Ecologic obsolescence: calculating the value at risk for stranded hotel assets

This is an abbreviated version of the full article, which can be found on our website, linked below.

The failure to convert hotels to become net-zero carbon emitters has a major impact on the bottom line by incurring carbon credit expenses or penalties as well as excess energy consumption levels. This article analyses current asset performance, future goals and the value at risk from foregoing necessary conversions to net-zero carbon by 2050. Failure to do so results in stranding of assets – a term the real estate industry should understand as a new form of “ecologic” obsolescence. Asset owners could face impairments (present value) from US$30,000 to US$230,000 (!) per key for an obsolete 5-star hotel– a large part of which can be mitigated while improving the bottom line.

Green House Gas emissions and reduction targets

Among a global drive to decarbonize the economy, governments across the world have signed up to drastically reduce carbon (or GHG: greenhouse gas) emissions. The United Nations Framework Convention on Climate Change (UNFCCC) with 197 countries represented, through the Paris Agreement in 2015 and the 26^th Conference of Parties (COP 26) in Glasgow 2021 implemented specific measures towards mitigating climate change by restricting temperature rises to well below 2⁰C above pre-industrial levels via the reduction of GHG emissions.

CRREM pathways

Globally, the real estate sector is responsible for 36% of total energy consumption and 37% of total GHG emissions. Naturally, residential real estate plays a large role along both dimensions. However, non-residential uses may be more challenging and costly to decarbonize. To achieve the intended goal of decarbonization by 2050, the EU funded a research project named Carbon Risk Real Estate Monitor (CRREM).

"CRREM aims at developing a tool that allows investors and property owners to assess the exposition of their assets to stranding risks based on energy and emission data and the analysis of regulatory requirements. By setting science-based carbon reduction pathways, CRREM faces the challenge to estimate risk and uncertainty associated to commercial real estate de-carbonization, building a methodological body and empirically quantify the different scenarios and their impact on the investor portfolios."

CRREM set regional ‘pathways’ to gradually limit and reduce GHG and energy use to achieve the targets by 2050. It is important to emphasize that both metrics vary heavily by locale based on the carbon intensity of the electricity grid today and the energy use on site due to climate conditions among other factors. Thus, each country in the EU has its own pathway for different uses (residential, office, hotel, etc) and CRREM provided pathways for a selection of international markets as well. Notably, hotels are the assets with the largest carbon footprint and energy use, similar to inefficient office buildings and only trailing industrial manufacturing properties (where the processes and machinery within can create an abundance of GHGs and consume significant energy).

Stranding risk as ecologic obsolescence

The failure of a building or infrastructure to reduce GHG emissions and energy use below the pathway target at any point in the future results in a so-called ‘stranded’ asset. This is akin to a form of obsolescence. Next to functional (from outdated features) and economic (from changes in market conditions) obsolescence, a stranded asset could be considered to suffer from ecologic obsolescence or to be ecologically obsolete. Ecologic obsolescence is different from economic obsolescence in that market and environmental conditions need to be recognized as two distinct domains (the environment may deteriorate while markets continue to perform well, something we have observed more frequently in the last decade). At the same time, ecologic obsolescence can be understood as a combination of functional and economic obsolescence due to the transition risk.

Case Study: 5-star Hotel, Sydney

The point in time when ecologic obsolescence is reached is illustrated in the detail below by example of a typical Sydney 5-star hotel and the two Australian CRRREM pathways. The energy usage and carbon footprint are based on the Cornell Hotel Sustainability Benchmarking Index (CHSBI) average values for Sydney 5-star hotels. For this analysis, we have assumed a hypothetical hotel starting in 2020 as show in the first table.

Decarbonization pathway for a Sydney 5-star hotel

The chart illustrates how a stranded asset (via the decarbonization pathway) incurs additional expenses to remediate ecologic obsolescence by buying carbon credits.

Assuming a hypothetical scenario, where this hotel’s carbon footprint remains constant until 2050, carbon credits will need to be purchased annually after becoming ecologically obsolete in 2025. The chart uses the example of a hypothetical Sydney 5-star hotel of 500 hotels rooms and 50,000 sqm GFA with a carbon footprint based on the average value from the Cornell Hotel Sustainability Benchmarking Index (CHSBI). The cost for each carbon credit is based on the Australian Carbon Credit Units (ACCUs) price as of 21 December 2021 (AUD49 per metric ton increased at inflation of 3.0% annually). The detail shows how the annual carbon credit expense increases to US$689,000 by 2050 or US$291,000 deflated to 2021 dollars (cumulative US$4,626,000 through 2050 in today’s dollars). This is a significant expense impacting a hotel’s bottom line, asset values and ultimately, investor returns while carbon credit prices are assumed to be increasing at inflation while it can be expected that prices will outpace it (see chart on ACCU prices towards the end of this article). A similar approach was adopted for CRREM energy reduction goals.

Quantifying ecologic obsolescence of 5-star hotels around the world

Adopting the above methodology, we analyzed twelve other markets around the world. All cities are based on the same hypothetical asset of 500 room with a GFA of 50,000 m². The carbon footprint and energy uses are based on the CHSBI and pathways limits on CRREM. Findings are shown in the second table.

Applying carbon penalties per the City of New York's LL97 (at US$268 per ton CO₂ and well within the ranges outlined under the scenario analysis by NGFS) to the sample of markets, paints a more dramatic picture, shown in the third table. The combined penalties and savings for a 500-room, 5-star hotel ranges from US$31 million to US$115 million or US$63,000 to US$230,000 per key. While this is based on LL97 penalties, projections from the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) shows a steady increase in carbon pricing where many markets would be above LL97 levels, as high as US$1,647 per ton CO₂.

Conclusion

This analysis has shown the expenses, savings and penalties attributable to stranded asset through ecologic obsolescence. All stakeholders in the industry should work towards meeting CRREM pathway limits and reduce the industry’s carbon footprint and energy use for existing properties. For those that want to find out how this can be done, please contact the author. Embodied carbon presents another challenge for new hotel projects, which calls for more documentation and analysis

Dan Voellm
CEO
+852 3628 3871
AP Hospitality Advisors

View source