March 20th, 2023
As funds now have to give detailed assessments of their sustainability ranking, the days of paying lip service are over.
By Ami Kotecha, Co-Founder and President of Amro Partners
Few can argue against the urgent need for transparency and accountability when it comes to ESG-related claims. As of January 2023, regulations came into force under the EU’s SFDR (Sustainable Finance Disclosure Regulation) requiring financial market participants, including real estate funds, to file quarterly reports outlining their ESG performance against precise and transparent sustainability goals.
Funds must explain both how they will integrate sustainability risks into investment decisions – and the true impact of these decisions on the environment and on social outcomes. Instead of relying on vague sustainability reports that pay lip service while continuing ‘business as usual’, investors will be armed with the real information allowing them to confidently assess those funds that are genuinely aligned with their values.
The first reports are due on 30 June this year – a mere three months away. SFDR applies to any financial market participants marketing their products in the EU, so UK companies cannot look away. The UK is also responding with its own SDR (Sustainability Disclosure Requirements) Framework, currently under consultation.
Funds cannot simply classify themselves as sustainable. They must demonstrate the degree of sustainability and self-declare as Article 6 (grey) or Article 8 (green) or Article 9 (dark green), demonstrating in each case how they are achieving their ESG goals. They assess themselves against 32 indicators ranging from GHG emissions and carbon footprint to human rights policies, gender pay gaps and anti-corruption and bribery.
Dark green represents the hallowed Article 9, the highest ESG standard. In other words, promoting specific sustainability objectives, such as actively reducing carbon emissions in line with the Paris Agreement. Green represents Article 8 (funds that promote environmental and social characteristics but do not have an overarching objective), while grey represents Article 6 (they may integrate sustainability risks into investment decisions but are not promoted as having ESG objectives.)
The ‘No Harm’ principle
Under the framework, real estate funds, whether equity/debt/real estate – it applies to all asset classes, are required to disclose any negative impact on ESG that is present at entity or asset level. According to Morningstar, in practice a very small percentage of existing funds can classify themselves as ‘dark green’, with the vast majority falling into the ‘grey’ category.
A major stumbling block for the real estate sector is the ‘no harm’ principle enshrined in the regulation, which considers an investment to be sustainable only if it contributes to an environmental or social objective and does not cause significantly harm to the environment or any other social objective. Arguably, by nature, real estate development and operation has a negative impact on the environment, for example via Scope 3 emissions, despite our best efforts to mitigate, reduce and offset.
This makes it difficult for real estate funds to classify themselves under Article 9, but not impossible. Funds should expect to move up and down the classifications as they make changes to their portfolios, until such time that the transition to dark green is complete. There are a few funds that have now achieved that status, such as Bridge’s Property Alternatives Fund V and KGAL’s Core 5 LIFE Fund, but they remain very much in the minority.
A high bar for sustainability
The ‘no harm’ factor is the crucial one for the real estate sector to navigate and while it is difficult, it should be viewed as a rigorous pathway to get us there in the end, rather than as an impossibility. Acquiring older assets with a transition plan in place that focuses on progressing from ‘grey’ to ‘green’ will become a competitive advantage. There is an opportunity to apply a systems thinking approach to capital allocation and value creation, while embedding sustainability.
SFDR sets the bar high, but it provides a comprehensive framework for ESG-focused design, development and investment, enabling us to create socially and environmentally impactful projects that supersede disparate Net Zero strategies. As capital values begin to align with sustainable outcomes, those who take the time to become literate and competent at scaling under these rigid standards will be ahead of the game.
This article was first published exclusively on React News.
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