31 August 2023
ESG & Real Estate:
Where are we now?
ESG is now likely one of the top three priorities for all Gallagher real estate clients and prospects. In other words, it is very much here to stay, but the drive to deliver net zero is not linear, and everyone is moving at different speeds due to disparities in appetite, ability and pressure from stakeholders, most notably investors.
Yet company structures are changing; many have appointed a head of sustainability and made public commitments with milestones ranging from 2030 to 2050. While there is no legal requirement, the direction of travel is being propelled by the UK government’s goal to achieve net zero by 2050.
Measuring Sustainability
A crude measurement of a building’s energy efficiency is its energy performance certificate (EPC) – a moment-in-time measure of performance. Whilst far from perfect, it is what the government is currently using as the basis for legislation review and reform, and landlords are therefore keen to move their assets up the scale.
Minimum energy efficiency standards (MEES) changed in April this year – new lettings of sub-standard (below a rating below E), non-domestic properties now extend to the continuation of any existing lease. In 2021, the government issued a consultation and said it plans to raise MEES for let buildings being increased to C by 2027 and to B by 2030.
Purchasing real estate to purely let is now rarely producing the necessary returns, and many see redevelopment as an essential part of adding value. Real estate prices have generally dropped due to a number of factors including rising interest rates and inflation, and a big challenge for UK real estate financiers is short-term debt. Many firms will be in a position where they need to refinance soon, but they may struggle due to the huge increases in interest rates and, therefore, the cost of debt.
The new MEES legislation has prompted two distinct responses: some clients are selling their underperforming assets with a "brown discount", while others are strategically buying these assets to improve them and achieve a "green premium". As a good example, rising occupier demand for greener buildings has led to a 9% increase in rental premium for timber buildings.
Alongside MEES, biodiversity net gain legislation will come into force from November 2023 on all developments in the UK that are yet to receive planning, meaning new projects must deliver an overall increase of at least 10% on the biodiversity of the development – and maintain it for a minimum of 30 years. This will be a challenge, particularly in urban locations. The likely consequences are that developers will be forced to compensate by increasing the biodiversity of the UK elsewhere. Greenbelt land’s value is set to rise as developers look to farmers and landowners, essentially offering them money to help increase the biodiversity of their land to offset the development.
Carbon Credits
There is a booming global market putting a price on carbon and beginning to trade it like any other equity. When companies and property owners are unable to achieve net zero based on their assets alone (due to various reasons, including embodied carbon), they must find another route. One potential solution is to fund/develop/plant trees directly; another is to buy the carbon credits from someone who is already doing the work, and then monetise them via trading. This comes with a whole host of issues, as has already been well publicised in the press in some cases, around the sellers of the carbon credits committing fraud, and/or the buyers not performing due diligence properly, and inadvertently greenwashing.
A whole insurance market is evolving rapidly in response to this growing sector, looking to provide reassurance around the validity of carbon credits purchased and tracking the ongoing development of projects which have promised to deliver carbon credits in the future. A number of MGAs are creating products in response to this rapidly growing industry, and undoubtedly large property owners have already started to consider how carbon credits might ultimately need to play a part in their net-zero strategies.
Operational & Embodied Carbon
The move towards net zero has been mainly focused on operational carbon. With many sustainable actions landlords can take: solar panels, green roofs, EV charging points, the sad reality is that energy-efficient measures change a building’s risk profile, and from most insurers’ perspective, they increase the risk. Solar panels, for example, pose an increased risk of fire and reduced access to the roof; green roofs are combustible – the theme replicates across the majority of measures.
We are also waking up to the enormous amount of embodied carbon that exists within buildings. There has been a sea change; even as recently as 5 years ago, it was generally the default strategy to knock a building down at the “end of its life” and build something new in its place. Architects and designers are now looking at a building’s carbon life cycle and considering how easy it will be to deconstruct structures and use materials again. Campaigns to refurbish over demolish are also gathering momentum. M&S’ plans to demolish and rebuild its flagship Oxford Street store placed the issue firmly in the public eye and prompted a public enquiry, the results of which are expected shortly after being delayed. Even when there has been approval for works to be demolished, it is normally only on the proviso that low-carbon materials will be used instead.
But how easy is it to utilise sustainable materials in practice? Presently the only sustainable mass-produced material as an alternative to steel and concrete is engineered/mass timber. Steps are being taken to decarbonise the steelmaking process and also reclaim steel, while the construction industry is perhaps a decade away from a truly scalable sustainable concrete solution. Timber is not a perfect alternative for every building, but it is the only material that is currently capable of being carbon negative.
Insurer Sentiment
Insurers, at a strategic management level, are certainly empathetic to the plight of businesses in their efforts towards net zero. There is some appetite to support, but it is coupled with apprehension and uncertainty as to how to translate intention into underwriting. Timber does not present the same risks as steel or concrete and insurers still need to understand what good looks like for sustainable construction.
Insurers remember one high-profile mass timber construction claim in the UK 2014, but there has been nothing related to buildings that use mass timber elements of note since then, which is ironically part of the problem. Without the performance data, underwriters are left unsure of how to price sustainable buildings, and can only rely on trust and science.
A major fire claim on a mass timber building could make or break the industry in terms of insurance. If the fire performed as expected, it would act as a proof of concept – supporting the evidence from large-scale testing and providing insurers with comfort that fires within timber buildings can be controlled and contained to compartments. But the risk remains that doesn’t happen, and it sets the industry back by 20 years.
Yet the government has recognised the need for more timber within construction and a Timber Industries All-Party Parliamentary Group has been consulting with the insurance industry on how this can safely be achieved. But the government moves slowly too, and there is a general consensus that the private sector must take the lead.
The pace of change is ramping up. Sustainable buildings come with a different risk profile; that is undeniable. Yet we have come an awfully long way in the last two decades, and attitudes are moving in the right direction, but insurance doesn’t move quickly either. Not all insurers are the same – a select few are beginning to be proactive in this space, but some are still reeling from losses in the traditional real estate space and there is insufficient pressure or motivation in certain areas.
Insurers are also still learning to trust the construction industry again. In the aftermath of the 2017 Grenfell Fire, building practices emerged that insurers were simply not aware of, and this eroded trust, which is now slowly being accrued, project by project. Bringing new technology into this narrative is challenging, especially when it is competing with known quantities like steel and concrete. Yet insurers have realised that they won’t understand what they don’t ask about, and the market communicates with clients in a way that didn’t happen pre-2017.
The role of the broker has never been more important in articulating messaging around sustainability in construction. Not all insurers are equal and there are pockets of innovation and expertise that we can access on behalf of our clients. Gallagher is a market leader in retrofitting buildings and mass timber, and we are well-versed in finding the right solutions for clients and navigating the insurance market. Please get in contact if you would like to discuss any of the issues raised in this article.
Insurers, at a strategic management level, are certainly empathetic to the plight of businesses in their efforts towards net zero.
There is some appetite to support, but it is coupled with apprehension and uncertainty as to how to translate intention into underwriting.
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