How will new carbon-reduction regulations affect the global economy? Those grappling with this question should consider the example of Britain, which implemented sweeping new rules on April 1, 2010. The UK’s Carbon Reduction Commitment Energy Efficiency Scheme (CRC) will directly affect approximately 5,000 organizations, public and private. The CRC aims to reduce carbon emissions produced by large “low energy-intensive” organizations by approximately 1.2 million tons per year by 2020, and to reach an 80% reduction by 2050.
The UK’s real estate investment trusts (REITs) serve as a valuable test case for the impact of CRC. Commercial property currently accounts for 14% of total UK carbon emissions, and as REIT tenants include other large corporations and government agencies, their response to CRC will ripple throughout the UK economy.
The new carbon scheme’s impact on British REITs is the topic of an April 2010 RiskMetrics ESG Analytics Issue Brief. This article summarizes our report’s main findings, our methodology, and some of the implications of the CRC’s “carrot and stick” approach to carbon reduction.
Big Electricity Consumers to Pay for Carbon
The CRC presents a clear risk to companies that fail to reduce their carbon emissions. The scheme implements new fees and regulations for organizations that consumed over 6,000 MWh of half-hourly metered (HHM) electricity during 2008. Disclosure and reporting of energy and carbon emissions are required for those that consume less than 6,000 MWh but over 3,000 MWh of electricity per year.
For large regulated companies, carbon allowances will be priced at GBP 12 per ton of carbon derived from energy consumption for the initial 2010-2013 phase. Subsequent phases (2013-2020 and 2020-2027), will add caps to the total supply of allowances, with prices set by auction. A league table will be compiled at the end of each reporting year naming the best and worst performers. This will be used to assess financial rewards and penalties for regulated firms.
Carbon Pricing Both Carrot and Stick
Allowances are sold by the Government at the beginning of the annual reporting year. In the CRC’s later phases, allowances will be sold by auction to CRC participants, and there will be no cap on the pricing. Participant organizations can buy or sell additional allowances by trading on the secondary market.
The CRC also promises to reward firms for their carbon emissions reduction. All the revenue raised by the annual sale or auction of allowances will be “recycled” back to participants, depending on the organization’s position on the league table. In effect, the “dirtiest” companies will contribute to their cleaner competitors’ balance sheets.
This best-in-class bonus is designed to accelerate over time. By the fifth year, its value can be up to 50 percent of the share of the company’s regulated carbon emissions, multiplied by the amount available in the recycling pot.
Projections of CRC’s Impact
For fully participating British REITs, we attempted to estimate the costs of CRC and predict the leaders and laggards on the eventual league table. The researched firms include Big Yellow, British Land, Great Portland Estates, Hammerson, Land Securities Group, Liberty International, SEGRO, Shaftesbury, and TR Property Investment Trust.
There are two main components to our evaluation:
1. CRC Exposure: We have mapped out the level of risk exposure of the U.K. REIT companies’ operations based on their carbon reduction targets, actual carbon emissions and the size of the companies including market capitalization, revenue, and total floor space owned/managed. As CRC cost is based on carbon derived from energy consumption, the larger the company’s operation, the higher the energy and CRC costs.
2. Carbon Management Quality: Using our proprietary Carbon Beta Analytics platform, we have evaluated companies’ carbon management quality by benchmarking their governance structure, GHG reduction target, energy efficiency and/or emission mitigation strategy, renewable energy strategy, supply chain emissions, and carbon related product development/profit opportunities.
Our carbon footprint benchmark incorporated each company’s absolute carbon emission and size of the company (revenue and floor space owned/managed as proxy for size).
We used electricity as a proxy for energy, as electricity tends to be a significant portion of total energy consumption for a REIT. Based on companies’ public disclosure, we gathered the data of the company’s electricity consumption and cost for the financial year 2009. Where data was unavailable, we estimated electricity cost based on the average electricity price in 2008. Cost of CRC allowances was calculated by converting electricity into carbon tonnage and using the GBP 12 unit price.
Already a Wide Gap between Leaders and Laggards
Based on our analysis, we found that the top REIT is committed to achieving 1) Building Research Establishment Environmental Assessment Method (BREEAM) Excellent certification (the highest level) for all new developments; 2) a minimum BREEAM Very Good rating for all office refurbishments with a construction cost over GBP 3 million (USD4.5 million); and 3) an Energy Performance Certificate (EPC) rating of no more than 60.
We found that the leaders are separated from laggards by significant margins. For example, the best-performing REIT currently emits 2.8 tons of CO2 per square meter of floor space owned and managed. By contrast, the worst-performing firm releases 79 tons of CO2 to operate the same amount of property. Clearly, the carrots and sticks of CRC could upend the competitive balance of the British real estate sector.
Costs and Benefits to Trickle Down
Our research suggests that as both tenants and landlords will pay more for their energy usage, both parties to place more demands on each other. As tenants, including large retailers, corporations and government agencies, will bear significant costs associated with the CRC, we expect demand for green buildings to rise substantially.
We expect U.K. REITs to develop strategies and products, monitor and strengthen operating performance, and improve tenant engagement efforts to meet regulatory demands, and retain tenants.
Those that still adopt a wait and see approach are playing a dangerous game. Until now, property owners could rationalize underinvestment in efficiency measures. While laggards paid a penalty in energy costs, they also avoided spending scarce capital on their properties. Under CRC, investors may no longer find this to be a fair tradeoff. Carbon costs, penalties, and cash transfers to league leaders will upend the calculus of the real estate sector, rewarding REITs and investors who commit to “greening” their portfolios.
Chaoni Huang is a London-based RiskMetrics ESG Analyst, and she is part of the Financial Services team.