From brown to green: financing real estate decarbonisation

Approximately 80% of the buildings which will be standing in 2050 have already been built. With buildings responsible for around 33% of global greenhouse gas emissions and 40% of global energy consumption,[1] it is critical that existing real estate stock is decarbonised in order to deliver on the ambition of the Paris Agreement and achieve “net-zero” by 2050.

As it stands, it is estimated that 97% of existing commercial property stock will not support the transition to net-zero.[2] The industry warns that these brown assets will fall victim to the “brown discount” if left untouched – less energy efficient commercial real estate, coupled with rising energy prices, will become increasingly difficult to let and sell, leading to reduced rental income and asset value, and exposing asset managers and owners to the very real risk of stranded assets.

Across the real sector, the discussion has often focused on “green” development such as building carbon neutral real estate.  Many traditional lenders have also focused their sustainability initiatives on financing renewable projects. Less attention has been given to develop specific energy efficiency solutions, activities which result in the “greening” of existing brown real estate assets.

However, the market is shifting and in this article we explore the landscape of the financing options available to asset owners and managers to fund these types of projects with examples drawn from the US, UK, Singapore and Hong Kong SAR markets. 

How to “green” brown real estate stock?

A “green” building is defined by The World Green Building Counsel as one that, “in its design, construction or operation, reduces or eliminates negative impacts, and can create positive impacts on our climate and natural environment”.[3]

There are various ways in which a building can be made green. One of the most obvious ways is to procure more green sources of energy or distributed green energy (eg. installing rooftop solar panels) through a power purchase agreement or leasing arrangement with energy producers. However, there are other ways to green a building such as refurbishment and retrofitting works (e.g. converting to LED lighting or installing a smart energy control system). Often, a combination of these approaches may be adopted and green projects can vary in scope. In any event, the upfront costs of these types of projects, as well as any costs associated with causing disruption to occupiers, can be significant. Consequently, for many asset managers and owners who do not wish to use equity or cash savings, greening their portfolios is conditional upon access to external financial support.

In the residential market there are numerous public and private financing options available to homeowners, local authorities and housing authorities, which are often driven by government policy to encourage retrofitting works that make homes warmer and cheaper to heat. In the commercial real estate sector, the sources of external funding fall into two broad camps- upfront funding for energy efficiency projects (through public policy initiatives, loans or the capital markets) or a zero-upfront funding arrangement in partnership with an energy efficiency service provider. These solutions should be seen along a spectrum, with financing often consisting of a combination of solutions.    

PUBLIC POLICY LED INITIATIVES

The US is a trailblazer in developing financial products to fund energy efficiency. In 2006, the US launched PACE (property assessed clean energy), a form of property-linked finance (PLF).

In US states where PACE programmes are available, local government may choose to either:

• issue PACE bonds to investors, the proceeds of which, can be used to fund energy retrofits both in the commercial and residential sector; or
• in an open-market model, PACE financing is made available by private lenders to property owners through public-private partnerships.

PACE represents long-term funding which can be used to cover up to 100% of the up-front costs of green retrofitting. PACE loans are typically provided for a term of 20 years. Repayment is made over the term of the loan through a voluntary tax assessment, which is secured by the property by way of a tax lien and paid in addition to the owner’s property tax bills. The assessment is property-linked as opposed to attached to the individual asset owner, which results in repayment obligations transferring to the new owner when a property is sold. This means whoever owns the property and is benefitting from the energy efficiency measures, is also responsible for paying for that benefit. Non-payment results in the same repercussions as failure to pay any other tax.

The huge benefit to this source of financing is that it taps into large sources of private capital and allows repayment to be spread across many years, without requiring any upfront payments. In light of the energy crisis in the UK, the Green Finance Institute is continuing to conduct research into PLF, which is not currently available in the UK.

In Asia, Singapore offers many attractive schemes to support energy efficiency projects. The Green Mark Incentive Scheme for Existing Buildings 2.0 (GMIS-EB 2.0) supports projects that pursue higher standards of energy efficiency and will be eligible for higher rates of funding, for example:

• under the scheme, buildings that achieve the highest Green Mark rating of zero energy after retrofitting will get $45 for each tonne per carbon dioxide-equivalent (tCO2e) reduced, capped at $1.2 million; and
• those buildings that achieve the super low energy rating will receive $35 per tCO2e reduced, capped at $900,000, while those that get a platinum rating will receive $25 per tCO2e reduced, capped at $600,000.

The scheme is applicable to privately-owned existing buildings, with a gross floor area of at least 5,000 sqm, and includes commercial and institutional buildings, light industrial buildings and residential buildings where retrofitting is to common areas. It is valid from 30 June 2022 until the available funds have been fully committed or by 31 March 2027 (whichever is earlier).

In 2017, Singapore’s National Environment Agency (NEA) launched the Energy Efficiency Fund (E2F) to help industrial companies improve energy efficiency. The E2F supports a wide range of energy efficiency efforts, such as energy assessments, energy efficient design of new facilities and energy efficiency investments. Complementing this is the Building Retrofit Energy Efficiency Financing (BREEF) Scheme which is valid from 2011 until now. Facilitated by the Building and Construction Authority (BCA) and participating financial institutions, the BREEF Scheme offers financing to pay the upfront costs of energy retrofits of existing buildings. The BCA and the participating financial institutions share the risk of any loan default. To qualify for the scheme, an energy performance contract (discussed more below) must be in place, the retrofits must result in the building achieving the basic Green Mark Certified rating and the building must maintain this rating for the period of the loan tenure.

GREEN AND SUSTAINABILITY LINKED LOANS

Historically, the strategy for identifying eligible sustainable projects taken by development lenders such as, the World Bank, International Finance Corporation (IFC) and Asian Development Bank (ADB), has been distinct from commercial lenders. A development lender’s sustainability and environmental agenda has long informed its lending mandate. For example, many development banks require projects to adhere to the IFC’s Performance Standards on Environmental and Social Sustainability (IFC Standards) – a set of standards which encourages environmental, social and governance (ESG) concerns to be risk assessed and managed throughout the lifecycle of a project. 

Over more recent years however, sustainability is now firmly on commercial banks’ agendas and ESG considerations of large scale construction and development projects. Not only because of changing customer demand, which is pushing for greener investment, but also because most financial institutions have their own targets and reporting mandates to demonstrate the ways in which they are successfully mitigating the risks of climate change and the transition to net-zero.

However, the more obvious way for lenders to show their commitment to sustainability is through financing new green projects or developments. For many lenders, financing energy efficiency initiatives may have less immediate benefits. On the one hand margins might not be as high as funding new developments as the benefits are in savings instead of revenue and savings may be challenging to measure without certain agreed protocols. Also, there may be complicated interactions with existing leases and any existing financings in place. Further, funding energy efficiency solutions may not share the same optics as funding a brand new renewable producer. On the other hand, investing in these sorts of projects helps lenders align with their climate reporting obligations and energy efficiency can produce long-term stable cashflows which can back yield-based products.

There are a growing number of examples of banks providing green loans towards energy efficiency projects. In 2019, HSBC, Barclays and Natwest made a 5-year GBP 450 million revolving credit facility (RCF) available to Derwent London plc, one of the largest UK Real Estate Investment Trusts (REIT). It was the first RCF provided to a UK REIT which includes a green tranche which aligns with the Loan Market Association’s (LMA) Green Loan Principles (GLP).  The green tranche can only be used by Derwent London plc to fund projects that align with Derwent’s “Green Finance Framework”, which was externally reviewed to ensure compliance with the GLP. Activities that align with Derwent’s Green Finance Framework include retrofitting and energy efficiency improvements across their portfolio.

The LMA subsequently published guidance on the application of its GLP in the context of retrofit projects[4]. This guidance provides a further framework for assessing which retrofit projects may qualify as eligible green projects, noting that it is expected that any such retrofit project should result in a “material improvement in the energy efficiency of, and result in a material reduction in the carbon emissions associated with, the buildings being funded”. The guidance also suggests some retrofit-specific standards and certifications to assist with determining the ‘greenness’ of retrofit projects, including the BREEAM Refurbishment and Fit-Out rating, RICS SKA (used for non-domestic fit-outs), PAS 2035 (used for domestic fit-outs) and TrustMark.

Another instrument is the sustainability-linked loans (SLL) based on the LMA’s Sustainability Linked Loan Principles involving setting “sustainability performance targets” for the borrower to meet.  Often, if a borrower does not meet these targets, then the interest rate is ratcheted up, though it is also possible for ratchet downs that provide a clear incentive to borrowers to pursue sustainability initiatives. OUE C-Reit in Singapore recently entered into an SSL with a syndicate of Asian and international lenders incorporating interest rate reductions linked to predetermined sustainability performance targets. These dovetail with the Reit’s water and energy efficiency reduction targets.  In the UK, investment manager Barings’ sustainability-linked GBP 48.6 million loan to Phoenix Group to fund the acquisition of a retail and leisure park in Romford, UK will be used to retrofit the existing buildings to increase the EPC ratings, achieve BREEAM “Excellent” rating, and enhance the biodiversity net gain in the area.

GREEN BONDS

Asia’s vibrant capital market scene has seen rising activity in the green bond space. Like green loans, issuers of bonds that raise cash for "green" projects should apply industry standards, such as principles on green debt from the International Capital Market Association. In Hong Kong SAR, the Global Real Estate Sustainability Benchmark (GRESB) released Green Bond Guidelines for Real Estate, which provide clear sector-specific guidance on how to identify eligible green building projects, implement and manage investment proceeds, and communicate green bond outcomes to stakeholders. Proceeds must be used exclusively to finance or refinance projects that fall under one or more of the “Eligible Categories”, which includes energy efficiency.

Singaporean real estate companies have been leaders in this area. In 2017, the first green bond by a listed company was issued by CDL to refinance an existing green loan on an asset that had undergone various energy and water efficiency upgrades, including the major retrofitting of chiller plants and installation of energy-efficient lightings with motion sensors. In 2022, CapitaLand Ascott Trust (CLAS) partnered with the International Finance Corporation (IFC) to launch IFC's first sustainability-linked bond in the hospitality sector globally. Proceeds of the loans will be used to refinance CLAS' existing borrowings and to further decarbonise three of CLAS' serviced residences in Southeast Asia, including reducing electricity consumption. Like other capital market solutions, these green bonds are often used to primarily refinance existing debt.

ZERO UPFRONT FUNDING

Another alternative source of funding that involves no upfront capital outlay is in partnership with energy efficiency service providers (EESCOs). Some EESCOs are energy service companies (ESCOs) but not always. In all cases, the defining feature is that the EESCO enters into a form of performance contract with the asset owner, called an Energy Performance Contract (EPC).  Historically, the majority of EPCs have been with the public sector (through public-private partnerships), and in more recent years, the private sector has adopted this arrangement.

The EESCO covers the upfront cost of designing, installing and maintaining the energy efficiency solutions required to upgrade the owner’s current systems with a view to achieving guaranteed cost-savings for the system owner, for an agreed period of time. Even if the EESCO does not provide the required capital, it can work with lenders to obtain financing. The ongoing performance and cost-savings achieved by the system upgrades are monitored throughout the term of the contract. If the guaranteed annual cost reductions are not achieved, the EESCO covers the shortfall. If they are exceeded, savings are shared equally between the parties.   Benefits include being able to finance retrofits, whilst freeing up capex to spend in other ways. If debt funding is in place, then the ESCO’s savings guarantee is sized in order to meet debt service.

Beyond offering an EPC, as EESCO may also offer a contract for a wide range of energy efficiency as a service (EEaaS) such as Singapore company BPP. Some companies are going further in their offering and branding themselves as net-zero as a service provider (eg Johnston Controls[5]). EEaaS is a form of performance, off-balance sheet financing solution. The EESCO identifies and implements strategies to achieve pre-agreed savings targets over the term of the contract. The EESCO pays for the project development, construction and maintenance costs. The system owner outsources all risks for implementing these measures to the EESCO, who assumes full responsibility for the cost of implementing the contractually agreed savings targets. The owner pays the EESCO the savings and savings are measured against historical data.  If the system upgrades do not meet the pre-agreed savings then the EESCO bears the cost, however, if they do, then the energy savings are shared between the parties.^[6]

Another route for lenders to support energy efficiency projects is to finance the EESCO’s project through project financing or other forms of loans. Risks will need to be typically assessed as in other types of projects and the EPC or equivalent contract becomes key. As a first in Asia, UOB launched in 2021 their U-Energy platform, an integrated financing platform that allows customers to finance energy efficiency equipment through green loans or to provide loans to the ESCO.

Conclusion

Although, and as discussed in our last article, it may be still be a challenge to accurately quantify any “green premium” or “brown discount” that can be associated with existing stock, it is widely understood that, in the long-term, the cost of inaction will far exceed any initial investment. Faced with the inevitability of brown discount, energy efficiency improvements present asset owners managers with a huge opportunity to retain and enhance the value of their portfolios to maximise returns for their investors.

In all cases, reporting requirements are key and the ability of owners or managers to capture data to evidence efficiency and real savings. To mitigate against claims of “greenwashing”, it may be prudent for owners and managers to start now to gather data. To attract financing solutions, it will be critical to be able to measure efficiencies apart from complying with applicable regulations. In deciding which financing solution to adopt, owners and managers will also have to think about the interaction with any existing financings on their buildings, balance sheet treatment and impact on existing leases.

Asset managers have a tremendous incentive to tap into these financing options discussed above to unlock further value in their existing assets. Although energy efficiency may have received less press, the roadmap to net-zero requires real estate players to make significant investment in making their existing portfolios more energy efficient, not only to reduce their overhead costs and carbon emissions, but also to avoid the very real risk of stranding their assets. In our next article, we will explore how the construction industry plays a vital role in real estate decarbonisation. 

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[1] United Nations Environment Programme, “Energy Efficiency for Buildings”, 

[2] Fidelity International, “How big a threat is the ‘brown discount’?”,  https://www.fidelityinternational.com/editorial/blog/how-big-a-threat-is-the-brown-discount-447270-en5/

[3] World Green Building Counsel

[4] LMA, “Guidance on the application of the Green Loan Principles in the real estate finance (REF) lending context – Retrofit projects” , https://www.lma.eu.com/search?search_paths%5B%5D=&query=green+loan+principles&submit=

[5] https://www.johnsoncontrols.com/media-center/news/press-releases/2021/07/07/johnson-controls-launches-openblue-net-zero-buildings-as-a-service

[6] https://betterbuildingssolutioncenter.energy.gov/financing-navigator/option/efficiency-a-service