What is ESG?

2020 was a watershed year for Environmental, Social and Governance (ESG) investing in real estate as pandemic- and climate-related disruption, along with growing recognition of social inequity, prompted investors to adopt a more robust approach to sustainability-related risks.

As the concept of ESG is now playing a much more prominent role in how companies operate, investors are embedding ESG considerations into every stage of the property lifecycle, from due diligence to acquisitions and from leasing to asset management. Thus, real estate investors are devoting more thought to ensuring how their portfolios can navigate through future crises.

ESG in Real Estate

With operational emissions (energy used to heat, cool and light buildings) accounting for 28% of all global carbon emissions and embodied emissions (materials and construction processes during the entire building lifecycle) generating a further 11%, pressure is growing on building owners, operators and occupants to reduce their carbon footprint.

While carbon reduction efforts may not necessarily generate higher investment returns, they will play a prominent role in preserving asset value as occupiers increasingly shy away from properties with subpar environmental performance. As occupiers and investors are drawn to properties that are more sustainable, these assets will be worth more.

Although property certifications such as LEED, BREAM and NABERS will remain important measurements of buildings’ environmental performance, the focus is shifting to initiatives such as the World Green Building Council’s (WGBC) Net Zero Carbon Buildings Commitment, which calls for all buildings to have net-zero carbon emissions by 2050.

Other initiatives include the Race to Zero, a United Nations global campaign that challenges companies, cities, regions and financial and educational institutions to halve global emissions by 2030 and already has signatories equivalent to half of global GDP.

ESG Considerations for Real Estate Investors

With ESG now playing a much more prominent role in how companies operate, investors are embedding ESG considerations into every stage of the property lifecycle, from due diligence to acquisitions and from leasing to asset management. Investors in real estate have also recognized the importance of managing ESG risk.

The industry, a major contributor to carbon emissions and rarely celebrated as a positive contributor to society, has been criticized in the past for its sluggish progress in this area. Now, those who build, buy, or manage property are expected to ensure their buildings meet environmental standards, have positive social impact, and that stakeholders in them operate in a responsible manner.

Green Construction Materials

In addition to the building and construction industries accounting for almost 40% of annual global carbon emissions, manufacturing of concrete and steel each account for about 5%.

Viable alternatives, such as timber, are much more environmentally friendly due to carbon sequestration. Compared to an average steel and concrete building, which emits 1,000 to 2,000 metric tons of carbon dioxide during construction, a timber building will eliminate emissions by sequestering 2,000 to 4,000 tons of carbon dioxide.

Timber construction costs vary by property type but on average can match or reduce costs relative to conventional materials. Timber also provides more cost certainty and can reduce construction time significantly due to pre-fabrication.

How do ESG-based loans work?

Bank loans are rapidly being restructured to include sustainability clauses. Lenders that have found a nexus between ESG-based lending and sustainability are incentivizing borrowers to transition the world to sustainability. ESG-based lending refers to general-purpose loans linked to the ESG performance of borrowers.

Thus, such kinds of loans work through tweaking margins. The margin of the loan is tied to the ESG performance of the borrower, where the lender issuing ESG loans includes clauses or covenants the borrower should achieve. If the borrower achieves the KPI targets set by the lender, the pricing of the loan is discounted, whereas if these targets are not achieved, a premium is added to the pricing of the loan. However, many mistake green loans for ESG-based loans, as corporates use both terms to showcase “sustainability”.

ESG Loans and Green Loans – Is There a Difference?

The main goal for ESG loans and green loans is sustainability. Although both terms are trending among bankers, ESG loans are issued with the objective of improving performance of borrowers in terms of ESG aspects, whereas green loans are issued solely to finance “green projects”, focusing only on one factor, the environment.

Why ESG-Based Lending Is Important for the Real Estate Market?

ESG-based, green and sustainable lending has picked up significantly the real estate sector in Europe, which is an indicator that European countries are the main driver of global warming. Buildings account for 40% of the energy consumption in the EU, prompting policymakers to reduce carbon emissions.

In the UK, energy performance certificates rate buildings on a scale from A to G, where A indicates the most efficient and G the least efficient; it will be considered “illegal” to let out a building rated F or G by 2023. The Netherlands expects to draw the line at buildings rated C or below.

To achieve sustainability goals, Europe’s real estate market is undergoing a wave of transformation, requiring investors and property owners to make properties occupiable from an ESG compliance perspective; 60-75% of the buildings would need to undergo substantial renovation, requiring total capital outlay of EUR 160-200 bn.

This is where ESG-based lending and green loans would come into play, as banks have always been dominant participants in the EU credit market.

EU’s Regulations to Support ESG

Numerous policies have been crafted to regulate ESG-based lending over the years. This includes sustainable finance disclosure regulation (SFDR), as many companies tend to greenwash their activities. Under this regulation, all asset managers and owners are required to report on the impact of sustainability risks on their investments and the adverse impact of their investments on sustainability factors.

Taxonomy regulations, the path to ESG labels, have been crafted. With buildings accounting for 36% of CO2 emissions in the EU, taxonomy regulations were crafted to clear ambiguities relating to economic activities termed “green”. These taxonomy rules are particularly important for the commercial real estate market, enabling a building to be classified as a “green building”. However, the main aim is to optimize the contribution of the real estate sector to Europe’s climate goals by transforming existing buildings and constructing new buildings in line with net-zero-carbon standards.

In line with these taxonomy regulations, lenders and borrowers need to be transparent in reporting green activities, and lenders are advised to take extra care when deciding on KPIs to measure the ESG performance of borrowers.

One more crafted regulation is Fit for 55, which aims to make buildings in the EU fit for a greener future by reducing their greenhouse gas emissions by 55% (versus 1990 levels) by 2030 and reaching carbon-neutrality by 2050. Under this directive, real estate managers or owners need to consider energy performance of buildings, the use of renewable energy, and the use of clean energy while avoiding polluting fuels.

ESG-Based Loans in Egypt

Egyptian banks are striving for sustainability. Only two Middle East-based banks are founding signatories to the UN’s principles for Responsible Banking, and both are Egyptians. The Egyptian government was also among the first to introduce a sustainable development strategy in the wake of the Paris Agreement 2015, while the sovereign was an early issuer of green bonds.

Further, hosing the UN climate conference (COP27) has clearly focused the minds of Egypt’s policymakers and industry executives. The CBE introduced guiding principles for sustainable finance in July 2020 that covered several topics, including capacity building, stakeholder involvement, and climate risk management.

As regards new regulations, they reflect the fact that sustainability is a comprehensive issue. Thus, banks are asked to bolster their green portfolios, introduce sustainable finance products, and assess environmental risk across projects. Lenders also need to put in place new policies and procedures, create and staff new sustainable finance departments, and prepare and publish annual sustainability reports. Sustainability reporting has to start from 2024, while creating policies and demonstrating proof of progress have deadlines in 2023.

Banks are still in the process of clarifying some aspects of the rules with the regulator, but a change in mindset over the last few years means that Egyptian lenders are not at a standing start. Several banks have made great headway in pushing sustainability to the fore. For example, CIB was a founding member of the UN’s Net-Zero Banking Alliance (NZBA) and it is the only Egyptian to have issued a green bond. HSBC Egypt is similarly well advanced on its sustainability journey, as the bank has a dedicated ESG specialist on its risk team. The lender will also focus on making sure that its existing sustainability procedures match the CBE’s new requirements and fill in any gap.