ESG and property investors: a view from above

This article was first published in issue 392 of the Property Law Journal (November 2021) and is also available on lawjournals.co.uk.

Helen Auden and Meghan Hatfield consider ESG investment and what challenges and opportunities lie ahead.

It is becoming increasingly important for investment managers to implement a more creative approach to their investment strategies in order to diversify and incorporate ESG-positive assets into their portfolios.

As the United Nations Climate Change Conference (COP26) summit draws ever closer, the focus on environmental, as well as social, issues is at an all-time high with this year’s summit set to be one of, if not the, most important environmental conferences in recent times.

As environmental and social issues continue to climb up public and political agendas, ESG factors are increasingly becoming a key consideration for investors across many markets. Indeed, research indicates that ESG funds and indices outperformed standard benchmarks during the coronavirus pandemic and the interest in sustainable investing is expected to grow considerably in the months and years to come.

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, the relevance of ESG to the real estate sector has never been in question. Now, governments are racing to respond to the environmental and social threats that not only lie ahead but already face us, and with a body of new ESG-focused legislation and strategies expected to be implemented in the near future, the relevance of ESG to real estate investors has never been greater.

The meaning of ESG

ESG is the green buzzword of modern times – but what does it actually mean? In simple terms, the acronym stands for “environmental”, “social” and “governance”. However, its exact meaning and relevance is highly dependent on the sector in question, and it spans a variety of factors. In a real estate context, the focus tends to be on the “E”, being energy efficiency and emissions from buildings. On the “S” front, it covers how properties impact society (for example, the health and wellbeing of occupiers and the local community) and on the “G” front, it spans diversity, culture, and reputation at the property owner, occupier and management company level.

So, what are the main drivers behind why ESG has become more important, and more relevant, to the property industry than ever before, and why are real estate investors increasingly choosing to base their investment strategies around ESG-focused assets?

Why choose ESG?

The trend towards engaging with ESG issues is influenced by a variety of elements. Clearly there is the regulatory framework which is slowly, but surely, putting pressure on investors to make ESG-based choices. There is also a pressing need to mitigate risk, particularly climate-related risk, as highlighted in recent months by the rise in extreme weather events which have often had a direct, and disastrous, impact on property. In addition to this, and often the most appealing reason to choose to focus on ESG-credentials for property investors, is the potential increased returns that doing so can bring.

The correlation between sustainability and financial performance within ESG funds was highlighted at an industry-wide level in research carried out by Morningstar. Further, despite scepticism about the up-front costs associated with green buildings, studies indicate that financial benefits are generated during the life-cycle of a green building. More sustainable buildings will often have lower operational costs and higher occupancy rates, which, in turn, leads to shorter void periods, stronger yields and an increased capital value (see The Sustainable Buildings Market Study).

As a result, it is becoming increasingly important for investment managers to implement a more creative approach to their investment strategies in order to diversify and incorporate ESG-positive assets into their portfolios.

The legal landscape

The need to adopt such a mindset, however, goes beyond generating higher returns. It is becoming increasingly critical given the number of recent and impending legislative developments in this area. One of the key legal developments for ESG was the publication of the Financial Stability Board’s Task Force’s report on Climate-related Financial Disclosures (the TCFD). Not long after came the Non-Financial Reporting Directive in 2018. This directive places reporting and disclosure obligations on large companies to include non-financial information in their annual reports, including matters such as environmental protection and social responsibility.

This was then swiftly followed by the European Commission’s action plan for creating a framework for sustainable finance, and in 2019 the UK government followed this lead and published its own Green Finance Strategy. Under this strategy, by 2022, all listed companies and large asset owners will be expected to disclose in line with the TCFD recommendations.

More recently, in the summer of 2021 the FCA published a letter to the chairs of authorised fund managers setting out its expectations on the design, delivery and disclosure of ESG and sustainable investment funds. The letter annexes a set of guiding principles intended by the FCA to help firms apply its existing rules and, as such, there is no transition period before they can be said to take effect. The FCA’s approach is not surprising. In its business plan for 2021 / 22, achieving high-quality climate and sustainability-related disclosures to help consumers chose sustainable investments, promote trust and protect consumers from the misleading marketing of ESG-related products was included as one of the FCA’s seven priorities across all markets. Of particular relevance for the real estate industry is the fact that two of its key players, pension funds and insurers, are subject to their own specific ESG disclosure obligations.

While the regulations referred to above currently have a direct impact for certain financial services firms and other regulated industries, it will not be long until these measures find their way into the wider real estate industry. This process will be sped up as financial services firms request further information about assets and investee companies in order to comply with their own reporting requirements. It is not yet clear what approach the UK will take in relation to these disclosure requirements as far as the real estate sector is concerned but it might seek to align these with the recommendations of the TCFD. In 2018, the UN Environment Programme Finance Initiative (UNEP FI) arranged a scheme under which a group of institutional investors applied the TCFD recommendations to their practices, including in relation to real estate investments. A number of the institutions in the scheme worked with Carbon Delta, a specialist provider of climate risk data and analytics, on the development of methodologies for forward-looking, scenario-based assessments of climate-related risks and opportunities. A report was subsequently published by the UNEP FI which, among other things, looks at the benefits that scenario analysis can bring to real estate investment decision-making and where it should be developed further.

Many of the reporting requirements referred to above are aimed at increasing transparency, rather than changing behaviour and / or investment decisions themselves. However, that said, it seems that the hope is that this increased transparency will, in turn, drive improved performance – for example, through consumer pressure to make more ESG-focused investment decisions.

What this specifically means for the property sector remains to be seen. Yet, although questions remain over what the UK’s environmental laws will look like in the future, it seems more and more 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. Additionally, it is expected they will 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.

The importance of being aware of, and understanding, this evolving raft of legislation is not only vital from a compliance perspective, but also since it sets out the main risks and key criteria which need to be considered in order to develop a robust ESG strategy. The “UN Sustainable Development Goals” and “UN Principles of Responsible Investment (PRI): An introduction to responsible investment: real estate”, for example, set out broad ESG-focused objectives which can be used by investors to shape their investment plans.

Choosing the right investment

The type of asset an investor should acquire is clearly of great importance in terms of meeting their ESG-focused goals. This decision is multifaceted, and we look at a few of the key considerations below.

New v old

One option is to acquire a new asset which has minimal (or even zero) carbon emissions, is focused on the health and wellbeing of its occupiers and is designed with the needs of the local population in mind. This type of building may avoid the so-called “brown discount” associated with older properties, being the cost implications of higher voids, higher running costs, and higher exposure to the risk of obsolescence and depreciation as legislative requirements continue to tighten their grip. As a result of this, newly built green buildings may be seen as a “safer” investment option. Investors acquiring these types of assets may also have the opportunity to be involved early on in the development’s design and to request components that yield better ESG performance which directly fits with their own strategy.

However, not all investors are in the privileged position of having access to the capital required to acquire a new state-of-the-art green building. Not only are these assets often expensive, but they are also in limited supply (with 80 per cent of the buildings required in 30  years’ time already built). Investors in this position should not automatically disregard older buildings from their investment decisions – they can have particular characteristics and heritage which new buildings will not, often making them attractive directly as a result of their age.

If faced with buying an existing building with poor ESG credentials, one answer may be to “retro-fit” it (in other words, to refurbish it to a high standard to improve its energy efficiency). There are some easy wins in this area: upgrading insulation, moving towards low-carbon energy sources (eg solar and heat pumps), installing electric charging points, and using more economical electrical appliances.

However, while retro-fitting can carry a host of benefits, it is not always appropriate, or possible, to do so. For example, where an investor has a portfolio of tenanted properties, it will not necessarily be a quick or cheap option. The fact that less than 1 per cent of building stock in Europe is renovated each year is indicative of the fact that this is not necessarily the easy option. Yet, taking steps like these is likely lead to cost savings, both financial and operational, and have a significant positive environmental impact.

Energy efficiency of the building

Whether you are dealing with a new or an existing property, its energy efficiency will be key for ESG purposes. This is a particular area of concern for landlords at the moment given the changes under the minimum energy efficiency standards coming into effect from 1 April 2023, which will affect the ability to grant a new lease of, or even to continue to let, a property which is classed as “sub-standard”. These existing regulations, and the likelihood for further, stricter, legislation relating to the energy efficiency of buildings, increases the risk for older inefficient buildings to become obsolete if not properly managed. The Carbon  Risk Real Estate Monitor (CRREM) has published a set of tools which enable investors to determine the carbon threat within their portfolios, which will help to reduce the risk of their assets becoming stranded in this way.

Occupation

At the point of choosing which assets fit with their strategy, an investor may also want to consider the tenant mix. This has long been a way for investors to maximise returns through diversification of income. However, it can also be used to bolster an ESG strategy by allowing a property owner to address all three limbs of ESG by having the right mix of tenants (specifically, by renting the space to more socially and environmentally conscious occupants), and then requiring those tenants to adhere to ESG principles throughout their occupation.

There are a number of approaches that an investor may adopt to secure its desired tenant mix. For example, an investor may choose to negatively screen tenants by excluding certain tenant types which do not fit with the investor’s ESG strategy. Alternatively, they could choose to positively screen for tenants that have a social purpose and / or achieve their objectives in an ethical and sustainable way which fits in with the investor’s overall strategy.

Investors should be prepared to have a two-way relationship with tenants in order to further their ESG strategies. Tenants can clearly play a significant role in helping investors achieve their ESG goals and are likely to be more willing to engage with a landlord’s ESG requirements where they directly benefit from those strategies themselves; for example, through reduced utilities bills following improvements to the environmental performance of buildings.

Management and green leases

Once the assets have been chosen, that is not the end of the ESG story. The next area that investors can turn to in order to maximise their ESG potential is the management of those assets.

One way of doing so is to include green provisions in leases, which can take a variety of forms and cover a number of principles. For example, a lease could incorporate provisions relating to the performance and use of the building, the provision of data regarding ESG matters, or limit the type of business carried out by a tenant. A key consideration should also be the inclusion of flexibility to allow for the landlord to change its ESG approach over the lifetime of the lease. Exactly what is possible in each lease will be highly dependent on a number of factors, including the age and nature of the building, its location, whether it is single or multi-let, its intended use, and the bargaining power of occupiers. In order to maximise the likelihood of agreeing and including such provisions in leases, a landlord should make clear at the outset of negotiations with tenants that green lease wording will be a requirement in any new lease or renewal (outside of a statutory renewal under the Landlord and Tenant Act 1954 where the options are more limited) to enable the landlord, so far as possible, to achieve its ESG aims.

While reports indicate that institutional investors expect green leases to become the norm over the next decade, these clauses are still not yet standard in the market. Parties should therefore take care when incorporating such provisions to avoid, for example, inadvertently impacting the value of the asset or rent review potential. However, given the expected rise in green leases, investors should be prepared to include such provisions in new leases, including requirements for mandatory reporting of ESG data by tenants. This will become more crucial as investors are required to share and disclose more ESG-based data in the future and where access to building data will be vital in order to comply with such requirements.

It may be the case that in order to encourage tenants to agree to green clauses, landlords will need to consider offering tenants incentives to do so. For example, an investor could offer to contribute towards the costs of projects in return for the tenant taking steps to comply with the investor’s ESG requirements. Even if a tenant will not agree to green wording being incorporated into the lease itself, these provisions could be included in a tenant handbook or a memorandum of understanding relating to the use and occupation of a building.

Of course, a lot of occupiers will have their own ESG requirements, and this is likely to become more prevalent in the future. With that in mind, owners should carry out due diligence on prospective occupiers to enable them to identify potential tenants who might be more willing to cooperate with their ESG strategy than others.