In recent months it has been impossible to open a newspaper or website without encountering an article on the topic of ESG. “ESG” stands for “Environmental”, “Social” and “Governance” and together these acronyms encapsulate an agenda that is now having a major impact on every asset class including real estate.
Clearly there is a lot of talk about ESG – the pages of Property Week and the EG now have numerous articles in every edition – but what exactly does ESG mean in a real estate context and what should real estate owners be doing now in response to this agenda?
Background to the ESG agenda
ESG is by no means a new concept and has been in around in various guises since the 1960s. It gained formal recognition when the UN Global Compact was entered into in the year 2000 following on from the Rio Earth Summit in 1992 and the Kyoto Protocol in 1997. Originally it was termed socially responsible investing and the first index for funds with some social purpose was created in 1990 (the Domini Social 400).
The Global Financial Crisis added considerable impetus to the development of the nascent concepts of sustainable development and responsible investment which were enshrined in the UN’s Sustainable Development Goals and Principles of Responsible Investment respectively in 2018.
ESG reporting by companies is currently being driven by a combination of the imposition of mandatory governmental requirements – such as the climate related disclosures consistent with the Financial Stability Board’s Task Force for Climate-Related Financial Disclosures (TFCD) which are likely to be required of all UK listed companies and possibly large private companies by the end of 2023 – and also in response to the requirements of real estate investors such as FCA (Financial Conduct Authority) authorised asset managers or regulated life insurers and pension providers who themselves are also likely to be required by the FCA to make TFCD disclosures by the end of 2023.
Real estate investors’ requirements are not just motivated by regulatory compliance but also by the expectation of greater returns. The outperformance of ESG-orientated investment products is exemplified by the analysis by S&P Global Market Intelligence of 26 ESG exchange-traded funds and mutual funds with more than $250 million in assets under management. S&P found that from 5 March 2020 to 5 March 2021, 19 of the 26 ESG funds performed better than the S&P 500.
What does ESG mean in a real estate context?
Taking each of the ESG components in turn:
Broadly this limb covers issues such as climate change, natural resources, pollution, recycling and waste. In real estate terms, this had historically mainly focussed on the energy efficiency of buildings as designed as measured by EPCs and BREEAM, but will increasingly also feature:
- the actual energy performance of buildings in use (as contemplated in the recent Government consultation on introducing a performance-based framework for large commercial and industrial buildings)
- new tools such as NABERS as well as the embodied carbon consumed in the development process (now to be measured under the GLA’s new London Plan for certain developments)
- the climate resilience of individual buildings and property portfolios of large real estate asset owners (which may become a requirement of insurers of real estate).
This limb incorporates human capital and social opportunities. Again, in real estate terms, this limb focuses on a building’s impact on society, for example, the health and wellbeing of staff, tenants and the local community and community engagement. This limb has its roots in the Corporate Social Responsibility (CSR) agenda which was a rather loosely defined concept that has been commonly adopted since the 1960s in the business world partly to enhance the brand or reputation of a business.
There is also synergy with the social value initiative that has gained some traction over the last couple of years and has been adopted by a number of real estate companies to demonstrate their ESG credentials.
Governance includes factors such as governance structures, compliance with regulations, staff diversity and retention (which might overlap with the Social limb), culture, and reputation and which are applicable not just to the real estate owner but also to tenants, management companies and other on-site staff.
These factors are increasingly in the spotlight given the social and political upheavals that have occurred during the Pandemic in the United States and Europe and issues of diversity in the real estate industry have been the subject of campaigns in trade journals such as Property Week.
How is real estate reporting its ESG performance?
The big players in the real estate industry have already embraced not only the need to report their ESG performance but also the need to benchmark their ESG performance against their peers under an established benchmarking platform. A number of such platforms (e.g.MSCI, S&P DJ, Global Reporting Initiative, Carbon Disclosure Project) have arisen to meet the growing need to have independent measurement of ESG performance in the world of institutional investment which has of course to date been largely focussed on commercial rather than residential real estate.
It is difficult to assess how much of the institutional real estate investment universe in the UK is being benchmarked for ESG performance but it is likely to be a very high percentage.
In the early days of such benchmarking many cases, building sustainability factors such as BREEAM scores were seen as key indicators of effective corporate stewardship for ESG purposes but recently the benchmarks have become much more sophisticated with an increased focus on the social and governance dimensions of ESG.
According to a research paper on the benchmarking of real estate performance in ESG published by the Investment Property Forum (IPF) last year many property companies are now world leaders in ESG reporting, principally in Europe and Australia. Green building standards have facilitated this process, as have the various Green Building Councils and the International Initiative for a Sustainable Built Environment.
Possibly the most significant benchmark that has emerged for the real estate industry is GRESB (formerly the Global Real Estate Sustainability Benchmark) which was established in 2009. It is currently the leading global ESG reporting framework and benchmark not just for listed real estate companies but also private real estate funds, developers and investors that invest directly into real estate.
In 2020 more than 1,200 entities representing USD 4.8 trillion participated in its annual assessment of ESG performance. GRESB’s assessment collects data on a wide range of ESG issues which include climate risk management, climate resilience, zero carbon targets, gender diversity, employee turnover, gender pay ratio, human capital management, supply chain management, governance and board competence. Completing the assessment is a serious undertaking and not for the faint-hearted!
We are also seeing a number of sector and subject specific ESG benchmarks and sustainable building labelling systems emerge in the real estate arena. In the office sector last year, for instance, NABERS UK was launched. 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 and has been brought to the UK through the Better Buildings Partnership and BRE Group, which will administer the system. NABERS energy ratings will measure and verify the actual energy use of existing offices and provide a rating from 1-6 stars (and so will be similar to the Energy Star rating in the US).
These are however just the first fruits of the early harvests in the garden of ESG benchmarks and labels for the real estate sector. Expect to see new entrants emerge and battle to commence in earnest for the ultimate category-killer real estate ESG benchmark in the next year or two! No doubt ESG benchmark equivalents of prize-winning marrows will soon be unveiled!
What is the future for ESG reporting in the real estate world?
Real estate owners are caught between the twin pressures of regulation and the financial markets. Both – not necessarily for the same reasons – have clearly signalled their intention to encourage and where necessary mandate responsible business activity as measured through the prism of ESG factors.
Any real estate owner seeking finance or investment in the current business environment from any regulated institution or listed company will almost inevitably be scrutinised on this basis and will need to have an ESG story to tell. The best way to tell that story will be by reference to performance on a recognised benchmark.
There may still be deals being done in dimly-lit West End wine bars (when they all re-open!) but the real estate world is changing and real estate professionals and other practitioners will need to know not only their onions but also their Es from their Ss and Gs and their GRESBs from their NABERS!