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How carbon credits could resolve the split incentive for mid-tier building upgrades

Commercial Real Estate By Mathuran Marianayagam, Head of Building Performance Australia – 16 November 2022

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Mathuran Marianayagam

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Willow Aliento

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The split incentive is like the property industry equivalent of one of those great science puzzles. Academics, industry experts and policy-makers alike have looked at it from multiple angles and considered it almost impossible to resolve for many asset classes.

The crux of it is, how can owners be incentivised to improve their buildings if the main financial benefit of that investment goes to tenants who have reduced energy bills? In the premium commercial property sector, it has been resolved through a market shift that sees tenants willing to pay more for office space with a high NABERS rating.

But the problem remains largely intractable for mid-tier commercial office buildings, suburban independent retail and other properties where tenants are more of a captive audience.

We believe there is an opportunity to reframe this from the perspective of carbon emissions reductions and the financial instrument of carbon credits. This incentive for owners – an income benefit from emissions reductions quantified and valued as Australian Carbon Credit Units (ACCUs) – is already valid on the technical and policy level. The commercial buildings energy performance improvement method approved by the Clean Energy Regulator under the Emissions Reduction Fund (ERF) sets out the technical and operational process.

However, up until now there have been no ACCUs generated using this method within the ERF reverse auctions.

This is a significant missed opportunity. It also signals a lack of awareness of the very real costs of a business-as-usual built environment scenario. High emissions buildings – particularly those with aging inefficient building systems gearing for replacement, or those with on-site combustion of gas for hot water, space heating and cooling, catering kitchens and industrial processes – are exposed to the escalating price volatility of gas and the likely introduction of emissions pricing.

They are also exposed to loss of value, challenges around refinancing and potential increases in insurance premiums. As global finance increasingly looks for stringent ESG measures and moves towards preferencing low-emissions and net-zero assets, the risk of asset stranding becomes more acute for owners of inefficient buildings.

If we take onboard the recommendations of the IPCC Working Group III 2022 Report in relation to existing buildings - and reframe building upgrades and retrofits within the context of carbon credits generation as a positive on the project balance sheet - we can boost the business case for business-as-usual asset owners to step onto a net zero pathway.

Concurrently, the exponential growth in the green finance, green bonds and sustainability-linked loans offerings signals an opportunity to avert asset stranding and obtain competitive finance to do so. We are also seeing a maturing of the global carbon trading market, and an increased emphasis in Australia on offsets secured from on-shore projects with audited and verifiable emissions abatement outcomes. Climate Active certification, for example, is putting in place requirements for a certain proportion of offsets to be from Australian projects and ACCUs.

If we combine these trends, there is an opportunity for initial emissions audits of each tranche of buildings to establish benchmarks for current emissions and future emissions under a business-as-usual operational scenario compared to projected emissions following full all-electric and energy efficiency retrofit. The emissions reduction identified through comparing these two scenarios – supported by energy modelling for verification – potentially represents a new source of saleable carbon credits.

“we can boost the business case for business-as-usual asset owners to step onto a net zero pathway”

A crucial element of this is electrification as part of the retrofit and performance upgrade package.

Simply reducing electricity use and/or purchasing green power does not address the on-site Scope 1 emissions from gas combustion. These emissions are the Achilles heel of our collective decarbonisation trajectory. Engineering out gas will also deliver on the additionality requirements of the ERF methodologies because electrification abates emissions that otherwise would continue to be released. By contrast, as the mains electricity supply transitions to a higher penetration of renewables, there will hopefully come a point where all electricity use is renewable, and there would be no basis for ACCUs simply from reducing electricity use.

The process of quantifying emissions reductions from retrofits in the planning and modelling stage (and then during works incorporating smart systems to verify in real-time the emissions footprint) could also meet the requirements of products such as Green Loans, Sustainability-Linked Loans and Climate Bonds. This option of longer term, competitively priced finance should appeal to savvy owners, and conversely, the growing quantity of global capital looking for solid investment opportunities with high ESG value can engage with the retrofit market.

There are elements of this idea that still need to be resolved such as the lifespan of ACCUs relative to finance terms, and how to extend the ERF methodology to properties that do not qualify for a NABERS rating, or the new sectors added to the NABERS suite such as residential aged care, warehouses and cold store, but the basic premise is exciting.

Farewell split incentive – carbon credit retrofits means everybody wins.