On the Board room agenda: ESG & sustainability risks and opportunities throughout the supply chain

In this article we focus on implications for businesses in the real estate sector, as especially in the real estate sector ESG has become an important driver for business considerations, given the long-term nature of real estate investments. In turn, we outline the opportunities for companies to make their business models more resilient and future proof, as well as to benefit the bottom line when ESG and sustainability are handled properly.

A horizontal framework for the value chain

The EU Commission’s 2022 proposal for a Corporate Sustainability Due Diligence Directive (CSDD) is just the latest step in the direction of ingraining ESG and sustainability in EU business. The directive, once adopted, will set a horizontal framework in the EU to foster sustainable and responsible corporate behaviour. Furthermore, it will anchor human rights and environmental considerations in companies’ operations and through their value chains. Around 13,000 EU-companies and 4,000 third-country companies will need to identify, prevent, mitigate and account for their adverse human rights and environmental impacts. Adequate governance, management systems and measures will need to be put in place to that end, which may also directly affect smaller companies that are not directly in scope. The directive will have a major impact on how businesses operate and how they manage their supply chains.

From the bottom up: legal developments for the business

According to reporting by the EU Commission, buildings are responsible for approximately 40% of EU energy consumption and 36% of the energy-related greenhouse gas emissions, placing sustainability at the heart of the real estate industry. Making buildings more sustainable through the use of environmentally-friendly materials, energy efficiency technologies and circular waste streams is not only mandatory in light of the EU’s energy and climate objectives, but will – in the longer run -  also drive return on investment.

On a European level, the EU Commission’s “Renovation Wave for Europe” strategy aims to boost renovation of both public and private buildings as a driver for energy efficiency in the real estate sector. The December 2021 proposal for a revision of the Energy Performance of Buildings Directive contains targeted measures to accelerate a decarbonized building stock across the EU by 2050. This includes a gradual introduction of minimum energy performance standards for the worst performing buildings, a new standard for new buildings with the aim of achieving zero-emission and decarbonisation of heating and cooling, and obligations as to the integration of new technologies into energy systems. The collection and use of qualitative and quantitative data will become key in the design and operation of buildings, with the aim of reducing the ecological footprint.

However, ESG considerations for the real estate industry reach beyond these environmental and climate objectives. Awareness is growing that well thought through interventions in the built environment are not only critical to the well-being of occupants, but may also serve societal purposes. Planning and permitting regulations tend to focus more and more on the social dimensions of project development. It is now common to include public greenery in private projects, to integrate public facilities in privately owned buildings and to opt for mixed projects that foster social cohesion within local communities.

From the top down: sustainable finance, sustainability reporting, liabilities and opportunities

The financial markets have supported and financed ESG and sustainability initiatives for years, also in the real estate sector, and ESG related matters increasingly play a role in underwriting processes. Many financial institutions and investors finance, through green, social and sustainability-linked loans, bonds and derivatives, real estate assets and projects with a distinct ESG or sustainable profile. The financial markets have developed a consensus as to the current best practices in this respect, which led to the publication of principles and guidelines by various financial industry associations (such as LMA, ICMA and ISDA). As a result, companies borrowing money can now expect questions from financiers and investors on their ESG and sustainability strategies and ambitions.

A major impulse for the development of such green, social or sustainable products has been the implementation of disclosure obligations in relation to the extent to which assets and activities of businesses qualify as sustainable under the EU Taxonomy Regulation and its delegated acts.

For example, under the EU Sustainable Finance Disclosure Regulation (SFDR), asset managers managing certain ESG related funds may be required to provide disclosure as to what extent their investments are aligned with the Taxonomy Regulation. For this, they may need data on the ESG performance of real estate investments. Another example is that in due course large corporations will be required to disclose in their annual accounts the extent to which their activities are considered “sustainable” in accordance with the Taxonomy Regulation and financial institutions will be required to disclose in their annual accounts their “Green Asset Ratio”, which measures to what extent their outstanding loans (and other activities of financial institutions) can be considered sustainable. On top of this, regulatory and supervisory pressure on financial institutions has provided clear incentives for financial institutions to be “financing green”. It is now commonplace for companies taking out loans or bonds to benefit from a reduced margin of interest if the debt can be considered sustainable.

For example in relation to real estate financings, where a loan is granted for the purpose of financing the construction of buildings that are considered to be Taxonomy Regulation aligned, that in and of itself may lead to a reduced interest rate, if the loan meets the criteria of a “green loan” or a sustainability linked loan. In addition, the relevant lender(s) will be keen to include the loan in the “Green Asset Ratio” calculations, which is of benefit to the lender(s) and their investors. On the other hand, if the requirements for qualifying as a Taxonomy Regulation aligned loan are not met or certain sustainability KPI targets are not met, the interest rate would increase, leading to higher interest costs for the relevant company, which funds it could have used instead to invest in raising its ESG profile to ensure advantageous funding for the future. For the lender(s), if a loan is no longer Taxonomy Regulation aligned, their Green Asset Ratio would decrease, creating an incentive for financial institutions to hold or withdraw funding to non-Taxonomy Regulation aligned borrowers and activities. With that pressure on financial institutions, companies unwilling to do their part for ESG might even become “unbankable” in the long term.

With the increased disclosure of ESG data in annual accounts, the risk of liability increases where the data do not measure up to legal, regulatory, supervisory standards, or even societal standards upheld by NGOs or activist groups. “Greenwashing” or using unsubstantiated ESG data, or not disclosing relevant data at all, could open up companies and their directors to civil liability to investors and society at large, criminal liability and administrative fines and penalties of supervisors and other authorities.

Conclusion

Including environmental and social considerations into real estate strategies can create opportunities for real estate companies, their investors and their financiers, and can foster long-term value for their real estate portfolio.

The carrots of access to financing and advantageous financing conditions and the stick of liability – for companies and their directors – if they get ESG and sustainability wrong will keep ESG and Sustainability high on the agenda for board rooms for years to come.