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ESG Regulation for Real Estate

26 May 2023

Echo, Sierra, Golf (ESG). It’s hard to have a conversation in the Real Estate sector without ESG being mentioned these days.

From tenants to asset managers, to investors, ESG is at the top of the list in key decision-making.  This dovetails with the global necessity to achieve a net zero and sustainable future, reinforced with the 2015 Paris Accord and subsequent COP gatherings. Moreover, the UK was the first G7 country to sign its commitment to net zero greenhouse gas emissions by 2050 into law. 

Where do we in the UK Real Estate funds industry currently stand with ESG market and regulatory challenges and opportunities? 

To achieve ESG goals, a number of practical aspects need to come together. First and foremost, there needs to be desire and motivation to achieve objectives. Real Estate investments have long been part of a diverse portfolio allocation for institutional investors. Over 450 of the world’s largest financial institutions formed the Glasgow Financial Alliance for Net Zero ("GFANZ") alliance, with an estimated $130 trillion of private capital committed to net-zero.  The tone was firmly set for the institutional investor community that net zero is locked-in to investment activities going forward. Institutional Investors will have set their own net zero targets and commitments and now expect the asset managers they work with to be aligned. 

Real Estate fund managers will also be taking note of the demands from tenants and occupiers, both commercial and residential. Positive ESG credentials are in demand and can be the obvious differentiator in rental levels between two similar assets. 

The stage is set and it seems the full cast and crew are ready, so what is the current status in this net zero journey for the UK Real Estate sector? 

“What gets measured, gets managed” 

Critical to the journey is the ability to credibly review performance and milestones against targets. At times, the long list of acronyms can be frustrating and confusing. Below, we take a closer look at some of the acronyms widely used in the UK. 

The Patent (TCFD) 

International investors may bemoan the regional and jurisdictional legislation that has appeared in recent years, each similar, but different and potentially creating nuanced reporting needs across global portfolios. It is worth remembering though that the parent to all the various environmental disclosures is common and it is the Task Force on Climate-related Financial Disclosures (TCFD). The TCFD recommendations on climate-related financial disclosures are widely adoptable and applicable across sectors and jurisdictions. They are designed to solicit useful, forward-looking information that can be included in mainstream financial filings. 

The recommendations are structured around four thematic areas that represent core elements of how organisations operate: governance, strategy, risk management, and metrics and targets. 

Sustainable Disclosure Requirements (SDR) 

In the UK, the SDR proposals issued by the Financial Conduct Authority (FCA), implement the TCFD recommendations alongside FCA guidance and principles. The proposals, as set out within a consultation document which closed for responses earlier this year, and the FCA policy statement are expected in Q3 this year. The FCA’s policy goals focus on combatting greenwashing across multiple asset classes and improving the level and clarity of sustainability information that investors receive. Whilst the labels are primarily intended to be used for products marketed to retail investors, managers also have the option to use these sustainable investment labels for products being marketed to institutional investors. 

How Real Estate institutional fund managers can prepare to use this new label system? 

Some may argue that the SDR label system is a regulatory burden that they would rather avoid and that managers that also operate in the European Economic Area are already having to give much attention and resources in meeting the EU’s Sustainable Finance Disclosure Regulation (SFDR) requirements.  

However, there are good arguments for UK managers to opt to use the labels voluntarily, the most compelling of these being that SDR provides credible labels for funds looking to market themselves as having sustainability objectives. 

We anticipate that SDR will provide a welcome step forward to create a clearer situation around labelling than that which evolved under SFDR. Later this year, the European Commission is expected to review the current approach of the European Securities and Markets Authority (ESMA) that SFDR is a disclosure framework and not a labelling system. 

SDR key provisions: in addition to product labels 

Managers will be required to make certain accompanying disclosures. Where sustainability-related features are integral to an investment policy and strategy, but the manager chooses not to use a label or is unable to do so because the product does not satisfy the criteria, the manager will need to ensure those features are communicated in a proportionate way to the sustainability profile of the product, in line with the FCA’s naming and marketing rules. In practice, this may often mean that the manager will not be able to use ESG-related terms in the relevant name and marketing. 

On the contrary, the FCA has started from the premise of creating a labelling regime and has put forward under SDR three fund labels that describe a fund’s intentionality regarding sustainability.  

The three proposed labels are: 

  • Sustainable Focus – for funds that aim to invest in assets that a reasonable investor would regard as environmentally and/or socially sustainable. 
  • Sustainable Improvers – for funds with an objective to improve the environmental and/or social sustainability of assets over time. 
  • Sustainable Impact – where the funds are investing in solutions to environmental or social problems to achieve positive real-world impact. 

Importantly, for Real Estate fund managers, the proposed Sustainable Improvers label offers a dynamic transition: an opportunity to attract capital in order to accelerate net zero goals. The label will be attractive for funds that wish to invest in assets that are stranded or currently unsustainable but where there is an objective to improve sustainability performance over time. 

Usefully, because the FCA proposes that there be no hierarchy between the three SDR labels, a Sustainable Improver fund focused on retrofitting existing building stock is intended to carry the same sustainability credentials as the focus and impact labels. 

It may also be the case that institutional investors, whether in the UK or elsewhere, accept the merits of the SDR labels for their own fund commitments. The FCA indicates that it has “developed a set of threshold criteria that all firms must meet, as well as some implementation guidance”. It says: “The criteria are objective, rigorous, and aim to ‘raise the bar’. At the same time, they provide flexibility to accommodate different sustainability objectives for continued evolution and innovation in the market within clear guardrails”. 

This approach from the FCA lends itself to institutional investors adopting SDR labels criteria as benchmarks for assessing sustainable products. 

Those adopting SDR could be at the forefront of a growing move towards clear sustainability labelling globally as other regulators also take action. The US is proposing an amendment to the ‘names rule’ to expand its scope to apply to any fund name with terms that suggest, for example, investment decisions incorporating one or more ESG factors. In the EU, ESMA is consulting on “guidelines on funds’ names using ESG or sustainability related terms”. ESMA’s objective is to provide fresh and firm direction on labelling following the SFDR situation where the market made its own interpretation. 

A significant point of context is that, according to the World Economic Forum, buildings account for nearly 40% of global greenhouse gas emissions, 50% of the world’s energy consumption, and 40% of raw material use. Our Real Estate sector must prepare for the ESG regulatory paradigm where anti-greenwashing measures and sustainability labels are here to stay. UK managers: get ahead of the curve, and be aware of the opportunities presented by SDR product labels. 

The next immediate challenge being faced down by the industry is the effective and timely gathering of real data, upon which measurement and monitoring can take place.  Look out for our next article where we discuss some of the practical and innovative solutions being used to gather energy data and improve environmental metrics. 

This article was written by Melville Rodrigues, Head of Advisory - Real Assets at Apex Group and Simon Vardon, Global Head of Product - Real Assets at Apex Group.

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