Real Estate: Is there a global approach to ESG?

Is the net zero goal by 2030 a reality for the UK?

In 2019, the UK became the first major economy to commit to achieving net zero by 2050. Achieving that target is both a legal and political imperative for the UK government, but 2050 is going to be a struggle, let alone 2030. There are many obstacles.

First, we need a clearly defined target. “Net zero” can be defined in different ways and can have several variables. For instance:

• Do embedded carbon and historic emissions need to be addressed as well as future carbon emissions?
• Can carbon offsetting be used rather than actually reducing emissions? If offsetting is allowed, what sort, and how much?
• Does capturing and storing carbon count as reducing emissions?
• What counts as “UK” emissions to be reduced? The Sixth Carbon Budget includes aviation and shipping emissions for the first time, but what about their supply chains?

Perhaps the government could use the UK Green Building Council’s excellent framework definition.

Secondly, we need to break our reliance on oil and gas. The market for electric vehicles is growing, but how we heat our homes needs action. Retro-fitting every oil or gas boiler with an alternative will take time and money, and requires both a skilled workforce and public engagement.

Finally, everyone needs to be on the journey. Improving the fabric of buildings is not enough. We must also improve how we use them. This will require behavioural change, far beyond driving an electric car and switching off the TV rather than leaving it on standby. Behavioural change has to be incentivised, probably with both sticks and carrots. Policy and legislation are heading in this direction, but the pace of change needs to be faster.

So, 2050? Hopefully, yes. 2030? There are only nine years left…

Is there a growing appetite for ESG-compliant funds within the Netherlands?

Dutch pension funds showed as early as 2017 that they attach great importance to ESG by entering into an agreement to improve the co-ordination and exchange of ESG expertise between pension funds. The agreement resulted in shared definitions and standards.

Since the agreement, sustainable investments with financial, social and environmental returns are no longer an afterthought or window-dressing tool. ESG has developed into a new standard for the Dutch real estate market.

Investors have become more aware of the physical risks that climate change can have on real estate. Changing sustainability laws and regulations contributed to that focus. For example, all office buildings in the Netherlands are required to have an energy performance rating of A, B or C from 2023. It is expected that this legislation will become even stricter over time, with all office buildings likely to need an A rating by 2030 and other asset classes being brought into scope in the future. Real estate funds are increasingly forced to anticipate the possible negative consequences that such legislation may have on their property portfolios.

Over time, the public perception of sustainability has also changed. Investors now attach more importance to contributing towards a sustainable future. Besides the financial position of a real estate fund, its social and environmental performance plays an important role for the investor when deciding whether or not to invest.

It is, however, important to note that there is no fixed definition of what an ESG-compliant fund comprises. Consequently, no ESG fund is the same and, as such, the specific ESG investment parameters of any given fund will determine how much of a force for good it can be. Nonetheless, there are certain industry standards that can be considered, such as the investor-driven global real estate sustainability benchmark (GRESB) for ESG compliance in the real estate sector.

How are German corporates complying with the environmental part of ESG and is this shaping investment choices?

German corporates have a sophisticated attitude towards complying with the environmental part of their ESG responsibilities, and we see this as increasingly shaping investment choices.

The EU Sustainable Finance Disclosure Regulation has tightened the environmental compliance requirements for companies. Although companies had included some environmental standards in their corporate social responsibility codes, these standards have become increasingly important with the advent of the Disclosure Regulation and the associated reporting obligations. The legislative goal is a climate-neutral economy. Although companies are not yet obliged to be climate neutral, EU regulations are increasing the pressure to formulate and implement a clear de-carbonisation path.

This also influences investment decisions. Financial investors often require tangible compliance with ESG criteria. Listed companies and larger companies within the financial sector are obliged to report on sustainability so almost all DAX companies have now introduced a sustainability board or committee. Although there are no reporting obligations for smaller companies, sustainability criteria are often observed. This is mainly because large companies pass these requirements downwards through supply chains and joint ventures.

As with many countries, German buildings alone are responsible for around one third of greenhouse gas emissions. This has resulted in increasing attention to environmental standards when purchasing or renting real estate. Renewable energy is increasingly attractive to investors as the most frequently used measure for improving sustainability, closely followed by smart metering and specific environmental criteria. And watch this space for the resurgence of green lease clauses reflecting the clearly defined emphasis of ESG on the German corporate agenda.

How is ESG impacting investment decisions by investment funds in Italy?

ESG regulation has slowly but significantly changed the Italian approach to investment decisions. Until recently, although many real estate funds focused some attention on ESG, this did not necessarily impact on their investment strategies. This is no longer the case.

The change in strategy reflects the following trends:

• Poorly performing buildings are becoming less attractive to institutional investors unless redevelopment and/or full refurbishment can be carried out. The main drivers for this change are reduced interest by investors and concern about future capital expenditure liabilities.
• There is an increasing level of environmental performance due diligence, as well as an increasing interest by funds’ investors in relation to building performance.

This last point shines a light on what is considered one of the main difficulties in transposing ESG to real estate: data availability and accurate measurement of building performance. In many cases, this data (which measures energy consumption) is only available to or is in control of the tenants. In older leases, there is often no provision granting landlords the right to access this data. Data availability has a significant impact on the timing of carrying out environmental due diligence. Without accurate data, environmental performance can be difficult to ascertain.

It is also important to note that the criteria for measuring energy efficiency of buildings is not clear. This has a direct impact on the disclosure requirements under EU regulations. Some funds are taking the position that the absence of clear and final criteria does not allow them to make a clear disclosure as to whether particular buildings in their portfolio may be considered sustainable for ESG purposes.

Like other EU countries, there is an appetite and understanding of the need to carry out the environmental due diligence required by EU regulations, but the practicalities of collecting accurate data means this is not always straightforward.

What are the particular factors influencing Mexico’s ESG policy?

In Mexico, there is a real tension between the public and private sectors’ adoption of the ESG agenda.

The government has recently agreed that, in accordance with the Paris Agreement on Climate Change, Mexico will commit to reducing 22% of its greenhouse gas emissions and 51% of its carbon emissions by 2023. However, recent legislative changes affecting the energy sector reflect an inconsistency with these goals. Public investment has instead been directed towards traditional fossil fuels such as coal and oil. These have been prioritised over renewable energy sources and a major, government-owned power company is now the main energy supplier in Mexico. This has in turn disincentivised national and foreign private investment in renewable energy in Mexico.

The government has also cut its budget in the environmental sector by more than 28%, indicating a regressive direction in sustainability. Take, for example, recent development projects such as the “Maya Train” which involves cargo and passenger trains that will cross five southern Mexican states. This project will adversely affect at least 800 hectares of protected jungle areas, and is a clear departure from other jurisdictions where ESG is ramping up the agenda with a growing concern for protecting the environment.

For its part, the private sector has taken a more prominent role in ESG matters. For instance, companies are investing in newly created sustainably-linked bonds which aim to encourage the integration of ESG reporting and corporate sustainability. Unlike other bonds (such as green bonds) which are issued for specific, environmentally friendly projects, these new bonds allow companies to obtain financing for general corporate use. To access this finance, they must meet specific sustainability performance targets, such as reducing greenhouse gas emissions, within a specific timeframe, following criteria aligned with the UN’s Sustainable Development Goals.

Is the US leading or following on ESG?

In many ways, the United States has been following the world in terms of defining what ESG means for companies and in creating uniform reporting requirements to track ESG policies. The market in the US has long been familiar with energy efficiency and “green” leasing, and has even adopted uniform benchmarks and standards for energy efficiency in buildings, such as the globally recognised Leadership in Energy and Environmental Design certification. However, the social and corporate governance aspects of ESG have not historically received as much attention in the US. It has only been over the last few years that we have seen more widespread adoption of all aspects of ESG in helping to drive both investment decisions and corporate policies. This uptick is highlighted in recent figures showing that in 2020 the net investment in sustainable funds in the US was more than double that of 2019 – and nearly 10 times more than in 2018.

While the US does not have uniform reporting requirements, such policies could well be on the horizon. In June 2021, the lower house of the US Congress passed the ESG Disclosure Simplification Act of 2021. The direction of travel is clear, as this Act would require public companies to report on their ESG metrics and would provide clearer, more uniform guidance on such reporting requirements. Similarly, the US Securities and Exchange Commission has been considering whether to mandate uniform ESG disclosures and recently invited comment on climate change disclosures.

If uniform ESG disclosures are brought in for public companies, it could very well move the US from a position of following the world in terms of ESG to leading the world in defining the scope of the ESG reporting requirements for public companies and institutional investors around the world.

Key takeaways

We see a real similarity in approach between the UK and the EU. The EU countries are united by the EU Disclosure Regulation, which has tightened the environmental compliance requirements. The UK has a similar legislative impetus and, although it has no legal disclosure obligation, many investors require this information in any event. The situation in Mexico indicates that different governments can backtrack as well as look forwards, resulting in a dichotomy between the public and private sectors. The US, on the other hand, was a slow starter but is now grasping the ESG bull by the horns and is on track to be a leader rather than a follower in this sphere.

One fact is inescapable: ESG is on the move and, while it takes many shapes and forms, previous attention on the environmental aspects looks set to change, with social and governance stepping into the spotlight.

An earlier version of this article appeared in Estates Gazette on 14 September 2021.

Authored by Jackie Newstead, Simon Keen, Jane Dockeray, Ingrid Stables, Carola Houpst, Maria Deledda, Sabine Reimann, Luis Lauro Gonzalez Martinez, Javier Camacho, and Scott Campbell.