Decarbonising buildings plays a critical role in achieving the EU’s goal of climate neutrality by 2050. Hence, the EU’s ambition to have the region’s building stock fully decarbonised by mid-century and reduce the sector’s greenhouse gas emissions by at least 60% by 2030. However, the absence of unified regulatory standards is restraining the potential for investors to get involved, writes Nicolas Toupin.
Accounting for about 40% of the EU’s energy consumption and for 36% of CO₂ emissions, and with 75% of EU’s buildings considered energy-inefficient1, a focus on enhancing energy efficiency and renovation appears to be obvious.
There has been little progress. According to the report on the evolution of the European regulatory framework for building efficiency2, just 0.2% to 1% of buildings in the EU are renovated each year. This is well below the 3% annual rate required to meet the EU’s climate objectives by 2030.
Addressing energy efficiency requires substantial investment. According to the Building Performance Institute Europe (BPIE), achieving the 2050 climate goal will cost about EUR 275 billion per year for building renovations in Europe alone. In response, the EU has committed EUR 648 billion to the Recovery and Resilience Facility (RRF); 37% is for climate-related expenses between 2021 and 2027.
However, public investment will not suffice; the financial sector is expected to facilitate flows towards greater energy efficiency, with a focus on renovating the worst-performing buildings.
Yet, the regulatory frameworks guiding sustainable investments, namely the Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy, do not provide harmonised guidance.3
What is a ‘sustainable investment’ in real estate under SFDR?
SFDR defines sustainable investment4 as
- An investment in an economic activity that contributes to an environmental or social objective
- One that does not significantly harm any environmental or social objective
- One that follows good governance practices with respect to sound management structures, employee relations, remuneration of staff and tax compliance.
There are limits for real estate investment. INREV’s paper entitled Falling through the cracks: SFDR’s impact on real estate investment outlines the complexity:
- Sustainable investment in real estate creates bias towards the ‘prime asset’ which does not significantly contribute to efforts required to decarbonise the building sector. According to INREV, “SFDR focuses on a snapshot of the operational sustainability of the underlying assets rather than the transition of assets”.5 Indeed, these ‘prime assets’ are already attractive to investors who seek to build ambitious ESG/sustainable portfolios. Moreover, INREV outlines the fact that SFDR ignores the importance of ‘embodied emissions’6 and stimulates unnecessary new development. Sustainable Investment under SFDR can be seen as a rigid concept and is nevertheless well suited for necessary investment to transform the existing building stock.
- SFDR concerns transparency issues, but does not offer a harmonized view on sustainable investment methodologies, thus leading market participants to adopt their own approaches. Consequently, this regime involves a potential risk of greenwashing and ultimately creates uncertainty.
SFDR does not encourage the necessary investment
This rigidity and uncertainty can be problematic as it may discourage investments in properties that are undergoing significant energy upgrades, but do not yet fully comply with the most stringent energy standards. According to a study by the Global Alliance for Buildings and Construction, investing in energy efficiency renovations could save 5%-6% of global CO₂ emissions annually, yet the current SFDR framework may hinder the redirection of capital toward these transitional assets.
As renovation plays a crucial role in reducing the carbon footprint of the existing building stock, a proper classification of these kind of investments can convince investors to unlock critical capital flows, encouraging further improvements in energy efficiency.
To meet the EU’s goals, a sizeable portion of the building stock will need to be renovated to improve operational energy use and life-cycle emissions, especially when combined with sustainable construction practices.
In our assessment, SFDR does not encourage the necessary investment in transition7 and may even lead investors to divest from existing inefficient assets.
The EU taxonomy is adding even more complexity.
EU Taxonomy – More flexibility on transitional assets
One of the most significant points of contention between the SFDR and EU Taxonomy lies in how they treat assets in transition, in other words, buildings under renovation.
The taxonomy recognises the importance of transitional activities in achieving long-term sustainability. Indeed, it acknowledges that a building undergoing major renovation or reducing energy demand by at least 30% is a sustainable activity. It thus classifies buildings that are making measurable progress toward decarbonisation investable, supporting the EU’s objective of cutting the carbon footprint of real estate.
With SFDR applying a stringent classification and the EU Taxonomy being more inclusive, investors are being forced to navigate a complex regulatory landscape where an asset that is considered sustainable under one framework may not qualify under another. This leads to:
- Uncertainty and misinterpretation
- Risk of greenwashing
- Investors not allocating to real estate being transformed and, instead, allocating to assets that are already sustainable.
Bridging the gap
We believe there needs to be a greater harmonisation between the SFDR and the EU Taxonomy. In addition, investors should be able to choose multiple approaches to defining sustainable investment under SFDR. This multiple approach could involve these options:
- Decarbonisation trajectories: methodologies such as Carbon Risk Real Estate Risk Monitoring (CRREM) or Assessing Carbon Transition (ACT) are one way to bridge this gap in the assessment of sustainable investments. Buildings that are on a clear path to achieving Net Zero Emission Building (NZEB) standards or have a structured plan for reducing their energy demand could be classified as transitional assets, thereby qualifying for inclusion in sustainability-related portfolios.
- ‘Best in class’ or ‘Best performers’: selection would not rely solely on the actual energy performance metrics, but also integrate factors such as renovation plans, capital spending programmes, life-cycle assessments, building materials, and the operational manager’s climate policies. This approach recognizes the broader context in which renovations and improvements are made.
- Recognition of certification standards: Certifications such as LEED or BREEAM suffer from a lack of transparency and a clear link with, for example, the EU taxonomy standards. Nevertheless, they are a complementary and powerful tool in evaluating the sustainability aspects of building management, renovation, and construction projects. Clearer guidance around the use of these certifications and a better link with the EU taxonomy’s ‘substantial contribution’ criteria can help bridge the knowledge gap for investors and provide a standardised approach to sustainability-related frameworks.
Conclusion
As the EU’s ambitious targets for improving the energy performance of building approach the first deadlines, there is still a lack of clarity between regulatory frameworks. The conflicting considerations of ‘sustainable investment’ under SFDR and the EU taxonomy presents a significant challenge to mobilising investments needed to meet the EU climate objectives.
To truly accelerate the transition toward a decarbonised building sector, clearer guidance for investors is critical. In the meantime, market participants can incorporate factors such as decarbonisation trajectories, multi-criteria evaluations, and certification standards that consider renovation. This would create a more holistic and supportive environment for investors.
[1] EU Commission: Energy Performance of Buildings Directive
[2] Source: BPIE (Buildings Performance Institute Europe
[3] Also see the table on p.7 of https://www.esma.europa.eu/sites/default/files/2023/ESMA30-379-2279_Note_Sustainable_investments_SFDR.pdf
[5] Also see https://www.inrev.org/system/files/2023-03/SFDR%27s-impact-on-real-estate-investment.pdf
[6] Separate from the carbon emissions from the energy used to operate a building, embodied carbon refers to the emissions from the material extraction and manufacture, construction, maintenance, refurbishment, and demolition of a building.
[7] Transitional assets refer to buildings that are on a clear path toward sustainability, but have not yet reached the highest energy efficiency standards.
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