We're kicking off 2022 with Logan Soya, Aquicore's Founder and Executive Chairman. In his most recent Medium article, Logan introduces carbon discounts and premiums and discusses the implications for real estate.
In 2022, carbon performance data, climate finance, and net-zero commitments from the capital markets will culminate in a tipping point that will begin to affect asset valuations.
Real estate investors are at risk of seeing asset valuations affected earlier than other asset classes, however, they have an opportunity to create plans now to align their investments with capital market expectations and outperform slower moving competitors.
This is the first of a two-part post to dive into what carbon discounting is and how it might work. In the first post, I’ll introduce carbon discounts and premiums and why they make sense. In the second post, I will provide a framework that investors can use to think about how they can apply this risk to their underwriting.
Let’s dive in.
Put simply, a carbon discount is a discount on the valuation of an asset that is underperforming against a carbon reduction target. Conversely, a carbon premium is a valuation premium for an asset that is over-performing against said target. Throughout this piece, I will occasionally refer to these price adjustments generically as “carbon valuation adjustments”.
I’ve often wondered how and when investors will incorporate the risks of achieving carbon reduction goals into the investment valuation process. Throughout my career, I have taken part in the evolving ESG narrative, and even founded a company for financially minded real estate investors centered on ESG data collection and analysis. COP26 and 2021 marked a turning point where this topic became essential for financial investors worldwide. Top insurers like Lloyds and governing bodies like the International Renewable Energy Agency estimate that between $10 trillion to $40 trillion worth of assets are at risk of becoming economically stranded over the next 30 years as the world transitions to a low-carbon economy.
All of this has led investors and analysts to ask: how do we incorporate these risks into our financial valuations for investments we are making today?
In 2021, the capital markets were abuzz with ESG as the latest Wall Street investment craze. Private equity, asset managers, ratings agencies and many more have all jumped into the fray, looking for ways to understand how climate data can be collected, synthesized, and monetized into reporting so that equity investors can show the inclusion of climate risk into their investments. However, as a former physics student, I’ve always found these scores a little shallow when it comes to reporting “science-based progress” towards climate change prevention.
It would probably surprise the casual observer to learn that, in most cases, ESG scores today mostly do not factor in a company’s progress towards decarbonization. As a recent landmark report by Bloomberg points out:
“most ESG reporting systems flip the notion of sustainability. Instead of measuring the risk that companies pose on the world, these ratings grade the risk the world poses on the company (and its profits).”
While the details of ESG indices warrant their own post entirely, the basic idea is that ESG scoring today measures the resiliency of an asset against a physical climate risk (e.g. sea level or forest fires), and not the progress an asset makes to decarbonize. Thus, if an investor sold a property in Miami to acquire one in New England, their portfolio ESG score would increase because the new asset possesses less physical risk from rising sea levels. This means the score may improve even if New England property has a bigger carbon footprint. This is an oversimplification — and only one of many issues with ESG reporting today — but you get the idea. (Bloomberg’s article above goes into excellent detail for those interested in learning more).
I expect and hope that more investigative reporting will press ESG and financial disclosure to tie more closely to science-based measures of climate performance instead of profit protection. While there’s still much work to do, I can thankfully say that 2021 marked a major shift: investors are now actively seeking more direct reporting capabilities of carbon emissions.
The most notable example of increased investor focus on climate performance reporting is the adoption of the Net Zero Asset Managers initiative (NZAMi). With over 220 signatories, including titans of industry like BlackRock, Brookfield, Invesco, Vanguard, and many more, signatories publicly commit to driving decarbonization goals within their investment portfolios. In total, asset managers have committed over $57 trillion, representing over 50% of the total AUM in the global capital markets.
To join, asset managers and corporations must publicly declare science-based carbon reduction targets that are aligned with the Paris Agreement’s goal of keeping global temperatures below 1.5 degC. To provide a trustworthy commitment to carbon reduction targets, the Net Zero Asset Managers initiative relates closely to the Science-Based Targets initiative (SBTi). SBTi provides a comprehensive framework for both Asset Managers and Corporations on how to set a carbon reduction target. By making these public commitments, capital market participants are effectively signing up to price good and bad performers against these goals.
In the scramble to define what ESG investing is, it is often easy to forget that the emergency in climate comes down to a single number, the concentration of carbon in our atmosphere. The investment community is wise to move quickly to adopt carbon performance into its underwriting.
Equity investors, lenders, and insurers across all asset classes are beginning the journey of learning how to incorporate the price of carbon performance. However, one industry that I believe will see adoption earlier than others is real estate (and sure enough, we have already seen early examples in late 2021 starting in Europe). I believe real estate will be subjected to carbon valuation adjustments earlier than other asset classes for a few key reasons:
Before moving on, I want to acknowledge the hundreds (if not thousands) of individuals who I have personally spoken to and worked with ESG data collection across my 10+ years in this space. It’s their efforts that have allowed data reporting and risk analysis to get to a place where we can even have this discussion!
As investors assess the future enterprise value of a real estate asset, what financial risks does a carbon premium or discount account for?
The points covered above create the perfect storm for all assets to be subject to carbon valuation adjustments from equity investors, debt lenders, and insurance companies alike, and hint at a future environment where buildings risk becoming economically stranded before they become physically stranded.
However, 2022 is a year of opportunity. Investors have the opportunity to make plans now that align their assets with upcoming capital market expectations. In fact, many of these required investments will involve retrofitting buildings with newer technology that actually will yield higher long-term cash flows.
In my next post, I will provide a framework for how investors can think about making a valuation adjustment to based on an individual assets carbon performance. Welcome to the new year. Please share your thoughts or comments!