Real estate fund and asset managers are working flat out to get their systems in order ahead of a wave of European ESG regulations set to come into force from March.
At a time when Europe’s economies are being urged to ‘build back better’ from the coronavirus crisis with a green recovery, the region’s real estate industry is undergoing a green revolution of its own.
The revolution is a legislative one, taking the form of a barrage of ESG regulations and sustainability initiatives which are set to be rolled out in stages from March. Although conceived with the entire financial services industry in mind, they will cover, and have major consequences for, real estate fund managers and asset managers.
With unwieldy names such as the Sustainable Finance Disclosure Regulation (SFDR), EU Taxonomy and Regulatory Technical Standards (RTS), they will hit at the heart of property companies’ business models, decision-making processes and reporting procedures.
Many have been on the drawing board since 2018, when the European Commission adopted its Action Plan on Financing Sustainable Growth. That, in turn, was inspired by the Paris Agreement on climate action from 2016, which saw nearly 200 signatories commit to combatting global warming. Then, a year ago, the European Commission presented its Green Deal, a set of policy initiatives with the overarching aim of making Europe climate-neutral by 2050. Although momentum has been disrupted by the Covid pandemic, sustainability and climate action are still firmly on the agenda of the European Commission and European governments – with a ‘green’ recovery forming the heart of the EU’s NextGenerationEU initiative for getting the continent back on its feet again following the crisis.
Legal experts and sustainability specialists agree the raft of EU regulations set to sweep across the industry are ambitious and far-reaching ‘There is no denying that the EU has lofty and commendable ambitions when it comes to sustainability,’ says Ronan Mellon, a partner at DLA Piper in London. ‘With its aims to decouple economic growth from resource use and make Europe the first climate-neutral continent by 2050, sustainability is firmly on Europe’s agenda.’
Abigail Dean, head of sustainability at Nuveen Real Estate, a global investment manager with around €27 bn of AUM in Europe, says the impending regulations mark ‘a big shift’ for the fund and asset management industry, since they will require firms to embed the three strands of ESG into the very core of their business procedures. ‘This marks the moment when the mainstreaming of ESG officially happens,’ she says, adding that the pace of regulatory change is likely to increase from this year.
Dean was one of a three-strong panel that took part in a webinar hosted by European non-listed funds body INREV late last year to brief the industry on the upcoming ESG package. The trio, including Matthew Baker and Kate Binedell, partners at international law firm Bryan Cave Leighton Paisner, outlined the key milestones that lie ahead (see timeline) and highlighted some of the practical issues and challenges.
Key regulations
The main pieces of legislation set to be rolled out (see chart) are the SFDR – also known as the Disclosure Regulation – the EU Taxonomy, and the Regulatory Technical Standards (RTS), although implementation of the latter two has been postponed following pressure from the investment industry. It argued that the March 2021 deadline was unrealistic given the huge reporting task involved.
SFDR imposes transparency obligations and periodic reporting requirements on asset managers and financial advisers with regard to the impact that the underlying investments of their products have on the environment, making it easier for end-investors to make informed decisions. It aims to establish an EU-wide reporting framework with a view to combatting ‘green washing’ – stating that products are green for marketing purposes when in practice they are not – and applies both at a manager and product level. The SFDR is also designed to make ESG funds easier to compare by forcing asset managers to disclose more on their investments.
The EU Taxonomy is a classification framework designed to determine whether an economic activity is environmentally sustainable, based on six criteria. The RTS, meanwhile, go a level of detail further, stipulating granular requirements for the content, methodology and presentation of disclosures. It will eventually also provide a template for how metrics should be reported, which is likely to bring significant changes to fund managers.
Challenging timelines
How are firms finding their way in the regulatory maze, how do they keep on top of progress when implementation dates keep moving, and how do they know if they are in full compliance?
‘Managing the regulatory burden, tracking the development of ESG regulations and keeping abreast of changes is a huge issue,’ attests Dean. ‘That is something I expect will continue inside and outside Europe.’
A slide presented during the INREV briefing entitled ‘Specific Challenges and Practical Considerations’ (see chart p31), illustrates how the industry is struggling to set priorities amid the raft of regulations coming its way. With the first set of rules due to come into force on 10 March 2021, many asset managers are still getting to grips with the fine detail of the various pieces of legislation while also trying to understand the big picture.
Nuveen’s Dean says one of the biggest challenges is dividing time between bureaucratic-type tasks on the one hand and implementation of measures on the other. ‘How do you get the balance right between spending a lot of time on administrative issues, such as ascertaining the scope of sustainability measures and understanding the exact wording that needs to go into policy disclosures, and the actual implementation of those measures?’
At the heart of compliance, she says, is ‘identifying what you actually need to do to have taken account of compliance risk in an investment’. Nuveen is making ‘good progress’ with its efforts, she notes, adding that the firm’s global structure adds a layer of complexity as its various national entities are regulated differently.
What is certain is that the new regulations are placing an enormous strain on company resources as firms review their systems and determine what needs to be just slightly adjusted or totally revamped in order to comply. A big challenge lies in anchoring ESG checks and balances across company departments and processes. Says Dean: ‘It’s not enough to have just one sustainability person within an organisation or a sustainability consultant. There needs to be a really good level of knowledge of sustainability issues across asset management functions, fund accounting, legal and compliance, product development and research, and probably a lot of other functions as well.’
Her views are shared by Alexander Eggert, managing director at Warburg-HIH Invest, a German investment manager with €12.1 bn of real estate AUM across more than 70 funds. ‘ESG is about much more than just hiring a head of sustainability,’ he says. His firm started preparing for the EU ESG regulations two years ago, an exercise which involved ‘changing almost every company process’, he says. ‘We had lots of brainstorming sessions to discuss issues like: what does ESG actually mean? How much attention should be devoted to ecological versus economic factors?’
Different shades of green
Warburg-HIH Invest now performs an ‘ESG due diligence’ on all its property transactions, with more stringent checks applied to assets where this is required by the fund product. Eggert describes this process as determining whether a product is ‘light green’ or ‘dark green’ (in the legal jargon, an Article 8 or 9 product) or even ‘black’ (where ESG plays no role). All in all, the past two years have been an intensive period as all company systems were reviewed. ‘We’re not talking about one ESG process, but about ESG in every process,’ he says.
Michael Schneider, managing director of Intreal, a leading German ‘service KVG’ or alternative investment fund manager focussed solely on setting up and managing regulated real estate funds for third parties, describes the ESG compliance challenge as ‘huge’.
‘Nothing like this has been established before, the measurements, requirements, everything is new,’ he says. Schneider estimates around a dozen people across the HIH Group, of which Intreal and Warburg-HIH Invest form part, have been involved in establishing and embedding the new ESG protocols.
With over €35 bn of AUM administered for close to 190 third-party funds, Hamburg-based Intreal is a big player in the German fund landscape and therefore sits squarely in the firing line of new regulations coming out of Brussels. It has joined forces with rival fund managers and industry associations such as the ZIA and BVI in Germany as well as European body INREV to relay its feedback and concerns about the new regulations to the lawmakers. ‘All these associations are trying to find solutions to issues that are very abstract,’ says Schneider.
Thanks to these efforts, a number of the new rules have been delayed to fine-tune details and give firms more time to comply. ‘Things will really gain momentum when the EU Taxonomy is finalised,’ says Schneider, adding: ‘This year will be very busy.’
The most important thing, many firms agree, is that the ‘starting point of the regulations is a good one’ and the ‘direction of travel is clear’.
‘Sure, it will take time and there will be adjustments, but I am pretty certain the time will come when ESG is in the genes of all company processes,’ says Eggert of Warburg-HIH Invest. ‘Regulation provides a framework, but the most important thing is that people care about ESG and investors care about it,’ he says. ‘That change needs to be there in the mindsets of decision-makers and those wanting to invest.’
Investor demand for sustainability is clearly driving the momentum behind ESG-compliant products, says Nuveen’s Dean. ‘The investment world is waking up to the challenges that climate risk and other sustainability issues present, and therefore the pace of regulatory change is quicker than in other areas.’
‘There’s a realisation that climate risk is significant in investment and is an externality that has not been properly taken account of until now, but needs to be,’ she says. ‘It needs to be integrated into investment decision-making not just to meet regulatory requirements but also to highlight risks to performance and value.’
Institutional investors, notably pension funds and insurers, are setting the pace when it comes to backing ESG principles. A survey of over 500 global institutional investors carried out last year by international law firm CMS revealed that 77% consider sustainable buildings to be ‘very important’. Some ESG executives within investment firms indicated that they can vote down a transaction at the investment committee stage if it does not meet ESG criteria – a clear sign that institutions are set to insist on this factor in the future.
Another survey of around 100 institutional investors conducted by Warburg-HIH Invest found that the majority (51%) expect higher long-term returns on real estate if ESG criteria are taken into account into investment decisions.
‘What the EU regulations reflect longer term is an expectation from the investment community that ESG risks are being properly assessed and that there is a good understanding of how sustainability risk can impact on values,’ says Dean. For asset managers, she points out, complying is a way of bolstering their credibility and warding off suggestions of green washing. ‘If you look at it from that perspective, you’re more likely as an asset manager to be compliant with the spirit of these regulations.’
Focus is mostly on the ‘E’ of ESG, but ‘S’ is coming to the fore
The bulk of the upcoming ESG regulations is focused on environmental sustainability and climate issues – the ‘E’ component – but the Covid crisis has turned a spotlight on social (the ‘S’) matters too. The importance of community has become increasingly apparent during the pandemic as people have had to rely on their neighbours for day-to-day support. Businesses, too, have seen that supporting employees and local communities is valued by the general public.
A recent example of socially aware investing is a fund dedicated to providing safe homes in the UK for women who are fleeing domestic violence or female ex-offenders who are homeless. The Women in Safe Homes fund, launched late last year by UK investor Patron Capital and social impact investment company Resonance, aims to provide over 650 affordable homes across the UK and has a target fund size of £100 mln (€109 mln). Patron claims the fund is the world’s first ‘gender-lens’ property fund, addressing issues such as domestic violence which have increased as a direct result of lockdown. Even before the pandemic, 60% of women referred to specialist refuges in the UK were being turned away due to lack of space.
Big Society Capital, a leading UK social impact investor, Patron’s MD Keith Breslauer and US investors, the John D. and Catherine T. MacArthur Foundation and the Lostand Foundation are the first investors into the fund.
Another UK impact fund is Social and Sustainable Housing (SASH), managed by specialist impact investor Social and Sustainable Capital (SASC). It aims to provide homes for 10,000 people who are homeless, or at risk of becoming so. At the same time, it seeks to generate stable, long-term returns for investors from the receipt of government-paid housing benefit. It does this by providing finance to high-performing social enterprises with a strong track record in the management of social housing to enable them to purchase properties. In early December the fund announced it had completed its latest round of fundraising, with commitments now standing at £58 mln (€64 mln). To date, SASC has committed in excess of £70 mln to more than 35 organisations across the UK.
Asset managers like Warburg-HIH Invest are also launching products that anticipate a growing focus on socially responsible investments. Last year, the firm launched a childcare investment fund (Warburg-HIH Zukunft Invest) targeting 20 day nurseries with a combined value of €100 mln.
Ten assets have already been acquired for the fund, which is targeted primarily at savings banks. Besides the ‘feel-good factor’ of investing in children’s futures, it makes sound business sense given the large shortfall in childcare spots in Germany. Says managing director Alexander Eggert: ‘Environmentally friendly new buildings and a focus on training and educating children constitute an excellent basis for sustainable real estate investments in a positive market environment.’