Financial Planning & Analysis

How Does Carbon Neutral Affect Real Estate?

The growing will by both corporate and political leaders to reach net-zero emissions of greenhouse gases (“GHG”) has resonated well with investors and consumers alike. The underlying complexity in achieving such an ambitious goal is no doubt a significant undertaking, and the myriad of existing and future regulations should be top of mind for every key decision maker.

While most industries will likely have to adapt over time, the crosshairs of impending impact are aimed squarely at modernizing commercial real estate to become carbon-neutral. The sector alone, including both construction and operations of buildings, contributes to 40% of GHG emissions. The implication of carbon neutrality is a combination of higher construction costs for new buildings and accelerated obsolescence across existing assets. As an unfortunate byproduct, real estate users will likely end up sharing some of the financial burden.

Applying the Greenhouse Gas Protocol Framework for Carbon Neutral Real Estate

Although not yet required, regulators and investors alike have requested companies report their emissions based on the framework developed by Greenhouse Gas Protocol (“GGP”):

  • Scope 1 (direct): Emissions related to building operations
  • Scope 2 (upstream): Emissions caused by energy consumed at the property
  • Scope 3 (indirect): Emissions from all other activities

While current U.S. laws are focused on Scope 1 & 2, largely due to ease of tracking and regulating, Scope 3 is likely to have the biggest impact in the future. Covering 15 categories of activities, Scope 3 is effectively a “catch-all” bucket that also includes emissions generated by tenants, be it waste management or even daily commute and business travel. Measuring and tracking such data is understandably much more difficult, but momentum is growing in making it mandatory to serve as the basis for future regulations and penalties, as Scope 3 emissions account for over 80% of a typical business organization’s total emissions per Intergovernmental Panel on Climate Change (“IPCC”).

Current & Potential Legislations Impacting Carbon Neutral Real Estate

Over the past decade, a number of states and cities have enacted various green measures affecting carbon neutrality in real estate. Largely driven by coastal, “blue-leaning” markets, recently announced or enacted goals are centered around commercial real estate. Examples include:

In particular, two recent prominent legislations will proactively punish businesses for excess emission:

  • Local Law 97 in New York requires most buildings over 25,000 square feet to meet new energy efficiency and GHG emission limits by 2024 (and a stricter limit in 2030 that is well below today’s levels). Failure to comply will result in a $268 fine per metric ton over the limit.
  • In Southern California, the Warehouse Indirect Source Rule (ISR) being implemented gradually since 2021 is requiring industrial warehouse users in Los Angeles, Orange County and Inland Empire to offset all emissions from vehicles coming in and out of facilities. ISR is effectively targeting trucks that are responsible for 70% of all smog pollutions in California and imposing an annual tax ranging from $0.19 to $0.85 per square foot.

While these new laws are local and being challenged, ongoing legal battles do not seem to have a strong chance of watering down the restrictions. Furthermore, the basic premise can be easily replicated in other markets and even serve as the precursor to more onerous mandates in the future. In particular, ISR by itself can have significant national implications as the Port of Los Angeles and Port of Long Beach collectively handle close to 40% of all cargo containers entering the United States.

Granted, the U.S. has lagged many nations on reaching carbon neutrality, and federal-level efforts and actions are relatively limited today. However, the Biden administration recently created the Building Performance Standards Coalition, joining over 30 political leaders in an effort to adopt various legislations and regulations by 2024. More importantly, SEC issued a proposal in March requiring public companies to report GHG emissions, audited climate-related financial risks and metrics, and information regarding their targets, goals and transition plans starting 2024 (based on 2023 data). Under the proposed guidelines, disclosures based on the aforementioned GGP framework will be required, with exemption for Scope 3-related reporting only if it does not pass the materiality test. Though fierce opposition is anticipated, the news is nonetheless a clear indication the regulatory burden will likely escalate going forward.

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Carbon Neutral Real Estate: Looking Beyond 2024

While predicting the exact measures dictating carbon neutral real estate today is essentially a fool’s errand, business leaders nonetheless should pay close attention in the coming years as new rules crystalize. Owners and users of assets with heavy energy consumptions, such as digital infrastructure, cold storage facilities, R&D space and leisure-oriented properties (e.g., retail centers, hotels and entertainment venues) will likely be most negatively impacted, while office and traditional warehouse space will likely experience a moderate level of impact.

Final Thoughts on Carbon Neutral Real Estate

Aside from staying informed on the legislative front, tenants can proactively consider a number of measures:

  • Reassess office space and travel needs. An easy, tangible path that can pay immediate dividends, reducing office space and business travel in the post-pandemic environment should be a relatively easy transition. Leading companies such as Zurich Insurance and Bain & Co. have announced plans to reduce emissions related to business travel by up to 70%, while others are in the process of reducing office space, as enterprises embrace broader acceptance of remote work and online collaborations. Tenants that wish to maintain a large footprint can either consider moving to newer vintage buildings or construct leases that have built-in options to expand or reduce square footage as needed.
  • Analyze energy consumed and craft an actionable plan. (EPA has published a guide for starters.) While digital metering systems and software have been around for a long time, most basic (free) systems simply do not provide data granular enough to thoroughly study usage patterns and properly identify root cause of any spikes or sustained high usage. In addition, tenants with triple-net leases may be subject to any laws targeting Scope 2 emissions as they are the party directly paying for energy usage.
  • Anticipate wider adoption of green leases to facilitate alignment between landlords and tenants in combating climate change. While the burden of compliance will more likely be placed on landlords, tenants should expect to share the pain through higher rents and/or lease provisions that can penalize users with excessive energy consumption. The aforementioned LL97 in New York is expected to cost approximately $20 billion in retrofitting cost and upgrades. As such, it would be unwise to assume landlords will happily absorb the entire bill.
  • For operators impacted by ISR, the path is less clear. The penalty can be reduced or even eliminated by deploying zero-emission Class 8 trucks and yard trucks and/or installing electric charging stations. However, such zero-emission vehicles are not expected to be widely adopted until 2040 at the earliest. Many users rely on third-party logistics and therefore do not possess direct control over their trucking operations.

Each of these choices involve complex, multi-faceted analyses, and tenants are well-advised to involve the finance and accounting teams in every aspect of the process. Following ASC 842, the financial ramifications on a GAAP basis can be significant, in addition to cash flow implications.

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