Overview
What is ESG? ESG (environmental, social, governance) is used as a framework to assess how a commercial real estate portfolio manages risks and opportunities that shifting market and non-market conditions create. These shifts include changes to environmental systems, social systems, and economic systems – all of which impact the landscape buildings are operated in. While there is no universal categorization for ESG issues, and some can be defined in different ways depending on the industry, company characteristics, and the business model, there are some fundamentals.
- Environmental criteria addresses a company’s environmental impact and environmental stewardship.
- Social criteria refers to how a company manages relationships with and creates value for stakeholders.
- Governance criteria refers to a company’s leadership and management philosophy, practices, policies, internal controls, and shareholder rights.
Why is ESG so popular?
In recent years, the appetite for tracking and prioritizing ESG factors in commercial real estate has exploded — and there a few key reasons why. Global acceptance of climate change and the material risks associated with it has driven up investment in green buildings and clean energy infrastructure. Regulators working to address this problem continue to enact stricter policies and standards. Investors looking to make sound business decisions have an increased desire for transparency and stakeholder engagement. As a result, ESG has become a strategic imperative for portfolios in order to create and sustain long-term value in a rapidly changing world.
What are the benefits of ESG?
Organizations that adopt and invest in ESG strategies can improve corporate reputation and culture, enhance risk reduction and opportunity management, and increase intrinsic value. Commercial real estate firms with sophisticated ESG strategies can increase asset value, lower operating costs, and unlock sustainable financing opportunities. The data collection and reporting practices foundational to any ESG effort also make it easier to comply with local, regional, national, and sector-specific disclosure requirements.
Factors that Impact ESG
Before you can create or adhere to an ESG strategy that’s right for your portfolio it is important to have a basic understanding of the issues and their impact on your business.
Environmental Issues
For commercial real estate, environmental issues arguably have the largest and most easily quantifiable impact on portfolio risks and opportunities. Climate change is the number one risk (and number one risk accelerant) facing commercial real estate portfolios today. It worsens both conventional and ESG-related risks. An increase in natural disasters due to rising temperatures present significant threats – in terms of physical safety as well as the monetary impacts of insurance, maintenance, and repair costs. Other environmental issues include natural resource scarcity which can affect supply chains, and pollution and waste which cause health concerns and can potentially result in legal and regulatory ramifications.
When trying to understand the business impacts of environmental issues on commercial real estate, it is helpful to understand the three major risk categories they fall into.
Physical risks have tangible, quantifiable impacts. Climate change can physically impact portfolio assets and surrounding infrastructure. For CRE, a good ESG strategy will address how to reduce disruption to building operations in the case of extreme weather events or long-term shifts in climate patterns. To inform your strategy, take stock of building codes and operations, the physical site, structure, and system of each asset, and depending on location, the risk of earthquakes, flooding or sea level rise, wildfires, or mudslides.
Transition risks are due to market and non-market shifts, including changing consumer preferences, and shifts in climate and environmental policy and associated technologies. For CRE, a good ESG strategy will address how to reduce exposure to climate-related transition risks, such as changes in energy sources, shifts in energy costs, and enhanced energy and emissions reduction and reporting laws.
Social risks are all about the human side of things. Severe weather, rising temperatures, poor air quality, and natural resource scarcity will result in certain regions being unlivable. For CRE, a good ESG strategy will prioritize the development and operation of buildings that are safe for occupants and the surrounding community. To inform your strategy, take stock of building safety and materials, contamination potential, health codes, emergency response plans, and occupant and community needs.
Social Issues
Unlike the “E” in ESG, the “S” is harder to measure at the asset level. The social dimension of ESG calls on you to invest in placemaking and explore how your assets deliver value for the communities in which they are located, beyond purely offering a place of employment. The welfare of communities that supply materials, house assets, production sites, and labor are linked to the welfare of company interests, improving (or harming) your bottom line and reputation. Financial and in-kind contributions to community causes may mitigate ESG-related issues that threaten both the company and the local community.
Looking beyond individual assets, the social dimension addresses company practices around human rights and labor management, including those of suppliers and other partners; as well as human capital management. How are you compensating for the skilled labor shortage? Uneven wage growth? Technology gaps? How are you building the skills of your workforce? In August 2020, the SEC deemed human capital management as a significant material risk and greater disclosure requirements will soon be a part of standard financial reporting.
Governance Issues
For commercial real estate, governance has less to do with individual assets or even portfolios, and more to do with how a business is structured and led, and how decisions are made. For example, an executive compensation structure tied to ESG benchmarks and a board-level ESG committee is a sign that the company is fully integrating ESG issues into their enterprise risk management system and long-term planning.
For a basic understanding of your company’s corporate governance think about these questions.
- What does your executive compensation structure look like? Is it tied to ESG benchmarks?
- What business ethics does your company subscribe to? How transparent are you with stakeholders? What kind of reporting practices are in place?
- Who is on your board? Are they diverse and representative of relevant stakeholders?
Good governance practices directly impact an organization’s ability to build investor, tenant, and community trust. Corporate governance structures that adopt ESG frameworks are better equipped to suss out changing conditions that could negatively impact operations, including stakeholder opposition, boycotts, government fines and litigation.
Creating an ESG Strategy Right for Your Portfolio
Where do you start when it comes to developing an ESG strategy that’s right for your portfolio? There is no uniform approach to determining which ESG issues are most important to the long-term success of your assets and most important to stakeholders. However, a good way to develop a holistic understanding of relevant ESG priorities that need to be addressed is by conducting two kinds of assessments: a materiality assessment and a risk assessment.
On a basic level, a materiality assessment consists of ranking the importance of environmental, economic, and social impacts by plotting these issues on an axis of importance to stakeholders (low to high) and an axis of importance to business success (low to high). Establishing which quadrant each issue falls into will help you prioritize issues and allocate resources effectively.
Once you have an idea of your priorities, perform a risk assessment that encompasses the physical, social and transition risks to your portfolio, including existing assets, new acquisitions and loan originations. Your risk assessment can be as broad or as narrow as necessary, focusing on a wide array of ESG considerations, or perhaps honed in on climate-related threats as an actionable and concrete starting point. If need be, deploy your risk or asset management team to perform on site assessments for your highest-risk assets.
For commercial real estate organizations looking to tackle the “E” in particular, the most robust approach to managing greenhouse gas emissions over the long haul is setting and committing to science-based targets. For those looking to deepen their impact across the board, aligning existing goals, targets, and programs with the Sustainable Development Goals is a good way to start.
Key Industry Standards and Certifications
There are a lot of players in the ESG ecosystem that are designed to meet the information needs of various constituencies, including investors, tenants, regulators, and community stakeholders. Each of the programs or organizations listed below are key to this ecosystem and provide green building certifications or standardized frameworks to prioritize relevant metrics, monitor, evaluate and report ESG performance. As your portfolio’s ESG strategy matures, you’ll likely make use of at least one if not all. Fortunately, there are certain sustainability KPIs that are relevant across the board.
Green Building Certifications
The Building Research Establishment Environmental Assessment Method (BREEAM) is the world’s leading sustainability assessment method for masterplanning projects, infrastructure and buildings. It recognizes and reflects the value in higher performing assets across the built environment lifecycle, from new construction to in-use and refurbishment.
ENERGY STAR, from the U.S. Environmental Protection Agency, provides tools and resources to help businesses identify cost-effective approaches to managing energy use in their buildings and plants. Its online tool, ENERGY STAR Portfolio Manager®, is used to measure and track energy, water, and/or waste and materials for commercial properties. ENERGY STAR scores are an industry standard for rating a facility’s energy performance.
LEED (Leadership in Energy and Environmental Design), from the U.S. Green Building Council, is the most widely used green building rating system in the world. It provides a framework for healthy, highly efficient, and cost-saving green buildings. LEED certification is a globally recognized symbol of sustainability achievement and leadership.
ESG Frameworks and Standards
The Carbon Disclosure Project (CDP) is an international non-profit based in the United Kingdom, Germany and the United States of America that runs the global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts. It has one of the most comprehensive dataset on corporate and city action.
GRESB, formerly known as the “Global Real Estate Sustainability Benchmark” because of its initial focus on the real estate sector, is a leading ESG benchmark for real estate and infrastructure investments across the world. It provides standardized and validated Environmental, Social and Governance data to the capital markets.
The Sustainability Accounting Standards Board (SASB) is an independent nonprofit organization that sets standards to guide the disclosure of financially material sustainability information by companies to their investors. SASB Standards identify the subset of ESG issues most relevant to financial performance in different industries.
The Task Force on Climate-related Financial Disclosures (TCFD) was created by the Financial Stability Board to improve and increase reporting of climate-related financial information. Its recommendations enable more informed investment, credit, and insurance underwriting decisions and, in turn, enable stakeholders to understand better the concentrations of carbon-related assets in the financial sector and the financial system’s exposures to climate-related risks.
Investing in Technology and Data Collection
Data is the foundation of any ESG strategy — and without it, everything you’ve learned thus far cannot be put into practice. In order to get a clear picture of portfolio performance, you need asset-level insights into energy consumption and carbon footprint. You’ll need to gather data from a variety of sources, which can include main electric feed monitoring, submeters, circuit-level meters, interval data provided by your utility company, and even your utility bills. There are several ways to monitor a building’s energy consumption, and choosing the best method comes down to a portfolio’s specific needs.
Data also unlocks another essential process for portfolios investing in ESG: measurement and verification. Frequently abbreviated M&V, measurement, and verification is a process for quantifying the precise impact on energy use of a conservation measure. It puts numbers to a difficult-to-quantify process and makes it easy to calculate the economic impact of an investment.
