ESG+R – What Is It and Why Are We Talking about It Now?
One of the market forces shaping the future of commercial real estate (CRE) investing and the built environment is the demand for a holistic approach to sustainable investing that applies an ESG+R (Environment, Social, Governance, and Resilience) framework to achieve strong risk-adjusted returns alongside positive societal impact. In this article, we will discuss the current state and trajectory of ESG+R frameworks in CRE and the incentives and regulation involved.
We will also focus on an important, yet relatively neglected, aspect of ESG+R—water resilience. We’ll see how there are both synergies with other aspects of ESG+R and unique challenges and opportunities that are important to address.
An ESG+R framework is a set of standards that an investor, a company, a lender, a customer uses to screen potential investments and decisions. Across the CRE industry, these standards are applied at all levels, from enterprise to investment to building operations based on the following interconnected pillars:
• Environmental – performance as a steward of nature with a focus on environmental sustainability and efficient use of resources.
• Social – management of relationships with employees, suppliers, customers, and across communities it impacts.
• Governance – transparency and accountability of operations including, diversity, executive pay, audits and internal controls, tax strategy, political activity, and shareholder rights.
• Resilience – capacity to identify, address, and mitigate risks, from valuation risk to climate- and weather-related events and global pandemics.
At its core, ESG+R is about creating long-term value for investors and society through managing risk, building resilience, and providing transparency with accountability. Making money and doing good can go hand in hand. The application of ESG+R metrics to real estate investments has spread deeply and broadly across the real estate industry over the last three years. Many investors and tenants now use ESG+R fundamentals as gating criteria; it is a boardroom topic that is no longer a “nice to have,” but is now a “need to have.” This increased focus is shining a light on areas and segments of the real estate industry that did not previously receive as much attention.
For instance, the focus on ESG+R in CRE includes the industry’s role in countering the effects of climate change. As much of the CRE industry and its clients are learning, CRE contributes about 20% of the annual global greenhouse gas (GHG) emissions, and these emissions fuel climate change, which is linked to the increasingly extreme and frequent disasters already impacting CRE and its clients. The maxim that “Sunlight is the best disinfectant” applies in this case. Now that we know, we must act. Now that our stakeholders–customers, investors, tenants, employees–know, they will require we act.
The Carrot: Follow the Money
The market advantages—and, increasingly, demands—for integrating ESG+R in CRE are being recognized more frequently now that ESG+R is a topic in boardrooms and discussed as a requirement for raising capital from institutional investors, leasing space to corporations, and meeting consumer demands to be a good corporate citizen.
The demand side of the equation is further illustrated by the growing universe of investors and companies who use ESG+R as gating criteria:
• The publication of BlackRock’s ESG Integration Statement in 2018 for their $8.6T portfolio of stock, bond, and real estate investments provided a jolt to investors to take a serious look at ESG.
• The number of signatories to the UN PRI (United Nations Principles for Responsible Investment), the world’s leading proponent of responsible investment for investors and asset owners, has almost doubled in the last two years. As of 4Q2021, the PRI has 4,375 signatories, representing $121T of assets under management across the globe.
• GRESB (Global Real Estate Sustainability Benchmark), a global standard for real estate ESG assessment has also reported a significant increase in the number of participants, up 24% to 1,520 participants in 2021 from 2020, representing $5.7T in assets under management across 117,000 individual assets. GRESB has recently integrated its resilience as part of the ESG metrics, requiring all participants to consider resilience as part of their core ESG strategies.
According to Morningstar, which tracks a universe of 392 sustainable mutual funds where ESG concerns are central to the fund’s investment process, sustainable funds attracted $51.1B of capital inflows in the US in 2020. This is almost 25% of all net flows into stock and bond mutual funds. Of these 392 funds, 296 are equity funds, with investors having the most choice across the 134 US equity funds that saw $23.7B of capital inflows in 2020 (Sustainable Funds U.S. Landscape Report, Morningstar Manager Research, 10 February 2021).
The demand for an active and robust ESG+R program is also from tenants and occupiers. Recent research from the Journal of Sustainable Real Estate highlights how buildings with an ESG strategy achieve better cash flows and higher sales price per square foot. Rents in BREEAM-certified assets were 4.3% higher while average sales price per square foot saw a 22.3% premium over non-BREEAM buildings. Both of these figures point to tenants’ and buyers’ preference for more sustainable buildings.
The Stick: Regulations
The U.S. Securities and Exchange Commission (SEC) recently proposed a new rule that public companies’ ESG disclosure requirements include climate-related risks. With this proposed rule the question is no longer if these requirements will impact the CRE industry, but rather how and what will the CRE industry disclose. The underlying premise of disclosures is to provide transparency and ultimately accountability, so in addition to the SEC’s requirements, investors will look for additional information to help inform their investment decisions.
On a property level, major cities and counties have been leading the way with legislation to address meeting climate goals through regulation around carbon caps. In a growing number of jurisdictions across the U.S., having a property-level performance standard for decarbonization is no longer optional.
Two high-profile examples are New York City and Washington, DC, where carbon cap regulations are already in place. There are financial penalties if buildings do not meet the required caps:
• New York City’s Local Law 97 places carbon caps on most buildings larger than 25,000 square feet—roughly 50,000 residential and commercial properties across the city. The goal is to reduce building-based emissions 40% by 2030 from a 2005 baseline. The caps start in 2024 and will become more stringent over time.
• Washington, DC implemented the Building Energy Performance Standards (BEPS) program to drive energy performance in existing buildings that are 10,000 square feet or larger, including historic properties. The goal is to reduce GHG emissions and energy consumption by 50% by 2032 compared to the baseline year of 2006.
In addition to financial penalties that arise from non-compliance, it is imperative to consider the capital markets perspective: Who is going to finance, much less pay a reasonable price, for a non-compliant building?
Deep Dive: ESG+Water Resilience
Buildings are part of a larger system, simply by the virtue of outside connections for water, energy, wastewater treatment, and other linkages. In CRE, focusing solely on the building itself to promote sustainability and resilience without acknowledging the connections to outside sources has produced disjointed and mixed results. For example, a net-zero energy building in a flood zone with limited access to drinking-quality water might achieve a LEED certification but has achieved little for resilience or its occupants’ health and wellbeing.
Apart from air, no other element is as essential to human existence as water. And water disruptions will quickly render buildings inoperable. Despite this, there has not been an integrated approach for water in CRE. Current practice and discussions in the industry around sustainability and resilience revolve around energy reduction and zero carbon goals, but focusing on those worthwhile topics to the exclusion of others—especially water—may lead to unwise investments and negative impacts on people’s livelihoods.
Water intersects all four pillars of ESG+R and could be a key instrument in ESG+R’s rapid and effective implementation, including by helping to address many of the climate and public health challenges CRE stakeholders face today.
Water in CRE: Too Much or Too Little
Water-related threats to the built environment and public health have significant implications for CRE properties and the industry’s finances. Mitigating such risks in a transparent way as part of building resilience is at the core of a robust ESG+R strategy.
A multitude of disasters struck the U.S. in recent years with rising frequency and ferocity (Figure 1). Over 90% of them are water-related, ranging from droughts and wildfires to floods and storms. In the most recent five years (2016-2020), the average number of disasters with over $1B in damage increased by 230% compared to the average for the past 40 years.
Top climate scientists, attributing the upward trend to global warming, have warned that the only way for us to avoid the worst impacts of global warming, is to reduce GHG emissions by 45% from 2010 levels by 2030. The monetary damage from extreme disasters totaled $450B in 2020 alone–almost half of CRE’s total contribution to the U.S. GDP< ($1.01T) and nearly nine times the capital invested in sustainable funds in the U.S. that same year.
The focus on GHG emission reduction and achieving net-zero carbon is critical to addressing the root cause of climate change, which, in turn, will build resilience and help reduce disaster risks. Armed with this knowledge, fortifying properties against climate-related risks is the first line of defense and an urgent action item that must be addressed.
Many property-level water solutions exist that can be tailored to specific geographies and risks; they could (and should) be coordinated with and/or integrated into energy efficiency and renewable energy strategies to support GHG emissions reduction/net-zero carbon goals. Such solutions include green spaces or underground cisterns to retain rainwater during heavy rains while serving building occupants during dry periods and water efficiency measures, such as water-efficient or waterless fixtures and greywater reuse for flushing and irrigation. When it comes to thinking about GHG emissions, water management, and climate resilience, we need to—and have the ability to—walk and chew gum at the same time.
Water in CRE: Not the Right Kind
Water quality in the U.S. has improved vastly since the late 1960s, when rivers near industrial facilities would literally . While there has been improvement, water quality woes across the country have not ceased. Examples include Flint, MI (lead contamination), Parkersburg, WV (PFAS), and cities served by combined sewer overflow (CSO) systems, which lead to sewer backups at homes and contaminate the waterbodies that supply seafood.
Over 700 cities in the U.S. rely on CSO, which commingles wastewater and stormwater in the same sewer pipes and discharges that wastewater directly into open waterways whenever the combined sewers are over capacity during heavy rain events.
Water quality issues are particularly complicated. For instance, interconnected waterways are often governed in a fragmented manner where upstream pollutants affect downstream communities that do not have a say. Also, regulators have to be on the watch for new pollutants that find their way into the environment and affect public health.
That said, a range of options exist at the property level—both in and outside of the building envelope—to ensure the health and wellbeing of the building users and tenants, and to create more tenant engagement opportunities on the topic. These options include on-site and/or rooftop landscaping that help with water quality while providing a respite to building occupants and water filters that target harmful chemicals such as PFAS.
Integrating Water into ESG+R in CRE
Looking ahead to the future of CRE from today, amidst a global pandemic and with less than eight years left on the clock until the deadline to meet critical climate targets in 2030, ESG+R offers an opportunity to do more with less in terms of tackling the challenges of climate change, resource shortages, and health and wellbeing.
Under GRESB, the water category is only 5% of the overall score, but the intersectional nature of water offers numerous opportunities to bolster ESG performance. For example, a green roof could be installed on a property where it could contribute to flood risk management and water efficiency by diverting runoff and using collected rainwater on site, while also reducing the building’s energy demand by insulating and cooling the roof and providing a rooftop green space for tenants to enjoy.
Building an integrated strategy around water presents additional opportunities to target multiple areas at once, from energy and water efficiency to reduction of greenhouse gas emissions and waste, and more robust tenant and community engagement. Such an approach also ensures water security is not threatened to boost energy efficiency—a larger piece of the GRESB scorecard—without context.
For example, the use of water-intensive evaporative cooling methods in CRE assets such as data centers remains popular as these methods result in energy savings; however, they are often used in water-stressed regions where they can exacerbate the water problem. Treating water as a built-in performance booster could ensure both the quality and quantity of this essential resource are in check. It is also an economical and effective way to meet multiple ESG goals at once.
Delivering Resiliency – ESG+R and Water
The building and construction sector is responsible for about 40% of GHG emissions, with commercial real estate contributing about 20%. The rise of ESG and the urgent need to reduce our GHG emissions to avoid the worst impacts of climate change place the CRE industry in a unique position to take transformative action and reap the benefits, both financially and reputationally. In today’s world, attracting top talent to teams, tenants to buildings, and customers to spaces, CRE companies must articulate their roles as corporate citizens.
In addition, aligning location-specific water concerns—too much, too little, or too dirty—as part of the organizational ESG+R strategy not only helps improve ESG performance across multiple areas through synergies but also ensures the long-term resilience of host communities and, in turn, the value of the physical assets. We would be remiss if we forget the fact that water is the most important element for basic human survival after air; it needs to be treated as such as we plan for the future.
ESG+R is no longer a choice. An active ESG+R strategy, one that integrates water and includes an actionable plan for CRE stakeholders to take concrete steps and communicate results, is essential for any company looking to stay in business.