The Sustainable Finance Disclosure Regulation – Reflections from the Real Estate Industry
The Sustainable Finance Disclosure Regulation (SFDR) has been brought in to achieve a number of outcomes which the market is crying out for – from bringing accountability and discipline to sustainability claims made by the ‘manufacturers of financial products’ (sic), to improving the quality and comparability of information about the sustainability-related performance of the financial products made available to end investors.
The question we set out to answer is whether, in its current state, the planned regulation is likely to accomplish the above.
What is the SFDR and what does it set out to achieve?
The SFDR strives to boost the comparability and robustness of sustainability claims and disclosures made about financial products. It defines indicators which must be measured and reported against by every financial market participant (asset managers, institutional investors, etc.) marketing a financial product as either promoting social or environmental characteristics (Article 8 funds), or having sustainability as its objective (Article 9). Disclosure requirements do not just cover funds marketed as ‘sustainable’ or ‘green’ either – Article 6 specifies that all funds need to disclose how sustainability risk is integrated into their investment decisions, and if a fund deems sustainability risk not to be relevant, the rationale for this decision must be clearly set out.
The regulation incorporates principles of double materiality; it requires financial market participants to explain both how they integrate sustainability risks into their investment decisions and processes, and how they consider the negative impacts of these decisions on the environment and social justice. The disclosure requirements are outlined in some detail in the Regulatory Technical Standards (RTS), accompanied by several appendices. The disclosures are intended to add on to those already mandated by existing sectoral legislations, thus aiming to provide harmonisation. They are also linked to the EU Taxonomy definitions of sustainable investment.
While the UK has exited the EU, UK companies cannot look away – SFDR applies to any financial market participants marketing their products in the EU. The UK’s Financial Conduct Authority (FCA) is also working on its own package of measures aimed at clamping down on greenwashing. Companies that do not consider sustainability risk cannot ignore the SFDR either - the regulation mandates that they must justify this in their disclosures.
If effectively implemented, a regulation with these aims should have the net effect of making sustainability a factor which can be easily assessed, interpreted, and taken into account by investors. Instead of digging through mountains of greenwash and vague sustainability reports that shine the spotlight on the few sustainable activities in a sea of Business-As-Usual, investors should be able to quickly sort the wheat from the chaff and make decisions accordingly. This increased transparency would serve to stimulate investee companies to transition away from unsustainable activities simply as a way to secure funding – and avoid sustainability risks becoming financially material to their bottom line.
Verco interviewed a selection of real estate owners and investors who were all at different stages of interpreting and applying the new regulatory regime. We collected anonymous views on the perceived clarity of the SFDR and the EU Taxonomy, as well as their predicted impact.
The responses suggest a shared view that, while the aims of the legislation are apt, it risks failing in its primary purpose of incentivising investments in sustainable activities by putting off investors and investees alike through excessive complexity and lack of clarity.
Saying that SFDR may well end up shooting itself in the foot is a controversial view and may not be entirely justified. In the current market, sustainability disclosures are becoming ever more widespread, and the need to differentiate between real claims and greenwashing grows in importance with each passing year. The regulation thus comes at the right time, and has a lot of positive elements. However, the prevailing feedback from the real estate market is that despite this, the SFDR is unnecessarily convoluted to the extent that makes it a burden rather than a help.
Applicability to real estate (or lack thereof)
A particular area of dissatisfaction is that the regulation in its current form, including the required disclosures, is not designed with the reality of real estate in mind.
A good example is the question of which principal adverse sustainability indicators listed in the Regulatory Technical Standards (RTS) of the SFDR are applicable to real estate companies. The majority of the principal adverse impact (PAI) indicators refer to investors in investee companies. A subset is explicitly labelled as applicable to investors in sovereigns and supranationals, and another subset – to investors in real estate. Whilst the common interpretation amongst respondents and consultants is that the latter are the only indicators that real estate funds need to report against, there are some industry players that have chosen not to take a stance at present and have left the door open to a variety of interpretations, including one which treats the term ‘investee company’ as the company occupying the building. The implications of such an interpretation are significant; if correct, it would inflate the reporting requirements to an extent which is likely to be seen as unfeasible for most real estate entities. There is a need for a definitive industry-wide stance on this question. It is also interesting why social metrics were deemed to not be applicable to real estate portfolios, as Table 3 of the RTS does not contain any indicators for this investment type.
Lack of definitions
Leaving the applicability of indicator sections aside, even the PAI indicators which are explicitly labelled as real estate-specific are not straightforward to report against. While ‘companies active in the fossil fuel sector’ have a clear definition in Annex I of the RTS, real estate assets ‘involved in the extraction, storage, transport or manufacture of fossil fuels’ (indicator 17 of Table 1) are not defined. This leaves some elements up for interpretation when reporting against this mandatory metric – for instance, whether an asset where the occupier is the head office of a company involved in these activities can be definitively ruled out from this category.
Poor choice of impact indicators
Further, there is some objection to the use of Nearly Zero-Energy Buildings (NZEB), Primary Energy Demand (PED), and Energy Performance Certificate (EPC) metrics in the equation for calculating the percentage of a real estate portfolio invested in inefficient real estate assets – the other mandatory real estate indicator. The metrics were selected to ensure consistency with the technical screening criteria established under the Taxonomy Regulation; presumably the Energy Performance of Buildings Directive (EPBD) and its definitions were also seen as the only framework that is somewhat universal across Europe. However, while this may be the simplest choice, many are aware of the flaws in this approach. Due to a considerable amount of flexibility in the way EPBD is implemented in various countries, and differing levels of maturity, an EPC rating in one EU country is not equivalent to the same rating in most others. Combined with the well-demonstrated issue of the disconnect between the theoretical energy performance metric such as an EPC A to G rating for a building and its real-life annual energy consumption and carbon emissions, this results in the PAI metrics not providing a meaningful reflection of a portfolio’s climate impacts.
It is noteworthy that the inefficient real estate asset exposure indicator also ignores non-European assets. The denominator of the equation is the value of real estate assets required to abide by EPC and NZEB rules. The denominator looks at assets with either a specific EPC rating (the shortfalls of which are discussed above), or a Primary Energy Demand (PED) value lower than the NZEB threshold applied in that country. The PED is a complex metric calculated not just from theoretical energy intensity but also from the building envelope information, information about the country’s electricity grid, and more, and usually only obtained from a specific proprietary software. There are metrics which could have been selected which would have allowed the calculation to be consistently applied no matter where the building is based, and thus cover multi-country portfolios and non-EU assets. Operational metrics are the obvious choice, but the market is not yet ready to use them.
Areas of uncertainty
Other areas of uncertainty or difficulty raised by our interviewees appear to cover all company types, not only real estate portfolios. For instance, the decision to enforce calendar-year-end reporting, while increasing comparability, will present significant difficulties to any company whose financial reporting is done on a non-calendar year end. The upcoming (yet delayed) Social Taxonomy introduces an additional area of uncertainty, as the scope, requirements and metrics for it are currently unknown. The same applies to the four remaining EU Taxonomy objectives, the details of which are yet to be disclosed at the time of writing this article.
The UK’s FCA is developing its own, related, Sustainability Disclosure Requirements (SDR) and investment labels, the final version of which is to be determined. The current proposal includes sustainable investment labels, disclosure requirements and restrictions on the use of sustainability-related terms in product naming and marketing. The consultation can be accessed via this link and is open to responses until 25th January 2023.
Yet another example of uncertainty is the regulation’s use of sustainability indices as one way to evidence progress towards sustainable outcomes. The index providers are not at present regulated, and the market does not have universally accepted or consistently applied indices at its disposal.
The current impact of the legislation on RE market participants
The companies we spoke to, many of which are considered market leaders in sustainability and are actively engaged in greening their portfolios, mostly classify their existing funds as Article 8. Under the current requirements they are finding it difficult – if not impossible - to meet the requirements for classifying any existing funds as Article 9.
The respondents mostly found that existing investors are not particularly sensitive to the classification of products as Article 8 vs Article 9, as they are familiar and comfortable with their chosen products and know the subtleties of their characteristics. The picture is different with prospective investors, who show a much higher interest in Article 9-labelled products – without necessarily understanding what such labelling involves or means. There is an expectation that it will become increasingly difficult to attract investment into funds which are not labelled as at least Article 8 from 2023.
Until the PAIs are aligned better with the climate impacts of a building in operation, this could be interpreted as a positive sign of the regulation working. However, there is at least one contra-indication. In its current interpretation, funds which can legitimately be classified as Article 9 must consist of buildings which are ‘already there’ in terms of their environmental impact – mostly new builds which are already nearly net zero in their performance, as measured via a theoretical energy performance rating.
Considering that 80% of the building stock that will be here in 2050 has already been built, we need to incentivise making transition investments into imperfect assets and upgrading their performance via refurbishment and operational interventions. This is the kind of action the industry needs if we are to stay within global carbon budgets and avoid catastrophic climate change. However, such ‘active’ funds risk being penalised in the eyes of the less-educated investors through their inability to achieve the coveted Article 9 status. The key takeaway from this – one stressed by many in the industry at present – is the crucial role that sustainability professionals must play in the education of investors.
A further finding is that there is little real consultancy expertise available to support real estate players in their reporting. Most of the companies interviewed made use of either in-house or external law advisors to determine the absolute minimum they needed to do – with a lot of sustainability resource being diverted to the increasingly burdensome reporting. A single industry-accepted real estate-applicable interpretation is sorely required and would be welcome.
How Verco can support you
While the consensus is that there are several technical criteria which are still very much open to interpretation, we hope that the next stages of the regulation will elaborate on the questions that many of us are asking. In the meantime, you can get in touch with us to discuss your disclosure needs and how we can support you. Whilst this complex piece of legislation evolves, our specialists closely monitor the changing regulatory requirements to keep you informed and prepared ahead of disclosure. We are also able to offer specialist advice on choosing the correct designation for your financial products, and to assist you with designing such products to meet SFDR requirements. Our reporting team has extensive experience creating bespoke data solutions to collect, process and analyse data required to report against SFDR.