Kaela Fenn-Smith, managing director, sustainability services & ESG UK & Ireland, CBRE, the world’s largest real estate advisor, looks at the new landmark Sustainability Disclosure Requirements introduced by the Financial Conduct Authority to boost transparency and combat greenwashing in sustainable investments, what it means for the real estate sector and why acting now is in their best interests.

The risks of climate change now need little introduction. We are already starting to live with the impacts of a changing climate on communities, businesses and supply chains. The most recent Intergovernmental Panel on Climate Change (IPCC) report delivered the unnerving news that the world is likely to overshoot the critical 1.5oC mark by 2030, exposing many of us to potentially serious impacts to our way of life.

In the face of global warming and climate change, companies are becoming increasingly aware that they must rethink their business practices and pursue sustainable development. Today there is an increasing understanding that financial profitability needs to go hand-in-hand with environmental integrity.

According to the World Economic Forum, buildings account for nearly 40% of global greenhouse gas emissions, 50% of the world’s energy consumption and 40% of raw material use. Capital and investment strategies are being called upon to drive greater sustainability in real estate and appropriate sustainability labels and disclosures will be crucial.

Becoming more transparent

After years of rather vague, unaccountable and sometimes ineffectual policy guidance around the naming and content of supposedly sustainable funds – including the European SFDR – a post-Brexit UK has needed a more thoughtful, detailed regulation to drive ‘decision-useful’ data with regard to sustainability.

The Sustainability Disclosure Requirements (SDR) regulation, introduced by the UK's Financial Conduct Authority (FCA) came into force on May 31st this year. It represents not only a significant milestone towards guarding consumers against greenwashed funds purporting to be sustainable, but also for investment managers that have historically struggled to build and market genuinely sustainable fund offerings.

This new disclosure framework has not been without debate, with practitioners still voicing concerns around pitfalls and uncertainty. These have typically emanated from the implementation issues experienced in trying to comply with the less than perfect European SFDR. While opinions still deviate, it is clear that a “business-as-usual” approach which inadequately reassures investors demanding genuine, evidence-supported sustainable investments, is going to be short-lived.

Reaping the benefits

While there might still work to be done to further tighten up regulations and provide clearer guidance, there is little doubt that embracing not only the letter and spirit of the new SDR regulations - and in doing so early and voluntarily - will reap financial and reputational benefits for first movers.

Among the many benefits, genuinely sustainable investments have proven to outperform non-ESG investments in the long term[1]. And prioritising ESG factors can also help ensure long-term resilience, as they are better prepared for changes in regulations, market conditions, and societal expectations. Funds that are already committed to demonstrable sustainable practices will undoubtedly have an advantage as and when new environmental regulations come into place, and may not require as many costly or disruptive adjustments.

There is also evidence to suggest that companies with clear and determined ESG goals are more likely to attract and retain valued employees - particularly the next generation of leaders who hold committed environmental values.

Businesses that are more conscious of ESG criteria – and are more likely to voluntarily align with SDR are also likely to be more adaptable. Typically they will be able to anticipate and mitigate the ongoing risks associated with climate change and adapt their strategies to stay ahead of new regulatory changes.

Despite “greenwashing” attempts to avoid scrutiny, ESG investing has become more popular – and demand for sustainable products and services will almost certainly increase as a more demanding and planetary conscious generation takes hold. In turn, existing company strategies should be motivated to develop and launch innovative offerings to increase their profitability, while promoting a positive brand image.

The transition from the EU SFDR to SDR

The Sustainability Disclosure Requirements (SDR) regulation, introduced by the UK’s Financial Conduct Authority (FCA) came into force on May 31st this year. It represents not only a significant milestone towards guarding consumers against funds that purport to be sustainable but may not be, but also for investment managers that have historically struggled to build and market genuinely sustainable fund offerings.

For real estate investments, the four new prescriptive labels might mean the following:

  • Sustainability Focus: For funds investing mainly in assets that are environmentally or socially sustainable, determined using a robust evidence-backed standard.‍ This might be, for instance, buildings that are already BREEAM Outstanding, and/or compliant with the soon to be launched UK Net Zero Carbon Buildings standard.
  • Sustainability Improvers: For funds investing mainly in assets that will be actively invested in to improve their environmental or social sustainability – for instance, improving their energy efficiency to become compliant with CRREM targets or any other credible decarbonisation pathways.‍
  • Sustainability Impact: For funds investing mainly in solutions to sustainability problems with an aim to achieve a pre-defined positive measurable environmental or social impact - such as affordable housing.
  • Sustainability Mixed Goals: Applies to funds investing mainly in a mix of assets that either focus on sustainability, aim to improve their sustainability over time, or aim to achieve a positive impact for people or the planet.

These labels are underpinned by a set of criteria, including that all products must have a clearly defined sustainable investment objective to improve environmental or social outcomes. At least 70% of the product's assets must be invested in accordance with that sustainability objective – and there needs to be disclosure of other assets held for any other reasons. Firms must also identify KPIs to measure progress against the sustainability objective and ensure there are appropriate resources, governance and organisational arrangements to support delivery of the sustainability objective. Last, but not least, firms must identify and disclose the stewardship strategy needed to support the delivery of the sustainability objective. Indeed, while not explicitly required by the regulation, it’s prudent to assume that a properly conceived theory of change and impact measurement framework should underpin the funds that end up using an SDR label.

Challenges still faced for real estate funds

Despite the SDR regulations being formulated to help investors easily categorise funds based on their sustainability attributes and strategies, some in the industry have concerns over potential issues with fitting existing funds into the new regime – particularly for real estate funds. One area of uneasiness is around the fact that it can be difficult to define the specific KPIs or improvement criteria behind the funds.

For instance, one criticism is that regulations might, in time, require buildings to achieve an EPC rating of C or B prior to letting or acquisition. This being the case, will it be legitimate to consider a so-called ‘brown to green’ real estate fund – so bringing assets from D and E ratings up to B and C ratings - genuinely ‘Sustainability Improver’? Or would such a fund merely be compliant with the law?

This is only one example of the issues likely to present challenges with label categorisations.

Timing and what to do next

For FCA-regulated firms which come under the scope of the new general anti-greenwashing rule requiring sustainability-related claims to be unambiguous, fair and not misleading, the SDR regime became effective from 31 May.

Investment managers and their funds (mainly those marketing to retail investors) can voluntarily opt-in as of 31st July in respect of labelling, classification, disclosure, naming, and marketing and distribution rules. For firms that manage or distribute these products, the rules also become effective as of 31st July.

By 2nd December, SDR rules become mandatory. With less than 6 months to be fully compliant – and with summer holidays in between to consider - fund managers should start implementing the rules now. If their core investment strategy is already in social or affordable housing, for example, they should consider marketing them under the Sustainability Impact label. For those considering establishing new funds, they should consider how these SDR labels might inform their investment strategy from the outset.

In time, it is expected that SDR regulations will introduce further, much-needed clarity on what sustainable investment products need to deliver and how that should be measured. In the meantime, for those fund managers concerned about the new labelling, it is recommended that you seek advice from an experienced real estate advisor.

[1] Morningstar analysed the performance of sustainable funds versus traditional funds over a 10-year period, and found that ‘58.8% of sustainable funds outperformed their traditional peers.’