ESG in real estate debt: Funding the transition to net zero?

The built environment is responsible for around a third of global emissions, the majority of which stem from building operations¹. As momentum behind sustainability in real estate continues to gain pace, lenders can play a key role in how the sector evolves as it strives to meet net zero goals.

In the EU, where almost 75% of building stock is energy inefficient, real estate is the single largest energy consumer, with heating, cooling and domestic hot water accounting for 80% of the energy consumed by citizens². The European Parliament adopted measures earlier this year to reduce real estate energy consumption and greenhouse gas emissions, while increasing the rate of renovations to improve existing standards³. Currently only 1% of existing buildings in Europe are renovated each year. New developments will have to be carbon neutral from 2028 onwards.

“Substantial renovations are necessary across geographies to improve existing real estate stock and reduce energy loss.”
 

In the UK, real estate accounts for 40% of total energy use and around a third of emissions⁴. The government has laid down ambitious plans designed to spur a ‘green revolution’ in real estate, requiring all homes and businesses to meet rigorous targets in order to lower energy consumption. Indeed, policies are already obliging developers, landlords and occupiers to focus on the environmental performance of buildings.

Addressing energy efficiency in real estate

Regulations setting out Minimum Energy Efficiency Standards (MEES) are making it increasingly unlawful to rent properties that do not meet the Minimum Energy Performance Certificate (EPC) requirements, bar some exemptions, with landlords facing serious sanctions for non-compliance. This means lenders will also have to navigate the changing regulatory landscape and consider ESG criteria when deploying capital.

Currently, non-domestic buildings in England and Wales need an EPC rating of E or higher to be viable for lease. From April 2030 rented property will be required to have at least a B rating. This poses a significant challenge for the real estate sector given that the vast majority of existing commercial stock in England and Wales – around 64% – falls below the B threshold for energy performance⁵. In real terms, over half a million individual assets need to be compliant with MEES within the next seven years⁶.

In Europe, a set of standards and accompanying technical reports have been established to support the energy performance of buildings standards, with the European Commission aiming to reach the target of at least a 60% reduction in emissions in the building sector by 2030 compared to 2015, and achieve climate neutrality by 2050.

Although there is little guidance on the level of capital required to decarbonise non-domestic assets, it will be a costly endeavour. Substantial renovations are necessary across geographies to improve existing real estate stock and reduce energy loss, while new developments would have to consider smart solutions and energy efficient materials to ensure buildings are compliant with net zero goals and regulation.

Funding the transition

Real estate debt investors could be crucial in helping fund the transition to net zero in real estate due to the levels of investment called for, but it is essential for lenders to have a solid understanding of how energy is used in buildings and what measures can be taken to reduce emissions and energy consumption in line with science-based targets. There are challenges, particularly where there is a lack of consistent data and reporting among borrowers, as well as a disconnect between some sustainability metrics and a lack of definition regarding what net zero actually means across the industry.

To play a role in the transition to net zero, lenders may want to consider improving the environmental performance of real assets over time, while also excluding investments which are considered harmful to the environment or society, such as assets which are involved in the extraction and storage of fossil fuels.

For sustainability-conscious lenders, opportunity may be found in new green buildings with strong ESG credentials, amenities and accessibility, but there is also a significant opportunity to fund the transition by improving the environmental performance of existing buildings, rather than just knocking down and developing new ESG buildings.

When financing or refinancing new or existing commercial and residential buildings lenders would need to ascertain certain criteria are met. We believe EPC and green building certification are the most readily available and consistent metrics for measuring environmental performance. These can be assessed from both day one, and over the term of the investment to show measurable improvement while also holding borrowers accountable.

Although lenders may consider excluding inefficient real estate assets as defined by the Sustainable Finance Disclosure Regulation – such as those with an EPC of C or below if built before 31 December 2020 – where proceeds of the loan are used to improve energy efficiency and the asset is expected to meet the relevant criteria upon completion of the renovations funded by the loan, then these assets will no longer be deemed inefficient. Once the relevant works are complete, they may even qualify as “green buildings” should they meet specific eligibility criteria.

When funding existing buildings that do not currently meet energy requirements, lenders can hold borrowers accountable by ensuring loan documentation includes specific clauses on energy performance obligations. This will typically require the borrower to improve overall energy efficiency and/or aggregate green building certification as well as meet specific thresholds such as EPC B or above, LEED Gold or above or BREEAM “Excellent or above”.

Working together

It is important for the industry to work together with key stakeholders in order to decarbonise the built environment. In our view, EPCs and Green Building Certificates are an important step to improving the transparency of ESG data being shared with the investment community. Using this data, we believe it is possible to improve the energy performance of real estate through a combination of green and sustainability-linked loans (as defined by a third party consultant), occupier and tenant exclusions and Key Sustainability Indicators, designed to measure improvement in a building’s green credentials.

As the case for decarbonisation in real estate grows, ESG-focused assets are becoming increasingly desirable. For lenders, this is a potential opportunity to improve environmental credentials whilst also enhancing investment performance. 

_{¹ IEA, “Buildings – Tracking report”, (iea.org), September 2022.
² European Commission, “Energy performance of buildings directive”, (energy.ec.europa.eu), December 2021.
³ European Parliament, “Energy performance of buildings: climate neutrality by 2050”, (europarl.europa.eu), 9 February 2023.
⁴ UK Government, “Rigorous new targets for green building revolution”, (gov.uk), 19 January 2021.
⁵ UK Government, “Energy Performance of Buildings Certificates Statistical Release: January to March 2023 England and Wales”, (gov.uk), 27 April 2023.
⁶ Gerald Eve, “Energy Performance in Non-Domestic Buildings”, (geraldeve.com), July 2021.}

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.