The Price of Innovation: An Analysis of the Marginal Cost of Green Buildings
While research shows that green buildings cost more overall, earlier research depicts that green commercial buildings still sell at a premium. Yet, why do we not have more energy-efficient buildings in construction? This paper dives deeper into both construction hard cost premiums as well as the developer's risk perception towards green buildings due to their inherent increase in upfront cost, all of which attribute to the lack of green.
Energy-efficient, green construction practices can have a substantial impact on environmental outcomes: buildings represent 30 percent of global carbon emissions and 40 percent of raw materials and energy consumption. Currently, green buildings represent only 5.4 percent of commercial office stock and even smaller in other real estate sectors. Despite the data showing that they have a value premium, ranging from 13.3 to 36.5 percent on transaction prices, why then, are green buildings not more prevalent?
One thought is that the value premium reflects not only cost savings and risk perception, but also the reality of higher construction inputs required to construct. This research paper further accesses the marginal cost of more efficient, green construction in an empirically rigorous manner.
This paper identifies UK as the largest commercial property market and uses the Royal Institution of Chartered Surveyors’ elemental construction cost database The Building Cost Information Services (BCIS) and the Building Research Establishment (BRE) BREEAM-certified environmental buildings database to assess the marginal construction cost for a set of 336 BREEAM buildings, matching projects on location and construction period with 2,000 non-certified construction projects built between 2004 and 2014. The study finds that the average difference in total costs is 6.5 percent, a large majority of which stems from a specific set of construction cost elements – design, preliminaries, substructure, external work, and finishings.
Despite these increases, the research still finds a positive gap between the average marginal transaction price and the average marginal cost, suggesting that the energy-efficiency gap in real estate may be due to both a market barrier and market failure - Dr Chegut
Controlling for building and contract characteristics, the paper determines there are higher marginal costs for more efficient, green construction and refurbishment projects:
Design costs are 32 percent higher than the costs of conventional building design
Fittings and finishes costs are 32-38 percent higher
Construction costs for highest rated green buildings are 31 percent higher on average, with a large spectrum depending on the ‘greenness’ of the building (BREEAM Outstanding buildings tend to be 150 percent higher than conventional design fees)
Green building projects take about 11 percent longer to complete
Despite these increases in costs, the research still finds a positive gap between the average marginal transaction price and the average marginal cost, suggesting that the energy-efficiency gap in real estate may be due to both a market barrier and market failure.
In theory, the increase in design fees represents a small percentage (approximately 3%) compared to total costs. So why does it stand as a market barrier? Looking at the real estate development process, the paper notes that design fees are generally paid up-front before construction and traditionally through the developer’s own equity. Because of this, the costs associated have a higher level of the risk premium and hinders developers in undertaking the risk associated with undertaking a project that both costs more, but also consistently takes longer to finish. Thus, the developer’s capital needs to be sunk longer before cash flows can be produced to pay debt service.
In the end, these findings help explain the limited growth of efficient building practices. A better understanding of these barriers will attribute to more diffusion of energy-efficient and sustainable building practices, and thus the necessary reduction fo the carbon externality from the built environment.