The consequences of climate change are making news headlines with alarming regularity. Populations are ageing and generational inequalities are growing. The gap between rich and poor is widening.
Our modern society is facing unprecedented and increasingly urgent challenges. In response to this, environmental, social and governance (ESG) has become part of our vocabulary.
But behind all the talk, do ESG principles have the power to fundamentally reshape real estate investment strategies? To what extent do real estate investors incorporate ESG factors into their investment decisions, alongside pure financial performance?
The UN’s 17 Sustainable Development Goals (which came into force on 1 January 2016) tackle environmental, poverty and justice issues. Many businesses and charities are starting to track their progress using these 17 goals. For example, the National Trust has decided to withdraw its investment in fossil fuels.
To date, most of the focus has been around the environmental aspects of ESG, with action on a global and local level. The steps towards change have been both regulatory and market-driven.
Impact on real estate
According to European Commission figures, buildings are the largest energy consumer in the EU, responsible for about 40% of energy consumption and 36% of carbon dioxide emissions.
Buildings also have a social impact: they are physically located in the communities they serve. They have a direct impact on the wellbeing of people who work and live in them. People are also employed in their construction, maintenance and use.
Governance is something that applies at a corporate level, but it will be increasingly important for heads of companies to know what is happening within their portfolios.
With funds available for high-performing ESG investments, this is something that should excite the real estate industry. Businesses with strong ESG credentials should use them as a competitive advantage.
The real estate industry is already accustomed to taking environmental concerns into account. Legislation requires buildings to have a minimum level of energy efficiency before they can be sold or let.
Planning policy requires the environmental impact of a development to be taken into account (not just the direct environmental impact, but also the indirect environmental impact, with consideration of things such as travel policies). Occupiers may also have their own environmental requirements and BREEAM ratings will usually form part of this.
Strong ESG-performing buildings are likely to be valued higher than comparable low ESG-performing buildings (although, there may be other factors affecting valuation, such as the age of the building). ESG performance is also important for reputational factors and attracting talent.
Monitoring ESG progress
Under new EU regulations, institutional investors and asset managers will need to disclose how they integrate ESG factors in their risk processes. Although not solely targeted at the real estate sector, investors and asset managers will be caught by these regulations.
The old adage that you can’t improve what you do not measure means that if we are going to make positive inroads, we need to be able to properly monitor ESG performance.
The wide reach of ESG means that this is difficult, both on an asset-by-asset and a portfolio-wide basis. Data is non-linear and therefore difficult to judge, but if it is to be relied on, it needs to be consistent.
There have been many attempts to benchmark ESG performance and, with the EU’s new taxonomy, perhaps it is now possible to all speak the same language, at least on environmental aspects. The taxonomy attempts to create a reporting tool for “sustainable” economic activities, by setting minimum standards. At the moment, this is just focused on environmental objectives, but it may in the future be extended to social objectives.
Construction and real estate is one of the macro sectors included in the EU Taxonomy, with four economic activities being covered.
The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) brings together both data users and data preparers and other experts and advisers to develop a global market-led consistent method of disclosing climate-related data. As part of its report, in 2017, TCFD identified governance around climate change as being key to bringing about change (it has to be led from above).
GRESB provides a benchmark encompassing the whole ESG piece (not just environmental) for entities holding real assets (on an organisational level, rather than on an asset-by-asset basis). In 2018, 903 entities were assessed across 64 countries.
The results showed that the vast majority of entities improved on their previous year’s scores. GRESB analyses data on an organisational basis, but this relies on data being collected at an asset level.
Another blocker is that ESG factors have not traditionally been measured and real estate professionals do not have the tools available to capture this data. New technology will help with this, particularly on the environmental side. Smart buildings incorporate monitoring technology which can be used to evaluate environmental performance, but also social impact. Technology will also help improve building efficiencies.
Five questions for the sector
It seems that ESG is here to stay, whether through market pressures or regulation. Therefore, the sector should consider the following:
- Do you carry out due diligence on the GRESB risk factors on an acquisition?
- Would green finance products help with making improvements to existing stock?
- Do your leases incorporate green lease drafting and do you actually use them to allow you to share/monitor tenants’ environmental data?
- How do you weigh up the competing tensions of allowing tenants the freedom to do what they need to do with their premises, while protecting your asset against actions which have an adverse ESG impact?
- Do you have the technology you require to properly evaluate performance?
The UN SDGs
- No poverty
- Zero hunger
- Good health and well-being
- Quality education
- Gender equality
- Clean water and sanitation
- Affordable and clean energy
- Decent work and economic growth
- Industry, innovation and infrastructure
- Reduced inequalities
- Sustainable cities and communities
- Responsible consumption and production
- Climate action
- Life below water
- Life on land
- Peace, justice and strong institutions
- Partnerships for the goals
EU Taxonomy
Four economic activities relating to real estate covered by the EU Taxonomy:
Construction of new buildings As a minimum, require an EPC of B or above and meet national requirements for NZEB.
Renovation of existing buildings As a minimum, require EPBD-compliant standard or produce a 30% energy saving.
Individual renovation measures, installation of renewables on-site and professional, scientific and technical activities Identification of particular renewable energy projects or building renovation measures (for instance, installation of solar photovoltaic modules or insulation).
Acquisition and ownership of buildings As a minimum, EPC rating of B or above or, if lower, which meets particular improvement criteria within three years of acquisition.
GRESB asks questions about the following aspects of an entity:
- Management
- Policy and disclosure
- Risks and opportunities
- Monitoring and environmental management systems
- Building certification
- Stakeholder engagement
- New constructions and innovations
- Performance indicators
Timeline of action towards climate change
- 1991 The United Nations Environment Programme Finance Initiative was launched, as the market’s initial attempt to respond to climate change. This is a collaboration between banks and other financial institutions which raises awareness of the environmental agenda within their industries.
- 2008 The Climate Change Act 2008 was introduced, which set targets to reduce greenhouse gas emissions to meet the Kyoto 2050 targets (80% reduction from 1990 levels). This introduced a Committee on Climate Change and paved the way for other green initiatives.
- 2011 Following the global financial crisis, Occupy London camped out around St Paul’s Cathedral, calling for better banking regulation, authentic global equality and a “positive, sustainable economic system that benefits present and future generations”; The St Paul’s Institute published its report Value and Values: Perceptions of Ethics in the City Today. This survey found that financial services professionals tended to agree with the statement that “companies should invest directly in deprived communities” and disagreed with the statement that “Corporate Social Responsibility has a negative effect on shareholder value”. Pure monetary return was not the only driving force for investment.
- 2015 The Task Force on Climate-Related Financial Disclosures (TCFD) was founded. This market-led response, chaired by Michael Bloomberg, supports the voluntary disclosure of climate-related data by private companies.
- 2016 The City of London’s Green Finance Initiative was launched to promote green finance and bring together expertise from financial institutions and government.
- 2019 The UK government’s Year of Green Action (YoGA); Climate change and clean water leap ahead on the agenda. Campaigners from the teenager Greta Thunberg to the veteran Sir David Attenborough have spurred a consciousness in the general population which has resulted in the increased popularity for pledges such as Veganuary and Plastic Free July; Extinction Rebellion visibly made their point through disruptive protests, calling on the UK government to tell the truth, halt biodiversity loss, reduce greenhouse gas emissions to net zero by 2020 and create a citizens assembly; In June, prime minister Theresa May announced that the UK would commit to net zero greenhouse gas emissions by 2050. The Climate Change Act 2008 (2050 Target Amendment) Order 2019/1056 makes the simple amendment to the 2008 Act, substituting the 80% target with 100%; July saw the first London Climate Change Action Week, with a series of events and conferences focused on the theme of climate change and the launch of the UK’s Green Finance Strategy. The strategy has two objectives: To align private sector financial flows with clean, environmentally sustainable and resilient growth, supported by government action. To strengthen competitiveness of the UK financial sector.
Cheryl Gurnham is a partner in the real estate transactions team at CMS Cameron McKenna Nabarro Olswang
