ESG and the Real Estate Sector – where are we and what’s hot?

Fuelled by the successes of COP26, Environmental, social and governance issues will continue to dominate the public and political agenda in 2022 with real estate investors and lenders alike focusing on the ever-growing ESG-focused legislation expected to be implemented over the coming months.

Long gone are the days when real estate investors and lenders sought and appraised real estate assets solely based on their environmental credentials. The Covid-19 pandemic has left an indelible mark on the real estate sector, pushing the ‘social’ and ‘governance’ limbs to the fore in 2021 and driving demand for real estate assets which are able to demonstrate compliance with all three of the environmental, social and governance limbs. 

What is ESG for real estate?

“ESG” stands for “Environmental”, “Social” and “Governance”. It is a broad acronym which encompasses a variety of factors which can largely be interpreted as follows:

• Environmental: This limb incorporates (amongst others) climate change, natural resources, pollution, recycling and waste. In real estate terms, this primarily focuses on the energy efficiency and emissions of buildings which are increasingly determined and assessed against “green” rating systems such as BREEAM, LEED, WELL, the newly emerging NABERS UK as well as the use of Display Energy Certificates and Energy Performance Certificates (see further below).
• Social: This limb incorporates human capital and social opportunities. Again, in real estate terms, this focuses on a building’s impact on society, for example, the health and 
  
  wellbeing of tenants and the local community and is driving demand for larger public green spaces, frictionless (no-contact) building access and support for local enterprises, such as cafes and shops. 
• Governance: Governance includes harder to quantify factors such as diversity, culture, and reputation and which are applicable not just to the property owner but also to tenants, management companies and other on-site staff.

The ‘legals’:

Whilst not the only engine of change, the labyrinth of ESG-focused legislation and policies are steering the real estate sector towards ‘ever greener’ investments and pushing the boundaries for ESG integration. To help navigate through this, we have highlighted a number of key legislative and policy developments (see further below in respect of rating systems) which impact those operating in the real estate sector below:

• Minimum Energy Efficiency Standards: Following the Government’s consultation on the Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 and the Government’s Energy White Paper published on 14 December 2020, commercial property owners who wish to let their property will be expected to achieve a minimum Energy Performance Certificate rating of B by 1 April 2030 (a significant increase on the current requirement for an E rating introduced in 2018), in addition to being required to comply with more stringent inspections of heating and air conditioning systems;
• GRESB: Formerly the Global Real Estate Sustainability Benchmark, is one of the leading bodies issuing standardised global benchmarks (aligned with international reporting frameworks, such as the TCFD, the Paris Climate Agreement and country-specific disclosure guidelines and regulations) against which institutional and financial investors monitor their investments, engage with their fund managers and make ESG critical decisions. Increasingly, investors are requiring fund managers and other financial institutions to achieve a sufficiently robust GRESB rating (e.g., 4 out of 5) without which they may not be prepared to invest their funds, or, more severely, look to withdraw their investment;
• Climate Disclosures: In December 2015, the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, established the Task Force on Climate-related Financial Disclosures (TCFD). From 2021, the Financial Conduct Authority requires premium-listed companies to either ensure that their climate-related disclosures align with the TCFD’s framework or provide a written explanation as to why they failed to do so. In November 2020, the Financial Reporting Council publicly announced that UK public interest entities (such as institutional investors and pension schemes in their capacity as real estate asset owners and managers) should, as a matter of course, report against the TFCD’s 11 recommended disclosures and the Sustainability Accounting Standards Board metrics applicable to their sector; and
• Taxonomy Regulation: On 22 June 2020, the EU Regulation on the Establishment of a Framework to Facilitate Sustainable Investment (known as the Taxonomy Regulation) was published. The Taxonomy Regulation introduces an EU-wide classification system (or taxonomy) of environmentally sustainable objectives. The purpose of the Taxonomy Regulation is to provide greater clarity for investors in financial products which purport to invest in sustainable activities or to promote environmental objectives. The Government has confirmed that it will broadly retain the taxonomy framework following the UK’s exit from the EU however it has not confirmed the extent to which UK law will align with EU law in this area.

Green Ratings - Are your buildings up to scratch?

In addition to the key legislative and policy developments mentioned above, there is also the more basic question of whether or not your building makes the grade when assessed under the numerous green rating systems being adopted in the real estate sector.  Green rating systems are a means of mitigating the direct and indirect environmental impacts of construction through the encouragement, measurement and recognition of sustainable building performance. There are approximately 600 green certification systems worldwide. However, BREEAM, LEED and WELL, all of which are applied internationally to measure relative levels of compliance or performance with the requirements they set, are the rating systems which are currently the most commonly used in the UK. BREEAM and LEED have certification systems for basebuild, fit-out, and in-use projects, while WELL evaluates the attributes of a building that impact occupant health. NABERS (the National Australian Built Environment Rating System) is an energy efficiency in-use ratings system that has been active in Australia for two decades but which has recently arrived at UK shores. It is being brought to the UK through the Better Buildings Partnership and BRE Group, which will administer the system. Currently, NABERS will only provide energy ratings for office buildings in-use.

Compliance with these rating systems generates lower long-term operational costs, an increase in capital value and attract higher rents and occupancy rates. In contrast, buildings with lower or no green ratings often result in a so called “brown discount” since they tend to suffer from higher occupancy voids, higher operational costs and are exposed to the risk of capital depreciation and obsolescence in the face of tightening ESG-focused legislative requirements. 

What does the future hold?

Sustained public and political pressure in this area means that the need for the real estate sector to engage with ESG issues is imperative and the requirement to report on such matters of greater importance. As a sign of the times, on 22 November 2021 the Department for Transport published the Government response to its July 2019 consultation and confirmed that it will introduce new requirements for installing electric vehicle (EV) charge points in new buildings in England. Investors and lenders will need to analyse the credentials of their investments through an ESG lens with the availability and quality of ESG-related disclosures becoming critical to their decision making.

Want to know more about ESG in a quick and digestible way? See our ongoing series of bite-sized Talking Points from our Real Estate team which discuss the hottest ESG topics in in the Real Estate Sector.