ESG disclosure regulations – a stick or a carrot for investors?

Originally published in IPE Real Assets in June 2024.

This article is co-authored by Simon Wyatt, Sustainability Partner at Cundall and Helen Newman, Director - Sustainable Investing at Fabrix.

When we look back at how we acted on climate change in 2023, the year will be remembered only as one of stagnation. In 2024 however, there is change on the horizon. Increased pressure from investors has given rise to a suite of new regulations, and with 70 countries including the UK signing the Declaration de Chaillot in Paris this March, change is definitely on the way. The Declaration de Chaillot is a foundational document for international cooperation which will enable progress towards a rapid, fair, and effective transition of the built environment that is dedicated to the decarbonisation and climate resilience of buildings.

Europe’s financial market is showing strong leadership with the Sustainable Finance Disclosure Regulation (SFDR) requiring all financial sector entities within the EU, including asset managers, to disclose their Environmental, Social and Governance (ESG) performance – and in response to the creation of the International Sustainability Standards Board (ISSB), similar regulatory standards in the UK, US and Australia are emerging.

Financial products, including real estate assets, which comply with these regulations are already starting to attract greater premiums, and benefit from higher liquidity and pricing resilience in the current market. Furthermore, the global nature of finance means these requirements are crossing borders especially given real estate portfolios often include investments in more than one jurisdiction. Anyone wanting to ensure their offerings have the greatest potential of attracting institutional capital will look to demonstrate compliance with as many of these global standards as possible.

2024 is the second year of SFDR reporting, and part of the SFDR disclosure framework is alignment with the EU Taxonomy (EUT). The EUT establishes criteria to define sustainable economic activities, including performance requirements for real estate. It already requires Whole Life Carbon (WLC) analysis for newly constructed assets, which will drive more consistent reporting.

The recent release of the second edition of RICS Whole life carbon assessment for the built environment guidance also offers a great opportunity for the UK to help lead the way in this regard. However, France, the Nordics (including Denmark and Finland) and the Netherlands have already stipulated challenging WLC and embodied carbon targets for new and existing developments. This will trickle down through French, Nordic and Dutch pension capital and through real estate investment vehicles backed by this capital – even where the underlying assets are located outside these jurisdictions.

Asset managers are getting to grips with reviewing and understanding the current performance of their assets, funds and portfolios. At the same time, they also need to produce comprehensive sustainability strategies for new developments, decarbonisation plans for existing assets, and climate resilience strategies for their portfolios as we transition to a low carbon economy.

The UK also anticipates a UK Green Taxonomy, which will increase the demand for sustainability advisors and building designers who understand both the interoperability and divergences between these frameworks, and can implement SFDR, EUT, ISSB and emerging UK Taxonomy requirements alongside the application of other global regulatory frameworks such as the Task Force on Climate-Related Financial Disclosures (TCFD) and the Science Based Targets Initiative (SBTi). These advisers and designers will also need the skills to set corporate level climate transition plans and high-level strategies for reporting and compliance. On top of this, they will also need to deliver the level of retrofit or new build design expertise which is necessary to bring assets into compliance and alignment with decarbonisation trajectories.

The ability to translate the finance disclosure (SFDR) and taxonomy (both forthcoming UK and EUT) requirements into detailed design briefs must be supported by experienced building performance engineers who have detailed knowledge of how buildings work and operate. They in turn can work with asset managers and the facilities management teams to help them realise optimal decarbonisation outcomes while satisfying the plethora of disclosure requirements. In short, investors, development mangers and asset managers should be looking to employ teams of people who know how to develop a strategy, and then also have the practical and commercial expertise to implement it.

This is a new area of specialty that multi-disciplinary engineering and design consultancies, like Cundall, are expanding. Collaborative teams combining sustainability consultants and engineers have the skills to interpret global regulatory drivers and develop practical strategies for compliance to help their clients drive greater investment value for their assets. They also have the network and knowledge to predict how climate and decarbonisation regulatory, reporting and disclosure requirements might evolve over time and help set strategies that both comply with the regulations as they stand now and help future-proof assets for how those regulations might look in the coming years as we draw closer to the Paris target milestone.

To assist one large Pan-European fund, Cundall has developed a bespoke reporting framework for existing assets and a development brief for new assets. This meets all the mandatory requirements of SFDR and the real estate section (Section 7) of the EUT with additional targets for real operational energy performance and upfront embodied carbon targets. It is also embedding Science Based Targets and CRREM (Carbon Risk Real Estate Monitor) to future proof the fund against further evolution of the SFDR requirements.

A major requirement of SFDR and other rapidly emerging global disclosure frameworks, is climate resilience and adaptation. Born off the back of the insurance industry’s recent losses due to the physical impacts of climate change, there is a growing emphasis on mitigation and evaluation of physical risks to individual assets and portfolios. With more companies falling into scope for mandatory corporate transition plans, we predict that all buildings will require bespoke physical risk assessments and adaptation strategies within the next three years, or risk insurance premium rises and asset devaluation.

Again, technical design services that specialise in building performance will be key to meeting these requirements while prioritising asset intervention balanced with available CapEx. Experts in this field can provide technical due diligence, particularly around managing heat waves, flash flooding and potential grid instability due to climate change. They can then advise clients on a retrofit pathway for their buildings that delivers quantifiable progress towards decarbonisation and climate adaptation, and accounts for fundamentals like leasing events. Indeed, incremental retrofit working around multiple occupiers maintains income and is likely to be increasingly preferable given current costs of capital.

Intelligent retrofit strategies will support the asset owner or asset manager to benefit from better risk adjusted returns and attract green finance for retrofit projects through financial instruments like green loans. So, it is not just about reducing risk and abating risk insurance premiums and devaluation, it is also about creating opportunity for cost-effective capital funding and defending liquidity.

What is certain is that to access and attract finance in the coming years, a greater level of sustainability performance and disclosure will be necessary. Now is the time to get in front of what’s coming down the line.