What is ESG?
Environmental, social and governance (ESG) credentials are quickly becoming an additional set of standards used in order to vet potential investments. These credentials have been previously acknowledged as ‘social responsibility’ and are now making a wider footprint on the world. Investors and property owners are now reconsidering where best to allocate their funds in light of this move to a more ESG friendly future.
How does ESG impact real estate?
Some commentators such as Knight Frank’s ‘The Investment Lab’, declare that ESG will be more important in investment decision making in 2022 than the pandemic, inflation or market cycles. An interesting assertion, which I consider further and discuss below.
Since April 2020, Domestic Minimum Energy Efficiency Standard (MEES) Regulations set restrictions on energy efficiency levels which means that properties with an EPC rating below E cannot be legitimately sublet, and for those properties that were already sublet prior to MEES, Landlords have until April 2023 to improve the rating to E or above. New leases will also be subject to the same restrictions. Lenders have started reflecting on these upcoming changes and we are seeing more refusals to lend on the basis of a low EPC rating. However, some wily and well capitalised investors see new opportunities; they can acquire the run-down asset, improve the EPC rating and then go on to sell or refinance at a premium. In turn, this is an incentive for investors to contribute to a more energy efficient property market whilst still retaining profitability.
We have also seen that, during the Coronavirus pandemic more than ever, investors had to take into account more considerations and not just treat the asset as an investment. Consideration had to be given to the people occupying the properties, whether that be their home or place of work. As we know, the pandemic left people and businesses struggling to pay their rent, and whilst usually this would be a credible basis for lease termination, the consideration of social responsibility and morality came into play. For example, we have seen numerous landlords granting rent concessions and deferred rent on the basis of goodwill, and as such, landlords were seen to be prioritising the people rather than their profitability; a rather promising prospect but one which may dissipate as we return to ‘normal’ post-pandemic life. Furthermore, since the Coronavirus Act 2020 came into effect, landlords were prevented from evicting tenants on the basis of non-payment of rent and investors and landlords were legally forced to consider the reality behind managing their tenants. Although, at the same time, some larger corporations were seen to be taking an unfair advantage of the same laws designed to protect smaller businesses and individuals.
Energy efficiency and rent concessions are however the tip of the iceberg in this respect; property owners who ignore their ESG do so at their own peril.
ESG in the law
Incorporating ESG into the law is an inevitability, and in fact has already begun to make a footprint on the legal framework. Many companies now also have their own net zero targets and landlords and investors have become more mindful of what the market demands. For example, pension funds and insurers, two players that possess significant investment holdings, are both subject to their own industry specific regulations. Pension funds are required to have transparency in the degree to which ESG criteria is incorporated in their investment strategies and similarly, insurance firms are subject to requirements imposed by the Prudential Regulation Authority.
Many companies look to law firms to reflect their own values and stance on climate change, and we, along with our contemporaries, are well placed to take on this opportunity. The Chancery Lane Project, which is a thinktank for lawyers around the world to develop ESG-related governance, will further drive such criteria to ultimately be embedded into the Global legal framework. Hopefully this will in turn encourage businesses and people to have a more positive impact on the social environment.
Ultimately, it is the hope that ESG friendly investments will align with the path to profitability for investors and property owners. It is well evidenced that conscious businesses provide greater returns to their stakeholders. In both residential and commercial real estate, no longer do investors solely consider location of the asset and quality of cashflow, but also the impact of the investment on the environment and the people around them. The property market is headed towards a polarisation between assets with excellent ESG fundamentals, and ones without. The Best vs. The Rest, one could say.