The Value of Green Financing for the Built World
With companies and governments making ambitious pledges at COP26, there has undoubtedly been a recent uptick around the climate risk narrative and drive towards sustainability as part of the ESG discourse. Of note also is the evolving definition of sustainability and how that has changed.
Capital and Financing Trends for the Built Environment
Five years ago, the built environment defined the achievement of 10%-15% energy reduction per annum as adequately sustainable. Presently, it’s about what the sector needs to do to get to net-zero by 2050. This is clearly more difficult when it was previously about not sitting still. At $326.5 trillion, worth almost 4x of Global GDP,1 the financing landscape for the built environment sector is poised for change with financial markets and fund flows increasingly directing capital towards companies that guarantee the achievement of Sustainable Development Goals (SDG) in addition to economic profitability.2
To date, over 160 Fortune 500 Global Companies have made net-zero commitments. Looking ahead, every company will need to craft a net-zero strategy where their building’s carbon footprint will constitute an integral part of that strategy to deliver on net-zero commitments made to stakeholders. These stakeholders include investors, the media and NGOs that will focus on the tough questions, namely the quantum of climate risk exposure and the net-zero strategy adopted to mitigate these risks. Simply put, the immobility of the built environment sector’s assets warrants the industry to think hard and objectively about ascertaining and mitigating the true climate risk around the assets they own.
Change Management through Technology
We observe that several of these companies, including but not limited to Real Estate Developers, have built out their Sustainability Teams and hired CSO’s to get the messaging right. But we are all cognizant that producing a nicely formatted ESG addendum within the annual report is an easy lift compared to the genuine change management that has to occur from within, including but not limited to technology adoption.
The owners of built environment assets will have to reconceptualize themselves into sustainability companies and go through a eureka moment where smart technologies deployed for net-zero purposes are new potential revenue models instead of mere cost items. Moving from this legacy business model, digital adopters within the built environment industry will ease their access to capital and various forms of green financing in a capital market setup that is increasingly discerning and dynamic around the pricing of climate risks.
Determining the Cost of Green Financing
The cost of financing is usually reflected in the weighted average cost of capital (WACC) or the borrowing rate. On the bond side, the spread between higher quality green bonds versus non-green bonds would be around 2-3 basis points (BPS). The spread gets disproportionately wider for the bonds with materially lower credit ratings. Institutional investors like GAM and Robeco are understood to flex the cost of capital by 15-25 BPS to discount cash flows. However, this may differ based on sectors and as the vagaries around climate risk become better defined.
On the built environment side, the spread on the cost of capital between a “green” and “brown” building in 2020 was estimated to be c. 50 BPS by Fifth Wall. Real estate is an asset-heavy business model and hence, a cost of capital-driven business. A discount rate that is lower to the tune of 50BPS will have a material impact on asset values and the future cash flows associated with those assets.
In addition, the World Green Building Trends report has shown that about two-thirds of owners and developers believe that greening a building will increase its asset value by 6% or more.3 For developers and investors, this trend creates a clear business case—realizing both economic and environmental benefits for the built environment are not mutually exclusive. It is no wonder that Larry Fink, the CEO of Blackrock, has linked climate risk as synonymous with investment risk. Specifically for the built environment, forgoing an opportunity to digitize and decarbonize buildings is an opportunity forgone to unlock long-term value for investors and stakeholders.
The Challenges and Opportunities for Green Finance
ESG reporting has been the mainstay of corporate disclosure to assuage public markets and stakeholders that tangible action has been adopted towards climate risk and utilized to justify access to sources of green finance. The primary challenge here is that the reporting landscape has constantly evolved with continual reporting methodology and frameworks changes. There are also too many standards where corporates end up choosing from an “alphabet soup” selection which precludes investor comparability. Corporate leadership will have to support the drive towards sustainability reporting as a journey in overall enterprise risk management and process refinement instead of a short-term reporting exercise to distinguish themselves in front of investors, both current and prospective.
The lack of comparability in ESG reporting is also playing out in the ratings ecosystem, which are used as proxies for investors to gauge business sustainability practices. The ratings landscape currently resembles the “wild west” where different firms derive their own proprietary ratings methodology and tiering with each firm unwilling to disclose their methodology’s calculus publicly. The lack of clarity around rating methodology construction is perpetuating further incomparability, which clouds investor benchmarking exercises. While it is understood that at least 50% of global asset owners are currently implementing or evaluating ESG considerations in their investment strategy by 2025, the level of senior management and Board of Director buy-in is also critical. Change management will have to be driven from the top. It would be superfluous to have a fully decked out Sustainability Team when the Board and C-Suite’s do not allocate adequate bandwidth to embed sustainability within its various business processes.
Access to green financing and global capital is a competitive exercise that corporates in general and players in the built environment will need to jostle for daily. Industry captains within the built environment need to rationally evaluate how they can be sufficiently forward thinking to navigate the spectre of climate risk, the evolving requirements of ESG reporting, and the transformational effects of technology on their business models, to ensure adequate access to capital markets which are increasingly looking to allocate capital to green and sustainable investments. Undoubtedly there will be costs to businesses, but senior management thinking must transcend beyond fixating on near-term overheads and compliance costs to unlock superior long-term value for all stakeholders. For these stakeholders will expect no less.
Strategic Sustainable Practices as Business Opportunities
Companies should not be deterred by going green and explore ways to decarbonize their buildings footprint for a sustainable built environment. If you are exploring how to future-proof your buildings against Climate Risk, you may wish to reach out to the Switch team.
Talk to a smart building expert to learn more about how Switch helps portfolio managers reach their sustainability goals.