Unboxing ESG in real assets
In the midst of a global pandemic, Apple announced its intention to reduce the climate impact of all of its devices to net zero by 2030. As Apple expands and needs more stores, offices and data centres, this will be a monumental task.
Globally, 39% of all carbon emitted comes from building and construction, and operational emissions account for about 28%.
Commercial property landlords and tenants can cut energy use by shifting to non-fossil fuel sources, by using less energy, or both. Opting for materials, logistics and construction methodologies with less carbon impact can also help.
‘Embodied’ carbon emissions account for the remaining 11% of emissions from building and construction. By comparison, air travel accounts for about 2.5%.
There is a window of opportunity as we reconfigure assets in response to COVID-19, where delivering healthy and low-carbon products can meet the needs of tomorrow’s occupiers.
When COVID-19 began spreading globally earlier this year, the concern was that environmental, social and governance (ESG) considerations would take a backseat as efforts were focused on battling the health crisis. In fact, the opposite may be happening.
Whether through the UK’s ‘Build Back Better’ initiative or the European Union’s ‘Green New Deal’, ESG considerations have a central role to play in COVID-19 recovery programmes. One of the main sectors to be affected will be real assets. They are long term, they transform communities, and they are crucial to economies.
Here, we consider four areas set to shape the ESG agenda for real assets: the path to net-zero emissions, transformation of the workplace, increased focus on social impact, and the embedding of ESG considerations throughout the lifecycle of investments.
MAPPING NET ZERO
Efforts to mitigate climate risks worldwide centre on the 2015 Paris Agreement, which seeks to keep global temperature rises this century less than two degrees Celsius above pre-industrial levels and, if possible, to 1.5 degrees Celsius. To achieve this, the world’s carbon emissions need to reach net zero by 2050, according to the Intergovernmental Panel on Climate Change (IPCC).
Nearly a quarter of the world’s top corporations have committed to climate targets, a fourfold rise since 2015. Local and national governments have their own targets. As governments and corporations reduce emissions, investment portfolios will need to align (see Chart 1). This means only buying assets where you have full confidence they can be decarbonised in time, and refurbishing, redeveloping or disposing of everything else.
The scale of the required transition is enormous. In the UK, for example, the expectation is for consumption to double in the next 30 years while net carbon must fall to zero.
The growth of renewable energy will not be enough to meet this need, particularly as wind and solar are intermittent. Achieving net zero will require significant investment to decarbonise both power and transport. The Government will need to provide the right framework to support investments in existing and developing technologies such as heat pumps, battery storage, carbon capture and storage (CCS) or hydrogen. Incentives could include higher carbon prices, as well as new regulation.
WORK, AT A DISTANCE
One enduring legacy of COVID-19 could be a fundamental change to working practices. Office buildings will likely accommodate fewer people on average as more employees work from home. Yet higher peak periods could be expected if more employees are coming into the office at the same time to seek face-to-face interaction and collaboration with colleagues, still an important ingredient to fuel the knowledge economy.
Upon returning to the office, occupiers are likely to expect more of a destination for their staff, accelerating the demand for modern, flexible office space with stronger environmental credentials such as energy efficiency, state-of-the-art digital technology, and greater emphasis on health and wellbeing.
With real assets portfolios likely to be reconfigured to adapt to this new world, asset owners share the challenge of managing partners and suppliers responsibly.
The rights of employees and communities will likely hold larger implications for real asset investors – not only in terms of the workplace but also the workforce. As responsible investors, asset owners can no longer be faceless bystanders – they have to become an integral part of the change required.
SOCIAL IMPACT: VITAL, BUT HARD TO MEASURE
The aims of the ‘S’ don’t always align with that of the ‘E’ and ‘G’ in ESG. Therefore, asset owners need a consistent process to guide how they balance the trade-offs in their investment decisions.
Questions around the social aspects of ESG are becoming more important. There is a lot of discussion about how to measure social improvements as part of an investment, which is challenging because social metrics are less quantifiable compared to environmental improvements.
Such difficulties have led more institutional investors to turn to the Sustainable Development Goals (SDGs) to target specific ESG goals. According to the United Nations
Principles for Responsible Investment (UNPRI), the recent push to use the 17 SDGs to set investment targets has the potential to help real asset investors obtain much better clarity on how they are shaping outcomes.
Asset owners and investment managers are beginning to use the SDGs to set targets for asset allocation or other elements of asset management.
Some governments are also using the SDGs to help shape their infrastructure planning and project design requirements.
INCORPORATING ESG THROUGH THE LIFECYCLE
Understanding ESG characteristics is a dynamic process; for real assets, this is even more complex given the longer timeframe of investments.
To truly invest for the long term, investors will need to embed ESG in their decision-making process – from origination through to investment management and finally disposal.
As with traditional financial analysis, ESG impact will differ according to the nature of project, sustainability credentials of the company and where the investment sits in the capital structure, among other factors.
Once assets are added to the portfolio, active ownership helps mitigate ESG risks and maximise value. Estimates suggest about 90% of European real estate was built before 1990, likely with poor-quality insulation, outdated heating systems that rely on gas, and poor air quality management. Yet according to commercial real estate firm JLL, office buildings with the highest levels of sustainability certification command significant rental premiums of at least 10% above average. This presents a significant opportunity to refurbish assets and realise the uplift in rents and asset value.
When it is time to divest or dispose of assets, asset owners have a responsibility to minimise the on customers, employees and wider society. In cases where assets are sold to another investor, due diligence will be key. ESG liabilities may extend far beyond the point of divestment.
Without absolute certainty on what tomorrow holds, the best way to futureproof portfolios is to constantly scrutinise the potential for change and make sure you are prepared for it.
Ed Dixon is head of ESG, real assets at Aviva Investors.
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