With the built environment, and buildings in particular, accounting for a significant proportion of energy usage, emissions and embedded carbon, addressing sustainability in the real estate sector is critical to meeting international sustainability targets and minimising climate change.
This is especially true in housing, with government estimates suggesting that energy use in residential buildings contributes 13% of all the UK’s greenhouse gas emissions.
Movement from green loans to sustainability-linked lending
Since the first recognised green loan was issued in 2014, the growth of sustainable finance has been rapid. Traditionally, green loans (which are intended for individual green assets) have been the mainstay of sustainable finance for funding housing development. However, more recently, across the real estate sector and in the housing market in particular, businesses are turning to sustainability-linked (or ESG) loans, which set ESG targets linked to potential margin reductions (or accretion) depending upon performance.
As the sustainable finance market continues to become more mainstream, more businesses will move towards using sustainability-linked loans, including businesses that have already dipped their toe in the water using green loans, because of the greater flexibility and potential financial upside. With greater flexibility, both in terms of applicability (with some ESG loans are not required to be used in connection with green buildings) and the range of key performance indicators (KPIs) that can be adopted, and with potential margin reductions often ranging between 10bps and 50bps for meeting targets, ESG loans carry a clear appeal.
That said, borrowers should beware; it is inevitable that, with increased upfront work to agree and document the metrics and associated monitoring requirements, the process of execution is slower (sometimes by as much as six months) and, coupled with the additional monitoring and reporting of ESG performance, often substantially more expensive than traditional loans. As such, ESG loans may not be for every business.
However, many of the initial downsides, in particular speed of execution, can be mitigated by being forearmed with a sensible ESG strategy and targets when approaching lenders.
Stabilisation of metrics
Key to ESG loans is the establishment of, and monitoring against, agreed KPIs. However, the overarching principles do not prescribe specific KPIs, allowing flexibility and for targets to be agreed on a case-by-case basis.
While metrics range across environmental, social and governance factors, some factors will be particularly relevant for housing. However, what may be appropriate for one business will not necessarily be appropriate for another. Similarly, businesses may be eager to avoid having KPIs common across the sector to avoid comparisons where they may not be appropriate.
Many commentators question whether there will be a move towards a homogenous set of KPIs adopted across various sectors, but this is unlikely – although, as the market continues to evolve, it is inevitable there will be some degree of harmonisation as patterns and trends emerge and experience of factors within the sector grows.
While the list of available KPIs in housing is more or less endless, common examples include: reductions in emissions (specifically scope 1, 2 and/or 3 greenhouse gasses); improving energy usage based on government’s standard assessment procedure; distribution of EPC ratings; ratio of renewable energy; and increasing supply of housing (and, in particular, affordable housing).
What to do about those trickier asset
Government figures show that over 70% of the housing stock in England and Wales was built prior to 1982 and over 15% before 1900. The ONS’s research shows that age of housing is the most significant factor in terms of its energy efficiency. However, while newly built housing will play an important role in the sustainability of housing, government figures indicate that 85% of existing stock will continue to be in use by 2050. Coupled with the carbon cost of new build housing, it is expected that managing existing buildings will also be a significant factor.
Although ESG lending will provide a solution for many businesses, for owners and investors in older stock, where the costs of retrofitting will be higher and ESG lending may not be available or appropriate, it is likely that other funding solutions will be required.