ESG in Real Estate – what do the current and upcoming European regulations mean for real estate asset managers?

With the real estate sector as a source of around a third of global carbon emissions and consumer of about 40% of global energy, it is critical for real estate asset managers to integrate sustainability into their portfolios and protect the value of investor money. The importance of sustainability is widely recognised and ever increasing by asset managers, asset owners and tenants and backed by numbers.

Since the beginning of this year we have advised an increasing number of real estate asset managers with the establishment of their sustainable real estate funds or on upgrading existing "normal" funds to sustainable ones. This is most of the time driven by investor demand. Especially European institutional investors subject to public scrutiny, such as pension funds, look closely and critically at the sustainability of the financial products they invest in. For example, side letter provisions are becoming more specific and sophisticated demanding exclusion of certain type of non-sustainable investments from their portfolios and detailed sustainability related data. Accordingly, sustainability has become one of the main points of consideration for real estate asset managers targeting European investors.

How sustainable are we talking about?

Currently, in practice "sustainability" in real estate means most of the time environmentally friendly and to a limited extent socially sustainable. Generally, the focus is on limiting greenhouse gas emissions of buildings through energy efficiency and green energy consumption, waste management and water efficiency. Socially sustainable real estate funds we see in practice are for example those investing in affordable housing.

Sustainable funds can also be defined by using a "greenness" spectrum. In simplified terms, there are three degrees of sustainability. At the far left end of the spectrum we see real estate funds which merely consider sustainability risks; i.e. the possible negative impact of climate change (e.g. real estate damaged by floods) on the value of the fund portfolio. Some call it the "single materiality principle". In the middle of the spectrum, are the funds which, in addition to considering sustainability risk, consider the adverse impact of real estate assets on the environment and/or the society. For example, by considering the energy efficiency of the building such as the building's carbon footprint when taking investment decision. Also called in the industry jargon the "double materiality principle".

At the right end of the spectrum we find sustainable real estate funds in the strict sense. These are funds where the asset manager sets specific parameters for asset selection with the aim to make a positive contribution to the environment and/or the society. In practice also called "green" funds (those focused on the environmental aspects). Example of green funds are those committing to a net zero target or those investing in green buildings which meet the requirements of the EU Taxonomy Regulation.

The sustainability rush in the real estate sector creates many opportunities but also risk of the “Greenwashing” or “Socialwashing”. The European Green Deal is focused on making Europe climate neutral by 2050. To finance sustainable economic activity and assets it is crucial to ensure private capital is directed to actual sustainable economic activities and assets. The European regulator has therefore been taking ground-breaking regulatory measures which have and will continue to have far reaching impact on real estate asset managers.

The first category of regulatory measures which directly apply to asset managers and their funds are the Sustainable Finance Disclosure Regulation (the “SFDR”) and the Taxonomy Regulation.

The second category of measures are not directly targeting asset managers but will have a profound impact on their European real estate portfolios.

SFDR – fighting greenwashing or socialwashing through transparency

The SFDR applies as from 10 March 2021 and introduces new sustainability-related transparency obligations for asset managers and asset owners (including certain insurance undertakings and pension providers) requiring specific disclosures towards investors in all stages of their investment: before they invest (in offering/marketing documents), on an ongoing basis (on the website) and ex post (periodic disclosures in annual reports).

The SFDR is based on the “double materiality” principle, with fund managers being required to report on both (i) the impact of sustainability risks on the investments and (ii) the principal adverse impacts of their investments on sustainability factors (the latter being a comply or explain obligation most of the time). These disclosure rules apply to asset managers whether or not they are pursuing ESG-related strategies. The requirements apply at the level of the manager (the entity) and/or at the level of a specific fund (the product).

For funds marketed as promoting sustainability or having sustainability as their main objective ("green funds"), the fund manager must disclose to what extent and how the promoted sustainability features or objectives are achieved. In other words it intends to make the asset managers "walk the talk" through disclosure.

It is worth noting that the SFDR also applies to certain type of asset owners such as certain insurance and pension product providers. This means these investors are now turning to their asset managers and requesting sustainability related reporting which will enable them to comply with their own regulatory disclosure requirements imposed by the SFDR. Asset managers targeting these institutional investors should be prepared to address such investor requests.

For an overview of the SFDR requirements please click here and for more detailed information our analysis of SFDR RTS requirements and the subsequent amendments to it here and here.

Taxonomy Regulation – a sustainability label

The Taxonomy Regulation is a classification system which determines whether an economic activity is environmentally sustainable. So the Taxonomy Regulation is focused on the environmental aspects, not the social (for now). In setting detailed parameters for economic activities to be considered environmentally sustainable, it forms the foundation of the EU’s programme to achieve an energy transition to a net zero economy by 2050.

To claim alignment with the Taxonomy Regulation in its current form, an economic activity will need to comply with demanding and granular technical screening criteria. For the investors, it creates a sustainability label which assures a high level of greenness of the financial product they invest in.

In the context of real estate funds the current technical screening criteria (which are still in draft form and are expected to be finalized by 1 January 2022) relate among others to acquisition and ownership of buildings which substantially contribute to climate change mitigation by, for example, having at least Energy Performance Certificate (EPC) class A (for buildings built before 31 December 2020). In other words, a fund which mainly invests in buildings meeting such screening criteria is considered environmentally sustainable and can be promoted as such to investors.

The Taxonomy Regulation creates a protected brand. This means real estate fund managers must be careful when talking about the "greenness" of their fund. Only those funds which comply with the strict screening requirements under the Taxonomy Regulation can market their funds as such. On the flip side, the real estate asset manager which is able to comply with such demanding requirements and sets up a Taxonomy Regulation compliant environmental fund may benefit from being a pioneer in the market.

For more information about the Taxonomy Regulation please refer to our note here.

Fit for 55 – regulating the downstream

The first wave of the EU's sustainability related regulation (the SFDR and the Taxonomy Regulation) targets asset managers and asset owners directly.

The second wave is targeting the investments (the downstream side) with major impact on asset managers. Real estate especially is one of the main pillars of the second wave considering its major role in greenhouse gas emissions and energy consumption. In the context of the its Fit for 55 the EU regulator intends to make buildings in the EU fit for greener future which means reducing its greenhouse gas emissions to 55% by 2030 (compared to 1990 levels) and reaching carbon neutrality (i.e. net zero) by 2050. To reach these targets the EU has recently put forward proposals. The key ones for real estate asset manager to be considered are the following:

• Revision of the Energy Performance of Buildings Directive;
• Revision of the Renewable Energy Directive which, through setting of new quantitative EU level targets, which intends to:
  • make it easier to integrate renewables into the grid (e.g. developing new technologies, integrating storage facilities and improving cross-border cooperation);
  • provide stronger incentives for electrification (e.g. heat pumps and electric vehicles) and the incorporation of new fuels such as renewable hydrogen; and
  • encourage energy efficiency and circularity (e.g. facilitating the use of waste heat).
• Introduction of Emission Trading For Building Fuels which will put a price on polluting fuels, encouraging producers to innovate and invest in clean energy, and offer it to end-users.

Real estate asset managers should consider analysing their current portfolios and assess the sustainability risks associated with the tighter regulation of buildings as soon as possible, one of the major risks being decreasing financial performance of the investments due to loss of value of the real estate asset or increased associated costs under the regulation.

Impact of ESG integration on deal sourcing and ongoing monitoring

1. Start holistically and start strategically – considering sustainable finance has come to stay and is going to evolve in the coming years and decades, real estate asset managers should think big; they should decide on the direction of travel of the organisation and reflect it in organisational ESG policies. The policy could be principal based and non-prescriptive which would help the relevant internal stakeholders to act in a consistent manner and communicate to external stakeholders sustainability vision of the organisation. We see an increasing number of real estate asset managers committing at the level of the organisation to net zero targets; e.g. targeting net zero by 2040.
2. Tailor and implement – where the organisation is large with business teams, investors and assets located in different geographical areas, being conscious about the differences around sustainability (e.g. US vs EU) is important for a successful sustainability strategy. This means, to successfully implement the sustainability strategy of the organisation, real estate asset managers should translate the above mentioned organisation-wide ESG policy into more specific sub-policies and procedures while staying within the broad parameters of the organisational ESG policy. They should consider setting specific targets for a specific segments of the business. For example, net zero targets are well perceived by EU asset owners as it reflects the real estate asset manager's true commitment to sustainability.

The type of policies you should review, adapt, upgrade for your business segment with a European nexus include the following:

• Risk management policies and procedures - sustainability should be an integral part of the risks management policy to enable the manager to properly capture the sustainability risks and related possible portfolio devaluation created by the sustainability profile of investments.
• Deal sourcing policies and procedures - here too sustainability should be an integral part of asset screening (basic high level screening to rule out major issues) and diligencing (more advanced checks) by using specific check lists. Development and major renovation projects will require specific policies involving factoring in sustainability aspects in a very early stage; e.g. during the design phase.
• Management and monitoring policies and procedures - during the holding period of the assets engaging with the relevant stakeholders and data collection are essential to monitor and measure the sustainability performance of the investments. Relevant stakeholders include the property managers and tenants which are important actors in implementing the sustainability policies and procedures and reporting to the asset managers through accurate data sharing.
• Distribution/marketing materials should be carefully reviewed and updated to make sure they accurately reflect all the relevant policies and procedures and are tailored to the target investors depending on their category and geographical location.
• Remuneration policy - Consider how and to what extent sustainability should be considered in the context of employee remuneration.
• Recycle – for those real estate asset managers who are already reporting under voluntary reporting standards such as GRESB, check the alignment with the applicable regulatory requirements and find out how much of the work already being done can be recycled to make the process of sustainability integration as resource efficient as possible. For example, there is a certain level of alignment between the disclosure requirements under the SFDR and GRESB reporting standards.
• Education – it is of utmost importance to educate the employees in all segments of the business (and beyond ESG teams) through trainings to ensure consistent implementation of the policies and procedures, well-functioning of the business and protecting the business against reputational damage.

Impact on non-EU businesses 

In real life, real estate asset managers' businesses are not limited to national or even EU borders. A typical scenario is where the real estate manager is located in the UK, Asia or the US and manages EU funds (usually set up in Luxembourg or Ireland) with service providers (e.g. in-house or hired AIFM, administration agent) in the EU. So the question is, to what extent do the above mentioned EU regulations apply to non-EU real estate asset managers.

Most of the new rules apply directly to non-EU asset managers and non-EU funds marketed in the EU. Where such direct application is not the case, non-EU real estate managers will nonetheless be considerably impacted by the spill over caused by the developments in the EU. After all, a US manager with an EU fund will be required to have appropriate organisational policies and procedures in place to manage its EU funds in line with the legal requirements applicable to such funds. As indicated above, EU investors (especially those subject to the regulations) will require their manager to address their ESG requirements irrespective of where the manager sits (EU or elsewhere).

Post Brexit, the UK regulator decided not to onboard at that time existing EU regulations; i.e. the SFDR and the Taxonomy Regulation. This means that these regulations do not directly apply to UK managers (at least for now). However, those managing EU funds or UK funds marketed to EU investors will still be considerably impacted by the regulations.

The UK decided instead to take its own measures to regulate sustainable finance.

1. The TCFD – in June 21 the FCA proposed extending mandatory TCFD reporting to (i) asset managers, life insurers, FCA-regulated pension providers; and (ii) issuers of standard listed equity shares, as part of the UK’s ambition to have fully phased-in TCFD reporting by 2025. Under the TCFD real estate asset managers will be required to disclose the integration of environmental risks in their investment decisions making.

The proposed timeline of application is as follows:

• From 1 Jan 2022 for large UK asset managers (i.e. enhanced SMCR firms that have AUM of more than 50 billion) and large asset owners (i.e. FCA regulated life insurers and pension providers that have £25 billion or more assets under management / administration ) – with the first annual report due by 30 June 2023;
• From 1 Jan 2023 for all other UK asset managers and asset owners that aren’t excluded under the £5 billion threshold above - with the first annual report due by 30 June 2024

In theory, the UK real estate asset managers have some more time (Jan 2023) to prepare for the new reporting requirements. However, where the investor base includes large asset owners listed above, the asset manager will need to be prepared to report under the TCFD already from Jan 2022 because such investors will turn to the manger for reporting to be able to comply with their own regulatory reporting obligations.

For more information about the TCFD please refer to our client alert here.

2. UK SDR – the FCA has published Discussion Paper 21/04 with proposals on the UK's Sustainability Disclosure Requirements regime (“SDR”). For more detailed information please refer to our blog post.

For real estate asset managers with businesses in the UK and the EU both set of rules may apply. While there are certain overlaps between the UK and the EU regulatory requirements, there are also important differences which managers need to consider and apply.

Conclusion

There is no turning back for the real estate industry and real estate asset managers. Standing still is not an option either. The only option is moving forward and moving fast to avoid being buried in the avalanche of regulatory measures or being left behind by their investors.