What German developers need to know: The impact of ESG rating on commercial real estate

Development in Germany is governed by both the German Federal Building Code and State building regulations. Where a zoning plan exists, development is permitted if it does not conflict with that zoning plan.   Otherwise, the rules governing building in inner-city and undesignated outlying areas apply. However, these provisions only regulate the physical development, not its sustainability credentials. For the construction of most buildings, the relevant technical regulations must be complied with. These technical regulations also include the German Buildings Energy Act which came into force on 1 November 2020. This law serves to implement various EU directives relating to the total energy efficiency of buildings and to promote the use of renewable energy and eco-friendly construction.

Environmental, Social and Governance considerations apply to real estate funds and to assets that become part of "green funds". Demand among investors for opportunities that meet ESG criteria has sharply increased.

The Paris Climate Agreement set out climate goals which has driven the ESG agenda. The Agreement was followed by the EU Green Deal, which was announced in December 2019.  The Green Deal refers to EU directives and delegated regulations of the European Commission on climate change mitigation. These include the Sustainable Finance Disclosure Regulation, in force since March 2021, and the Taxonomy Regulation, in force since July 2020.  These form the legislative core of the ESG requirements for the finance industry.

The Taxonomy Regulation was aimed at creating a classification system for ecologically sustainable economic activities. On 1 January 2022, this was supplemented by the Commission Delegated Regulation. To be an ecologically sustainable economic activity, it must: (1) make a substantial contribution to climate change mitigation; or (2) create climate change adaptation; and (3) not harm any of the other environmental objectives. The Regulations provide broad climate goals and numerous technical standards including some for the real estate sector. These apply not only to the construction and refurbishment of buildings but also to facility management.

The question is whether these rules are binding on new developments. Although not directly applicable, to the extent that the Directive has been implemented into German law, it applies to everyone. However, it is advisable to be familiar with the Directive itself because what is being planned and built today may be sold in 2–3 years' time. Currently, it is clear that the EU's objective of creating long-term incentives to (re)direct financial flows to developments having a positive environmental impact, is working.

For the reporting year 2022, all financial products, including real estate funds, which do not pursue a sustainability strategy will have to make the following disclosure: "The investments underlying this financial product do not meet the EU criteria for environmental sustainability". Companies are unlikely to want to include this statement. Even now, investors are examining whether real estate that is to be purchased or leased, meets ESG criteria. If they don't, investors may face the consequence of future price reductions or voids. This raises the question of what specific requirements real estate must meet in order to be ESG-compliant in the future. 

The issue is that the legislation does not specify the exact percentage of the investment product which must be sustainability invested. Instead, E, S and G are lumped together. Investors are particularly advised to examine what elements of E, S and G the investment focuses on.

Real estate can score on many counts in the E category. The S and G criteria relate to use and are constantly changing in real estate, as both the type of use and the occupiers do not stay the same. The S and G criteria may no longer be met in the future if there is a change in occupiers and/or ownership structure.  The ESG rating can vary depending on how the individual criteria are weighted.

With respect to E, four criteria must be met pursuant to the Taxonomy Regulation:

1.      substantial contribution to one or more environmental objectives;

2.      no significant harm to a/another environmental objective;

3.      compliance with minimum safeguards; and

4.      compliance with the technical screening criteria.

The Taxonomy Regulation provides six overarching environmental objectives, namely climate change mitigation, climate change adaptation, the sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, and the protection and restoration of biodiversity and ecosystems.

For real estate development, the building must meet the requirements of the German Buildings Energy Act. However, this only covers the statutory minimum requirements that apply to climate change mitigation in Germany. The criteria developed by the German Federal Government for new construction, already meet almost all the E criteria of the Sustainable Finance Disclosure Regulation and the Taxonomy Regulation, and also some of the S and G criteria.

Compliance with the requirements of the government's sustainable building seal of quality also satisfies a significant amount of the ESG criteria.  This seal of quality is  important to investors, as it is a state seal of quality for buildings that provides independent proof of compliance with the ecological, socio-cultural and economic quality.

Much the same applies to building certificates issued by the German Sustainable Building Council.   The difference being that, conformity with the GSBC's certificate is independently audited.  The LEED and BREEAM building certificates are similar but have a different focus and, in some cases, lower requirements. Developers are, in any case, advised to check as part of the development whether a building should be certified as part of the construction process.

Ensuring compliance with ESG criteria generally begins at the planning stage. Developers should calculate how much of the existing structure of a building will be retained and to what extent this has a positive effect on the CO² balance compared to demolishing the building and constructing  a new one. For new buildings, to comply with the second criteria set out above, at least 70% of the construction and demolition waste must be either separated or recycled. This must be properly documented.  

Proof of the quality of the construction materials is also important. At a minimum, all building materials must meet the criteria set out in regulations.  In particular these include bans on polluting materials such as Mercury.  In any case, documentation should include not only the percentages by weight and subcontractor certificates, but also proof of the origin of the building materials used and their certification marks.

Once built, the building systems should allow measurement of energy use. Measurement requirements should be reflected in the leases, and, for data protection reasons, the tenant must consent to this.  Green leases typically provide for this. Once energy use can be measured,  owners can consider introducing more energy efficient measures in the long term.

The EU recommends energy efficient building automation and control systems, thermostats and intelligent monitoring of electricity and heat loads as well as heat metering and the installation of sensor equipment. This must also be observed when looking at the S criteria regarding occupier health and well-being. Landscaping can increase the environmental rating, in many cases at a low cost. The planting of vegetation in a previously sealed inner courtyard, the use of native plants and the installation of nesting aids and insect hotels is usually more aesthetic than additional parking spaces. 

In summary, parties are advised to ensure extensive documentation of ESG measures, and to check in advance the criteria of any desired certificate or rating system and how the criteria are weighted. The costs of consulting an ESG specialist, particularly for the E and S criteria are justifiable.  Care should be taken to ensure thorough documentation from day one since obtaining documents and/or collecting data at a later point in time can be difficult. When letting premises, it is important to consider the permitted use of the premises and whether any G objectives could be undermined as a result of that use.

Authored by Sabine Reimann.