What does 'good' ESG in UK real estate look like?
If we aren't focusing on improvement at the macro level and fast, then there is little chance of reaching net zero targets or not breaching planetary boundaries.
8 minutes to read
What constitutes 'good' Environmental, Social and Governance (ESG) and how do you ensure incentives are aligned to the right goals, particularly when focussing on the E aspect?
Here I take a deep dive into what ESG in real estate looks like and ask, and do my best to answer, the questions that currently surround commercial and residential markets.
A few months ago I read Matt Levine's Bloomberg Money Stuff newsletter (referenced later in this article) where he succinctly summarises 'ESG elasticity' using the Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms.
"If you lower the cost of capital for already-green companies, they can't generally get much greener. If you lower the cost of capital for companies that are currently pretty polluting, they might be able to take a longer-term view and invest in energy-transition initiatives, new methods of manufacturing that use less energy, etc. But if you raise the cost of capital for companies that are currently pretty polluting, the long-term matters less, and they're more likely to pollute as much as they can while the polluting is good."
Put simply, are there bigger wins to be found in incentivising those industries that do the most harm meaning that they can transition faster?
We are at risk, across the UK and more widely, of falling short of climate goals. As with anything, it depends on which lens you are looking through. Yet, it is imperative to assess the impact as a whole and look holistically.
In recent years, we have seen many stories of companies going green only to discover this has been achieved through divesting and spinning off more polluting business areas, essentially moving the pieces around a board rather than improving or removing. Messaging is key here as to what the goals are, how they are being achieved and why, if applicable, divestment (i.e. selling off ‘bad’ ESG performing assets) is the only option.
Why does this matter for real estate?
Real estate is firmly in the regulatory sights due to its oversized (40% of total) responsibility for carbon emissions. Minimum energy efficiency standards have been implemented for commercial and rented residential properties, with proposals to raise these and introduce minimum standards for all homes.
The majority of real estate stock is largely ‘brown’ with 70% of commercial stock is below proposed 2030 minimum of EPC B and more than half of UK homes are below potential 2035 minimum EPC C. To meet our collective goals, and keep within Paris Agreement thresholds, this is a sizeable task that needs to be addressed.
Current regulation and benchmarking, and this article explains it well, tends to favour already ‘green’ stock rather than improvement, for now. To make a real difference and deliver on ESG commitments, surely there is a greater benefit to the macro-goal, i.e. greater levels of additionality, by taking the bad and improving.
For those holders of ‘brown’ assets, there are challenges to making them green; from expertise and skillset required to potentially high capital expenditure outlays , particularly in the current high inflation environment.
As one example, the cost of upgrading the UK rental housing stock alone could total nearly £18 billion. Across the industry the levels are much higher. That is not to say that given the right assessments, there may be opportunities for ‘quick wins’, such as energy-efficient lighting or controls, with lower costs available during the elevated cost period.
However, for investors with the requisite expertise, we do expect opportunities for refurbishing or repurposing brown assets with good bones as a result of expected polarisation in pricing between the highest quality stock and the lowest. This is due to softer demand for these ‘brown’ assets as well as potential nearer term challenges to securing financing for some of these.
Real estate occupier and operator decisions are increasingly driven by net zero commitments, mandatory disclosures, such as Taskforce for Climate-related Financial Disclosures (TCFD), EU Taxonomy, Sustainable Finance Disclosure Regulation (SFDR), Corporate Sustainability Reporting Directive (CSRD) and any other number of alphabet soups.
Our latest analysis demonstrates a shift in demand towards more energy-efficient office buildings because of these requirements as well as a need to attract and retain talent through promoting well-being at work. This will only reinforce the divergence between the ‘best and the rest’.
Some of the most common disclosures can create a focus on one number alone, reducing emissions, with no breakdown or caveat, so occupiers are driven to more efficient buildings. From the perspective of the building owner, does it makes sense to divest to make that number lower quickly? Should there be an additional disclosure of transition assets, or a weighting assigned to different types? Some initiatives do emphasise transition assets but there needs to be alignment across the industry and recognition of this.
The proposed UK Sustainable Disclosure Requirements (SDR), with initial disclosures from 2024, to clamp down on greenwashing may be a step in the right direction. Building on the EU's SFDR, which classifies financial products into three groups, the UK SDR would have products classified even more simply as:
- 'Sustainable focus': Products with an objective to maintain a high standard of sustainability in the profile of assets by ensuring 70% of the portfolio meets a "credible standard of environmental and/or social sustainability" or aligns with a specified environmental and/or social sustainability theme. For real estate this might reasonably be green-rated buildings.
- 'Sustainable improvers': Products with an objective to deliver measurable improvements in the sustainability profile of assets over time e.g. improving the energy efficiency of buildings.
- 'Sustainable impact': Products with an explicit objective to achieve a positive, measurable contribution to sustainable outcomes, this might include those carbon positive buildings.
The sustainable improvers label may be the key one of interest.
The big question is: will there be a significant return or cost differential with each to incentivise improvers over focus? If that's the case, will the gap or division be sufficient? The green finance industry is still in its infancy, and products are being defined and refined. Yet finance has one of the greatest potentials to unlock improvement with preferential lending, whether it is to improve green or finance green, but the divergence in cost/return has to be wide enough to be attractive – which may be easier now interest rates aren't at ultra-low levels and increase the aforementioned polarisation.
Cost and economic viability
This may again incentivise investors towards already sustainable buildings. As it stands, build costs have risen 24% since the beginning of 2020, according to data from BCIS, the cost of finance has more than trebled and often, the payback period for energy savings alone is long. Does the rental level warrant the capital expenditure required in commercial and rental properties?
Our previous research found a rental and sales premia for buildings with green certifications. Due to a growing supply/demand imbalance, rents may rise for the highest-rated buildings. But for those worse performing assets, if it takes considerable time to refurbish to a high standard, will there still be a rental premium that justifies the capital expenditure required once completed? Or if all properties were to be refurbished, will sustainable buildings become the market norm and the premia be eroded in the longer-term?
Or should it be viewed in reverse – if the majority of the market is ‘green’ then it becomes a ‘brown discount’ i.e. rental values fall or you may not be able to rent it out due to regulation or lack of demand and therefore it is unviable to do nothing. If this is the case, it may be that the brown discount becomes sizeable enough for those with the right expertise to purchase and refurbish whilst creating a health margin.
As it stands, for some investors there may be little incentive to refurb rather than buy already well-performing assets. Yet a combination of occupier demand, future increased focus on embodied rather than operational carbon, shortage of best-in-class assets, ability to secure finance and the expected polarisation in pricing might encourage and reward refurbishments by those with the right capability.
Natural capital and biodiversity credit
The biodiversity credit market is growing, especially with new legislation requiring a minimum 10% net biodiversity gain for large developments from November 2023 and all others from April 2024. But what are you paying for and how do you prove additionality? What is the baseline? I explore this with some of Knight Frank's experts in the latest edition of The Rural Report 2023/24.
One area we don't delve into is that some landowners have been employing regenerative techniques and nature-positive practices for years, will they be equally rewarded as someone who hasn't and is now starting or not at all? In some cases, will this new marketplace create a disincentive where proponents are put off 'doing good' or implementing 'bad practice' so they can be recompensated more when the market is more established? A question demonstrated by a Texas example. Is it a case of creating a common baseline against which all can be measured? Yet that discounts true additionality.
One could argue either way. Take Matt Levine, again, dissecting a Wall Street Journal Article about how both not chopping down trees can be good for carbon capture, as can chopping them down – but the fact is additionality (a genuine improvement) is what matters now. We need to make rapid improvements in the short-term to even think about the long-term.
There are many unanswered questions, but it is crucial to find the correct answers. For policy makers, clarity over regulation, and the development of financial incentives, or penalties will assist in market developments and perhaps a more sophisticated disclosure framework that doesn't purely report on one number, but looks holistically, is needed.
For investors and property owners, there is a need to assess and clearly set out ESG-related goals, perhaps instead of a net zero target it’s the ability to demonstrate additionality With SDR, although voluntary, being brought in it may be that financial incentives become great enough to create the differentials and make upgrading appealing and viable.
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