How to navigate the sustainable investment landscape?

The new regulatory landscape, as highlighted in our ‘Sustainable finance regulations respond to sustainability agenda’ article, is driving real change, influencing design standards, due diligence processes, and valuations across the EU and beyond. However, navigating the sustainable investment landscape is not without its challenges.

• Complexity: The principles of the EU taxonomy (defining a sustainable activity) and SFDR (requiring transparent disclosure) are sound. However, with up to 64 indicators, along with wider governance requirements to report against, investors can find assessing the asset’s fundamental environmental performance challenging.
• Accurate assessment: The taxonomy may not always correctly classify a sustainable activity. Whilst an existing ‘A’ rated asset would be classified as sustainable, the rating varies significantly by country and does not correlate well with energy performance. As a result, the classification is not providing investors sufficient confidence of assets’ sustainability performance.
• A cliff edge: Another pitfall is that an asset is defined as ‘aligned’ or ‘not aligned’. As such, an asset that is improved from a 'G’ rating to a ‘B’ rating would not be considered sustainable. An asset that is ‘A’ rated but is operated highly inefficiently would still be defined as sustainable. Again, this is not incentivising the allocation of capital towards sustainability activity.
• Unintended consequences: As the EU taxonomy drives demand for existing assets with excellent operational efficiency, it drives demand for newer assets. The taxonomy does not consider embodied carbon important and, therefore, does not incentivise investment in retaining existing buildings and materials. This drives demand for new assets, increases the risk of obsolescence and risks driving further bifurcation in the market.

There is a reason the famous economist Nicholas Stern said climate change was the greatest market failure the world has ever known. It is no surprise that the legislation does not provide a simple fix, nor solve all the challenges at once. The legislation is being developed and the EU (and other regulators) will establish the regulations to address the challenges set out.

How can investors best respond to the developing landscape?

1. Ambitious strategies should focus on fundamentals

The complexity of the landscape risks focusing minds too much on compliance rather than on the fundamentals.

We know that durable strategies will be those that focus ruthlessly on understanding and managing climate and wider ESG risks and opportunities. Those strategies need to focus on social and environmental impacts as well as tenant, investor and wider stakeholder demands.

Of course, regulations should not be ignored; rather, they should be used as valuable tools to support the assessment of risk and financial impacts, to understand environmental performance and disclose sustainability impacts.

2. Strategies must be rooted in financial realities

Sustainability strategies are no different to business strategies. Those that were (correctly) ambitious but lacked detailed financial analysis did not have investment plans behind them and so have often failed to deliver.

The IFRS S2 and EU taxonomy requirements to assess climate-related risks and opportunities should be embraced as they present an effective framework for properly understanding the financial implications associated with climate change. This gives sustainability and asset and fund managers the tools they need to develop robust strategies, rooted in financial reality – and so more likely to be delivered.

3. Strategies must be underpinned by engineering excellence

Tackling climate change and creating resilient property portfolios is not just a strategic and financial challenge; but also an engineering challenge. Time and time again, history has shown us that sustainability strategies, net zero carbon definitions, asset repositioning plans and climate risk assessments that do not secure the proper technical input at the very earliest stages, risk being impractical and more expensive.

As investors respond to the new regulatory frameworks and work to align with the EU taxonomy, it is essential that detailed design briefs and operational standards must be developed by combining experienced sustainability and expert engineering teams. Only in this way the ambitious, the optimal, the innovative, and the practical solutions can be found.

Setting ambitious sustainability goals is a necessary step, but it’s the innovation and practical solutions that truly mitigate risk, build resilience, prevent additional costs down the line, and ensures practical deliverability. By doing so, investors can provide attractive assets to lenders, insurers and prospective buyers, thereby, protecting value and increasing liquidity.

Conclusion

The sustainability landscape has evolved over millennia and is changing at an ever-accelerating pace. Just as the ancient Egyptians secured their civilisation for thousands of years by focusing on the fundamental impacts on their activities and environment, our sector must do the same.

By working in partnership, meeting all stakeholders’ needs, and ensuring ambitious strategies are underpinned by both financial realities and engineering excellence, we will ensure our sustainability strategies protect value and are durable in the context of an ever-changing and increasingly complex legislative landscape.