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Global real estate and ESG: How the EU, UK and US are responding to the climate crisis

13 April 2023

With governments across the globe warning that action is urgently needed to diminish global warming and address the climate crisis, we look at the response of the EU, UK and US, with a focus on real estate. Climate damage is making itself felt harder and faster than previously thought and the global temperature will not stop rising until carbon emissions reach net zero. How can the real estate industry help to achieve this goal and how is this being put into practice across the globe?

In Europe, the EU Taxonomy Regulation and the European Sustainable Finance Disclosure Regulation together with their delegating Acts are intended to create uniform EU-wide requirements for achieving the goals of reducing CO² emissions and curbing global warming. At the same time, a large number of EU directives have been issued that allow individual EU countries some leeway in implementing climate targets. Crucially, on 14 March 2023 the European Parliament adopted in its Plenary sitting the ITRE Report on the revision of the Energy Performance of Buildings Directive, which will represent a milestone in the decarbonization of the buildings sector for EU countries. This represents a decisive step and will seek to reduce building related emissions throughout a building’s entire lifecycle.

While there is a single climate target that Europe should become climate neutral by 2050 and cut at least 55 per cent of greenhouse gases by 2030 compared to 1990 levels, the way in which this target and the directives are implemented varies in different EU countries and this also differs from the strategies adopted in the UK and US. The following article provides an overview of the approaches taken by different countries.

United Kingdom

The UK is ahead of much of Europe in implementing legislation on minimum energy standards.

Since 2018, for example, commercial properties (non-residential buildings) must have an EPC rating of at least E before they can be subject to a new lease.

From 1 April 2023, the Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 were extended. Non-residential buildings which have an energy efficiency rating below E may no longer be let unless a statutory exemption applies or the building is excluded from the scope of the legislation. The energy efficiency requirements for non-residential buildings are now to be increased even further. The British government is aiming for a minimum rating of B for all rented non-residential buildings by 2030 and proposes a rating of C by 2027 as an interim target.

With the April 2023 deadline now in place, many landlords have now retrofitted their buildings so that they can demonstrate an energy efficiency rating of E. However, further investment is needed to meet the 2027 and 2030 targets.

The exemptions and limitations of the Energy Efficiency Regulations offer some relief to landlords, especially in relation to listed buildings or where all possible energy efficiency improvements have already been exhausted. Another exemption exists if landlords do not obtain consent from, for example, their tenants to carry out the work or if the cost of the improvements is not cost-effective. Utilised exemptions must be recorded in a publicly accessible register and are subject to a review every 5 years. Landlords who fail to comply with these regulations face significant fines, which increase the longer the breach has been in place.

Last year the UK also saw a much-needed review of the way in which the carbon factor is measured in EPC ratings for buildings, to take account of the increased contribution of renewable energy sources in the production of electricity (although the use of gas in a building can now mean a lower rating). There are also proposed changes to the ways in which energy efficiency is monitored in large commercial buildings (with the outcome of a consultation on the same awaited from the UK government), to further improve the energy performance of the UK built environment.

Another milestone for achieving the climate targets is the introduction of the UK's Sustainable Disclosure Requirements ("SDRs"), which are currently under discussion. The UK Financial Conduct Authority has commented on the proposals and is expected to publish its final requirements by Q3 of 2023. The SDRs will be comparable, but not identical, to the European Sustainable Finance Disclosure Regulation ("SFDR"). This presents a challenge for real estate funds operating in both the UK and the EU. The UK regulation will introduce a labelling scheme for funds, which is intended to ensure that retail investors can have confidence in the products on offer. It is also intended to combat any green washing.

Germany

Monitoring compliance with disclosure requirements and the question of existing investment obligations to achieve climate targets - these are important topics of discussion in Germany.

In the financial services sector, the Federal Financial Supervisory Authority ("BaFin") has been monitoring compliance with the Sustainable Finance Disclosure Regulation in conjunction with the Taxonomy Regulation since March 2021 in order to avoid "greenwashing" of financial market participants. The Fondsstandortgesetz ("FoStoG"), which was announced on 10 June 2021, also stipulated that auditors must check compliance with the requirements of the Taxonomy and Disclosure Ordinance on behalf of BaFin. To this end, BaFin, in consultation with the Institute of Public Auditors in Germany ("Institut der Wirtschaftsprüfer", "IDW"), prepared a practice note for auditors at the end of 2021, which is intended to provide them with guidance in the implementation of their tasks.

The EU Energy Performance of Buildings Directive was implemented in Germany in 2020 by the "Building Energy Act" (GEG). The initial requirements for the permissible annual primary energy demand of existing buildings and new buildings have now been increased by an amendment to the GEG, which came into force on 1 January 2023, to the effect that in future every new building must meet an efficiency standard of 55 percent instead of the previous 75 percent. From Germany's point of view, this represents a further milestone in achieving the EU's "Fit for 55" target of reducing net greenhouse gas emissions by at least 55% by 2030.

However, the revision of the Energy Performance of Buildings Directive, which is now under discussion, also requires a further tightening of the regulations in Germany, especially in relation to existing buildings. A further amendment to the Energy Performance of Buildings Act, which will stipulate an efficiency standard of 40 for new buildings, is already being planned for the beginning of 2025. This will be accompanied by the introduction of new energy certificates with an A+-A0 - G rating.

The obligation to install photovoltaic systems on all suitable roof surfaces on new buildings or in the course of any substantial roof renovation has also been successively introduced, albeit with individual differences in the various federal states. In addition, the German federal government has issued various directives with which, for example, measures to increase energy efficiency or investments by industry with regard to the provision of process heat from solar collector systems are financially supported.

Nevertheless, it is to be expected that further legal requirements will be enacted in order to achieve the goal of making Europe greenhouse gas neutral by 2050.

Netherlands

In the Netherlands, Dutch pension funds have led the way with their ESG policy, which is now being adopted by other companies. To make their organisations and portfolios more sustainable, companies have to comply with a growing number of laws and regulations. Various new legal and regulatory requirements came into force on 1 January 2023. Due to the many legislative initiatives in this area, the direction of travel is clear and we can expect requirements will be further increased over time.

The requirements that came into force on 1 January 2023 include the obligation from the Building Decree (Bouwbesluit), which stipulates an energy efficiency class of A, B or C for office buildings. There are exceptions, among others, for listed buildings, for office premises with less than 100 m² floor space and for office premises where the costs for the sustainability measures cannot be amortised within ten years.

On 1 January 2023, 10% of office buildings in the Netherlands had a rating of D or worse and 35% of office buildings had no rating at all. The municipality where the property is located can now order that the use of these buildings be stopped until a rating of C or better is achieved. However, other measures are usually taken first, such as administrative warnings, punitive orders for non-compliance and other administrative enforcement measures. By 2030, however, office buildings must have an energy efficiency rating of A.

We expect that the scope of this legislation will be widened to other asset classes in the future. Market participants are already increasingly focusing on the issue of sustainability, and the demand for green (certified) buildings is becoming more and more important when buying, renting or financing real estate in the Netherlands as well.

In the area of corporate governance, the Dutch Corporate Governance Code ("DCGC") has been updated with effect from the financial year beginning on or after 1 January 2023. The Executive Board as well as the Supervisory Board of listed companies shall focus on sustainable and long-term value creation when setting strategy and making decisions. While the DCGC only relates to listed companies, the Corporate Sustainability Reporting Directive ("CSRD") , which is to be implemented at a national level, affects a wider group of companies and the reporting requirements will increase significantly. In this respect, all companies subject to the Directive will have to start reviewing their reporting strategies and possibly adapt their bylaws and company rules to the requirements of the Directive.

Italy

The most discussed topic in Italy at the moment is the revision of the Energy Performance of Buildings Directive referred to above and its future impact on the market.¹

While the adoption of the first draft of the Directive by the Commission in July 2021 has gone relatively unnoticed, the imminent adoption of the final revised version has triggered unprecedented debate among both institutional investors and private homeowners. Many are wondering whether they can be forced to carry out maintenance measures in order to comply with the Directive and whether non-compliance can lead to the property becoming unrentable and impossible to sell.

Firstly, it should be clarified that the Directive is still in the approval process. The next steps for adoption are expected to be completed by mid-2023. It goes without saying that (i) until adoption, the provisions of the draft may be amended; and (ii) after adoption, the Directive must first be transposed into national law of the individual EU Member States to become effective.

In order to achieve the goal of an emission-free building stock by 2050, Member States are required to take the necessary measures to ensure that both new and existing buildings meet the minimum requirements within certain deadlines. According to the latest available draft of the Directive, new private buildings should be emission-free from 1 January 2028; existing residential buildings must achieve energy efficiency class E by 1 January 2030 at the latest and energy efficiency class D by 1 January 2033.² These targets, if confirmed with the above deadlines for implementation, are likely to be very challenging in a country like Italy, where the building stock is generally very old and low performing. According to assessments, 75.4% of Italy’s national building stock falls into classes E, F and G.

Many are therefore asking themselves in particular whether there will be exceptions, especially for the old stock, and what possible sanctions violations will entail.

According to the draft Directive, buildings that are or will soon be protected by law due to their historical or cultural significance, as well as buildings constructed on land under landscape protection, are excluded. The recitals of the draft Directive also allow Member States to set different criteria for achieving performance classes for buildings that have historical or architectural significance but are not officially protected.

In Italy, therefore, consideration is being given to how these provisions can be integrated into the Italian legal system, as there are different types of heritage protection in Italy (national requirements or requirements set by local planning regulations) and the landscape is also protected at different levels. The limitation of the exemption to national listed buildings is not considered sufficient in the public debate, as the number of listed buildings is limited and they are mainly owned by public institutions.

On the question of possible sanctions, the Directive does not provide per se for sanctions for non compliance; newspaper comments about possible restrictions on the sale or rental of premises that do not meet certain requirements (as currently provided for in the national regulations of other countries) are unfounded, as these restrictions could only be introduced by national legislation (which, according to the current debate in Italy, is unlikely to be the case).

While many industry players have expressed concern, others have stressed that the new directive offers a unique opportunity to bring buildings up to a new level of energy performance, especially because of the advanced age of the Italian building stock.

The debate in Italy is now likely to shift to the incentives to be granted to achieve the targets. This could be a major challenge in a country like Italy, where the 110% tax deduction bonus for certain renovation works, introduced two years ago encountered major difficulties in its practical implementation.

Poland

Currently, about 300 companies in Poland are subject to ESG reporting requirements. In the coming years, the number will increase to about 3,500 companies due to the new regulations for non-financial reporting. In Poland, more and more market participants are interested in behaving in a sustainable manner and also require this from their business partners, which is particularly evident in financing. However, there is still a large group of companies in Poland that do not have sufficient knowledge regarding ESG regulations.

The Corporate Sustainability Reporting Directive ("CSRD"), which is expected to be implemented in July 2024, poses significant challenges for companies. These challenges include the lack of long-term commitments, adequate policies and processes, management and oversight structures, board-level accountability and a systemic approach to ESG data collection and analysis.

A good example is the Polish Stock Exchange ("GPW"), which has produced an ESG guide to help listed companies prepare their first non-financial reports. Some ESG elements are also included in their "code of good practice".

In the real estate sector, building certification is increasingly becoming the standard in Poland as far as institutional ownership structures are concerned. In addition, one can see a growing market interest in green leases. This trend will become more and more pronounced due to the sustainability (or at least renewable energy) requirements that landlords and developers are placing on buildings, such as the installation of rooftop photovoltaic systems, as also seen in Germany.

Another main topic in Poland at the moment is EPCs for buildings, which implement the provisions of the Energy Performance of Buildings Directive. The proposal to revise this Directive is also receiving a lot of attention, as we are also seeing in Italy. The building sector in particular is in favour of the proposed changes, pointing out that improving buildings will, among other things, lead to lower costs for consumers and that building renovations are necessary.

U.S.

The US is tackling the climate crisis by offering tax incentives to real estate owners to install and generate renewable energy. The most important piece of legislation on this has been the Inflation Reduction Act, which was passed in 2022 and became the nation’s largest investment to date in combating climate change. The US estimates that the IRA will provide approximately $370bn (£306bn) in incentives.

The most meaningful of those incentives for real estate owners are (i) the investment tax credit and (ii) the production tax credit, which each apply to both commercial and residential real estate.

The ITC encourages real estate investment in solar, wind and other kinds of renewable energy through a one-time credit available at the time that a qualifying project is placed in service. The ITC base credit is equal to 6% of a taxpayer’s cost basis in its eligible property but can be increased to 30% if certain apprenticeship and prevailing wage thresholds are met with respect to the construction, repair or alteration of a project. In contrast, the PTC is an ongoing 10-year credit for the generation of renewable electricity at a qualified facility.

The PTC base credit is equal to the kilowatt hours produced and sold, multiplied by a factor of $0.03 (£0.02), subject to inflation adjustments. The PTC can be multiplied by five if the above-mentioned apprenticeship and prevailing wage requirements are satisfied.

These incentives can be supplemented by additional 10% tax credits in areas that have historically been tied to sites that generate non-renewable energy, such as brownfield sites, areas that employ or derive substantial tax revenue from non-renewable energy sources, and areas where coal mines have closed. Other “bonus” credits can be stacked onto a project, such as a 10% ITC bonus for wind and solar projects located in low-income communities or on tribal land.

On the residential side, the IRA also aims to make energy usage more efficient to reduce energy needs. For example, residential developers can receive credits of $2,500-$5,000 for each qualified dwelling unit that is sold or leased.

From industrial projects to commercial spaces and homes, the IRA is encouraging the development of new energy infrastructure and the reduction of energy usage through the use of tax incentives.

Conclusion

While the challenges and the approaches adopted undoubtedly vary across the globe, it is clear that the Real Estate industry in Europe, the US and the UK is very much rising to the challenge of reducing carbon emissions and the legislation coming down the pipeline and concrete steps being taken very much tie in with the ESG considerations which remain high on the industry’s agenda and looks set only to increase in importance.

Authored by Jackie Newstead, Sabine Reimann, Kerstin Schoening, Josh Savage, Carola Houpst, Katarzyna Debinska-Pietrzyk, Maria Deledda, and Ingrid Stables.