How regulation is driving permanent change in ESG mindsets

The green agenda is fast moving beyond net zero targets, reports Nicol Dynes.

ESG has become a must have and it’s already influencing the strategies of investors, occupiers and lenders. But while the current focus is on reducing CO2 emissions, because that is the first target, it has become equally important to focus on all three components of ESG – the environment, society and governance.

“Investors, banks, insurance companies, everyone is pushing for green investments and there’s a lot of talk about net zero targets, but ESG is a lot broader than that,” says Thomas Veith, partner, real estate, at PwC. “There will be a lot more regulation coming, so it would be advisable to have the full picture rather than just focusing on emissions.”

“It’s important to improve the buildings, but also the processes within the buildings,” adds Jens Böhnlein, global head of asset management at Commerz Real. “You have to have a purpose, define a clear governance process and think of what the social component means in practice and how you want to manage your assets.”

Questions are being asked now that were not asked before, he says, for example about where workers and materials are coming from. The level of scrutiny will only increase and regulations will become more strict, so now is the right time to act and define a clear strategy. 

More on ESG

“ESG is a necessity now, not an option, and if it doesn’t pick up speed then legislators will intervene,” says Assem El Alami, head of real estate finance at Berlin Hyp. 

Integrating ESG into every part of the business and making the strategy a reality is a challenge on a legal, practical and organisational level, but it also involves a permanent shift in mindset. It means redefining processes and learning your business again from scratch, and this is a difficult thing to do, says Peter Fischer, real estate leader at PwC Austria. “Bringing ESG into everyday life is also an opportunity to find a new market, but the challenge is the old mindset of the industry,” he says.

In the last year, however, the shift in mindset has occurred at a faster rate than expected. “Responsible investment has moved into the mainstream,” says Richard Hamilton-Grey, director, sustainability real estate, Europe & Asia-Pacific, at Nuveen Real Estate. “Investors are embracing impact investing to generate market rate returns and at the same time improve the asset and have a positive ESG impact.”

‘Our aim is for our portfolio to be 30% green by 2025, which is an ambitious target. It was easier with new assets but transforming old buildings is more of a challenge.’

Assem El Alami, Berlin Hyp

The prerequisite for impact investing, he adds, is being upfront about the intention, having a list of priorities and being clear about your objectives, be they carbon reduction or job creation, so that the impact can be assessed against targets. 

Transition risk and portfolio performance are becoming more of a focus. As awareness of ESG requirements grows, companies need more than abstract indicators to make informed investment decisions and evaluate the transition risk correctly, balancing capital investment plans against obsolescence.

Transforming existing buildings 

It is easier for new buildings to make the grade, but the next big challenge is to transform and improve existing buildings, making them ESG compliant. “We were the first mover among German lenders, giving loans for new green assets,” says El Alami. “Now we incentivise buildings that have a transitional risk, grey assets that need to be turned green and need a significant reduction in CO2 emissions. Our aim is for our portfolio to be 30% green by 2025, which is an ambitious target. It was easier with new assets but transforming old buildings is more of a challenge.” 

It is a worthwhile investment because the impact on value will increase in time. “The market will react and at some point companies won’t buy assets that can’t be transformed into green buildings,” adds El Alami. “As an industry we’ll have to price that in.”

Repurposing old buildings and bringing them up to scratch requires a clear plan and long-term vision. “You need to have a good understanding of your asset and to have a 10-20-year horizon,” says Böhnlein. “You must have some smart solutions to improve existing stock. We’re in the process of identifying the worst buildings we have so we can focus on them.”

Investing in transformation is a challenge but also an opportunity for real estate to add long-term value. “In Germany there are many opportunities to make old buildings ESG compliant, or to finance the transformation if you are a lender,” adds Veith.

In Chicago 70% of the office buildings have green certification

Companies are developing strategies based on transition risk. Market expectations vary in different countries, with Europe and particularly Northern Europe far ahead.

“Time horizons are the main difference, but it is a trend that is growing everywhere,” says Hamilton-Grey. “Even in Asia-Pacific in the last six months Japan, China and South Korea have made explicit commitments on carbon reduction.”

Experts agree that more clarity is needed on the impact of ESG compliance on valuations. “The consensus is that ESG compliance definitely has an impact on valuations, but we are still at the starting line when it comes to quantifying the impact and translating it into numbers,” says Dirk Hennig, partner, real estate valuation, modelling & analytics, at PwC.

There is a good understanding of ESG criteria and a strong demand to bring it into the valuation of assets, but there’s still no clear evidence in the market. The guidelines are still general and the industry must work out the priorities and how to move forward.

Clear criteria needed 

“We still don’t know how to bring ratings into valuations for balance sheet purposes, we have many steps ahead,” Hennig says. “We need clear criteria that can be measured and we need tools to assess ESG in the different real estate sectors. That way we can make sure the user understands the criteria the building fulfils, while the investor can value the building in line with ESG criteria.”

The legal aspect will play a key role in valuation by providing a structure and a reference point. “EU taxonomy has a strict framework and benchmarks for assets that will have to flow into the valuation,” says Johannes von Richtofen, manager, real estate valuation, modelling & analytics, at PwC. 

‘Capital values for offices in London have fallen by 20% quarter-on-quarter so there is an opportunity to buy assets, improve them and reposition them to core certified status.’

Vanessa Muscarà, Europa Capital

Benchmarks can then be turned into numbers. There’s a long way to go, experts agree, but it’s positive that these themes, in all their technical, legal and practical aspects, are now being discussed. 

“There is no statistical evidence yet, so it’s difficult to transfer the information to the valuers,” says Reiner Lux, managing director of Hypzert, a certification body for real estate valuers. 

In this process of modifying and improving the criteria for valuation, the role of the valuer is also changing. “The profession of valuer will change, moving more towards being a consultant,” predicts Lux. “They will give advice around value, rather than giving a figure.”

If ESG compliance could be equated to strong returns the transition would be much easier. The goal is to prove that certified buildings perform better and provide a more resilient income stream. Evidence from both the investor and the occupier side points to ESG-compliant buildings leading to better outcomes. 

“On the investor side, research proves that certified buildings achieved a higher distribution income to the client even if costs were higher,” says Vanessa Muscarà, director, head of research & strategy, at Europa Capital. “Returns now are driven by income, so we must keep occupiers happy, and when we go back to the office we must be as productive as possible.”

In a Harvard University study tenants of certified buildings achieved cognitive scores that were 26% higher because they were more rested, alert and productive, she adds: “The positive impact on employees is undeniable.” 

Tenants as customers

The pandemic has accelerated many changes when it comes to buildings and their occupation. As well a shift in perception that means tenants are now seen as customers, buildings that used to be purely symbolic have become functional as well.

“A green asset has symbolic value because people like to be seen working in such a building, it sends a clear message,” says Muscarà. “Now, post-pandemic, that building has functional value as well, because it’s clean and healthy, it makes employees feel safe.”

When it comes to green certification, the US is far ahead of Europe. In Chicago, for example, 70% of office buildings are certified, says Muscarà. The best-performing European city on this score is Warsaw, where 35% of buildings are certified, but it is the exception because it has a lot of new stock. 

‘You need to have a good understanding of your asset and to have a 10-20-year horizon. You must have some smart solutions to improve existing stock.’

Jens Böhnlein, Commerz Real

Most cities in Europe rank lower and across the Continent 60% of offices are more than 20 years old and in need of upgrading. But current market weakness can be an incentive to act and achieve a certification, adds Muscarà. “Capital values for offices in London have fallen by 20% quarter-on-quarter so there is an opportunity to buy assets, improve them and reposition them to core certified status.”

“There is a real opportunity for investors and current owners to refurbish and improve the asset to certification grade,” agrees PwC’s von Richtofen. “Bringing ESG into the building will make it more attractive for investors and occupiers.”

The growing emphasis on ESG is also changing the perception of tax compliance, which is now being seen more as a reputational asset and less as a burden. “There is a shift from tax being seen as a cost to being seen as a contribution to society,” says Dave Reubzaet, director, tax governance & sustainable tax, at PwC Netherlands. “It’s a change driven by Covid-19, but also by sustainable development goals.”

Transparent tax dealiings

The emphasis on non-aggressive tax planning, putting robust governance in place and being transparent in how tax is dealt with is significant. “In the tax world transparency hasn’t always been a given, so what’s happening is a big shift and in my view a very positive one,” adds Reubzaet.

“Tax is becoming more important because reputational risk has become more of a factor,” says Remko van Hijum, head of tax at Bouwinvest Real Estate Investors. “Pension funds and other institutions are more risk-averse now because their investments and behaviour are under increasing scrutiny from the public.”

Bouwinvest decided to assess every part of the investment policy from a tax aspect and in 2018 began to draft a company policy designed to create financial value but also value for society in different ways and over the long term. 

“The policy was adopted and became effective in January 2019 but we adjust it in line with the latest case law, legislation and our recent transactions,” says van Hijum. “The policy of course must be reflected in our behaviour, so we’ve improved our reporting to stakeholders.”

Late last year INREV published the first Tax Code of Conduct, based on five guiding principles related to governance and social responsibility. “The INREV tax code is a very good development, because it creates a standard,” explains Richard van der Linden, tax partner, real estate, at PwC. “It means that when you are talking of tax you are talking the same language and referring to the same things.” 

All companies are advised to develop a tax strategy that takes the ESG elements into account. “It’s important to know that tax is present in all three elements, in the E of Environment, the S of Social and the G of Governance, even if it might not be obvious,” says Reubzaet. “Paying your fair share and having a fair remuneration policy are part of the S, while codes of conduct, risk control and transparency reporting are part of the G.”

EU regulations ‘will finally put an end to greenwashing’

Legislation is set to determine compliance and stop companies from claiming green credentials they don’t deserve, experts tell Real Asset Insight.

“EU taxonomy, that became effective last summer, is a regulatory framework that puts an end to greenwashing,” says Christiane Conrads, EMEA real estate ESG leader at PwC Legal. “It’s part of a long and ongoing regulatory process, a complex system to promote environmental targets.”

A lot more work will now need to be done to specify the criteria. It is important to have clarity on what ESG means and on the metrics used so that it is possible to look beyond the claims made and differentiate between funds.

“The biggest deterrent for investors is that rules are not clear or homogenous,” says Karlien de Bruin, global head of ESG at Sanne Group. “That’s why it’s so important to have regulations to unify and clarify the metrics used and to have everyone work on the same basis. If you make a claim to be ESG compliant, you do it based on the taxonomy.”

‘We’re not directly affected by EU regulations, but we like to follow best practice. Some Ukrainian companies adopt EU rules because it gives them a competitive advantage and places them well in the market.’

PwC Legal Ukraine

Legislation is to be followed by metrics that are yet to be disclosed and with the need to report on compliance to the rules, so the market will be forced to move in the right direction and improve over time. “In time, there’ll be a constant improvement in returns as well,” says de Bruin. 

“ESG has become part of the business environment and international investors are the best ambassadors of ESF strategies,” says Olga Balytska, head of real estate at PwC Legal Ukraine. “But regulations should be as clear as possible, so they can be easily adopted.” 

New regulatory tool

The taxonomy is a new regulatory tool, while certification schemes are a market tool that have been around a long time and are useful in measuring sustainability, especially in new buildings. “Now certification schemes are adapting to be in line with new regulations and this will be a very helpful move forward,” says Conrads.

To have clarity and certainty, it will also be helpful to harmonise EU taxonomy with all the various regulations at national and local level on energy efficiency, promoting alternative energy sources and such like. “Rules change all the time,” adds Conrads. “New regulations come out, changing the way we do real estate due diligence, for example. Clients don’t want to face capex requirements to bring the building into line after they have signed the deal.”

EU taxonomy will have a transformational impact on the real estate sector. “The EU has taken the first step, coming up with regulations that try to nudge people in the direction of the Paris Agreement 2050 goals,” says De Bruin. “It’s a test run, but in a few years there will regulations in all jurisdictions because it’s a global issue.”

‘ESG is much more than climate change, which is an important part but not the full picture. The EU taxonomy contains minimum standards from a social point of view as well. In the end, it’s all about quality improvement.’

Christiane Conrads, PwC

Interdisciplinary teams will be needed to implement the strategy, as well as disclosure regulations, transparency and data exchange clauses. The market will develop and agreements will be adjusted. 

Quality improvement

“ESG is much more than climate change, which is an important part but not the full picture,” says Conrads. “The EU taxonomy contains minimum standards from a social point of view as well. In the end, it’s all about quality improvement.”

It is work in progress and the details need to be filled in to gain a complete picture. “In six months we will have made a lot of progress and will know a lot more,” adds Conrads. “It will be a whole new chapter for real estate.” 

EU legislation is very advanced and will be followed by other, non-EU countries.  “We’re not directly affected by EU regulations, but we like to follow best practice,” says Balytska. “Some Ukrainian companies adopt EU rules because it gives them a competitive advantage and places them well in the market.” 

There is also a space for government to step in and reward companies that comply with ESG rules to encourage others to follow.

“If you invest €20 million and follow ESG requirements the Ukrainian state will reimburse up to 30% of your investment, and this is proving to be a good incentive,” adds Balytska.