The Green Finance Paradox: Are We Funding Performance or Transition?

Mind the financing gap

There is a substantial need for transition finance that is going largely unrealised. The European Commission estimates total EU energy efficiency investment needs of more than €370 billion per year between 2021 and 2030, with the largest share going towards building efficiency measures. It doesn’t end there: estimated annual energy-efficiency investment needs remain at €303 billion for 2031–2040 and a further €288 billion between 2041–2050, to support decarbonisation and energy security objectives.

All in, the bill comes to around €9.6 trillion. The EU is looking to the private sector to finance a substantial amount of this bill. But commercial real estate debt markets are operating within a challenging context. High interest rates, tight lending conditions, refinancing pressures, and wider economic uncertainty have impacted the availability and pricing of debt.

Despite the challenging market conditions, EVORA’s experience is that the clients most resilient to these challenges are those with established green debt offerings. However, whilst a significant portion of transactions relate to green projects, this has mostly centred on refinancing existing debt, funding acquisitions of existing buildings, or continuing capital programmes on operational assets. That is to say, the uptake for financing new green projects and underperforming stock has been low.

If the EU is to achieve its decarbonisation goals, capital must be deployed to the lowest performing stock. What we are observing is that capital is being deployed, albeit slower than pre-COVID times, and often to already green buildings. But with the transition bill so high, this raises a fundamental question.

Are we directing enough capital towards the buildings that need it most?

In the context of the sluggish debt market, it is clear why green loans are popular and transition finance is less so. It is increasingly the case that a discount on loan terms exists for green projects in commercial real estate lending – the so-called green discount in which preferential terms are offered to high-performing buildings. The discount doesn’t necessarily reflect the valuation of the property as it might in equity deals.

In lending, it most commonly relates to the interest rates offered. For borrowers this is critical. Even a relatively small pricing difference can matter: a reduction of 10 to 20 basis points, for example, is a small discount but can become meaningful over the course of a large real estate loan especially when market rates are particularly high. Lenders are willing to offer such preferential loan terms despite the difficult market environment because the underlying assets have a lower risk profile, both in regard to sustainability and economics. This is because green projects tend to retain market value and yield higher returns. In turn, this creates more certainty for the lender. Conversely, the opposite is true of underperforming assets, which tend to be exposed to more risk and in turn makes them less attractive for lenders.

The existence of the green discount in part reflects the growing relevance of sustainability to investment and credit decision-making. But it also reflects a commercial reality. In a sluggish lending market, sustainability can differentiate a financing proposition, support more attractive pricing for borrowers, and present less risk for lenders. In contrast, underperforming stock often comes with inherent lending and sustainability risks.

This raises a fundamental issue – a green debt paradox in commercial real estate: the buildings that are already green are most likely to qualify for preferential sustainable financing. Meanwhile, inefficient and underperforming stock that requires the greatest investment to transition faces greater credit, valuation, and execution risks.

It is important at this point to make clear that financing a green building is not the same as financing the green transition. A green building requires very little intervention, and often there is little additionality created in green loan deals since the project is typically being re-financed or undergoing acquisition. Financing the green transition involves providing substantial capital to address fundamental risks associated with the underlying asset. This distinction matters because European building stock remains overwhelmingly made up of underperforming assets.

The European Commission estimates that 85% of EU buildings were constructed before 2000, 75% have poor energy performance, and renovation rates remain low. Consider as well that buildings account for around 40% of energy consumed in the EU. Improving building stock is fundamental to achieving decarbonisation objectives. Beyond energy demand, the EU is facing a changing climate. Soaring temperatures this summer have exacerbated the need to make buildings more resilient. Improving insulation, ventilation, and cooling capacity will also come with significant costs.

Regulation is increasing the financial consequences of poor building performance. In England and Wales, MEES places letting restrictions on buildings below an EPC E level. At EU level, the revised EPBD is designed to accelerate renovations of the poorest performing building stock by introducing Minimum Energy Performance Standards (MEPS).

For lenders, this creates an important connection between sustainability performance and credit risk. An inefficient building may require significant capital expenditure, face regulatory constraints, suffer from higher operating costs, become less attractive to tenants, or experience reduced liquidity and valuation support. In the long term, assets that cannot be transitioned may face obsolescence or ‘stranding’.

The problem is that the assets most in need of transition capital are often the hardest to finance. They can require substantial CapEx, have greater uncertainty around the scale and timing of the required works, carry higher transition risk, and have less covenant headroom. For a lender assessing risk on a loan, the question is not simply whether an asset can become more sustainable; it is whether the borrower can execute the required investment while balancing economic, regulatory, and operational challenges along the way.

So how do we address the paradox in which green assets are easier to finance and carry lower risk profiles, whilst transition assets, desperately in need of finance, are harder to finance and come with inherent risks? Sustainable lending may need to rethink risk. We are not asking lenders to ignore risk entirely just to finance poor-performing buildings. Quite the opposite. The opportunity for lenders is to become better at understanding, structuring and managing transition risk.

The Road to Financing the Transition

There’s an obvious opportunity for transition finance. There are swathes of building stock that need to undergo improvement works, and plenty of lenders who are keen to deploy capital with the right risk management controls in place. But lenders need confidence that their capital is going to drive the transition and reassurances that capital will be used in a cost-effective way. Transition loans and sustainability-linked loans provide mechanisms for doing this.

Sustainability-linked loans are where the financial terms are linked to the borrower’s achievement of predefined sustainability targets. The proceeds do not necessarily need to be used for specific green projects; instead, the interest rate or other loan terms can change depending on whether the borrower meets agreed sustainability performance targets.

These targets could be centred around reductions in energy use or emissions, improvements in EPC ratings, or progress against a decarbonisation pathway. A transition loan differs in that it is a use-of-proceeds instrument, much like a green loan, but instead of financing a green project the use of proceeds is tied to decarbonisation projects.

Rather than treating sustainability as a static characteristic of the collateral, these structures connect financing to a measurable, sustainability improvement programme designed to help transition real estate stock.

For transition finance to work, borrowers and lenders must work together to create a credible, costed, and measurable plan to improve the underlying real estate. 4 key things need to occur that will give lenders the confidence to invest in transitioning assets.

• Creating a performance baseline

To effectively deliver credible transition finance, the lender and borrower need to establish a baseline of performance for the underlying asset or portfolio. This could include the energy and emissions performance, EPC position, or alignment to a recognised decarbonisation framework like CRREM.

• Finance the transition pathway

Once a baseline has been set, a transition pathway underpinned by improvements that address key risks and opportunities should be created. The transition pathway needs to be costed and essentially translated into an investment plan. In doing so, the debt facility can directly support the implementation of the transition pathway. This creates confidence that the capital is being used to deliver results.

• Measure outcomes, not just expenditure

To ensure the transition plan is measurable and delivering as intended, sustainability KPIs material to the investment plan should be set. This is crucial, because CapEx by itself does not guarantee improvement. We must measure success based on outcomes supported by credible and measurable targets, not just the amount of capital deployed. KPIs such as energy use intensity, emissions or performance against the CRREM pathway can be used to demonstrate progress. And, by tying the finance to KPIs, lenders can evidence that the finance has driven improvement, thus demonstrating additionality.

• Verify progress

Finally, to ensure the transition finance is credible the programme should be monitored. Annual sustainability monitoring and reporting, including the verification of the KPIs, provide accountability through the loan’s life. Where appropriate, a lender may introduce consequences for underperformance, such as changes to pricing or other contractual mechanisms. The idea isn’t to create a punitive structure for the sake of it, but to ensure that sustainability commitments remain connected to the financial relationship.

Appetite for transition finance must grow. There’s certainly a need for it. This is not to frame green finance and transition finance as competing concepts. They are complementary. Green finance rewards existing performance and creates a market signal that sustainability can create value

Critically, transition finance can direct capital towards the assets that need it most. Together, transition finance and green finance can fundamentally shift capital allocation across the real estate market. But it will require lenders to fund credible transition pathways.

Deploying capital with confidence

We’ve seen that some lenders are willing to wade into a challenging market and offer preferential terms to green projects. In the next few years, we need to see the next phase of sustainable real estate finance.

Green loans will still have an important role to play in changing the economics of the market. But a financing structure that enables a poorly performing building to become materially more efficient can deliver a different, potentially greater form of environmental additionality.

EVORA believes transition loans and sustainability-linked loans frameworks provide lenders with the necessary structure to deploy capital with impact, deliver this additionality, and ultimately drive the transition.

Lenders will still need to balance risks and opportunities in the market. That is why we help prepare our clients by equipping them with a suite of sustainability risk management processes and tools that give them the confidence to deploy capital.

Whether our clients just need extra assurance or simply don’t have the internal ESG resourcing required to perform enhanced ESG due diligence, we support them by assessing a deal’s underlying performance, creating KPIs and monitoring performance.

We continue to work with debt funds to tie sustainability to the economics of a deal, so that capital can be channelled where it is needed most – funding the transition.