Investment in ESG: a real estate view – part 1
Insight
Whilst the concept of ESG investing is not new, it is only in recent years, as environmental and social issues have continued to rise up public and political agendas, that ESG factors have started to become a key consideration for investors across many markets. Indeed, research indicates that ESG funds and indices have outperformed standard benchmarks during the coronavirus pandemic and the interest in sustainable investing is expected to grow considerably in years to come. [1]
With the built environment being one of the largest energy consumers in Europe, making up 40 per cent of total energy consumption and 36 per cent of CO2 emissions [2], the relevance of ESG to the real estate sector has always been indisputable. With a body of new ESG-focused legislation and strategies expected to be implemented over the next year, the importance of ESG to real estate investors only looks set to increase as governments strive to respond to the environmental and social threats that lie ahead, with such legislation likely to shape the global economy for decades to come. This was recently seen in the UK on 8 July when the government released its summer statement in which it has committed to funding decarbonisation schemes for social housing, public sector buildings and residential homes.
So, what does ESG investment look like in the commercial real estate sector and what challenges – and opportunities – lie ahead?
The meaning of ESG
ESG, which stands for “environmental”, “social” and “governance”, is a broad acronym which covers a variety of factors, the relevance of which largely depends on the sector in question. So, taking a step back, and looking at what “ESG” actually means for property purposes:
- E: Environmental factors consider aspects such as the energy efficiency and emissions of buildings.
- S: Social factors include considerations around how properties impact society, for example the health and wellbeing of occupiers and the local community. This area is likely to become of even greater importance as a result of the fall out of COVID-19, and there will be a real requirement for property owners and employers to consider their buildings’ impact on the people using them.
- G: Governance factors cover aspects such as diversity, culture, and reputation and, in a real estate context, may apply to both the ultimate property owner, as well as the occupiers, and any management companies and on-site staff. Again, in the current climate, governance is firmly under the microscope - in recent months we have seen both the huge civil rights and anti-racism movement spearheaded by Black Lives Matter, the “Greta effect” with public support for groups such as Extinction Rebellion rapidly growing, and the thousands of end consumers who had threatened to boycott various chains for refusing to pay their staff, or for remaining open amid ambiguity regarding what is classed as an “essential business”.
We explore in detail below what these criteria look like in practice but, before doing so, we consider the legislative developments that are steering investors towards ESG-focused investments.
The legal landscape
One of the key developments relating to ESG was the release of a report by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures’ (TCFD). The report was followed by the implementation of the Non-Financial Reporting Directive in 2018, which requires large companies to include non-financial information on matters such as environmental protection and social responsibility in their annual reports. The next year saw the European Commission release an action plan aimed at creating a framework for sustainable finance and in 2019 the UK government published its Green Finance Strategy in which it made clear that, by 2022, all listed companies and large asset owners are expected to disclose in line with the TCFD recommendations.
More recently, the UK’s Financial Conduct Authority has announced that it is proposing to introduce a new rule which, from 2021, will require premium-listed companies to either ensure that their climate-related disclosures align with the TCFD’s framework or explain why not. The Financial Reporting Council also announced earlier this year that it will be reviewing how companies evaluate, report on and address climate change risks, and assessing whether the standards set out in its new Stewardship Code (which, amongst other things requires asset owners and managers such as institutional investors and pension schemes to consider and integrate ESG factors into their investment strategies) are being met.
The real estate sector, specifically, is subject to an evolving wave of new legislation as the government continues to respond to ESG-related issues. We will not consider all of these as they are extensive. However, by way of example, two of the biggest players in the real estate investment market, pension funds and insurers, are subject to their own industry-specific obligations. Pension funds are required to disclose the extent to which ESG criteria form part of their investment strategies. Insurance firms, which are regulated by the Prudential Regulation Authority, are subject to equally stringent obligations. These developments, together with the government’s Green Finance Strategy, indicate that TCFD-based disclosures are likely to become mandatory for certain companies, including those in the real estate sphere, in the not too distance future.
Across the water, the European Commission has recently closed a consultation on the Non-Financial Reporting Directive, its aim being to improve the disclosure of environmental data so that investors are better equipped when making investment decisions. The Commission suggests that better information from investee companies is needed if the objectives of two new regulations (the regulation on sustainability disclosures in the financial services sector and the regulation on a classification system (taxonomy) of sustainable economic activities) are to be achieved.
If, and how, the UK government will implement such EU initiatives remains to be seen. It has stated that it will be creating a new governance framework “which is tailored specifically to a UK context” [3] and the Environment Bill 2019-21 is not expected to return to Parliament until later this year. It is worth noting that many of these legal reporting requirements are broadly aimed at increasing transparency (rather than changing performance directly) with the hope that this transparency will itself then drive improved performance. For further information about proposals by the European Commission to put ESG considerations at the heart of the UK financial system please see the 2019 article "Sustainable Finance: an overview of the European Commission's proposals" by Grania Baird and Kya Fear of our Banking and Finance Team.
While questions remain over what the UK’s environmental laws will look like in the future, it looks likely that commercial building owners will be expected to achieve a minimum Energy Performance Certificate rating of at least C, if not B, by 1 April 2030, as well as be required to comply with more stringent inspections of heating and air conditioning systems, following the government’s respective consultations on the MEES Regulations and the Energy Performance of Buildings (England and Wales) Regulations 2012.
Why choose ESG – the importance of investment resilience
The growing inclination to engage with ESG issues is, however, not only being driven by far-reaching legislative developments and the ever pressing need to mitigate against risk, but also by the potential returns that stronger ESG credentials can bring. On a macro-level, for example, research carried out by Morningstar indicates that there is a correlation between sustainability and financial performance within ESG funds [4]. On a more micro-level, while some analysts are sceptical about whether greener buildings do attract higher premiums, citing the fact that green buildings suffer from expensive upfront costs [5], studies indicate that, when measured over the life-cycle of a building, there are financial benefits to being green. More sustainable buildings, for example, often generate lower long-term operational costs, attract higher rents and occupancy rates, and tend to see quicker lease-up times and an increase in capital value [6].
In contrast, buildings with lower green ratings are thought to suffer from a so called “brown discount” since they often have higher voids, are more expensive to run and are exposed to the risk of obsolescence and depreciation as legislative requirements continue to tighten. The Carbon Risk Real Estate Monitor (CRREM) has, in fact, recently published a set of tools which enable investors and asset managers to determine the carbon threat within their portfolios to reduce the risk of their assets becoming stranded in this way.
Conclusion
It is not surprising that, as a result of the growing public and political pressures, legislation and regulations focusing on ESG reporting are set to increase in importance (and volume) over the next few years. This area of law will therefore grow in complexity, and as investors continue to analyse the ESG credentials of their potential investments, their decisions are likely to be influenced more and more by the availability and quality of ESG-related disclosures. It will take time and a dedicated effort to ensure that these legislative changes are implemented, and that they have the desired effect of improving ESG performance in the long run.
To read our follow-up article "Investment in ESG: a real estate view – part 2: Developing and implementing your ESG investment strategy" please click here. In this article, Mark Gauguier and Jay Sattin explore how an investor can develop and implement an investment strategy with the aim of accumulating a portfolio of commercial properties with strong ESG credentials.
We will shortly be publishing a further article, in which we will explore the ways that it is possible to measure the success of ESG in respect of real estate investments, what options are available to commercial property investors to ensure that their assets are ticking the ESG boxes required to meet stakeholder requirements, and finally what the future of the ESG legal landscape in respect of real estate might look like.
If you require further information about anything covered in this briefing, please contact Helen Auden, Meghan Hatfield and Barbara Webb, or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, August 2020
Footnotes:
[1] FT Article- ESG funds continue to outperform wider market
[2] European Commission: New rules for greener and smarter buildings will increase quality of life for all Europeans, April 2019
[4] https://www.ft.com/content/733ee6ff-446e-4f8b-86b2-19ef42da3824
