The growing trend of ESG integration amongst companies and investors is more than a decision about doing what is socially responsible or morally right. Growing evidence suggests that ESG integration may be a key differentiator, providing organizations with a competitive advantage and leading to improved long-term financial performance compared to peers. Over 80% of corporations in the S&P 500 now publicly report their performance against environmental, social and governance standards, according to the Governance & Accountability Institute.[i]
ESG or Environmental, Social and Governance are commonly defined as the three central pillars used when measuring the sustainability or ethical impact of a business or company. These three central pillars can cover a wide range of topics across an organization. A United Nations led initiative, the Principles for Responsible Investment (PRI), defines these pillars to include the factors listed in Figure 1.
These factors are quite broad and cover a variety of issues that may not be applicable to some companies or industries. Rather than a company focusing on a full range of ESG factors, it is essential for companies to understand which of these issues are material, or likely to impact the financial condition or operating performance of their company. Identifying these material concerns and working to collect data, disclose current performance and improve future performance will help create the most value for the company and its shareholders in the long run.
Drivers of ESG in Commercial Real Estate
The Sustainability Accounting Standards Board (SASB) provides guidance around determining financial materiality for companies across a wide variety of industries. The real estate industry, which is listed under the infrastructure sector, is perhaps unsurprisingly focused on material environmental issues as shown in Figure 2 below.
In the United States, commercial and residential buildings account for approximately 40% of total energy consumption.[ii] Historically, real estate companies have focused their ESG efforts around reducing energy usage and associated emissions. As cities continue to adopt more stringent emissions reduction targets, more and more real estate owners and operators are integrating environmental performance as part of their business strategies. Furthermore, investors are paying attention to ensure they are investing in companies that integrate environmental factors. Looking beyond investor demand, environmental performance can help real estate companies attract lucrative tenants who are increasingly seeking efficient, healthy and green certified buildings. Incorporating these factors can lead to increased profitability through higher property values, tenant attraction and retention and improved return on investment.
In addition to investor and tenant driven demand, successful ESG programs enable real estate entities to optimize operational performance, identify and mitigate risks and gain a competitive advantage in the industry.
ESG programs provide real estate companies with the ability to identify relevant material risks and opportunities to factor into asset acquisition and inform their business strategy. Managing risk creates long term value creation, drives sustainable financial performance and increases shareholder value. For example, in a 2017 CFA Institute survey, 65% of investors said that their motive for taking ESG issues into consideration was to help manage investment risks.[iii]
The impacts of climate change have already influenced real estate markets at the global scale. 35% of REITs’ properties are exposed to climate hazards. Of these, 17% of properties are exposed to inland flood risk, 6% to sea level rise and coastal floods and 12% to hurricanes or typhoons.[iv] Successful ESG programs enable real estate portfolios to better identify and manage risks, particularly those posed by climate change, and make more informed investment decisions based on their findings.
Additionally, successful ESG programs inform a proactive approach towards regulatory compliance, as energy and water benchmarking requirements are adopted in more cities on a national scale. Portfolios with a comprehensive sustainability strategy and data management platform are positioned to be ahead of the curve and readily able to adapt to meet local environmental regulatory compliance standards and avoid fines and penalties and potential reputational risk.
Real estate portfolios tracking and monitoring energy and water usage across their properties are also better able to mitigate future price risk as commodity prices in certain geographic locations may fluctuate due to climate change or other events. Proactively identifying properties in areas subject to these risks may allow real estate owners to take necessary precautions such as negotiating for long term fixed price power purchase agreements.
Operational & Financial Performance
Operational performance including energy and water consumption, greenhouse gas emissions, indoor air quality, safety and waste management are material factors to measure sustainability in the real estate sector. Companies with a comprehensive ESG strategy equip investors and real estate managers with quantifiable data to measure performance. This provides actionable opportunities to prioritize assets for energy studies, capital upgrades, retrofits, green building certifications, and more. ENERGY STAR, LEED, and GRESB provide standardized frameworks to prioritize relevant metrics, monitor, evaluate and report ESG performance, and contribute to increased transparency across the real estate sector.
There is a clear relationship between successful ESG strategies, financial performance and the increasing demand from investors and tenants to support the business case for ESG integration. Several studies across the real estate industry, and one conducted by the Harvard Business School, illustrate the improved long-term financial performance attributed to ESG integration, demonstrated in Figure 3. While the Harvard Study does not specifically screen for REITs, it can be inferred that real estate companies, especially those with longer term outlooks on their portfolios would stand to benefit the most from focusing on ESG.[v]
In the real estate industry, environmental initiatives such as reducing energy or water usage have historically been attractive to asset owners because of their tangible financial benefits, i.e. reducing operating expenditures. However, as the industry moves forward, companies need to think longer term. While reducing operating expenditure is important in the short term, considering future risks such as energy and water price risk, climate change related risks, and reputational risks due to social or governance issues is what will truly bring the long term sustained performance that companies and their investors demand.
Written by Jordan Chan and Amit Paul, CodeGreen Solutions
[i] “85% Of S&P 500 Index® Companies Publish Sustainability Reports in 2017.” 85% Of S&P 500 Index® Companies Publish Sustainability Reports in 2017, Government & Accountability Institute, Inc., 2017, www.ga-institute.com/press-releases/article/flash-report-85-of-sp-500-indexR-companies-publish-sustainability-reports-in-2017.html.
[ii] U.S. Energy Information Administration – EIA – Independent Statistics and Analysis. (2018, May 3). Retrieved February 13, 2019, from https://www.eia.gov/tools/faqs/faq.php?id=86&t=1′
[iii] CFA Institute. (2017). Environmental, Social, and Governance (ESG) Survey (Rep.).
[iv] Climate Risk, Real Estate, and the Bottom Line (Rep.). (2018, October). Retrieved February 13, 2019, from Four Twenty-Seven and GeoPhy website: http://427mt.com/wp-content/uploads/2018/10/ClimateRiskRealEstateBottomLine_427GeoPhy_Oct2018-6.pdf
[v] Eccles, R. G., Ioannou, I., & Serafeim, G. (n.d.). The Impact of Corporate Sustainability on Organizational Processes and Performance (Working Paper No. 17950). National Bureau of Economic Research.