Request Free Trial
August 31, 2023

Regulation and data issues blamed for UK commercial property’s slow progress on net zero

Commercial real estate London
Difficulties in obtaining ESG data, unclear planning guidance, and a historic lack of government attention are seen as hampering the commercial real estate sector’s environmental goals (Photo: Chris Ratcliffe/Bloomberg)

UK commercial real estate emissions have remained broadly flat over the past decade, while investors and policymakers wrestle with how to decarbonise the sector.

Policymakers in the UK are pushing to rein in the greenhouse gas emissions generated by commercial real estate, as the sector prepares to meet progressively harder minimum energy efficiency standards in England and Wales by the end of the decade.

Around a third of the world’s final energy – that used by end consumers, like households and industry –  is directly consumed in buildings, largely for heating space and water, with more than 64 per cent of this sourced from fossil fuels, according to a report by academics from the University of Oxford and Ghent University. With the UK having made a legally binding commitment to achieve net zero emissions by 2050, legislators have been forced into action over buildings’ energy consumption.

While the lion’s share of buildings’ emissions are generated by residential buildings in the UK, commercial real estate has made heavy work of slashing its greenhouse gas emissions. By 2020, commercial property had cut its annual emissions by only 5 per cent compared with 1990, according to real estate group CBRE, while in 2019, the sector’s emissions were 2 per cent higher than those experienced in 1990.

This compares poorly with the gains made by residential property, which by 2019 had seen emissions fall by a fifth compared with 1990.

Difficulties in obtaining ESG data, unclear planning guidance, and a historic lack of government attention over commercial real estate are seen as hampering the sector’s environmental goals.

“Trying to manage a portfolio efficiently from a physical standpoint – not just to make sure that the building holds up, but for net zero – is a totally new challenge for the commercial real estate market,” says Kathryn Janda, a principal research fellow in organisations and non-domestic buildings at the Energy Institute, University College London.

There are, however, commercial incentives for improving the green credentials of commercial real estate.

“Commercial tenants – many of whom have their own sustainability and net zero targets to meet – have their own requirements for low-carbon design,” says Polly Firman, sustainability associate at infrastructure investor Actis. “By offering customers a renewable or low-carbon power supply in a more resource-efficient building, landlords can attract top-tier tenants and secure greater value from their assets.”

Lack of access

The UK, the US and the EU are all legislating to improve data availability for financial markets with greater disclosure requirements, which will fall on the real estate industry.

But a lack of access to ESG data is undermining the sector’s efforts to decarbonise. Data privacy concerns, poor transparency from building owners or managers, or merely a lack of interest are responsible for difficulties in obtaining this data, according to a note by the European Association for Investors in Non-listed Real Estate Vehicles.

“Both the listed and private real industry have not been very capable of making public to the market what ESG data points should be available,” says Egbert Nijmeijer, co-head of real assets at wealth manager Van Lanschot Kempen. This data includes information covering carbon emissions, social impact and governance, he adds, observing that regulators are working hard to make this data available.

“It’s a burden for the financial industry and the real estate industry – but at the same time this data needs to become available, otherwise we cannot steer investments in sustainability,” Nijmeijer says.

Transparency over ESG can also have an impact on deals, with data helping to attract “green premiums” for buildings. “If you’re able to put everything out there in the open, you can let the market decide,” says Jonathan Hale, head of ESG consulting at real estate consultancy Knight Frank. 

This can include data on buildings’ progress towards decarbonisation and the capital expenditure involved, enabling investment teams to build models that sometimes enable preferential terms on debt, he adds.

“The market [is] favouring transparency over nasty surprises, which can then lead to brown discounts, and when you’re in a deal scenario, you probably want to make sure that you’re presenting the asset fairly and obviously looking to get the best return.”

The risk of litigation with respect to claims regarding buildings’ environmental credentials is also on the horizon, Hale says. “I hope no one will get found out, because I honestly believe that the sector’s moving in the right direction, but there will be [a few] transactions in the next two to five years that will be questioned,” he adds.

Missing net zero guidance

The anticipated arrival of rules that will compel commercial properties in England and Wales to have a minimum energy performance certificate of C in 2027 and B by 2030 (where A is the highest rating) is tightening the screw on commercial real estate asset owners. 

The Minimum Energy Efficiency Standard regulations “are causing a headache to our clients, largely because there’s a need for guidance and concern with the ratings potentially going up in 2027 and 2030”, says Rebecca Davison, partner at law firm Howard Kennedy.

Existing rules governing building planning applications, meanwhile, are creating confusion in the market, with the government facing calls for further clarification, says Mark Harnett, partner at law firm Fladgate.

He points out that the term “net zero” is not present in the guidance followed by local authorities when they consider planning applications, which instead refers to a need to transition to a “low-carbon future”.

Last year, an inspector appointed by the UK government rejected a proposal by West Oxfordshire District Council to introduce a net zero requirement into its development plan, partly because doing so was inconsistent with national planning policy. 

In July, however, a planning application for the demolition of a celebrated London store belonging to retailer Marks & Spencer was rejected, along with the planned construction of a replacement building.

A key reason for the decision was that the demolition of a structurally sound building was viewed as contrary to national planning policy because of the loss of embedded carbon. Also known as embodied carbon, this refers to the greenhouse gases emitted during the construction of a development.

Although national policy does not specifically address embedded carbon, Michael Gove, the secretary of state for levelling up, housing and communities, decided that the demolition was contrary to the need to transition to a low-carbon future and national policy encouragement for the reuse of existing resources.

“There have been calls for the government to introduce ‘net zero’ as a central theme in its national planning policy so that it then becomes embedded in local authority development plans when they are updated and is properly taken into account when applications are considered,” Harnett says. “At present, confusion reigns.”

Too complicated 

The government’s ability to use regulation to drive the commercial real estate sector towards decarbonisation is, however, up for debate. 

“You cannot legislate something that is this complicated effectively, because one size does not fit all, and government needs to be fair,” says UCL’s Janda. “It makes sense that regulation is actually something that cuts off the worst part of the market, it does not encourage the best part of the market. It’s just not that kind of a tool.”

It may therefore fall upon investors to take the lead on ESG in commercial real estate. While some asset managers are vociferous over the ESG improvements they have made to their buildings, other owners have overlooked the need to upgrade their property. Buildings that have been victim to underinvestment leave owners exposed to transition risk. 

New net zero regulations could have a significant impact on real estate valuations if a landlord has historically underinvested in capital expenditure, potentially making buildings impossible to lease or leaving landlords faced with increasing vacancy rates and declining rents.

“Capex has been underestimated by some landlords in the past,” says Nijmeijer at Van Lanschot Kempen.

While buildings that fail to meet environmental requirements pose a real risk to their owners – with owners of buildings breaching the new MEES rules for more than three months facing a maximum penalty of £150,000 – less green buildings also present an investment opportunity.

“Lenders are understandably concerned not to compound the risks present in their existing lending books by underwriting new loans on assets which do not comply, or can’t be brought into compliance economically,” says Richard Vernon, group head of real estate for Emea and US at law firm Ashurst. 

“Where properties can’t meet this threshold they will quickly become stranded assets, and values will fall significantly. Some opportunistic investors are already lining up funds to acquire such assets for repurposing or redevelopment,” he adds.

A service from the Financial Times