Shifting ESG Legislation: Risks and Opportunities for Property Owners
In recent years, Environmental, Social, and Governance (ESG) legislation and market expectations have evolved rapidly, driven by global challenges such as climate change, biodiversity loss, social inequalities, and geopolitical instability. As elsewhere, these new regulations are shaping the future of real estate investment in the UK. For asset owners and investors, these changes present both risks and opportunities.
As ESG regulations grow more stringent, resilient assets, those that are future-proofed against regulatory changes, are likely to increase in market value and carry fewer capital and operational expenditure costs for owners and buyers. Communicating this resilience to the market, regulators, and buyers is imperative, as is ensuring effective coordination with supply chain partners so all parties are contributing to upholding ESG performance.
Brown Discounting
“Brown discounting” refers to the practice of discounting real estate assets due to poor sustainability-related performance. For example, an asset may be priced below the market rate because the seller has factored in the cost of transitioning the building to achieve net zero carbon emissions within the offer price.
While these assets may initially appear cheaper, they entail increased capital expenditure to transition, or have difficulty in resale if the upgrade works are not completed. Experienced sellers use brown discounting to mitigate their own risks, knowing that the value of such assets will likely depreciate over time; and they look to exit before buyers understand and can fully appraise the cost risks. Buyers must be vigilant in identifying brown-discounted properties to avoid financial pitfalls after acquisition.
Essential Due Diligence for ESG Compliance
To avoid falling for brown discounting, asset owners should prioritise the following due diligence measures:
Energy, Water, and Waste Data: At pre-acquisition, requesting the past three years’ worth of data on energy, water, and waste usage for tenant and landlord areas is crucial. This data helps assess the true energy efficiency and greenhouse gas intensity of a building. Tools like the Carbon Risk Real Estate Monitor (CRREM) can be used to evaluate stranding asset risks, appraise the capital expenditure and programme required to transition the asset and forecast the costs of carbon offsets post-2050 if net zero in operation can’t be achieved.
EPC Assessments: Buyers must ensure that Energy Performance Certificates (EPCs) are up-to-date and supported by thorough assessments and physical inspections. Plans to increase the Minimum Energy Efficiency Standards (MEES) EPC threshold, for office space in particular, to an EPC rating of C or even B (by 2030) are still in consultation, but asset owners must be vigilant at future-proofing in the event that this legislation is adopted. Also, in June 2022 the EPC calculation methodology was changed, typically impacting buildings that use gas by worsening their EPC score. If a building has gas and the EPC was lodged before June 2022, the EPC score will likely worsen at the 10-year renewal which could impact investor or funding agreements, MEES compliance or even tenancy contracts if a tenant has completed a fit-out that could have influenced the EPC.
Utility Measurement and Reporting: There is an increasing requirement for accurate utility data collection for landlord and tenant areas. The presence of utility sub-meters and smart meters for accurate, remote collection of utility usage data is essential. The installation of smart sub-meters reduces labour requirements for monthly meter readings, helps identify utility use efficiencies to save cost and resources, and improves reporting and benchmarking outcomes.
Physical Climate Risk Assessments: Engaging with insurers to conduct comprehensive climate risk assessments is essential to understand how climate may influence the long-term insurability of a building. Understanding future risks related to floods, storms, and other climate-related events can help mitigate insurance premiums and exclusions in cover, as well as inform strategic upgrades to protect the asset.
Communicating Successful ESG Strategies to the Market
Before buying, requesting specific ESG-related information is very important to identify and mitigate misunderstood financial risks. This data can inform investment strategies, business plans, and negotiation tactics with sellers. Gathering specific ESG-related information is essential for sellers too. As buyers become more sophisticated in evaluating ESG risks, property sellers must provide comprehensive ESG due diligence packs to uphold an asset’s value, which should include the following:
As-Built Performance: An ESG asset ledger detailing the technical as-built benefits of the building.
Operational Performance: An ESG dashboard or report that houses all ESG operational data to evidence the building’s previous performance and future performance trends.
Asset Improvement Strategy: If the asset requires upgrade works in the future, providing a detailed strategy with cost estimates for achieving future resilience will help inform a prospective buyer’s due diligence and decision-making. This could include EPC improvement plans or net-zero transition assessments.
The changing landscape of ESG legislation presents both challenges and opportunities for real estate asset owners. By understanding and adapting to these changes, asset owners can enhance the resilience and value of their portfolios. Proactive ESG strategies and thorough due diligence will not only mitigate risks but also unlock new opportunities for growth and investment in a rapidly evolving market. Explore the key ESG certifications shaping the market today, or read how we implement ESG policies as a company.