In December 2021, as the world busied itself managing the Omicron wave and reckoning with emergent inflation, the European Commission, to little fanfare, announced a new policy aiming to radically alter the trajectory of building decarbonization on the continent. In order to meet its goal of reducing GHG emissions from buildings by 60% by 2023 (36% of EU emissions come from buildings, the single biggest source), the Commission set a target of a 3% annual renovation rate for European buildings, up from the current rate of 1%, and laid out plans to enforce that policy through a series of punitive measures targeted at landlords (more on that below)[1]. Just two months later, the urgency around building energy efficiency and decarbonization was ratcheted up further as the Russian invasion of Ukraine initiated price shocks across European energy markets (in some cases, prices spiked more than 30x their long-run averages). Soaring energy bills left individuals and businesses reeling and underscored the importance of energy efficiency as an immediate means by which to reduce energy consumption, improve energy independence, and lower GHG emissions. While an aggressive renovation target is a reasonable first step, Europe’s policy framework is largely silent when it comes to the scale up on the supply side. EU policy must be far more comprehensive to meet the Union’s laudable building decarbonization goals.
So, how does the EPBD aim to triple the renovation rate, almost overnight? In simple terms, it directs each member state to give an Energy Performance Certificate (“EPC”) to all residential and commercial buildings based on their energy efficiency characteristics, with the worst performing 15% of buildings receiving a G-level rating (the rating system runs from A-G). Under the new regulations, G-rated commercial buildings must “be renovated and improved to at least energy performance class F at the latest by 2027 and to at least energy performance class E at the latest by 2030. [Similarly], the worst-performing residential buildings [must be renovated] to at least class F by 2030 and to at least class E by 2033.”The target rate of renovation would put the EU on pace to renovate nearly its entire building stock by 2050. These regulations have sharp teeth: if buildings don’t meet the minimum acceptable EPC at a given time, they cannot be rented or sold until they have been renovated up to the current minimum standard.
In essence, the EU is betting that the nightmarish specter of stranded real estate assets will drive owners to renovate and do so quickly. There are plenty of assets at risk: 85% of the continent’s buildings were constructed last century, and just over 50% of the Union’s buildings currently have a woeful EPC rating of E or below. 30% of buildings are rated F or G and must be renovated over the next 7-10 years or face the prospect of being stranded.
While the EU has provided some modest funding to its member states to support renovation efforts, it pales in comparison to the need. The EU has allocated 9B Euros annually towards renovation efforts from their Recovery and Resilience Facility. The Buildings Performance Institute estimates that to reach the 3% target, 90B Euros in annual spending is required. The EU’s overall targets are both laudable and essential, but the stick-based approach ignores key practical realities of tripling renovation activity.
Let’s take insulation as an example.
For real estate owners, installing highly rated thermal insulation is one of the most effective means to improve an asset’s energy efficiency.
Our estimates, accounting for factors like the mix of new construction vs. renovation and ownership rates, suggest conservatively that Europe’s insulation sector must increase its production by 70% just to be able to supply enough insulation to meet demand under the EU’s 3% renovation rate target.
Unfortunately, scaling up the production of standard building materials isn’t a trivial or inexpensive task. Construction of just one new insulation manufacturing facility can cost more than $150M and take anywhere from 2-4 years from planning to full production.
In insulation alone, our estimates suggest that European manufacturers like St. Gobain, Rockwool and Knauf need to invest $25B on new production facilities just to be able to meet the EU’s renovation targets, and that capacity is needed immediately.
Building material markets are competitive and manufacturers operate on relatively thin margins, meaning they can’t fund the level of capacity build out that is required out of their own free cash flow alone (especially as margins have been dashed due to higher energy prices).
This predicament isn’t limited just to the insulation market. It’s also a challenge facing companies supplying HVAC systems, electrification solutions, and hot water heaters, just to name a few. Investment tax credits, production subsidies, and accelerated planning processes, not to mention the expansion of skilled labor capable of executing renovation projects, are all critical tools needed to support building material manufacturers as they ramp up capacity in line with climate targets. Without those policies, supply will lag demand, leading to high prices and missed decarbonization targets.
Luckily, the EU is currently crafting a new climate bill meant to counter the United States’ Inflation Reduction Act. The bill is likely to contain myriad glitzy incentives for advanced manufacturing, clean energy production, and for all sorts of infrastructure to support decarbonization efforts. Those investments are needed and welcome in the race to net zero. However, if Europeans aim to have both a comprehensive and effective approach to the net zero transition, they can’t afford to ignore the more prosaic decarbonization needs of the building sector. Support for scaling building material manufacturing won’t garner any flashy headlines, but it might the most important thing the EU can do to drive decarbonization and energy independence.
If you are working on building decarbonization, electrification, or any climate solution for the real estate world, feel free send me a note at max@keyframecapital.com and let’s chat.
[1] The EU defines renovation rate as the percentage of total building square footage across the union that is renovated in a given year.
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