A method for estimating the impact of climate-related transition measures and the physical risks associated with climate change on European real estate returns has been published by AEW in what the manager believes is “a precise and significant step” towards helping the industry meet its obligations under the Paris Agreement.
The methodology, which has been a work in progress for four years, defines transition risk as the cost of making the necessary energy intensity reductions required for properties to meet obligations set out in the Paris Agreement – an international treaty that provides a framework for countries to reduce greenhouse gas emissions to limit temperature increases to 1.5 degrees celsius by 2050. In addition, the methodology takes account of physical climate-related risks as a result of damage caused by extreme weather events.
AEW calculated the average cost in euros per square metre of the investment needed for an asset to reach the decarbonisation requirements of the Climate Risk Real Estate Monitor, a European Union funded programme that sets out a pathway for buildings to reduce carbon emissions to keep countries in line with the Paris Agreement.
To calculate this, the manager used city-level retrofitting data from consultancy Arcadis to estimate the costs of upgrading buildings in specific locations. The resulting annual energy intensity reduction costs are expressed as a percentage of the prime capital value, based on consultant CBRE’s figures for year-end 2022 for each of the 196 city-sector segments in AEW’s sample.
AEW concluded that European prime assets face a ‘risk premium cost’ of 15 basis points of the asset’s total value per annum related to energy intensity reductions. In addition, AEW applied 3.9bps per annum for preventing flood risk and a further 0.4bps per annum for negating sea level rises. In total, it concluded prime assets face an average 19.4bps climate risk premium across markets covered by the manager.
For secondary assets, AEW calculated that to meet energy intensity reduction targets there will need to be an average 46bps of capital expenditure per annum against capital values.
In the findings released today and shared exclusively with Real Estate Capital Europe, AEW presents the cost impact of transition risk across 196 European market segments. For major prime markets, it reports assets in the French cities Lille and Lyon have the highest climate risk premium, estimated at 47bps and 41bps, respectively. London, meanwhile, has the lowest climate risk premium, calculated at around 8bps. German cities Hamburg, Frankfurt and Berlin are also below the average climate risk premium.
AEW is one of several companies and industry bodies attempting the complex task of finding a method of assessing the impact on values of transitioning assets to net zero. The Urban Land Institute, for instance, has published its own definition of transition risk that includes 12 separate risks.
Explaining AEW’s focus on the costs of reducing energy usage, Hans Vrensen, head of research and strategy, said: “We are aware and appreciate the holistic approach and many other elements – other than transition risk – that go into many of the multiple building assessments available. But at the end of the day, what is really going to make a difference in terms of climate change is a managed reduction in the use of fossil fuels. Therefore, on a market level, we see that reducing energy [consumption] is the most important factor. Reducing operational energy inefficiency in existing buildings should be our top priority as it allows us to meet climate targets.”
Vrensen also believes lenders are increasingly focused on requiring borrowers to address energy efficiency upgrades. “Lenders will be investors’ allies in this challenge. What they clearly want to avoid is for owners of secondary buildings not putting the required energy intensity reduction capital in. If there is a chance the bank will end up with the collateral assets if the loan defaults and it is not in line with energy efficiency regulations, it might have a big impact of the lenders’ expected loss. Therefore, a lot of bank regulators, and banks themselves, are asking for energy efficiency improvements to avoid this.”
In a deep dive analysis of the topic by REC Europe in September, market participants, including debt specialists, highlighted the urgent need for a method of estimating the cost of transition risks to current property values.
Vrensen said AEW’s methodology provides the “most precise market-level estimate possible today” as better data and analytical tools allows the industry to improve.
“We are very close in terms of quantifying climate-related transition risk on a market level. More importantly, the numbers we are coming up with are more manageable than many others seem to believe. In our view, the reality is that as an industry we can tackle this.”
As a result of the updated methodology, AEW calculated a lower than previously estimated transition risk cost – in 2021 it had estimated 48bps for prime property. The report also highlights differences across sectors, with prime high street assets having the lowest impact – at 6bps on average – while prime logistics had the highest cost impact at 48bps.
AEW’s previous reports on climate risk, in 2021 and 2022, also attempted to quantify the impact of energy transition and physical climate hazards. However, this year its analysis is based on the latest version of CRREM, known as 2.03, as well as estimates from German reinsurance company Munich Re on river flood risks.
Since January, the tool has included higher decarbonisation standards linked to the Science-Based Targets Initiative, which defines best practice in emissions reductions in line with climate science. The manager has also used data provided by CFP Buildings, a consultancy that offers software for building owners to calculate cost savings from energy-efficiency improvements.
“New data and analytical tools allow us to test our market-level estimates across city-specific market segments,” said Vrensen. “For each property type, for each country, there is now a consistent methodology and standard that is helping people in the industry to implement the changes that are needed.
“The number is also manageable in such a way that the incremental costs of energy efficiency improving cap-ex probably already fits into many of the existing long-term asset management plans already in place.”