How ESG is shaping investment value

ESG comprises three pillars; environmental, social and governance, all of which collectively contribute to effective performance, with positive benefits for the wider markets, society and world as a whole.

Once a niche concern being pushed forward largely by legislation, ESG is today increasingly front and centre of investment decisions. The built environment is currently responsible for 40% of energy consumption in the EU and as a result, facing increasing scrutiny on how to manage and reduce this level. 

A move towards ESG investing in commercial real estate is not just occurring at the European level, but is a global phenomenon. A recent survey of global real estate investors covering over $ 1.1 trillion of AUM, by the United Nations Environment Programme Finance Initiative (UNEP FI), REALPAC and Bentall Kennedy, found that 93% of investors now include ESG criteria in investment decisions, while 83% have seen an increase in investor demand for sustainability disclosure. In addition to fulfilling this demand by investors, the benefits of lowering of risk and meeting the increase in demand by tenants for green buildings, are also drivers for the funds to look towards ESG.

How is ESG shaping investment value?

There is strong evidence that investors are increasingly seeking buildings that are committed to sustainable practices. However, a key concern is the impact sustainability measures will have on their portfolios. This hypothesis has been conducted previously in research projects and has recently been replicated by M&G Real Estate using their own European certified buildings. Their findings demonstrated that the assets had incurred higher operating costs (+31bps) due to implementing sophisticated technologies. However, by achieving a higher rental income (+53bps), this compensated for the increased expenses and resulted in higher cash flows for distribution (+19bps). Additionally sustainability can mitigate the impact of obsolescence, improving resilience and enhancing the value of the asset. Despite, the increased demand for sustainability disclosure by investors, many companies still provide inadequate ESG information. This makes it harder for investors to measure performance of the underlying assets. 

Further support for ESG can also be seen by major European banks. According to the UN Environment’s Inquiry, 8 out of 10 banks surveyed provide green lending for commercial real estate. For example, Lloyd’s Banking Group established a £1bn lending initiative. This strategy of ‘green tagging’ incentivises the borrower to implement green infrastructure and as a result is granted a discount of 20bps on purchases over £10m.

How is technology impacting sustainability in offices?

At first thought, technology and sustainability seem mutually exclusive as one requires electricity to improve processes, with the latter driven to prevent environmental degradation. However, with pioneering advances of technology becoming more omnipresent, it is imperative for office buildings to implement these in order to reduce their carbon footprint and compliment the surrounding SMART city initiatives taking place.

With automation currently pervading the built environment, this will enable tenants and landlords to identify trends that will in turn foster better decision-making, further optimise resources, maintain the longevity of fixtures and make facilities management more productive and effective. Further enabling automation, is the employment of the internet of things (IoT) as both work concurrently to improve office sustainability and enhance user interaction with the building. Additionally, through the intercommunication of SMART systems and the ability to ‘memorise’ tenants’ preferences, the IoT is able to record real-time data. By harnessing this big data, both parties can use intelligent scheduling of features to provide optimal work spaces and enhance investment value in a sustainable way. It is expected that by 2021 over 3.6 billion connected devices will be installed in commercial buildings. By leveraging new technology, 84% of IoT devices have the potential and are currently addressing the sustainable development goals (SDGs) as defined by the United Nations, according to the World Economic Forum. This highlights how the two concepts of technology and sustainability can be mutually reinforcing and future proof the industry.

The tenant premium from ESG 

The strength of ESG practices by tenants contributes to the tenant covenant. Better ESG practices means for a better performing tenant and reduced risk of under-performance requiring tenant requests for rent reductions and lease breaches. For example, undertaking regression analysis of 121 listed global retailers, we found that the Thomson Reuters ESG emissions score* and environmental innovation score** increased revenue per share by $900 and $770 per share respectively, for each 1 unit increase in respective scores, significant at the five percent level. Additionally, the emissions score also increased standardised free cash flow of the retailers, significant at the ten percent level. 

ESG value from protecting against obsolescence

Today many offices have obtained green certification such as BREEAM or LEED and certain legislation such as the Minimum Energy Efficiency Standard (MEES) applicable in England and Wales, sets minimum energy performance ratings for being able to let a building. This is another way how ESG can shape investment value, in terms of sustainability, by mitigating risk of obsolescence as a result of the introduction of legislation. With pressure on many governments to meet globally agreed sustainability goals, we might expect and increase in such legislation in the future. 

How ESG is shaping value in the development process

It is important to consider sustainability throughout the whole life cycle of a building. This includes location, design and overall construction. In OECD countries, the built environment is responsible for 30% of raw material use and 40% of solid waste generation. Therefore, it is crucial to ensure the sustainability of materials, technologies, transportation of equipment and amount of fuel used by vehicles during the construction process whilst minimising waste; before the building has even been built. The best means of assessing these factors is with certification, such as BREEAM.

Investors and developers have a significant responsibility in adhering to the Climate Change Act which aims to reduce greenhouse gas emissions by 80% by 2050 by establishing five carbon budgets. Out-of-town business parks are regarded to be carbon intensive as they have limited transport provisions. However, schemes can be implemented e.g. car shares and organised buses to encourage sustainable means of commuting. In this respect, realistically it will be a challenge to meet sustainability targets in every facet of building construction. 

Key Takeaways/ Recommendations

1. Building owners should carry out whole-building retrofits whilst ensuring to evaluate systems as a whole, as many are intrinsically linked and one design strategy may meet multiple sustainable objectives.

2. Tenants and landlords must be willing to collaborate, communicate and landlords must share data regarding consumption in the office building in order to instigate sustainable measures.

3. With an abundance of data and technological advances, comes much opportunity, but it can be a challenge, to keep up to date in a fast changing environment. This can be achieved by working with experts who can help navigate the changing technological and ESG landscape. 

*What goes into the emissions score?

This comprises 47 different checks ranging from the presence of policies on and outputs of a variety of emissions such as CO2, NOx and particulates, to waste recycling ratios and environmental provisions.

**What goes into the environmental innovation score?

This comprises 30 different scores ranging from vehicles and fleet fuel emissions to environmental R&D spend, water technologies and sustainable building products