Exploring ESG and its Evolving Influence on the Commercial Real Estate Industry

Introduction to ESG & Sustainability

We’ve all heard the buzz-term “ESG,” but what is it, why is it important, and how can firms and funds approach integrating it? In this article, we aim to explain some of these outstanding questions, and how ESG can be accretive to value.

Environmental, Social, and Governance (ESG) factors provide a framework to evaluate the sustainability and ethical risk management practices, and impact, of a company or investment. While ESG is sector ubiquitous and is applied to a multitude of organizations, attention has increasingly turned towards the real estate industry in recent years. The development of The Paris Agreement’s ambitious, and legally binding, climate action requirements compounded with the fact that the real estate industry is responsible for approximately 40% of annual global greenhouse gas (GHG) emissions, pressure for the sector to decarbonize is continually rising.

In the context of commercial real estate, investors, regulators, and other stakeholders will use ESG factors to assess how an investment is managing its environmental impact, its treatment of employees, tenants, and communities, and the quality of its governance practices. ?By investigating these factors, stakeholders are seeking to identify and assess which measures might influence how dilutive or accretive an acquisition might be with consideration to ESG.

Broadly, the environmental pillar is comprised of subcategories that advance climate change mitigation and adoption. Climate change mitigation encompasses the measures necessary to reduce an organization’s GHG emissions – including energy efficiency improvements, renewable energy integration, low-carbon material use, and carbon offset purchasing. Similarly, climate change adaptation consists of preemptive actions to ensure preparedness for a climate change-influenced world. Some measures include incorporating resilient design strategies into buildings, implementing energy-efficient heating, ventilation, air conditioning (HVAC), water-efficient systems, adaptive land-use planning, and engaging with local communities to understand their specific climate-related concerns. Additional environmental efforts involve implementing effective waste management strategies, enhancing indoor air quality, incorporating mechanisms to protect biodiversity, and implementing strategic management practices, such as green lease clauses and tenant engagement systems.

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Why Sustainability is Important

Climate Risk

Generally, climate risk encompasses two categories: physical and transitional. Physical includes vulnerability to extreme weather and other natural climate events, and transitional refers to the impacts of a changing market, new legislation, and technological development.

Transition risk embodies the challenges embedded in the long-term global shift towards a low-carbon economy. This encompasses a spectrum of factors, including evolving regulatory frameworks, shifting market expectations, and advancement of sustainable technologies. Alignment and/or compliance with globally recognized ESG frameworks, such as The Taskforce on Climate-Related Financial Disclosures (TCFD) and The Sustainable Finance Disclosures Regulation (SFDR) is a growing market expectation. Simultaneously, legislation aimed at reducing carbon emissions and promoting cleaner practices is continually emerging. Technological innovations, such as renewable energy solutions and efficient resource management systems are also important to consider for both the return on cost for long-term efficiency, and lasting appeal in a forward-looking market.

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Reputational Risk

As stakeholders increasingly scrutinize how companies manage their environmental impact, employee and communal relations, and governance practices, the potential for reputational risk is significant. An adverse incident related to sustainability or ethical concerns can quickly compromise the trust of stakeholders and the broader public. In recent years, large organizations have faced financial consequences as a direct result from greenwashing claims. In one instance, misrepresentation of ESG credentials resulted in a total of $25 million in fines—the largest greenwashing penalty ever imposed on an asset manager by the US Securities and Exchange Commission (SEC). The organization also suffered an additional 13.5% devaluation in shares after an article was released on the matter by the Wall Street Journal. As more companies are identifying as “ESG leaders,” reputational risk works as a double-edged sword: firms are eager to maintain leadership amongst their peers, yet evidently, must be strategic and confident that any ESG practices or targets they commit to are feasible and legitimate prior to public disclosure.

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Disclosure Risk

Many regulators are proactive, requiring companies to provide disclosure of their ESG risks, practices, and performance to investors. Disclosure requirements are often aligned with industry standards and frameworks that require companies to conduct comprehensive climate-risk assessments to understand how these risks could impact their portfolios, and associated financial performance.

TCFD has gained popularity throughout the real estate industry in recent years. It aims to promote the transparency of financial risks and opportunities associated with climate change. To date, over 120 regulators and governmental entities worldwide support TCFD, and 8 countries bodies have established requirements aligned with TCFD; this number is expected to increase in coming years.

SFDR became mandatory for firms seeking to raise capital from the EU in March of 2021. The regulation mandates a wide range of market participants, including fund and asset managers, to disclose how they integrate sustainability risks into their investment process.

One year later, in March 2022, the SEC proposed rule changes that would require publicly traded companies to disclose climate-related risk factors that are material to their business, including disclosure of scopes 1, 2, and 3 greenhouse gas emissions (direct and indirect emissions, including indirect emissions produced throughout a company’s supply chain).

Expectations are continuing to advance, largely through frameworks and proposed legislation, causing fund-level disclosure to no longer be seen as leading practice for many investors, but as a mandatory exercise. By opting out of voluntary climate disclosures, funds will be limiting their investment opportunities.

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What to Report to Investors

When communicating with investors, certain key aspects must be addressed to provide a comprehensive view of an organization’s commitment to sustainable practices and responsible investing. How ESG is integrated throughout the investment lifecycle should be thoroughly articulated, emphasizing elements in which ESG factors are considered in the investment process and decision-making. The company's alignment of ESG considerations with overarching business strategies and long-term objectives should be evident, and preferably include any (quantifiable) targets or commitments in areas such as decarbonization, green building certifications, or other ESG-related initiatives.

As climate-related risks are widely considered amongst investors and regulators, providing thorough assessment of both physical and transition risks is preferred, and in some cases, required. Detailed methodologies, including scenario analyses, should be disclosed to identify and quantify risks in either category. If risks are identified, a clear strategy for mitigation is valuable in demonstrating a plan for resilience and adaptability.

Providing data-driven insights on energy consumption, GHG emissions, water usage, waste management, and social impact indicators provides a quantifiable basis for evaluating ESG performance at both the asset and fund level. Reporting to frameworks such as The International Sustainability Standards Board (ISSB) S1 / S2, which includes TCFD, SFDR, The Corporate Sustainability Reporting Directive (CRSD), Global Real Estate Sustainability Benchmark (GRESB), and The Global Reporting Initiative (GRI) can aid in providing comprehensive transparency across asset types, locations, and relevant operations.

At the organizational level, detailing governance practices as to how ESG oversight is conducted provides confidence to stakeholders that ESG and climate-related risks, goals, and targets are appropriately managed and integrated throughout the business. Specifically, illustrating how the Board oversees ESG matters, how committees are established, if any ESG-specific committees/roles exist, and external partnerships have potential to enhance both the business’s ESG performance and respective investor confidence.

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Target Setting & Implementation Challenges

Continuously, more organizations are publishing ESG reports and making commitments towards decarbonization, diversity & equity, and responsible governance. Yet, implementing the necessary actions to reach these targets can be challenging without a structured framework. With the buzzword of “greenwashing” becoming a concern that both investors and consumers are increasingly screening for, companies are implementing quantifiable, measurable, and science-based targets to assure the legitimacy of a sustainability action-plan to their stakeholders. These targets can be referred to as SMART Targets, an acronym for Specific, Measurable, Achievable, Relevant, and Time-Bound. ?Once the targets have been produced, the business must then implement programs to manage their commitments and demonstrate their progress against targets.

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Data Challenges and How to Overcome Them

Robust ESG data collection is a challenge that most real estate companies face, as collecting utility data ranging from hundreds to thousands of assets across various locations is a complex operation. If the majority of assets in a fund are occupied by tenants, it can add to the challenge. Beyond direct building emissions, accounting for indirect emissions, or scope 3 embodied emissions, is a recurring obstacle due to the lack of granular data availability. In commercial real estate, scope 3 emissions most materially account for embodied emissions from building material and tenant-use emissions.

To overcome these challenges, investing in data collection systems and establishing partnerships with reliable third-party providers is essential, as these collaborations can ensure accurate, up-to-date, and consistent data, enhancing the credibility of any reported metrics. Moreover, collaborating with suppliers, engaging in industry initiatives, and employing data-estimation methodologies can also help in filling in gaps when direct data is unavailable.

Navigating these data-related challenges demands strategic investments in technology, collaboration, and standardized practices. By taking the necessary steps to overcome these obstacles, companies can provide accurate, meaningful, and transparent ESG information to investors and regulators.

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Role of Software & Selecting a Partner

To aid with the complexities of data collection, in many cases, ESG reporting can be streamlined through software platforms. Choosing the right software partner is a pivotal decision that requires careful consideration. A reliable software solution should provide a centralized platform for data collection, management, and analysis, facilitating the aggregation of diverse data points from various assets and locations, including various ESG metrics such as energy consumption, GHG emissions, water usage, and social impact indicators. This unified approach enhances data accuracy and reduces the risk of errors associated with manual data entry.

The software should additionally align with industry standards and reporting frameworks such as The Carbon Risk Real Estate Monitor (CRREM), GRESB, and SFDR, which ensures seamless integration and enables the generation of standardized reports that align with the preferences of investors and regulators. Moreover, a comprehensive solution should also support scenario analysis, allowing companies to model potential climate-related scenarios and assess the impact at the portfolio level.

Ultimately, the role of software in ESG reporting extends beyond data management—it's a strategic tool that allows businesses to efficiently navigate the complexities of ESG integration and meet the growing demands of investors and regulators. By selecting a software solution that covers vast ESG metrics, adheres to reporting standards, and offers other functionalities, organizations can enhance their ESG performance, increase transparency, and position themselves as leaders in sustainable investment practices.

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How Can EVORA ?Help?

EVORA Global is an industry leading sustainability advisor offering end-to-end climate solutions for real estate investors.? With a broad range of expertise, leading from strategy, reporting, to our in-house software platform, SIERA , EVORA provides best-in-class services to guide Sustainable Real Assets through an ever-changing, climate-influenced market.

Our teams of experts have worked with several global firms whose investments include both equity and debt, feature broad geographic diversity, a wide variety of asset types, and a mix of regional support.? We are adept at organizing teams that deliver services both across and within regions, tailoring our work to suit these varied needs and coordinating the reporting on these outcomes globally.

Contact EVORA to explore how our industry-leading expertise and innovative solutions can guide your organization towards a more resilient built environment.