I really don’t want to talk about ESG. (Actually, I do but pretend I don’t to bolster my well-earned reputation for balance…Hah!). ESG is so politically fraught…one person’s lodestar is another shibboleth. Tribal totem of the left and right! You get on the wrong side of this amongst the majority of the chattering class (e.g., any whiff of failure of enthusiasm), and you’ll be uninvited to all of the very best, bougiest cocktail parties. (Okay, I don’t get invited to them anyway.)
Let me set the stage by saying in this commentary, I’m only going to talk about lending, credit and the impact of ESG on the value of debt investments. There are lots of reasons, championed by some and disparaged by others, that we should or must pursue ESG goals. There are substantial constituencies within the polity, both among our elected leaders and the apparatchiki that hold that pursuing E is critical to saving the planet and pursuing S and G are critical to saving our souls. I am disinclined to dive into the epistemological foundations of what we now call virtue and whether commercial real estate participants should or ought to pursue virtue (as distinct from meeting legal obligations and pursuing value) with respect to E and S and G.
Now, let’s be clear. There’s a lot of good stuff for business in the ESG universe. It’s mostly around E. We’ve seen enormous governmental subsidies for “green” technologies…the subsidies for green cars are just the tip of the iceberg. CPACE (and PACE) is the superstar opportunity for real estate as we move further into the ESG universe. CPACE, for all its 50 state and multiple jurisdiction complexity, provides a roadmap to the development of a successful financial product, a clearly understood need and a reasonable (if somewhat painful) clear path towards execution. Dechert, recently obtained a private letter ruling indicating that the IRS will treat CPACE liens as good real estate assets for REMIC. This will open new, probably lucrative and certainly fascinating, opportunities to do E profitably in the commercial real estate space.
Green bonds? Yep, another area for moneymaking. Look, anywhere in the economy where the government socializes loss and allows private gain, it’s a good place to be. This play could be turbocharged if we end up with another Democratic administration.
But this commentary is only about credit and then notions of the market value of financial instruments through the ESG lens.
Let’s go back and pick ESG apart. These three little letters are each encumbered by a significant weight of meaning. Start with E. When people are talking about ESG, they often are really talking about E. E has got the most attention as it has the (largely chimerical) beguiling charm of easy quantification. As the old saying goes, you can’t manage what you can’t measure, and as E can seemingly be measured, there is an alluring metric for those who feel the need to do something!
Telling commercial real estate lenders to pay attention to the E of ESG, to the extent E is tied to property performance, is like teaching grandma to suck eggs. E, in this case, has been a part of underwriting for a very long time. Wetlands? Check. Flood? Check. Fire? Check. Energy efficiency and the impact on operating costs? Check. Environmental contamination, either on the site or attendance to the operation of the tenants in the building? Check. Hurricanes? Got it covered. Coastal flooding? Covered. Earthquakes? Yep. Asteroid strikes, MAGA rebellions and Largely Peaceful Protests? Got it covered! These are all known elements of good, traditional CRE underwriting.
Where this all becomes more problematic is when the conversation moves on to carbon footprints and, let’s face it, when folks are talking the E of ESG, this is usually where the energy (no pun intended) can be found. Carbon footprint is where metrics get dodgy, where it’s hard for multiple observers of a property to replicate outputs. Is it just HVAC? Does it need to account for vehicle usage? How about public transportation? How about the building material fabrication process? Tenant usage issues? Upstream? Downstream? From an operational point of view, there are lots of footprint calculators available online. Easy-peasy! Trouble is, the coefficient of agreement amongst these calculators is low.
We’ve got some law here focused on E and that body of law, designed to restrain, incentivize and disincentivize behavior continues to grow and change.
Disclosure is a key component to playing the ESG game. Both California and certain other states and the SEC (as well as the EU) have weighed into the carbon footprint issue and all include both upstream and downstream carbon footprints and the required disclosure. California says yes, but its rules don’t become effective until 2026 and 2027. Exactly how all this will play out in the contest between state and national law is unclear, but California is a hard jurisdiction to ignore. The SEC backed off its recently issued rule which included Scope 3 Disclosures awaiting the resolution of litigation in the Fifth Circuit.
Other federal agencies, including the banking agencies, are considering how to incorporate E (and perhaps S and G) into their approach to their core function of assessing safety and soundness which heretofore has not included ESG (other than traditional commercial real estate underwriting criteria). Recently, the Federal Reserve proposed new “principals” as to how large banks should manage credit risk with climate risk (adding it to the stress testing, etc.) This aligns with the existing regulatory advice from the other banking agencies and likely will lead to more.
Also noteworthy, the Labor Department just issued a Final Rule allowing plan fiduciaries to take into account E (and all of ESG) “potential financial benefits” when selecting investments. That Rule went into effect in early 2023. Sundry fiduciaries will now have to access the “potential financial benefits” of ESG when making fiduciary decisions. On the other hand, for those plan fiduciaries who have already begun to take ESG into account, this Final Rule might be a balm.
With Chevron decided, we’ll perhaps see more caution and less enthusiasm around the regulatory estate’s penchant for big ideas. Maybe agencies will be a bit more careful with the relationship between regulatory initiatives and underlying statutory laws. But think camel’s nose here. The swell of regulatory action will, ultimately, not be denied.
If the E in ESG is clear (and perhaps measurable), S and G are more challenging. As to S, it’s certainly easy to see the alignment between S goals and low-cost housing, workplace housing, Section 8 housing, etc. It also seems to be clearly about things like co-location of multi-family, retail or job-creating industrial assets near needy populations, populations that need jobs, that need housing and needs access to retail. I get that, so if I put a grocery anchored strip in close proximity to an underserved neighborhood, I should be seeing significant S cred, right? That is easy, but there are harder questions. How does one think about a power plant employing hundreds of workers being co-located with an economically needy population? Good jobs perhaps, but significant negative environmental externalities, how does one balance employment and pollution?
Also challenging, does a building that is not purpose built to meet one of these relatively straightforward S goals have an S profile? Does an office building in Hudson Yards have an S score? Is it S neutral? Can something be S negative? I haven’t seen any credible efforts to articulate any sort of quantitative scale of S-ness.
Similarly, there has been lots of discussion and analysis around G’s alignment with profitability amongst corporate players; there have been studies of Fortune 1000 companies that, putting aside cavils about survey procedures and math, suggest that good G is good for business. Here, we need to distinguish “old G” from “new G.” Old G has a lot to do with the value and performance of commercial real estate loans. It really matters who the borrower is. Just ask anyone who got through the Great Recession. Integrity, experience, scale, expertise, good systems and a good track record of stewardship and management are crucial. But should other things be taken into account? Let’s call all of those things the “new G.” How about a management team that’s inclusive? Does a good DEI policy matter? What if it’s the management team contains underserved constituencies in positions of authority? Are those credit positive? If they have a management team that has a stakeholder focus as opposed to a shareholder approach to governance, is that important? The data is not so compelling here.
If a decision is made to embrace ESG as essentially net positive for credit, or value, then one must confront the extremely thorny question about how to measure ESG and how to convey this information to investors and other counterparties. At the moment, there is a multiplicity of offers on hand from wannabe rating services around ESG, yet there appears to be a relatively low coefficient of agreement (it’s called the Cohen’s Kappa…I looked it up) amongst the outputs of these offerings. That is a considerable challenge to the industry. To quantify the credit impact of ESG, how we quantify ESG should be based on a common set of definitions, common protocols, common agreements on what is measured and how to measure it. The results of one consultant’s analysis of ESG profile should be replicable by others. We are regrettably nowhere near that today. This indeterminacy impacts, in the first instances, how one thinks about the profile of a property to be acquired or financed and how and what information could be conveyed to counterparties in connection with the transaction.
The indeterminacy attendant to a dynamically changing legal environment makes credit and investment decisions around ESG challenging. Moreover, two factors exacerbate that situation. First is the blue state, red state divide. These two separate polities continue to mitosis-ly and myopically divide around ESG issues, making managing a national portfolio and selling financial assets or securities into multiple jurisdictions increasingly fraught. We are already seeing red state public retirement authorities reacting negatively to an investment manager’s commitment to ESG while that same commitment will obtain plaudits in a blue state? How do you deal with that?
Finally, because all things ESG remain a political lightning rod, the evolution of the body of law around ESG will remain extremely sensitive to the changing political winds. The outcomes of the 2024 election cycle might have enormous consequences. The opportunity for confounded expectations in the next few years due to radical changes in the direction of the law and changing market conventions is something that cannot be ignored.
Frankly, when thinking about ESG and commercial real estate lending, we need to tease apart credit and the impact all of this may have on the value of financial assets. They are different things. If ESG characteristics are credit good, that means good ESG scores should increase the likelihood of a borrower to paying its coupon and meeting its contractual obligations and paying off the outstanding principal amount at maturity. As I’ve observed, much of E and G is clearly credit good and it’s been part of commercial loan underwriting for decades. If S really means governmental subsidies, well, that’s good too! But, does a low carbon footprint impact credit? Are the societal goals of a good carbon footprint too attenuated to drive actual credit decisions? If a low carbon footprint is associated with reduced operating costs, then clearly it is credit positive. But if it doesn’t? Still a good thing? As to S and G, the same sort of distinctions can be seen. If it becomes received wisdom that a good G score improves the performance of businesses, then surely the commercial real estate lending market will follow and recognize the credit implications of the good G score. As to S, it can be impactful if tied to governmental subsidies (think low-cost housing, Section 8, etc.) but otherwise, it’s hard to say.
While there is considerable opacity around the relationship of much of ESG to credit, it is clearly already a value metric. If you are a cynic, think tulips. In some respect it really doesn’t matter whether ESG is credit positive if there is a buyer for the product who will pay up for good ESG. The ratings agencies could move the needle here by directly reflecting the calculations of levels to take into account E, S and G, including carbon footprint issues. While all the agencies are rapidly increasing their capacity to provide ESG profile information regarding transactions, at least at the moment none of the agencies would yet say that they’re reflecting the ESG profile into actual ratings attachment points. That’s something to watch. If ratings get a bump for good ESG, that would impact value, right?
It is pretty clear that right now that some (many?) will pay up for ESG even without ratings migration. Green bonds are an obvious example. Will purpose-built exposures to the ESG goals become more than its current niche-y product? The $64 question is whether (or when) we get to a place where ESG is broadly viewed by investment managers, portfolio lenders, banks, securitizers and other market participants as delivering a clear and sustainable premium (to put it another way, assets that don’t have such criteria receive a clear and sustainable discount). Do we get to a point where a good ESG score is absolutely required to make a loan or to sell a bond? I don’t know. Stand by.
The securities laws can put a particularly sharp point on much of this. When securities are sold, either with respect to a pool of financial assets or a pool of underlying real estate assets, investors customarily rely upon covenants, representations and warranties and other assurances of the issuer regarding the condition and characteristics of a property. To the extent a property’s ESG characteristics are material, disclosure will be required and disclosure will carry with it a potential liability. It appears to me to be a mine field.
Anything one says about ESG may subject the issuer (and other deal parties) to liability under the securities law obligations regarding material misstatement and omissions. What if the issuer used the wrong consultant and provided data which is unduly favorable? What if our consultant is looking at the wrong data, embracing the wrong scales? How to deliver information which might enhance the value of a bond or an asset without liability for error? That’s difficult, especially when the data is so messy and the legal and market standards are rapidly evolving. The urge to oversell will be real. The risk of overselling will be real.
My take on all of this is, at the end of the day, we need to engage but with at least a soupcon of caution.
So, here’s my dos and don’ts:
- Obey the law. (Duh)
- Understand the state of play, keep up, monitor developments in law and regulation, understand what market participants are saying and understand what various consultants have on offer. Engaging in the space is not easy. It seems like we’re always trying to catch up to the flood of new developments across the market from changing perceptions of value to new law and regulation. It’s going to take a lot of work to stay on top of this.
- Harvest data along ESG axes and add more E, S and G to the diligence process. You may need this information or want it to generate value, if not today, then tomorrow.
- Be ready to engage in bold change. ESG has and will continue to materially affect the way we do business, but be cautious about venturing too far outside the confines of the herd.
- Be extraordinarily careful regarding securities disclosures. Make it absolutely clear there’s a variety of opinions on all ESG metrics. Be clear on what metrics are used for purposes of disclosure and which were not. Be clear as to what is and what is not a representation. Make puffery clearly puffery. Be clear about promised performances. Be clear there’s a great deal of variability around the conclusions around ESG characteristics and much disagreement around core elements of these concepts and how to measure them
- Get involved in CREFC, MBA, RER or your favorite trade organization to help monitor and implement policy developments. There’s simply too much going on, too much complexity, too many moving parts for all of us to figure this out separately. We need to rely on our trade organizations to help. There’s still a lot at stake in the legislative and regulatory arena, at each of the national, state and local levels and ESG law will remain, for a considerable period of time, a constantly changing landscape. The expertise (and PAC dollars) of our trade organizations is critical important.
- Certainly, consider lending, selling and investing in ESG products where there is a demonstrable demand, and then satisfy that demand. Where the government has socialized risk and allowed private gain, we should participate with a smile. CPACE is the superstar here. This looks like a robust new product in the CRE space where everyone (at least everyone trying to make a buck in real estate) can get behind) can get behind this new product, this new regulatory regime. Green bonds? Certainly! But, don’t get over your skis. The rules of this game remain mutable.
At the end of the day, make sure that the greeniums are worth the grisk.