Real Estate. ESG. 2023.

Greenhouse gas emissions are at their highest levels and huge steps need to be taken in order to meet net zero commitments.

Getting to Net Zero - I wouldn’t start from here…

2022 broke many climate records – the UK’s hottest summer, Europe’s highest temperature of over 48C recorded in Sicily, devastating droughts, storms, floods and wildfires around the globe. Keeping 1.5C alive is looking particularly challenging (and in fact, almost certain to be breached – at least temporarily). 

Increasingly extreme weather events and changes in climate impact on real estate assets, through rising sea levels, increasing subsidence and flooding. Ultimately, this will impact on insurance premiums, insurability and the value of real estate assets. Banks now consider climate change risk one of their top exposures and estimate that £525bn of assets will be at risk by 2050.

The recently published Mission Zero Independent Review of Net Zero, commissioned by the Government, recognises that net zero is a huge economic opportunity and that the private sector is key to the net zero transition. It includes “25 by 2025” recommendations that can realistically be delivered in the next couple of years. Key among the “priority missions” and recommendations that will affect the industry include:

  • Focus on renewables, including solar and onshore wind
  • Emphasis on circular economy and reduction of waste
  • “Net Zero Local Big Bang” – a planned unblocking of the planning system to give local authorities and communities “the power they need to act on net zero”
  • Energy Efficiency for Houses, including gas free homes by 2035 and new Net Zero Performance Certificates
  • Embedding nature and habit restoration throughout transition plans, maximising co-benefits for climate and nature wherever possible 
  • Publishing a Land Use framework by mid-2023
  • Backing at least one Trailblazer Net Zero City, Local Authority and Community
  • Review of incentives for decarbonisation (including through tax/capital allowances)
  • Proposed overarching finance strategy for delivering net zero

ESG issues will continue to be of increasing importance this year so what can we expect to see and how will this impact on the real estate industry? 

Key themes for 2023

Flight to quality – beware of FOMO

The leasing market slowed towards the end of 2022 and a two-track market is emerging, with only top quality, sustainable space showing resilience in demand. Research by Savills found that the “greenest” London buildings make up less than 10% of the market but around 60% of all space leased in 2022.

We will see increased occupier interest in the ESG credentials of space. Occupiers are realising that they need top-quality, sustainable premises in order to compete to attract and retain talent but that the stock of “good” property is limited. Furthermore, the growing trend by occupiers to re-evaluate and rationalise their space requirements post-pandemic will accelerate, with a demand for quality, flexible space over quantity. Some occupiers will look for greener and longer leases. At the same time, expect increased demand for “plug and play” CAT-A+ fit out for short term occupancy or as a flexible ”add on” to an occupier’s longer lease.

Will the jury come in on the extent of the green premium and brown discount properties attract based on their sustainability? A growing body of evidence of both is there. Research by CBRE identifies the risk of future discounts as potentially the biggest single driver of UK real estate investors’ behaviour. JLL have identified the growing competition between investors to acquire sustainable assets and gain “first mover” advantage. Their Sustainability and Value – London Offices Investment report found increasingly higher prices for sustainable assets, anticipating higher returns and lower risks.

EPCs – save the date

MEES legislation is increasingly making building stock obsolete, with estimates that 75% of the office market falls below the 2030 required standards.

Key dates are:

  • From 1 April 2023 any pre-1st April 2018 leases of a sub-standard property which are still in existence will come within the regulations.  For such lettings a landlord will have to improve the asset rating of the property to an E, unless they can claim an exemption under the regulations. 
  • On 1st April 2025 buildings with ratings of D and E will come within the regulations.  Landlords will still be able to grant leases of D and E buildings but subject to a deadline of 1st April 2027.  By that date, landlords must have improved the rating to C or claimed one of the statutory exemptions.
  • On 1st April 2027 the same process applies to C rated buildings. Landlords can still grant lease of such buildings but subject to improving the rating to a B by 1st April 2030 or claiming an exemption.

These dates may change. Mission Zero recommends that all new non-domestic buildings should be EPC B from 2025.

There will be a divide between landlords who can afford improvements and those who can’t. LandSec have estimated that it will cost £135 million to improve their portfolio. For some, the cost of carrying out improvement works will be prohibitive and outweigh potential returns. The market will then be left with illiquid stranded assets.

Retrofitting – the new normal

To improve the environmental performance of UK building stock (80% of which will still be here in 2050) and stand any chance of meeting our net zero targets, an enormous retrofitting programme is required. However, with building costs increasingly dramatically (up 20% from 2020), value engineering often means environmental performance “nice to haves” are the first to be excluded.

New builds make up just 3% of building stock per year. The supply for green buildings greatly outweighs demand, particularly in London. With retrofitting estimated to take a third of the time of new development, for many landlords it will be the only viable option. Expect a change in mindset from developers as the perception of the need to “retrofit first” gains weight and an increase in refurbishment projects – these already comprised an estimated 84% of construction projects in London in the last 6 months.

Retrofitting is much more straight-forward on a vacant building, but a landlord will have few opportunities to get vacant possession between now and 2030. Carrying out works with tenants in occupation brings many more challenges, with consideration needed of lease provisions on access, disturbance, quiet enjoyment, health and safety requirements, and out-of-hours working among others. For some, it will be essential to comply with MEES Regulations.

The recent BCO Circular Economy in Offices report recommends incorporating circular economy principles into fit-out and new-build offices, with developments designed for disassembly. More prefabricated elements should be used, to avoid disruption from onsite works and priority should be given to locally sourced materials, with lower embodied carbon, as well as using re-used, recycled or recyclable materials. It also recommends that landlords avoid carrying out a CAT-A fit out which the tenant will then rip out for its own fit out. Co-operation and co-ordination is key.

Standards and regulations – embodying consistency

There is increasing clamour in the industry about the lack of clarity and consistency in defining net zero. Hopefully that will be assuaged by the UKGBC UK Net Zero Carbon Buildings Standard, expected 2023. For a landlord, improving the environmental performance of a multi-let portfolio and comparing performance against other properties are challenging if there is no consistency.

Quantifying embodied carbon is going to be enormous challenge. Embodied carbon will only become a greater proportion of a building’s emissions as operational carbon is reduced. There is a clear growing need for whole life carbon assessments. The expected introduction of Part Z Building Regulations on Carbon Assessment and Carbon Efficiency, requiring whole life carbon emissions to be assessed and reported and reasonable provision to be made to minimise carbon emissions on development, will help.

Reporting obligations – DATA DATA DATA!

Expect more and more stringent legislative and regulatory requirements. Taskforce on Climate-related Disclosures (TCFD) obligations have been in force since April 2022. Currently applicable to listed companies; banks or insurers with more than 500 employee; UK-based AIM companies with 500 or more employees; LLPs with 500 or more employees and a turnover of more than £500m; and non-listed companies with 500 employees or more and a turnover of more than £500m, expect this list to be expanded. Companies not currently obliged to disclose may still be required to report if they are within the supply chain of larger companies who are bound.  

More organisations will produce net-zero transition plans. The Transition Plan Taskforce (TPT) launched in April 2022 recommends companies publish a transition plan in 2023, with an update in 2026 and information relevant to the plan included in financial reporting in the interim. Plans should set out emissions mitigation and climate adaptation ambitions, with short, medium and long-term actions (and how to finance them) identified.

Internationally, US SEC regulations are set to be introduced in Q1 2023 and reporting standards under the EU Corporate Sustainability Reporting Directive are expected to be published in 2023, before coming into force in 2025. The International Sustainability Standards Board are also reviewing their climate and general sustainability-related disclosure standards following the consultation which ended in July 2022.

Organisations will need data and established internal frameworks in order to meet reporting requirements. Expect to see landlords and tenants looking for greater collaboration and data sharing, with submetering and sensors to measure energy used. Data will be key – if you don’t know the data, you can’t report. It is possible (though not perhaps imminent in 2023) that the Government may look to legislate on the disclosure of data.  

Washing and Hushing – running out of hiding places

As more organisations develop net zero plans with a renewed focus on what is actually quantifiable, measurable and achievable, occupiers, investors and funders will increasingly raise climate risk questions and increase their ESG requirements.  This increased push for sustainability disclosures comes on top of the developing regulatory framework.

There will be increased scrutiny from banks and regulators. We have started to see the backlash against “green washing”, with companies including HSBC and Innocent Drinks having adverts banned and H&M facing claims relating to its “Conscious” product branding. Research has shown that 20% of corporate risk incidents linked to ESG stem from greenwashing, so this backlash is set to amplify, as consumers and investors become more discerning.

The Competition and Markets Authority published its Green Claims Code last year and further EU anti-greenwashing regulation is expected. The consultation on the FCA Sustainability Disclosure Requirements, a package of measures designed to clamp down on greenwashing has just closed (January 2023). An “anti-greenwashing” rule is proposed, requiring all regulated firms to ensure sustainability claims are clear, fair and not misleading. 

Greenhushing is also becoming an increasing problem, with organisations reluctant to share progress on sustainability initiatives, perhaps for fears of facing claims of greenwashing or reputational damage from seemingly not making enough progress. Other organisations are greenhushing by falsely trying to appear more sustainable, without publishing data to back up their claims. According to a survey by Sensu Insight, 86% of UK adults want to see more transparency from businesses on their environmental impacts, initiatives and targets, so greenhushing will become increasingly damaging – and increasingly difficult as disclosure requirements increase.

But organisations will need clarity in policies and regulations in order to report accurately. They’ll also need quality data to evidence their claims. Scope 3 emissions are going to be a challenge, with estimates that supply chain emissions are 11.4 times higher than operational emissions. While this may be difficult, organisations should consider whether that’s because of lack of data or lack of resources invested in collection.

Offsetting – the last resort

The industry may want to tiptoe around the offsetting minefield. The controversy surrounding carbon credit schemes, as recently seen with Verra, reduces credibility and increases scepticism in offsetting solutions. However, offsetting will ultimately be inevitable. Emphasis must be put on offsetting as a last resort, which is only considered once all available steps have been taken to reduce emissions and improve energy efficiency so far as possible, maximising the use of on-and off-site renewables. It is not an option to permit business as usual. Any schemes must be of high quality, certified and independently verified.

Natural capital – at the heart of development

The Office for Environmental Protection has warned of “a deeply concerning decline in biodiversity”, with repeated evidence of species and habitat degradation. The Government’s Environmental Improvement Plan sets out how it intends to meet targets set at COP15 on water quality, biodiversity and waste. Ambitiously, it wants everyone to live within 15 minutes’ walk of green space or water and to create or restore at least 2000 square miles of new wildlife habitats. Whilst it has long been recognised that access to nature leads to improved health and wellbeing, critics have argued that the Plan does not go far enough.

Increasing regulation will affect landowners and developers, with the Taskforce on Nature-related Financial Disclosures (TNFD) set to officially launch this year.  The SBTi Forest, Land and Agriculture (FLAG) Guidance will affect companies linked to land-intensive activities across their value chain, enabling them to set science-based targets which include land-based emissions and removals.

The much-touted Biodiversity Net Gain requirements are expected in November 2023. Developing with nature has been a theme for many housebuilders and master developers for some time, but this is a change of emphasis in the regulations. Where not deliverable onsite, developers will be looking to purchase offsite credits for biodiversity net gai, as well as carbon and nutrient neutrality, giving owners of rural land and green space opportunities to re-purpose land to provide these credits. We are already seeing activity in the marketplace as landowners and land managers prepare to register biodiversity net gain sites and expect more in 2023.

Mission Zero makes a big push for solar and onshore renewables, providing further opportunities for those with suitable land. Expect more battery storage projects and innovative solar panel placement, perhaps following the French example of mandating solar panel installation over car parks.

Leases – any colour you like, as long as it’s green

To take the necessary steps to net zero, landlords and tenants must ensure green leases are business as usual. These leases demonstrate the parties’ commitment to improving the environmental performance of the building and provide a legally binding basis for doing so. Provisions can encourage the necessary collaborative relationship and crucially, set out an agreed process for data sharing. Whilst it is standard for leases to now include provisions requiring the tenant not to worsen the environmental performance and EPC rating of a property, landlords may also start to impose greater restrictions on their tenants’ fit outs to ensure the increasingly stringent ratings are met. Expect landlords to use lease events as opportunities to carry out works and/or insert green lease provisions, rather than waiting for termination. Landlords and tenants will have to agree who bears the costs of works/dilapidations, perhaps based on who benefits from reduced costs/emissions.

So much to do, so little time

The real estate industry is collectively faced with the responsibility and challenge of building properties that meet sustainability criteria, that will remain viable, safe and resilient in fluctuating climates and provide for a competitive yet affordable market. Exploration of these themes show that there is much to do and much that can be achieved before 2030. The much-needed shift in mindset in the industry is definitely underway, underpinned by the increasing evidence of green premium and brown discount in the market.

UN Agencies at COP27 declared that “the future economy is waste-free, circular and net-zero”. Expect retrofitting and developing new property to circular economy principles, with whole life carbon assessments, to come to the fore. Increasing knowledge in the industry is key. Meaningful datasets are an extremely valuable tool and if the industry can capture large and reliable information on energy usage, efficiency and waste, we’ll see improved analysis and understanding of what climate mitigation strategies and ventures are worth it, and those that are not.

Market direction indicates (as Mission Zero suggests) that being green will be an economic opportunity, not just a burdensome responsibility. 2023 will feel like it’s a bit of both.

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Every piece of content we create is correct on the date it’s published but please don’t rely on it as legal advice. If you’d like to speak to us about your own legal requirements, please contact one of our expert lawyers.

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