The transition risks of climate change for corporate real estate: Compliance and litigation

Our industry is engaged in an important dialogue to improve sustainability through ESG transparency and industry collaboration. This article is a contribution to this larger conversation and does not necessarily reflect GRESB’s position.

The consequences of climate change and environmental degradation are undoubtedly core business risks. While individuals may enjoy their day-to-day lives disengaged from the looming threat of climate change or otherwise unconvinced of its relevance to the present moment, businesses cannot afford this same apathy. They must look to future scenarios to weigh investment risk and ensure long-term growth opportunities. The impact caused by the global warming of around 4°C, among other environmental-related risks, such as biodiversity loss, could have dire implications on the value of global financial assets. The physical risks associated with climate change are the most immediate and transparent risks: the mass destruction of physical assets and infrastructure due to extreme weather, supply chain system failure due to dwindling availability of certain raw materials, rising insurance costs, consequences to capital allocation due to perceived threat of flooding, and more frequent outages or failure of energy grids due to extreme temperatures will pose significant challenges in the future. However, the growing risk of compliance and litigation in response to the uptick in climate-related rules and regulations should also be at the forefront of business owners’ minds. One thing we can be sure of going into 2024: ESG litigation and regulatory enforcement will expand and greenwashing will remain a continued focus.

Responsible for approximately 40 percent of all greenhouse gas emissions globally, the real estate sector has particularly been confronted with high climate risks and will face fundamental changes as the global economy decarbonizes to meet climate goals. Homeowners and small and medium-sized enterprises (SMEs) are already struggling to afford coverage as insurance prices rise due to the increasing frequency of severe disasters, and in the face of rising losses, some insurance companies in at-risk areas have decided to limit the amount or type of damages they can cover, cancel policies, or leave the market altogether. Tacking on the transition risks associated with mounting compliance costs for new reporting mandates and building performance standards, real estate firms must be well prepared to absorb and accommodate a new market landscape. Below, some of the foremost transition-related risks are outlined: namely, stricter building standards, greenwashing litigation, and compliance with additional reporting standards.

We manage what we measure, so climate disclosure mandates that help companies clarify energy costs, govern risks, and set and meet targets will enable the public and regulators to evaluate company performance and punish laggards. This is where the risk to corporations comes in. Regulators around the globe are finalizing rules that would require companies to publish standardized information after years of patchy voluntary ESG reporting based on a host of frameworks. In October, California Governor Gavin Newsom signed two bills that will usher in significant climate-related disclosure requirements for thousands of U.S. public and private companies that do business in his state. SB 253 requires companies that are active in California and generate an annual revenue exceeding USD 1 billion to publish an extensive account of their carbon emissions starting in 2026. SB 261 requires companies with USD 500 million in annual revenue to prepare biennial reports disclosing climate-related financial risk in addition to the measures they have adopted to reduce and adapt to such risk. Beyond these two laws in California, the U.S. Securities and Exchange Commission’s (SEC) more widely reaching and highly anticipated climate-related disclosure rules are expected to come into effect later this year.

It is also important to note that California’s new emissions laws force companies to reveal more about their emissions profiles and include fewer accommodations for discretionary reporting than the proposed SEC mandates. The overlap in companies subject to both rules could result in companies including emission information in SEC filings that they would have withheld were it not for California’s rules, ultimately exposing them to more shareholder scrutiny and raising the risk of a legal challenge to their climate claims.

Increased disclosure requirements typically come with increased liability risk and compliance efforts. Company directors can be held liable for inaccurate statements to investors. The SEC can impose fines or refer serious cases to criminal authorities. Shareholders can also sue corporate executives if they feel they have been misled by information in SEC filings or other public statements. Ultimately, corporations will face risk if they do not compile investor-grade sustainability and carbon emissions data that holds up to audit scrutiny with data accuracy and completeness — a feat which can be time-consuming and costly for unprepared entities.

Research shows that litigation against climate-related greenwashing, or ‘climate-washing’ litigation, which seeks to hold companies to account for various forms of climate misinformation before domestic courts and other bodies, is gaining pace. The intense investor and public pressure on companies to have strong ESG stories, coupled with the historically “voluntary” nature of many ESG disclosures, has heightened the risk of allegations that a company is not walking the walk with respect to its sustainability targets and green products. With all the technology and data available today and with greater incentives for whistleblowers to report companies that are noncompliant, it is much more difficult for companies that are not meeting their sustainability goals and regulatory expectations to fly under the radar. Failed efforts are likely to surface quickly causing reputational harm and potential lawsuits.

As ESG regulatory regimes expand, governmental bodies and private parties are likely to continue to increase their engagement, enforcement, and litigation efforts on such matters. This risk has given rise to the term “greenhushing” where companies refrain from reporting on climate or sustainability goals out of fear of being penalized. Rather than shut down on sustainability initiatives and claims, companies should engage in heightened efforts to avoid making environmental claims that may be overstated, inaccurate, or misleading in any way.

Government policies such as carbon taxes and efficiency standards can affect the bottom line of real estate assets, with the most carbon-intensive assets facing a distinct disadvantage or risk of regulatory fines. In some regions, costly retrofits may be required to bring inefficient buildings up to standard before being sold or leased. Leaders across the U.S. are exploring building performance standards (BPS) as a way to reduce excessive building energy use and carbon emissions. BPS (also referred to as Building Energy Performance Standards, or BEPS) are state and local laws that require existing buildings to achieve minimum levels of energy or climate performance targets by certain phased-in deadlines. As BPS becomes more commonplace, building on the work of mandatory benchmarking ordinances, building owners, architects, consulting engineers, and facility managers — who have historically been most concerned with implementing energy code requirements as the primary energy-related regulations – will need to have a thorough understanding of the local BPS targets in addition to energy codes. As a part of the National BPS Coalition, over 40 cities, counties, and states have committed to pass building performance policies and programs by Earth Day 2024 (April 22, 2024) to reduce carbon emissions from buildings.

Reaching these performance targets will require addressing energy use and emissions in new and existing buildings through retrofits and operational strategies if corporations do not want to be subject to heavy fines and penalties.

• Tax increases and fines for not meeting emissions thresholds
• Decrease in subsidies for certain carbon-intensive technologies
• Extra costs from reporting requirements: Increasingly comprehensive reporting regulations require a growing number of metrics, which increases the pressure on the asset and property managers as well as portfolio managers to obtain and track the new metrics from tenants, customers, suppliers, portfolio companies, and other stakeholders. Reporting investor-grade emissions and sustainability data will also require labor- and time-intensive data collection processes, in addition to external consultants and auditors to aid in the process.
• Additional investment costs to bring the real estate portfolio in line with national laws: Though such regulations are likely to be accompanied by governmental subsidies, businesses may still incur high retrofitting costs or risk their assets being priced out of the market. New buildings are also likely to become subject to more demanding construction and energy efficiency standards, thereby increasing costs.
• Enforced rules that properties can only be rented if they meet a certain energy standard: Buildings that do not meet certain standards may become illegal to build, rent, or sell, thus resulting in premature obsolescence and significant write-downs.

Ultimately, real estate corporations must consider the wider set of impacts that the risks of compliance and litigation may have on their businesses. Even in avoiding the risk of fines for noncompliance, corporations will face the cost of decarbonizing buildings, and accurately reporting their data. Some questions to ask regarding your own climate risk preparedness include:

• Are there any new governmental standards on energy efficiency, on fossil fuel use, on pollution and waste, or otherwise that impact assets within our portfolio’s footprint?
• Do we have emissions data for our clients? Do we also have data on non-CO₂ emissions (e.g., fluorinated gases)?
• What does our exposure to higher-risk assets look like? What are the terms of our financial relationship (e.g., debt/equity, tenor)?
• How do the emissions intensity, energy demand, and energy costs of our client assets compare to industry and regional averages?
• How much are clients investing in low-carbon retrofits?
• What investments have our clients made in on-site generation?
• What are the energy standards that new builds are adhering to in the areas where my portfolio is located?

This article was written by Caroline Pittard, Sustainability Content Specialist, at WatchWire.

References

United Nations Environment Programme “Sectoral Risk Briefings: Insights for Financial Institutions” (March 2023)

United Nations University – Institute for Environment and Human Security (UNU-EHS) “Interconnected risks: Uninsurable future” (2023)

David Carlin, CeFPro “The ripple effect of physical risk” (2023)

Deirdra Funcheon, Axios Miami “Report warns of a real estate “climate bubble”” (September 2023)

Mark Segal, ESG Today “Less Than 1 in 3 Boards Have a Strong Understanding of ESG Risks Affecting Their Companies: PwC Survey” (October 2023)

Steve Blonder, Reuters “The litigation risks that companies face in an age of ESG” (September 2023)

Misato Sato, Glen Gostlow, Catherine Higham, Joana Setzer, and Frank Venmans, The Grantham Research Institute on Climate Change and the Environment “Impacts of climate litigation on firm value” (May 2023)

Jon McGowan, Forbes “SEC Climate Disclosure Rule Most Likely Not Final Until 2024, Effective 2026” (October 2023)

Isla Binnie, Forbes “Companies fear lawsuits from California’s climate disclosure rules” (October 2023)

National BPS Coalition

United States Environmental Protection Agency “Benchmarking and Building Performance Standards Policy Toolkit” (February 2021)