sector needs to reduce its total emissions by 95% by 20502. In most cases this requires “retrofitting” – reducing energy consumption and increasing operational energy efficiency through changes to the structural fabric and internal systems of the building.
Given that most buildings require some form of upgrading, current levels of activity are insufficient. The Global Alliance for Buildings and Construction (GlobalABC) monitors how the real estate industry is responding; its Buildings Climate Tracker or ‘decarbonisation index’ shows that since 2017, global progress towards the net zero target has been negative3.
BUILDING DECARBONISATION ACTUALLY GOT WORSE SINCE 2017
What is actually involved in retrofitting our building stock, why has progress been so slow – and what will be needed to spur the real estate industry into action?
Where do I start?
Assessing what may need to be done to a building typically involves monitoring and benchmarking current energy use, identifying opportunities for improvement and then implementing the required upgrades. Each project will vary with factors such as lease length, timescales of carbon reduction targets and availability of capital or financing, but activity broadly falls into three categories.
High impact, low-cost actions to reduce energy demand
Focus first on operational changes and optimization, starting with capturing accurate verified data on how and when space is utilised, occupancy patterns and times of day energy is consumed to maximize efficiency. Installing automatic metre reads and sensors helps identify what systems or parts of the building drive energy consumption and enable an assessment of performance benchmarking. This supports accurate allocation of current (and potential future) costs, and forms the basis for carbon accounting, across different aspects of the building and between different occupiers in a multi-let property.
Introduce physical energy efficiency improvements for medium cost and high impact
There are quick wins which most owners and occupiers should exhaust before progressing to larger scale, more intrusive works. Improving the way building management systems and equipment are utilized and recommissioning M&E systems can extend their life and bring performance closer in line with the original design intent. Lighting upgrades to LED are commonplace, delivering short payback returns and medium scale savings.
Higher cost structural changes
Heating and cooling are key sources of energy demand and upgrades to improve the building’s fabric, thermal efficiency and energy source need to be considered. This includes facades, wall and roof insulation and improved glazing. Replacing fossil fuel supplied heat with alternatives such as heat pumps and potential self-generation via solar panels, is key to achieving net zero.
Barriers to entry
Identifying what is required is one thing, but coming up with a practical plan to do it is a different matter. Progress in retrofitting the existing building stock has been slow because there are substantial hurdles to be overcome, which typically fall into two categories: practical and financial.
From a practical perspective, most buildings were simply not designed with retrofitting in mind. Once the “quick wins” have been secured, the remaining improvements necessary can be invasive and difficult to implement while a tenant is in occupation. Lease structures mean that building owners may have limited rights to make retrofit upgrades, while occupiers will understandably be reluctant to incur the costs or disruption associated with major building works unless they result in a direct and realizable benefit during the term of the lease.
Occupiers are increasingly keen to minimize their carbon footprint4 and if the perceived benefits of upgrading their space, whether financial or otherwise, are sufficient then they may be keen to collaborate with the landlord in finding a workable solution. This is particularly the case where the property has strategic importance in the occupier’s overall workplace strategy, and they envisage remaining in occupation beyond the term of the existing lease. In such cases, recent experiences of remote working and the adoption of more flexible working practices may well facilitate vacating the space for the duration of the works without undue disruption.
However, negotiating such agreements with all the occupiers of a multi-let building is likely to be difficult. Building owners therefore face major challenges in planning retrofits around lease breaks and expiries. The likelihood is that most early retrofit projects will fall into one of three categories:
- the public sector - where a wider range of factors are typically included in the cost-benefit calculation;
- owner occupiers - who are well placed to capture the full operational savings as well as any resulting capital value uplift5
- or buildings in single occupation and subject to longer leases, in cases where both landlord and tenant can see sufficient value in undertaking the work.
The more significant the work required and the greater the number of tenants affected, the harder it will be to develop an acceptable plan of works and thus the greater the temptation for the landlord to “kick the can down the road” and delay any upgrades until they are unavoidable.
As challenging as the practical difficulties may be, the primary barrier to retrofitting buildings can often be cost and financing. It is extremely difficult to generalize about the cost involved given that what is involved will vary enormously from one building to another. Upgrading a well specified 1990s building is a very different prospect to an older brick-built structure that may date back to the early 1900s.
It is even harder to generalize about whether such expenditure makes commercial sense, given the huge variation in rental and capital values between and even within markets. The fact that so little retrofitting is underway suggests that either the issue has yet to register on the radar of most building owners, or that such retrofits do not – as things stand – appear cost effective and commercially viable. If the former, one suspects the level of activity is set to rise dramatically of its own accord. However, experience of working with many major investors suggests that developing a watertight financial case for a retrofit is often a challenge – a problem that urgently needs to be addressed.
Where the operational energy savings from a retrofit are significant and demonstrable, this can create a “revenue” stream that can be used to fund the initial capital expenditure. There are various ways this could be utilised to finance the work required. Reduced operating costs together with other realizable intangible benefits to the occupier may result in a higher level of rent. Alternatively, depending on the way the lease is structured, the landlord may be able to hold the rent and service charge constant, allowing them to directly capture the benefit of lower operating costs as additional net income6. In many cases, particularly where the tenant will suffer some degree of inconvenience during the works, an apportionment of the financial benefit between landlord and tenant is likely.
We are already seeing a wide range of different funding mechanisms being developed, with numerous lenders entering the market for retrofit financing7. The growing evidence of a differential in rental and capital values between green buildings and the wider market will help support business cases for retrofits8, particularly as this differential is expected to grow.
In such situations, governments may have a role to play in structuring or channelling finance to enable retrofits to occur, albeit that an encouraging range of private sector funding is already starting to emerge. However, there are always likely to be situations where retrofits are not currently financially viable. This could be because of the level of cost involved relative to current or expected future levels of rent, or because the payback period is too long to justify the investment. This is where the public sector has a key role to play, and where both “carrot” and “stick” are expected to be deployed.
Where there are circumstances relating to the building or the parties involved, grants or other financial incentives can be deployed to help bridge the financing gap. Older buildings, charities or low-income individuals could be offered combinations of grants, loans or tax reductions to incentivise building works. Many such schemes already exist, especially for private homeowners in the residential sector9; we expect to see significant expansion of this approach in most countries in the years ahead. Given the “green PR” benefits associated with such initiatives, a swathe of such announcements around the time of COP26 is anticipated.
Whether compelled in order to avoid their assets being stranded, or encouraged by the rebalancing of the cost-benefits associated with retrofitting, the market will be forced to adjust.
But ultimately, governments are likely to fall back on building standards and emissions regulations to compel the private sector to undertake the work required. While some foot-dragging is likely, a combination of international treaties and public opinion will force governments to act. Investors and commercial landlords are a soft target for politicians and there is little reason to think that the real estate sector, which is so clearly so integral to reducing emissions, will be given an easy ride.
The approach governments will adopt is already becoming clear. In England and Wales, by 2030 it will be impossible to grant a lease on a commercial building unless it meets energy standards that are currently only attained by the top 15% of the stock. The Netherlands is pursuing a similar strategy from 202310. In New York, progressively more punitive emissions charges will render substandard buildings so expensive as to eventually be effectively unlettable11.
Whatever the specific mechanism, governments will force occupiers to focus on the limited supply of buildings that meet the required standard. This will drive up rents on better buildings and push down the value of the remainder. Whether compelled in order to avoid their assets being stranded or encouraged by the rebalancing of the cost-benefits associated with retrofitting, the market will be forced to adjust.
In Europe, the Carbon Risk Real Estate Monitor (CRREM)12 project is specifically designed to help investors identify assets at risk of “stranding” from net zero targets, to encourage them to undertake the necessary retrofitting sooner rather than later. There will undoubtedly be those who hold out until the last minute, in the hope that governments will blink first, and the threatened regulatory squeeze will never fully materialize. But with lenders and investors being compelled to identify, evaluate, and publicly disclose the carbon risks associated with their portfolios13, the financial markets may not afford them that option.
The current pace of retrofitting may appear slow, but expect COP26 to mark a watershed in the acceleration of activity.
1https://globalabc.org/sites/default/files/inline-files/2020%20Buildings%20GSR_FULL%20REPORT.pdf 2https://iea.blob.core.windows.net/assets/4719e321-6d3d-41a2-bd6b-461ad2f850a8/NetZeroby2050-ARoadmapfortheGlobalEnergySector.pdf 3https://globalabc.org/sites/default/files/inline-files/2020%20Buildings%20GSR_FULL%20REPORT.pdf 4Link to “(Work)Force of Nature Trend #3 5See Chain Reaction, where we comment on Walmart’s $2billion capital raise via the largest U.S. green corporate bond offering in history which they intend to deploy across a range of decarbonization initiatives. 6Such an approach requires the landlord to be able to capture the benefit from the reduced energy costs, which is not possible if the lease specifies a direct cost-based service charge. It may be possible in situations, like co-working operations, where landlords charge a fixed “all in” charge for space rather than allocating specific costs to occupiers on a transparent “pass through” basis. 7See The colour of money 8See Dollars and sense 9For example… https://www.cmhc-schl.gc.ca/en/professionals/project-funding-and-mortgage-financing/funding-programs/all-funding-programs/canada-greener-homesneed source that reviews the subject and/or examples … 10https://business.gov.nl/amendment/ban-office-buildings-are-not-energy-efficient/ 11https://www.urbangreencouncil.org/content/projects/all-about-local-law-97 12https://www.crrem.eu/ 13See The colour of money