Sustainable Finance: value creation in Real Estate with positive sustainability outcomes

by Hugh Falcon, Senior Analyst, Longevity Partners 

The world is running out of time to limit the worst effects of climate change. If we are to avoid the effects of extreme temperature rises, increasingly frequent and severe natural disasters, and biodiversity loss (among other issues), the world must achieve its Net Zero Carbon emissions targets by mid-century. To ensure this happens, a very large volume of capital dedicated to sustainable investments will be required each year, from now until 2050. This requires a re-orienting of capital flows to sustainable investments, and progress towards this will establish a clear synthesis between ESG and finance more generally.  

In monetary terms, it is estimated that a shift of $6.3 trillion towards climate related investment is needed each year for the next decade in order to stay on track with the process of decarbonising our economy; and the private sector will need to make up 70% of the direct investment required to reach Net Zero Carbon targets. There is much room for improvement in the buildings sector, as it makes up nearly 40% of global carbon emissions and to align with the Paris goals, by 2030 all new developments must be built with Net-Zero Carbon energy systems, and existing buildings must undergo retrofitting to reach the same standard at a rate of 5% annually. Delay in achieving these targets could lead to additional direct costs of $2.5tn for the sector in the next eight years.  

Differing estimates exist on the cumulative price tag of transition investments needed to decarbonise the built environment. Despite this, it can be agreed that there are a number of economic incentives present in both the short- and long-term, which make this form of investment worthwhile. In pure monetary terms, investments in the decarbonisation of the built environment will generate longer-term productivity gains, ranging from direct savings from more efficient energy systems and building materials, to a comparative increase of rental and retail value. Indirectly, targeted investments to achieve Paris’ agreement goals will see a reduction of transition and dependency risk at an individual asset level for an investor, making an investment more profitable over a 10-year timeframe. 

Furthermore, there are increasingly abundant and stringent forms of disclosure, carbon-accounting, and targets that are slowly but surely becoming mandatory for all asset holders. Mitigating transition risks by anticipating future regulations, which are being driven by states and supernational institutions, who have been increasing disclosure requirements and incentivising the carbon transition with financial levers, will be a must for participants in the real estate.  

From an issuer perspective, the increasingly significant influence sustainability is having on decision-making in the real estate sector has been partly attributed to leaders recognizing the positive impact of ESG performance on their cost of capital, which is 0.4% lower in the MSCI World Index for ESG leaders compared to laggards. The changes in regulation and rising disclosure standards, as well as lower cost of capital, have elevated the entire market’s demand for investment in climate change mitigation and adaptation projects, and sustainable private sector financing will be integral to the sector achieving Net Zero Carbon emissions by 2050.  

 

Green Bonds and Loans: unlocking value from sustainable assets 

Green Bonds and Green Loans are fixed-debt instruments with a built-in governance structure, which mandates that proceeds be used for projects with positive environmental and/or social outcomes. (Green Loans also require independent reporting and target setting). They are an increasingly popular tool in in the real estate market used to capitalise on new, high-quality development projects, as well as sustainability projects at existing assets. 

The Climate Bonds Initiative recorded that as of the end of 2021, a cumulative $2.8 trillion had been raised in green, social, sustainable, and transition bonds globally (collectively abbreviated to GSS+ bonds). The rate of issuance has been growing on a year-by-year basis, evidencing the fact that the private sector has become receptive of this demand – GSS+ issuance grew 46% in 2021 compared to 2020. With 16,000+ GSS+ debt instruments having been issued cumulatively up to the end of 2021, there are many examples of sustainable bond issuance in recent years. For instance, in the real estate market, Digital Realty, an owner of data centre real estate investment trusts (REITs), has used green bond issuances to fund energy efficiency and renewable energy projects for its data centres to greatly reduce energy intensity and carbon emissions. Canary Wharf Group issued a £906.3m tranche of green bonds in April 2021 to specifically fund its commitment to deliver Net Zero Carbon by 2030.  

The North American real estate sector is a prime example of the strength and demand for this form of debt issuance; green bond offerings made up 16.4% of all capital raised through REIT debt offerings in the country from Q1-Q3 2021. Different forms of sustainable bonds have also greatly increased in popularity; sustainability-linked bonds grew 10-fold year on year, and green bonds  only made up 49% of total issuance in 2021. While this shows that the demand for these debt instruments has increased exponentially, it also proves that, to meet supply, the ESG debt market has become diluted with transactions that only just pass as being sustainable. As the market catches up to the shortage of sustainable debt instruments of the highest quality, being able to finance or issue Green Bonds and Loans of a high standard that will pass a Second Party Opinion test will begin to be even more highly sought-after by asset managers, especially as we are currently heading into a period of higher interest rates. 

 

The benefits of GSS+ Bonds and Loans for issuers 

GSS+ debt instruments provide access to a deep pool of capital looking to finance Net Zero Carbon: asset managers all over the world now have Net Zero Carbon targets for their financed emissions. At the same time, there is increasing demand from clients who want their money put to work in a sustainable manner. Furthermore, transition risks have been incorporated in every asset manager’s risk matrix; they have a fiduciary duty to avoid investments in stranded assets, such as buildings with poor energy efficiency ratings. By virtue of looking more closely for potential sustainability issues in investments, when a well performing asset only raises green flags, then real estate asset managers can capitalise on the opportunity by issuing a Green Loan. 

Issuing sustainable debt sends the message that an organisation has a tangible commitment to achieving sustainability: this is down to increased transparency through the issuance and use of proceeds process, thereby improving its relationship with investors. This gives them a clearer idea of what projects the loan is financing and the progress over time toward sustainability targets. 

Green bonds generally tend to trade at higher prices, known as a ‘greenium’, which lowers cost of capital for both corporate and government entities. This is due to reduced information asymmetry, improved liquidity, as well as lower perceived risk for investors. Green Loans reduce the cost of capital further for issuers, if they achieve sustainability targets agreed at issuance.  

COVID relief and climate change mitigations funds issued by central banks pegs the release of trillions of Euros and Pounds to sustainability goals: private firms looking to access this capital, readily available to them and at a decreased interest rate, need to create tangible achievements pegged against a sustainable financial transaction. This in turn is sold in the form of a bond and purchased by banks. 

SFDR, EU Taxonomy, and TCFD requirements also contribute to this ‘greenium’: sustainable finance regulations have been formed to ensure financial flows go to investments which will fund the transition to a low carbon economy. There is a limited supply of eligible investments and many different financial market participants such as pension funds, central banks, and Real Estate Investment Trusts are racing to fill their portfolios with them. Particularly now with the creation of article 8 and 9 funds (subject to SFDR regulation), funds are trading Green Loans and Bonds at a premium in trying to adhere to the strict regulatory requirements outlined by the European regulation. 

 

How we can help you navigate the sustainable finance field

The opportunity for issuers and investors alike in the real estate sector to capture the benefits of sustainable debt is too big to ignore, even during current turbulent market conditions. Longevity Partners has the expertise to guide you through sustainable debt issuing and investing processes, offering services that run the gamut of GSS+ and traditional sustainable finance. 

At Longevity Partners, our services include the development of Green Loan & Bond Frameworks, conduct external reviews and Second Party Opinions, assessment of potential green loans against Green Loan Frameworks, and advise on the development of sustainable finance governance. Further, we conduct ESG Risk Screenings on potential investments and work across our services to provide market and policy reviews for our clients, whilst consulting on ESG strategy and disclosure. Get in touch with our team today at info@longevity.co.uk to find out how we can help you achieve your sustainability goals. 

 

 

References: 

Climate Bonds Initiative (2022) Climate finance is cheaper than catastrophic climate damages: IPCC’s Latest Report. Available at: https://www.climatebonds.net/2022/04/climate-finance-cheaper-catastrophic-climate-damages-ipcc%E2%80%99s-latest-report  

Climate Bonds Initiative (2022) Sustainable Debt: Global State of the Market 2021. Available at: https://www.climatebonds.net/files/reports/cbi_global_sotm_2021_02f.pdf  

Canary Wharf Group (2021) Canary Wharf Group Successfully Issues Multi-Tranche Debut Green Bonds. Available at: https://group.canarywharf.com/press-release/canary-wharf-group-successfully-issues-multi-tranche-debut-green-bonds-120421/  

Deloitte (2020) Decarbonization of Real Estate: End-to-End Business Transformation. Available at: https://www2.deloitte.com/global/en/blog/responsible-business-blog/2020/decarbonization-of-real-estate.html  

Digital Realty (2022) Green Bonds. Available at: https://www.digitalrealty.com/about/sustainability/green-bond  

ICMA (2021). Green Bond Principles. Available at: https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/green-bond-principles-gbp/  

LMA (2021) Guidance on Green Loan Principles. Available at: https://www.lsta.org/content/guidance-on-green-loan-principles-glp/ y 

LMA (2018) Green Loan Principles: Supporting environmentally sustainable economic activity. Available at: https://www.lma.eu.com/application/files/9115/4452/5458/741_LM_Green_Loan_Principles_Booklet_V8.pdf  

MSCI (2020) ESG and the Cost of Capital. Available at: https://www.msci.com/www/blog-posts/esg-and-the-cost-of-capital/01726513589#:~:text=Companies%27%20ESG%20profiles%20correlated%20with%20cost%20of%20capital&text=29%2C%202019.&text=In%20the%20MSCI%20World%20Index%2C%20the%20average%20cost%20of%20capital,even%20higher%20for%20MSCI%20EM 

Net Zero Carbon (2021) Decarbonisation delays in the real estate sector could cost businesses $2.5tr. Available at: Decarbonisation delays in the real estate sector could cost businesses $2.5tr (netzerocarbon.com) 

S&P Global Market Intelligence (2021) Green bonds growing as a share of REIT debt issuance. Available at: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/green-bonds-growing-as-a-share-of-reit-debt-issuance-66559830  

UKGBC (2020) Building the Case for Net Zero: A feasibility study into the design, delivery and cost of new net zero carbon. Available at: https://www.ukgbc.org/ukgbc-work/building-the-case-for-net-zero/ 

Zenghelis, D. (2021) What are the likely costs of the transition to a sustainable economy?. available at: https://www.economicsobservatory.com/what-are-the-likely-costs-of-the-transition-to-a-sustainable-economy 

Zhang, R., Li, Y. and Liu, Y (2021). ‘Green bond issuance and corporate cost of capital’. Pacific-Basin Finance Journal, 69. Available at: https://www.sciencedirect.com/science/article/pii/S0927538X21001335  

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