How policy is decarbonising the built environment

Morningstar research reveals upside and downside risks

Our built environment – the structures in which we reside, work, and play – contributes significantly to our enormous carbon footprint. If society hopes to realise its long-term goal of net-zero emissions, dramatic action needs to be taken.

A sobering 37% of global energy-related carbon emissions emanate from the existing building stock and from the construction of new buildings. Consequently, decarbonising buildings is a central component of the long-term net-zero strategies of major economies globally.

The carbon footprint of a building is dominated by the energy it consumes over its useful life—referred to as its operational carbon emissions—but it is by no means the only source.

In addition, the carbon emissions generated during the manufacture of a building’s materials, construction of the building, and any subsequent maintenance or renovation and demolition and the removal and disposal of building material also contribute meaningfully to a building’s lifecycle carbon emissions. To date, these more “hidden” sources of a building’s carbon footprint – referred to as embodied carbon emissions – have garnered less policymaker attention than they ought to.

Significant progress made on operational carbon, with more to come

Operational carbon refers to the carbon emissions associated with the energy used to operate a building or piece of infrastructure over the course of its life.

The control of a building’s ambient temperature via heating, cooling, and ventilation systems accounts for the majority of this operational carbon burden. Consequently, the electrification of heat sources—to get homes ready for the eventual transition to power generation from renewable sources—is key to improving the operational carbon credentials of newly-constructed homes and buildings.

Progress has been made on the operational carbon front over the past two decades, with US and European building standards mandating incremental improvement in the energy efficiency of newly-constructed homes and other buildings. All newly-constructed buildings in the European Union must be “nearly zero-emissions” from 2021—with very high energy performance and a significant amount of energy from renewable sources.

Looking across the value chain, we think homebuilders are most exposed to rising operational-carbon standards. With these companies generally lacking pricing power, their profit margins are at risk as building standards progressively mandate improved operational-carbon outcomes over the coming decade.

However, opportunities also exist for suppliers of building materials and systems that reduce a building’s operational carbon. For example, suppliers of innovative heating, ventilation, and air conditioning, or HVAC, equipment stand to benefit from increasing operational-carbon requirements as heat pumps or other electrified space heating become standard. The decarbonisation of the entire building stock should drive a long-term tailwind for the industry as energy-efficiency retrofitting of the existing building stock takes place over coming decades.

Upside and downside risks as the embodied carbon discussion matures

Embodied carbon emissions refer to carbon emissions generated during the manufacturing processes of building materials and systems, as well as those generated during construction, repair, refurbishment, and demolition.

Embodied carbon’s contribution to the lifecycle emissions of built assets accounts for a sizable 11% of total carbon emissions globally. As power generation transitions toward renewable sources, embodied carbon is expected to contribute as much as 50% of the built environment’s carbon emissions over the 2019-2050 period, according to the World Green Building Council.

Consequently, we anticipate a coordinated global effort on embodied carbon, given its meaningful contribution to the built environment’s carbon footprint. We think high-mass building materials—such as clay brick—will be challenged. Conversely, lightweight exterior wall alternatives such as timber, vinyl, and fiber cement boast more favorable embodied-carbon credentials and are likely to enjoy a structural growth opportunity.

Opportunities abound for investors

As built-environment carbon standards evolve, we see two avenues for astute investors. The first is to select attractively valued construction-related stocks operating in segments of the value chain that are subject to low lifecycle carbon-related risk or likely to benefit from lifecycle carbon policy tailwinds. These include HVAC suppliers, lightweight building materials manufacturers, and real estate service providers.

The second way for investors to profit is to gain exposure to construction-related stocks that feature heightened carbon-policy risk, yet trade at a significant enough discount to fair value to provide sufficient margin of safety.