What Obama, the Real Estate Sector, and 130 Investors Have in Common

Wednesday, September 7, 2016

While a typical summer is characterized by a lack of real news, leading the press to cover anything that’s even remotely newsworthy—or not – (we have a word for it in Dutch, “cucumber time”), the past two month have yielded enough stories to keep the average journalist busy: the Olympics, flooding in Louisiana, the ongoing civil war in Syria, fallout from Brexit, terrorist attacks across Europe, and the list goes on. So, you’re forgiven if you happened to have missed three newsworthy events that happened this past week:

  1. A group of 130 investors, controlling USD 13 trillion in assets, called on the 20 largest economies (the G20) to ratify the Paris climate agreement, to accelerate investment in clean energy, to implement strong carbon pricing, and force disclosure of climate-related financial risk.
  1. Real estate became the 11th sector under the Global Industry Classification Standard – the leading classification system for stock exchange-listed equities worldwide. Real estate was previously part of the “financials” sector, but it has been decided that the world’s largest asset class should indeed stand on its own.
  1. And most recently, President Obama and President Xi Jinping (China) jointly ratified the Paris climate change agreement at the start of the G20 meeting in China (the cost of which reportedly exceeded that of the Rio Olympics).

While each of these events is important, they risk being overshadowed by the latest tabloid-worthy news. Taken together, however, they represent a significant turning point in how the world will deal with global warming going forward. After all, legally-binding emissions reduction commitments from the world’s two largest economies – together representing 38% of global emissions –  will have major implications for public policy to reduce carbon emissions from energy generation, automobiles, manufacturing and the real estate sector. But, as we know so well in the post-Volkswagen era, regulation only gets us so far.

Thus, commitment from 130 of the world’s largest investors is welcome news. After all, money talks, especially when it is USD13 trillion. Their request to the G20 can provide immediate impact for companies connected to financial markets (i.e., almost all). They ask for more focus on and clarity about the implementation of the Paris climate change agreement. Most importantly, they want action from national governments and transparency from investments—to see government follow through on its commitments and put money to work in companies that provide solutions to this global challenge.

Finally, the recognition of real estate as a standalone sector may also bring more attention to the role that buildings can play in slowing down what many have called the most pressing issue of the 21st century – climate change. More visibility to investors will likely lead to more scrutiny about environmental, social, and governance performance, as real estate is asked to step-up to practices and performance expected from other asset classes. Attention from engaged, responsible investors will provide opportunities for recognition and constructive feedback that can motivate the sector to realized its potential to address the global challenge of climate change.

Buildings and a Low-Carbon Economy

While many countries have focused on energy supply as a solution to a low-carbon society, phasing out fossil-fuel-fired power plants and subsidizing the transition to clean energy, using less is another important part of the solution. Indeed, the 130 investors referenced above called for “strong regulations that encourage energy efficiency.” The recent Clean Power Plan proposed by the United States Environmental Protection Agency (EPA) allows for investment in [building] energy efficiency as a substitute for cutting carbon emissions from actual power generation. Across the ocean, the European Union aims for a 20 percent reduction in energy consumption by 2020, based solely on “cost effective” measures that are paid back through reductions in energy bills. And China has included energy efficiency as a cornerstone of its current five-year plan, with the ambition to retrofit four million square feet of non-residential space.

Buildings are thus increasingly the focus of both regulators and investors, though regulators are really second to the party. The property sector itself has had an aggressive head start with a 25-year history of voluntary action to define and recognize leadership on energy efficiency and, more broadly, sustainability through standardized certification schemes. BREEAM, used predominantly in Europe, is the oldest building sustainability label and was first developed by a UK-based organization in 1999. LEED followed, becoming the green building label of choice in North America and many emerging economies, along with other schemes like Green Star (Australia), HQE (France), CASBEE (Japan) and HK BEAM (Hong Kong), which have also been around for at least a decade. Complementing these voluntary schemes, building codes have been around in most countries since the 1973 oil crisis, recently coupled with building energy disclosure programs in Europe (energy performance certificates, EPCs), Australia (NABERS), and the U.S. (EPA Energy Star). Taken together, these tools and initiatives have already institutionalized high performance green building practice.

The Role of the “Invisible Hand” in Driving Market Transformation 

However, all these initiatives are not enough to address the scope of the global climate challenge. They are not big enough, fast enough, or far reaching deep enough to achieve the necessary emissions reduction or prepare society for inevitable climate change. The sector still consumes 81% of electricity in the U.S. and is responsible for about 40% of carbon emissions globally. For real market transformation to happen, we need something more radical. Or perhaps a concept that’s as old as Adam Smith’s “invisible hand” (first coined in 1759) – the capital market. The capital market is able to weed out lemons, or bad investments, and to let money flow to those investments that are most attractive. With current regulation, but also the ever-more-visible materialization of changes in climate (e.g. flooding, drought, torrential downpour, but also smog, heat waves, etc), investors should be wary of buildings exposed to these issues. And vice versa, investors should be attracted to buildings that have a more favorable carbon-risk profile, with less exposure to climate-change-related risks.

There are signs that the capital market is indeed starting to find its way into the acronym-heavy world of energy efficient, sustainable, or “green” real estate. Bloomberg last week reported that “property investors are obsessed with the A/C in your office.” There is emerging academic evidence that buildings with more favorable energy efficiency and sustainability characteristics perform better in the marketplace. And, like the 130 investors calling for clarity regarding the policy and market implications of the Paris agreement, there are 60 investors that are calling upon the real estate sector, upon GICS Code 60 to provide transparency in the sustainability performance of companies and the operational performance of underlying assets. These 60 investors are united in their belief that GRESB provides practical global framework to measure the sustainability of real assets.

A Global Language for ESG in Real Estate

GRESB provides a global language to give insight into the energy and sustainability issues that are material and specific to the real estate industry (GRESB separately analyzes the infrastructure sector). The GRESB Real Estate Assessment includes critical performance indicators – energy consumption, carbon emissions, water consumption, waste management – as well as on- and off-site renewable energy generation. And the use of green building certificates. Given that the performance of a portfolio of assets is so heavily dependent on the company managing the assets, the incorporation of sustainability issues in the acquisition, management, and disposition of assets is also measured. And of course, how the company interacts with its tenants, its surroundings, and its supply chain.

Today, investors using GRESB data represent USD7.6 trillion in assets. Some of these investors have called on the real estate sector since 2009, and this year we have the opportunity to look at the impressive results of their long-term engagement. Companies and funds participating in GRESB have significantly improved their performance since 2009. On average, companies and funds improve each year they participate with those participating the longest having the largest gains in ESG performance.

Real Estate Reducing Footprint

But of course, the interest is not just in the number of companies disclosing, but also in the energy and sustainability performance of the portfolios and underlying assets. This year marks a milestone for GRESB with the release of the new GRESB Rating. The goal is to make sustainability simpler and more actionable for investors. The GRESB Rating digests thousands of data points to provide a categorical indicator describing the relative sustainability performance of companies and funds around the world.  This data reduction inevitably sacrifices some details, so GRESB continues to provide high-level Scorecards and detailed Benchmark reports for investors interested in getting into the details.

Overall the new GRESB data translates into some early indication of real market transformation: the 2016 data shows a reduction in energy consumption of 1.2% from 2014 to 2015, or almost 1,000GWh. That’s the equivalent of 74,000 U.S. homes. Carbon emissions went down by 2%, or 427 kilo tonnes of CO2. That’s the same as taking 90,000 cars of the road (not those efficient Japanese cars, but proper gas guzzlers). Water consumption decreased by 1.9% - about 1,200 Olympic pools (even for Michael Phelps that’s a long time swimming). And 2% less waste went to landfill, the equivalent of 15,000 truckloads.

Warning signs

These numbers are encouraging, but should also be a warning sign. The numbers are encouraging because the market transformation taking place in the global real estate sector began long before a global climate agreement and corresponding climate policy had been put into place, driven by the capital market, the apparent business opportunities in reducing resource consumption, and perhaps by the animal spirits unleashed by bringing high-level transparency in the sustainability performance of companies and funds to the C-suite.

The numbers are also a warning. Progress is nowhere near the level required to realize global climate goals and the sector may (or may not) be ready to meet rising expectations. As the global real estate sector will get more attention from investors following its recognition as a stand-alone, mature industry, and from policy-hungry politicians searching for an outlet for their carbon-reduction aspirations pledged under the Paris agreement, they will quickly and inevitably be attracted to the building-sector’s abundance of cost-effective emissions reduction opportunities. In turn, investors will reward those best positioned to help address near-future sustainability and climate change challenges. But they can only do so based on objective information. Investors, companies, and other participants in the real estate market need to be able to differentiate leaders from laggards. In today’s business environments, answers to these questions must also be clear and simple. We think that preparing for tomorrow starts with a simple question: What is your GRESB rating?