ULI Product Council Insights: What’s Next for Real Estate ESG

How can investors know when they are truly investing in sustainability?

Experts discuss the effectiveness of policies that are aimed at increasing energy performance in buildings; the challenges of measuring and reporting climate-related physical and transition risks; strategies for navigating the complexities and uncertainties of environmental, social, and governance (ESG) investing; and related trends.

Don’t Miss: ULI Global Sustainability Outlook 2023

Which policies are having the biggest impact on improving buildings’ energy performance and decreasing greenhouse gas emissions in the real estate industry?

Brenna Walraven: The European Union’s Sustainable Finance Disclosure Regulation is an anti-greenwashing regulation that will require contractual commitments to meet certain environmental or social criteria improvements, including annual reporting on progress against these over time. In the United States, building performance standards have been adopted by seven jurisdictions thus far, and another 30-plus have made some type of commitment to put these standards in place by 2024. And the U.S. Securities and Exchange Commission’s proposed rules requiring both public companies and, likely, private funds and registered investment advisers to disclose both climate risks and greenhouse gas emissions (scopes 1, 2, and, if material, 3), while not directly addressing energy performance standards, will in effect require firms to demonstrate how they are reducing climate risks and emissions.

Chris Brooke: Climate disclosure requirements mandated by regulators, such as stock exchanges and monetary authorities, will be highly effective because these not only represent compliance requirements, but also become corporate requirements, which need to be embedded in the way organizations function and deliver ESG in order to report the results to shareholders, stakeholders, regulators, and investors. The introduction of the International Sustainability Standards Board’s climate disclosure rules is going to take standard setting, consistency, and measurement to the next stage. In addition, in many countries, building codes are becoming more stringent around energy efficiency, building design, and sustainability. As governments become more proactive regarding their net zero carbon policies, that will naturally drive people to build more efficient buildings.

Aaron Jodka: There has definitely been a move toward ESG for investors—a strong interest in acquiring, operating, and owning sustainable assets. Other than LEED and Fitwel and some of the other certifications, however, there is still some opacity about how sustainable an asset really is. Having a plan, a timeline, and definable goals is really important. So municipalities, cities, states, and regions are coming up with plans to reach definable goals by a certain timeline—say, all buildings achieving net zero emissions by 2050, which is the target for Boston’s Building Emissions Reduction and Disclosure Ordinance [BERDO 2.0]. These kinds of ordinances allow owners and future investors to start planning.

Hyon Rah: Right now, the three energy performance standards that are most motivating building owners to do something in the United States are Washington, D.C.’s Building Energy Performance Standards; New York City’s local laws, including Local Law 97; and Boston’s BERDO 2.0. The key to motivating building owners is to tie noncompliance to negative consequences, like the fines for violating New York City’s regulations. I expect a lot of other cities and regions are going to switch from incentive-based energy performance guidelines to strict mandates. The proposed SEC rule on climate-related risk, while not yet codified, has put public companies on notice. And because of the Scope 3 carbon disclosure requirements, which involve emissions from suppliers and service providers, we’ve already been hearing from our clients who are not public companies but who want to think through and implement their pathway to net zero carbon.

What are the primary challenges in moving toward greater standardization in measuring and reporting climate-related physical and transition risks?

Brooke: The key challenge seems to be data. We need an industry collaboration agreement on what data we are using to measure risk, how to get hold of this data, and how to use it. A number of different organizations have come up with different standards, but not everybody wants to align 100 percent. They may each have their own agenda or focus: some might be more focused on embodied carbon, some on net zero, some on operational efficiency. The other challenge is to balance technology with reporting. There is a range of great technology solutions out there, but a lot of them are created to solve one individual problem or measure one aspect of a building. We need a holistic building performance model.

Rah: Three big challenges come to mind. First, there is a mismatch between incentive structures and actual climate-related risks, especially in high-value real estate markets. For example, places that are highly vulnerable to floods, sea-level rise, and droughts remain tempting prospects for businesses to site industrial and office buildings because of various tax and policy incentives. Second, there is a lack of standardization in modeling methodologies used to predict climate-related risks. The same site can yield very different risk profiles depending on the type of modeling or the vendor. Third, most risks are calculated based on monetary damage, which makes it difficult to fortify the areas where communities are in a vulnerable position not just physically but also financially. Based on the models currently in use, a large area of very high risk but low monetary value may not be categorized [as being] as vulnerable as a small area of very-high-value properties. Social equity and strong communities are an integral part of sustainability, and we need to find ways to do better.

Walraven: The old adage still holds true: you can’t manage what you don’t measure. Presently, it is still extremely difficult to get whole-building data in most states and with most utilities. Some utilities just don’t have the capacity. And there are still tenants who are very reluctant to share data, which further complicates access, reporting, measuring, and monitoring. Also, climate risk assessments, typically generated by third-party companies, are often difficult to interpret and thus can add complexity and challenges with implementing risk reduction strategies as well as with appropriately characterizing the risks within both financial and ESG reporting mechanisms. Recently ULI issued a report, How to Choose, Use, and Better Understand Climate-Risk Analytics, that I think is really helpful, because these are big databases with algorithms and analysis, and unless you’re a science geek, it’s not easy to understand them fully.

What kinds of innovative strategies exist or are needed to address the uncertainties and complexities of ESG investing?

Jodka: International investors, particularly those with a portfolio in Europe, have been able to see the transition to more carbon-neutral, energy-efficient buildings already because Europe is ahead of the United States when it comes to energy efficiency. So they can see what works and what the challenges are and apply that knowledge to their properties in the United States. When it comes to alternative sources of energy generation in the United States, we’re still trying to figure out what’s fair for municipalities, owners, and utility companies. For example, states like New York and Massachusetts have a high level of solar power adoption, even though they are not the sunniest states, because they have net metering, and building owners who generate excess electricity from photovoltaics can sell it back to the utility or get credit. If we could figure out ways to make that work for both users and utility companies in more states, we could see some real gains.

Walraven: Automation of data capture through innovative metering methods is still an area of opportunity that will provide greater visibility into performance, which will make it easier to understand, underwrite, and invest in ESG opportunities. Another strategy, engaging with tenants, may not seem innovative, but it’s critically important to reducing complexities, getting better insights, and aligning interests with stakeholders. For example, as landlords engage more with tenants on transparency and focus on performance, risk and uncertainty will be reduced. As one example: for emissions inventories and reporting, if landlords and tenants can share more information, then information will be based more on actual data/performance and less on proxy/estimated data, which again will improve confidence and reduce uncertainties. Not a lot of chief executive officers of publicly held companies like the word estimates in anything that they’re disclosing, particularly for which they have fiduciary and legal obligations.

Rah: We need monitoring mechanisms and safeguards in place that can more easily prevent practices that might look good on paper in terms of ESG criteria focused on energy and carbon but in fact do not have a good impact environmentally or socially on the ground. An example of this would be data centers located in areas that have a high level of water stress achieving energy efficiency and lower carbon footprints through water-intensive cooling methods. This can be damaging to the communities and the businesses themselves in the long run. We don’t yet have good metrics to take these effects into account.

Brooke: ULI recently issued a report called Mitigating Climate Risk Impact to Real Estate Value in the Greater Bay Area, and one of the proposals is to create a group forum, bringing together key stakeholders—owners, investors, developers, auditors, valuers, government officials, regulators, and financiers—to develop key strategic objectives for China’s Greater Bay Area. These types of industry collaboration are very encouraging, especially if they focus on a portfolio or an area, set key objectives, and develop pilot projects. For investors, there is a lot of ongoing work on physical risk assessments and transition risk assessments and thinking longer term. If I’m an asset manager and my fund life is seven years, previously I may only have been worried about the next seven years. But now, more people are considering what happens beyond that because if you need to sell the asset, you need to present a case to the buyer that the asset will meet building performance standards.

What other significant trends do you see?

Rah: Of all the disasters that are happening, over 90 percent are water related—not just flooding, but also wildfires because they have a lot to do with groundwater depletion and dry vegetation. Water is a finite resource we need to survive, and the viability of the real estate market depends on it. You can’t have a thriving real estate market in places where people don’t want to live. So we need to talk more about water security. The Lake Mead reservoir and Hoover Dam, for example, supply not only water to about 25 million people, but also hydropower, and the drought has been shrinking the lake at an alarming rate. As we approach 2030, the real estate industry has to think about things in a more systemic, interconnected way, and water is a big part of it.

Brooke: The discussion about embodied carbon in relation to retrofits versus new construction is still in the early stages in Asia Pacific in comparison to Europe. Another issue is whether insurance is a sufficient risk mitigation tool, and the answer is, probably not. Insurers are already requiring a lot more detail around physical risk assessment and transition risk assessment so that we avoid having stranded assets in the future. Similarly, the capital markets will be even more focused on which transactions and assets they will be financing.

Jodka: There is some concern about the push for electrification, whether for vehicles or buildings, in terms of the energy grid’s capacity. Do we have the system in place today that can allow for this? I’ve heard conflicting answers from experts. There’s likely to be a need for heavy government investment in our energy grid to make sure we can handle the future of energy use. It’s clear that ESG policies are very important to large real estate occupiers. They are willing to pay a rent premium to occupy buildings that meet their standards. There are going to be great opportunities to retrofit buildings and add tremendous value. And some assets will outperform because of their ability to measure and display their energy use and meet the investment criteria of pension funds and other institutional capital sources. Other assets won’t check enough boxes and will be less attractive to these investors.

Walraven: While the internet of things, artificial intelligence, and other new technologies have transformed and will continue to transform efforts around climate risk mitigation and ESG outcomes, people still play a critical role. People need to make decisions, approve, implement, and engage to get the best possible outcomes with lower overall risk. Presently, demand for good ESG talent is exceeding the supply. We joke that in the real estate community, in particular, there’s a bit of musical chairs going on, where great folks are getting “new opportunities” and moving to new companies at every level of ESG roles. What the real estate, ESG, and educational communities need to continue to work at improving is growing good talent to fill these roles.

RON NYREN is a freelance architecture, urban planning, and real estate writer based in the San Francisco Bay area.