Chinyelu Oranefo looks at sustainability trends, regulations and finance in real estate.
The sustainability theme in the real estate industry is not a new one. Some might trace it back to the introduction of BREEAM standards in the 1990s, but perhaps most of us became aware of this as a sector issue following the implementation of the Energy Performance of Buildings (Certificates and Inspections) (England and Wales) Regulations 2007, soon followed by the introduction of green leases. In any case, it’s a theme that requires consideration in all phases of the real estate lifecycle.
There has been significant interest in environmental, social and governance (ESG) criteria, both at the asset and investor level. For some investors, ESG itself is an investment theme which leads them to favour assets with a social, education, health or environmental dimension.
More broadly, ESG awareness seems to be driven by investors keen to know that investees – and their assets – are being managed in a manner that is less likely to fall foul of the commercial and legal risks that are perceived to be mitigated by a strong ESG performance. Moreover, there is research indicating that a business is more likely to be more productive and profitable longer-term where ESG is embedded into its operating philosophy.
Sustainability standards
GRESB has established itself as a popular ESG benchmarking method in the real estate sector, but there are others, such as that offered by MSCI, and the UNEP FI Responsible Property Investment report sets out its own framework. There are also independent consultants that can conduct ESG analysis and deliver ratings, such as Sustainalytics, and the usual suspects in the ratings industry, including Bloomberg.
ESG-related information is increasingly sought from operators in order for ESG assessments to be made as part of a due diligence process, to guide investment decisions or monitor continuing performance. A key challenge has been data collection, either because the data doesn’t exist or because there is no access to it contractually or otherwise in the first place. Secondly, the amount of information itself can place significant administrative burdens on management teams, which are often reporting to several institutions – each using a different benchmark system – as well as meeting new non-financial disclosure requirements. It is hoped that the development of legal documentation, AI/smart data collection in buildings, and the convergence of benchmarking systems will ease these challenges.
Accusations of “green washing” and “box ticking” exercises are rife in the sustainability arena. One area where the value of ratings has been queried is in relation to the BREEAM certification system, where it is understood that, in many cases, properties which have achieved the outstanding certification on practical completion are in practice managed at a standard well below this once handed over to the operator. It will be interesting to see whether certification systems might be expanded to incorporate a “continuing” compliance test to address these “performance gap” concerns, and perhaps even to deliver a rating based on the level of embodied carbon in the building materials used.
Sustainable finance
Often, in order to achieve (and indeed maintain) the required “E” rating, an existing asset may have to undergo improvements or retrofitting to raise standards or dedicate additional funds to increase maintenance budgets and employ more skilled staff. Alternatively, asset managers or operators might simply want to improve supply chains and operating methods or set goals relating to the “S” component of ESG, which they feel will improve staff wellbeing and/or performance. The last five years have seen financial institutions develop specific products to cater for these objectives, and the past 16 months have seen industry standards emerge in an attempt to create some consistency between them.
Following the example set by the International Capital Market Association’s Green Bond Principles, the Green Loan Principles (GLPs) and Sustainability Linked Loan Principles (SLLPs) have been developed by the Loan Market Association to standardise the methods by which new sustainability-themed products are assessed and delivered. Key commercial and residential debt providers such as Lloyds, Barclays and HSBC have all developed products, with the latter taking a lead in establishing standard legal provisions for theirs. These facilities can be used to meet funding gaps for projects involving anything from asset acquisitions, development or achieving UN sustainable development goals.
Depending on the context and the internal policies of the institution involved, these loans may also benefit from some kind of margin ratchet improvement where objectives are met. It is worthwhile noting that many institutions have themselves set ESG-related objectives which are to be reflected in their asset portfolio, eg the divestment of oil, gas and coal assets. This might be seen as pandering to the latest fashion to retain or entice investors. Alternatively, we may be witnessing a move to “transition” to a more sustainable economic model that can withstand the kinds of future economic shocks predicted by Mark Carney as governor of the Bank of England, in his “Breaking the tragedy of the horizon” address on climate change and financial stability in September 2015.
EU taxonomy
Carney was also key in highlighting the need for the development of an EU position on sustainability, and this resulted in the EU Commission’s Action Plan on Financing Sustainable Growth report in 2018.
While the initiative encompasses various strands, such as the Non-Financial Reporting Directive and the EU Green Bond Standard, the cornerstone of the commission’s work has been the EU taxonomy for sustainable economic activities. This draft regulation, which is due to be put into effect by Q1 2020, provides a road map for integrating sustainability into the EU financial system.
Its primary method for achieving this is by defining what constitutes a “green economic activity”. Investments made into assets meeting all four criteria may be marketed as “green investments” within the EU. It is also envisaged that, in the near future, such investments will benefit from preferential capital allocation treatment (a “green support factor”) as a means to stimulate the re-directioning of capital towards these activities, and away from activities which will prevent the EU from meeting its Paris Agreement commitments.
Criteria for real estate
Given that the real estate sector alone accounts for around a third of EU energy consumption and greenhouse gas (GHG) emissions, it is not surprising that the key environmental objective to be met by the real estate sector is that of climate change mitigation.
The taxonomy includes technical screening criteria which are framed principally around energy performance, eg a 30% energy saving on renovations, EPC ratings of B and above and the installation of renewable energy on-site. The “do no significant harm” criterion requires, among other things, the exclusion of hazardous substances, recycling 80% of building materials at “end of life” and the use of timber from sustainably-managed forests.
An underlying theme throughout the technical criteria for real estate is that, in order to be taxonomy compliant, the asset needs to meet the energy and GHG emissions performance of, as a minimum, the top 15% of building stock. These criteria are expected to be revised and expanded over time to include, among other things, full life cycle and embodied carbon assessments. It should also be noted that buildings associated with fossil fuel activities are excluded from the taxonomy.
Other sustainability trends
Aside from the established “push” factor of environmental regulation and the “pull” of the savings that can be derived from lower energy costs, the real estate industry is experiencing other less obvious sustainability-linked pressures. In terms of demand, it is now not uncommon for buyers to decline to look at assets where the tenant participates in an industry which is deemed unacceptable from an ESG/ethical perspective, or likely not to fare well in the near future, eg tobacco or plastics.
Estate agents are also reporting a trend for tenants to prefer assets which perform well environmentally and/or cater for health and wellbeing, in the belief that this will assist them to attract and retain staff and improve productivity. This in turn is affecting valuations by raising demand for properties that cater for these values (though there is some discussion as to whether this demand confers a “green/value-driven premium” or has a penalising effect on assets which do not).
In any event, all asset owners need to be taking these additional factors into account, and institutions such as the RICS are aware that there might be a need to more comprehensively address these issues in survey reports.
Given that the Green Finance Strategy announced in July makes clear that, post Brexit, the UK will at least mirror, if not exceed, the EU approach on sustainability, it seems likely that we will be seeing more ESG-themed regulation in the property sector. Meanwhile, GRESB, BREEAM, the LMA and organisations such as the UK Green Building Council and the newly established Green Finance Institute will be influential in establishing how to meet market demands, as the sustainability theme continues to gather momentum in the real estate sector.
What is ESG?
A set of factors which investors and commercial players are increasingly taking into account when reviewing business models in order to navigate a post-financial crisis, climate change-concerned world. The 17 UN sustainable development goals are often used as a reference point for establishing ESG strategies that are relevant to a particular enterprise; however, in the real estate industry the most relevant areas are:
E is for Environment – energy, water, waste, greenhouse gas emissions, embodied carbon
S is for Social – working conditions, health and safety, wellbeing, community engagement
G is for Governance – bribery and corruption, pay standards, reputation, board diversity
Green loan principles – key features
- Loan proceeds may only fund a “green project” and related expenditure
- Objectives and criteria for the green project should be clearly documented
- Proceeds to be kept separate from other funds
- Reporting must demonstrate compliance with set objectives and criteria
Sustainability linked loan principles – key features
- Borrower to have a corporate level sustainability or corporate social responsibility strategy
- Sustainability performance targets set by reference to KPIs or external ratings
- Loans applied to general corporate purposes but no penalty if targets not met
- Periodic reporting and external review
- Can relate to “E” or “S” in ESG
Breaking the tragedy of the horizon
Speaking to the insurance sector in 2015, the governor of the Bank of England, while acknowledging that there was currently little incentive to any market to deal with the future risk of an economic shock precipitated by climate change, also saw the path to de-carbonisation as a major opportunity. He identified three categories of risk to be addressed to make the financial system climate change-proof:
- Liabilities risk – physical risk where assets are destroyed or damaged or become stranded
- Liabilities risk – where financial responsibility must be taken for claims arising from physical or other losses, eg litigation
- Assets risk – where the value of asset portfolios is diminished due to the above
What are green economic activities?
There are four taxonomy criteria:
- Contributes substantially to one or more of six environmental policy objectives
- Does no significant harm to any other environmental objective
- Complies with the minimum social safeguards
- Complies with minimum sectoral technical screening data
Chinyelu Oranefo is a senior associate at CMS LLP
