Decarbonizing Buildings with Retrofit: Understanding the Economic Ecosystem and Adoption Barriers

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Nearly 40% of global greenhouse gas emissions come from buildings, thus reducing the carbon footprint of buildings is crucial for a sustainable future. We are currently at a pivotal moment in this effort, with increased alignment between government, business, investors and tenants today. This alignment is driven by a number of factors, including:

1. Environmental concerns: As awareness about climate change and its impacts grows, there is increasing pressure on the building sector to reduce its carbon footprint. The numerous extreme weather events that occurred globally in 2022 and 2023 served as a vivid reminder of the increasing effects of climate change on our built environment
2. Government regulations: Many governments around the world have introduced regulations and incentives to encourage the adoption of energy-efficient technologies and practices in buildings, including the IRA and EU’s Renovation Wave.
3. ESG Demand from investors: A growing percentage of portfolios, from individual savers to large institutions, are being allocated toward sustainable strategies as investors aim to use their capital to contribute to a more sustainable world. In 2021, ESG-integrated funds received over $500 billion in investments, resulting in a 55% increase in assets under management for ESG-integrated products.

It is worth reviewing some of the recent government efforts to promote energy-efficient buildings:

U.S. Inflation Reduction Act

The Inflation Reduction Act (IRA) is a groundbreaking climate legislation in the U.S. It could cut GHG emissions up to 43% below 2005 levels by 2030 with its $370 billion investment in climate and clean energy. The IRA could also create up to 1.3 million new jobs and reduce air pollution, avoiding nearly 4,500 premature deaths annually by 2030. Most provisions of the Inflation Reduction Act of 2022 became effective Jan. 1, 2023.

Many of the IRA provisions aim to decarbonize buildings, including homes and businesses. It targets both new and existing buildings to promote electrification by incentivizing homeowners and builders to refurbish or build their buildings or facilities with more energy-efficient electric alternatives. The IRA’s incentives and programs aim to speed up the adoption of efficient, all-electric appliances and equipment in homes and buildings, improving the health of homes while reducing power bills. These incentives target both residential and business/local government. For example, the IRA includes $4.3 billion for direct consumer rebates on whole-home upgrades that achieve 20% to 35% household energy savings. Low-to-moderate income (LMI) households can receive rebates ranging from $4,000 to $8,000 per household for efficiency upgrades and non-LMI households can receive rebates ranging from $2,000 to $4,000.

EU Energy Performance of Buildings Directive

The fourth version of the Energy Performance of Buildings Directive, known as the EU’s Renovation Wave, aims to increase retrofitting and decrease building emissions by 60% before 2030. Additionally, a new Energy Efficiency Directive will further drive change within the EU.

National policies are also supporting these efforts. For example, Italy’s superbonus scheme reimburses homeowners 110% of the cost of energy-efficient equipment, resulting in increased adoption. Germany has implemented measures to reduce energy consumption by 9% before 2030 and will ban new fossil fuel heating systems by 2024. The UK is taking steps to encourage energy conservation and plans to prohibit new gas heating systems and boilers by 2025 and ban them entirely by 2035. The French government also offers a range of incentives to incentivize building owners to retrofit their buildings and enhance energy efficiency. These incentives include tax reductions or refunds for homeowners who undertake energy efficiency improvements in their primary residence, as well as interest-free loans that enable building owners to finance energy-saving measures.

Even with the global efforts to encourage the retrofitting of buildings, including governments’ incentives worldwide, some building owners still lack the motivation to make these changes to their properties. There can be several reasons why a building owner might avoid retrofitting to a more energy efficient building, which touches on our next topic: the principal-agent problem.

A Potential Principal-Agent Issue in Real Estate Asset Ownership

Before retrofitting a building, an owner will typically evaluate the potential return on investment by considering factors such as future revenue streams, historical rent roll, and vacancy rates.

A principal-agent issue arises here when there is a conflict of interest between the owner (principal) and the person operating the asset (agent). In the context of building retrofitting, the building owner is the principal and the tenant is the agent. If a building owner invests in retrofitting their building to make it more energy efficient, they may incur significant upfront costs. However, if the tenant pays the utility bills, they are the ones who will benefit from lower energy costs as a result of the retrofit. In this case, there may be a lack of motivation for the building owner to invest in retrofitting their building since they will not directly benefit from lower energy costs.

The consideration of property taxes also comes into play. In certain instances, building owners may choose to transfer property tax costs to their tenants by raising the rent. This is commonly achieved through a lease arrangement known as a net lease, where tenants assume partial or complete responsibility for property taxes, insurance fees, and energy costs in addition to the base rent. While retrofitting a building can offer competitive advantages and positive marketing opportunities to attract environmentally conscious tenants and investors, it can inadvertently lead to higher property taxes due to the increased value of the property. This is particularly true in many urban areas in the U.S. which more heavily tax commercial assets vs. residential. As a result, building owners may exhibit hesitation in making such investments as they face limitations in passing on the escalated taxes to their tenants (although equally reducing energy costs — six eggs in one basket, half dozen in the other).

There are several measures to mitigate this principal-agent issue in the form of rebates or incentives. Building owners may be eligible for incentives or rebates from utility companies, government agencies, or other organizations when retrofitting their buildings to be more energy-efficient. The availability and amount of these incentives vary depending on location and other factors. Some of the available benefits are as below:

• Energy efficiency rebates: Many utility companies offer cash rebates for retrofitting a building to be more energy-efficient. These rebates can apply to specific equipment or systems such as lighting, HVAC systems, and insulation.
• Demand response programs: Some utility companies offer incentives for participating in demand response programs, which are designed to reduce energy consumption during peak demand periods. Building owners may receive payments for reducing their energy usage during these times.
• Net metering: For buildings with solar panels or other renewable energy sources, net metering allows building owners to receive credits on their energy bills for the excess energy they produce and send back to the grid.
• Tax credits: The federal government and some states offer tax credits for building owners who make energy-efficient upgrades to their properties. These tax credits can help offset the cost of retrofitting a building (including tax credits from the IRA).
• Grant programs: In some cases, government agencies may offer grant programs that provide financial assistance to building owners who are retrofitting their properties to be more energy-efficient. These grants can help cover the costs of equipment and installation.

To accurately assess the future of the building sector and combat global carbon emissions, we should first explore the distinction between embodied and operating carbon, and its importance to retrofitting existing buildings.

Embodied carbon refers to the total emissions used to source, manufacture and transport materials used to construct a building as well as the construction methods employed to erect the structure and the end-of-life demolition. On the other hand, operational carbon refers to all the energy used in managing and maintaining the function of a building.

According to IEA, the buildings and construction sectors are responsible for approximately 40% of global energy-related carbon emissions annually as of 2018, of which 67% is due to building operations (from energy needed to heat, cool, and power buildings) and the remaining 33% (referred to as “embodied carbon”) from the manufacture of building materials and products such as steel, cement, and aluminum, and the construction process itself.

It is worth noting that reducing operational carbon emissions from buildings is a critical component of global efforts to address climate change in terms of the proportion. Retrofitting existing buildings to be more energy-efficient and transitioning to renewable energy sources can help reduce these emissions and contribute to a more sustainable future.

The carbon emissions from operations can be reduced through the decarbonization of the electricity grid in the long term. The timeline for achieving a 100% renewable energy grid in the US varies by region and depends on many factors such as government policies, technological advancements, and public support. A group of researchers at Stanford led by Mark Jacobson, professor of civil and environmental engineering, has set out to prove that a 100% renewable energy grid by 2050 is not only feasible but can be done without any blackouts and at a lower cost than the existing grid.

While the EU has not set a specific target to run on 100% renewables, it has set a target to increase the share of renewable energy sources in its energy mix to at least 32% by 2030. This target was established as part of the EU’s Renewable Energy Directive, which requires all member states to increase their share of renewable energy in their final energy consumption. Some individual countries within the EU have set more ambitious targets for the share of renewables in their energy mix. For example, Denmark has set a goal to run on 100% renewable energy by 2050, while Sweden aims to achieve this by 2040.

The following illustration showcases how retrofitting buildings can play a crucial role in reducing carbon emissions prior to achieving grid decarbonization:

• Scenario 1: 80’ building without retrofit nor grid decarbonization
• Scenario 2: 80’ building with grid decarbonization (100% renewable in 2050)
• Scenario 3: 80’ building with retrofit and grid decarbonization (100% renewable in 2050)

The above graph is based on several assumptions:

• The contribution of embodied carbon and operational carbon will remain constant unless retrofitting or grid decarbonization measures are implemented.
• The grid worldwide will be decarbonized in a linear manner every year, reaching 100% renewable energy by 2050 (based on U.S. data).
• Retrofitting the buildings will result in a 30% reduction in their operational carbon emissions through decreased use of fossil fuels.

Buildings are responsible for emitting approximately 10 billion tonnes of carbon annually out of a total 36.3 billion tonnes according to IEA’s most recent data. The analysis above shows that retrofitting buildings can help reduce global carbon emissions by up to 5% per year until 2050, which translates to 1.8 billion tonnes of annual carbon. To put this in a more intuitive perspective, 1.8 billion tonnes of carbon emissions is equivalent to roughly 1.8 billion tonnes of CO2e, or the annual emissions of a country like India, which is one of the world’s largest emitters. To put it another way, it is also equivalent to the annual emissions of multiple coalitions of several countries combined. For example, it is roughly the annual emissions of the European Union (EU) or the combined emissions of the United States, Germany, and Japan.

Reducing carbon emissions up to 1.8 billion tonnes annually would represent a significant step towards mitigating climate change and achieving global emissions reduction targets. Given that the transition to renewables is not expected to be complete for approximately 30 more years, these annual emissions reductions can add up to a significant amount of carbon avoided over time.

The above analysis conservatively assumes that existing buildings can achieve a 30% reduction in carbon emissions after retrofits. However, current research suggests that the impact of retrofits could be even more significant. According to a study published in Nature Communications, stock-wide implementation of shallow and deep retrofitting packages along with onsite photovoltaic generation potential in eight cities worldwide could reduce energy use and carbon emissions by up to 66% and 84%, respectively.

Adding to this, retrofitting buildings can also facilitate the integration of renewable energy sources like solar panels, wind turbines, and geothermal systems in several ways:

• Structural suitability: Retrofitting buildings can involve making structural changes to the building to make it more suitable for integrating renewable energy sources. For example, installing solar panels may require reinforcing the roof to support the weight of the panels or installing wind turbines may require a taller building or structure.
• Electrical upgrades: Retrofitting buildings can also involve upgrading the electrical system to accommodate renewable energy sources. This may include installing inverters to convert the direct current (DC) generated by solar panels or wind turbines into alternating current (AC) that can be used to power the building or feeding excess energy back into the grid.
• Storage solutions: Retrofitting buildings can also involve integrating energy storage solutions, such as batteries, to store excess renewable energy generated during peak production periods for use during periods of low production. This can increase the efficiency and reliability of renewable energy systems and reduce the need for backup power sources that rely on fossil fuels.

This can further reduce carbon emissions by replacing fossil fuel-based energy with cleaner, renewable energy sources.

There are numerous ways to retrofit a building to improve its energy efficiency and reduce its carbon footprint. Presented below is an illustrative diagram showcasing various ways in which a building can be retrofitted:

Some additional innovative examples of building retrofit that have been more recently introduced:

• Green roofs: Adding a green roof to a building can provide insulation, reduce stormwater runoff, and provide additional green space.
• Heat recovery systems: Installing heat recovery systems can recover heat from exhaust air and use it to heat incoming air or water, improving energy efficiency.
• Building-integrated photovoltaics: Building-integrated photovoltaics (BIPV) integrate solar panels into the building envelope, providing renewable energy and reducing the need for separate solar installations.
• Energy storage systems: Installing energy storage systems, such as batteries, can store excess renewable energy generated by the building, allowing it to be used when needed.
• Radiant heating and cooling: Radiant heating and cooling systems use pipes or panels to circulate heated or cooled water or air, providing efficient and comfortable heating and cooling.
• Smart lighting: Smart lighting systems use sensors and controls to adjust lighting levels based on occupancy, reducing energy waste.
• Daylighting: Daylighting strategies, such as skylights or light shelves, can provide natural light to interior spaces, reducing the need for artificial lighting and improving indoor air quality.
• Electric vehicle charging stations: Installing electric vehicle charging stations can encourage the use of electric vehicles and reduce greenhouse gas emissions from transportation.

As technology advances, retrofitting buildings for energy efficiency and sustainability is likely to have an even greater impact. The advancement of technology can play a crucial role in reducing the carbon footprint of buildings through retrofitting, and ongoing research and development in this area can help accelerate progress towards a more sustainable built environment.

Eugene Lee is an investment banking associate at Credit Suisse and former MBA intern at GS Futures, which originally published this article on Medium.