ESG Considerations for Fund Real Estate Risk Management
In recent years investors and stakeholders have turned their focus to Environmental, Social and Governance (ESG) criteria when screening investments. Managers of a Commercial Real Estate Fund can utilise ESG considerations to assess how their portfolios manage risks and opportunities arising from changing market and non-market conditions. ESG Considerations include factors such as financial risks that are attributable to climate change and increasing support from governments for the so-called “green assets”. This article sets out some considerations for taking a risk-based approach to ESG and ESG factors specifically relating to Real Estate.
Managing a Fund that implements ESG factors is a challenge due to the relevant regulatory requirements. Specifically, it includes integrating sustainability risk factors into existing Risk Management Frameworks. A Sustainability Risk can be defined as “an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of an investment.”
Regulators worldwide are making ESG disclosures mandatory, i.e. the EU has implemented the Sustainable Finance Disclosures Regulation (SFDR) in order to provide transparency on sustainability risks and to consider any adverse sustainability impacts of investment processes. On 30th of April 2019, European Securities and Markets Authority (ESMA) published its technical guidance on proposed amendments to the UCITS directive and the AIFM directive to integrate sustainability risk factors. The proposed amendments relate to:
Due Diligence on Investments (Sustainability Risks);
Due Diligence on Investments (Principal Adverse Sustainability Impacts);
Conflicts of Interest;
Risk Management Policy;
To tackle the above amendments, firms should ensure that they have in place the relevant updated policies and procedures as proposed in the guidance. These can include a proper risk register that will be used to identify and monitor all the possible risks, including the sustainability risks that refer to the ESG component, and constantly monitor any updates in the relevant legislation to keep up with the obligations. These will also help the company to identify any potential conflict of interests it might have because of the integration of the sustainability risks in the risk framework. Remuneration policies should also be updated to link the risk-adjusted performance and not encourage excessive risk taking that will cause an increase in the sustainability risks. Subsequently, sustainability risks will be taken into consideration as part of the investment decision-making process.
Apart from the regulatory requirements necessary in establishing an ESG Fund, identifying and managing properties that cover aspects of the ESG factors can also pose a challenge. According to Bloomberg, the world’s largest wealth fund, the Sovereign Wealth Fund of Norway, stepped up its ESG focus on real estate to ensure its $30 billion property portfolio satisfies the carbon neutrality goals set out in the Paris Agreement. In 2016, the Paris Agreement set the requirements for combatting climate change. The Agreement states that the global temperature levels must not rise by more than 2 degrees Celsius, preferably not more than 1.5 degrees Celsius, compared to pre-industrial levels. The member states of the EU are part of the 195 parties that have signed the Paris Agreement.
It is known that Real estate and infrastructure are highly correlated due to the high levels of energy consumption and a strong dependence on fossil fuels such as oil and gas. As a result, there is substantial pressure to reduce carbon emissions from buildings. Therefore, the creation of new sustainable buildings using eco-friendly materials or installing car electric chargers in new residential and office buildings, is becoming a necessity that will help the environment covering the “E” factor from ESG and reducing the sustainability risk of that specific asset.
The ‘social’ component is also an important factor. To assess the social component of a real estate asset, investors should pay particular attention on the relationships between property developers and the local communities that they operate in and whether they are creating places that improve the standard of living of the habitants of that community. Social sustainability is not just about improving the standard of living of the local community. It also includes how the real estate developers behave towards their employees i.e. exploitations of workers. Factors that cover the ‘social’ component of ESG can also contribute towards reducing the sustainability risk.
Moreover, since the start of the new decade the global pandemic has intensified uncertainty of the global economy. Real Estate is an industry that contributes towards combatting the pandemic. For instance, buildings are now focused on ventilation. Specifically, ventilation systems need to be upgraded and reconfigured to be able to allow patient isolation in more rooms or entire sections of a hospital or a building, separating them between non-infected hospital patients.
Subsequently, the abovementioned factors might contribute towards improving the Net Operating Income (NOI) of a property, and indirectly the Return on Investment of the Fund holding it, over time through increased demand, lower bills for the tenants due to more energy efficiency or better water usage that can result in tangible financial benefits i.e. reducing operating expenditures.
New real estate developments are under pressure from both a regulative perspective and the financial markets. A recent study by the CFA Institute shows that 65% of investors said their motive for considering ESG issues was to help mitigate investment risks. The shift towards more ESG compliant real estate has already started and is tackling the two abovementioned pressures. “E”, “S” and “G” are going to become even more visible and urgent in new real estate projects, making these assets more attractive to be included in funds.
The definitions of sustainability risks can be particularly wide, and they can cover a plethora of components. Thus, ESG real estate properties can be particularly difficult to identify and value because of the variety of ESG approaches that can be used. As a result, it is obvious that the assessment and monitoring of the sustainability risks will not be simple to address.