The growing popularity of sustainable real estate funds means that UK fund managers will need to embrace the Sustainability Disclosure Requirements (“SDR”) issued by the Financial Conduct Authority (“FCA”) on November 28 2023. This new regime establishes labelling and disclosure rules to govern the way in which funds may be marketed with regard to their sustainable or impact credentials. The SDR regime raises the bar compared with equivalent regimes of other jurisdictions and marks the UK out as a global pioneer in this area.
In order to assist managers to equip themselves for SDR, I set out two simple key recommendations below.
Become familiar with SDR
At the risk of stating the obvious, managers must make sure that they are thoroughly familiar with SDR. The FCA states that its SDR “aim … is simple – financial products that are marketed as sustainable should do as they claim and have the evidence to back it up”. The SDR package “has consumers at its heart”, with elements of the regime also applying to professional or institutional investors. What may not be so obvious is the fact that SDR must be embedded throughout the fund manager’s organisation. SDR is for all staff, not only for ESG specialists.
While the 200+ page SDR Policy Statement may appear daunting, the FCA has indicated both that SDR is a “a simple, easy-to-understand regime” and that the regime is founded on light-touch principle-based regulation. SDR investment labels are real estate user-friendly. This avoids the dangers of different market participants inventing their own labels linked to disclosure requirements in Articles 8 and 9 of the EU’s Sustainable Finance Disclosure Regulation (“SFDR”).
SDR runs with four investment labels: each subject to a 70% minimum threshold. Importantly, the labels are not designed to be in a hierarchy: “each is designed to deliver a different profile of assets” and investor preferences. The main elements set out below include two helpful examples (based on proposals I submitted to the FCA) in which the FCA expressly refers to real estate applications:
- Sustainability focus: invest in assets that are environmentally and/or socially sustainable, determined by a robust, evidence-based standard of sustainability like a ‘Green Future Emerging and Frontier Market LTAF’ which aims “to achieve capital growth over the long term and a positive environmental impact by investing in climate themes that contribute towards the mitigation of climate change and adaptation of society to negative impacts of climate change” that invests in “resilient real estate”.
- Sustainability impact: achieve a pre-defined positive, measurable environmental and/or social impact – with an example of a ‘Social Impact Real Estate Fund’ that “aims to provide capital and income growth through investing in and owning socially positive real estate assets” and focuses on alleviating homelessness.
In relation to the other two labels, I suggest examples which can usefully be adopted for real estate strategies:
- Sustainability improvers: invest in assets that have the potential to become more sustainable, determined by their potential to improve environmental and/or social sustainability over time. An example of this might be a real estate fund that attracts institutional capital for net zero transition strategies: retrofitting or refurbishing ‘stranded’ underlying assets into ‘green’ buildings and applying best practice transparent, consistent and verifiable metrics.
- Sustainability mixed goals: invest in assets that meet or have the potential to meet a robust, evidence-based standard for sustainability, and/or invest with an aim to achieve positive impact, which does not fit into the previous three categories. An example, I suggest, is a fund that holds a mixture of sustainable and transition real estate assets.
In addition, as I have advocated, the real estate sector must reduce greenhouse gas (“GHG”) emissions – each of Scopes 1, 2 and 3 – from fund promotion through to fund structuring and operations. This approach could have various practical consequences. By way of example, if a UK fund manager promotes a fund’s sustainability credentials, that manager may prefer to operate the fund in the UK (rather than on a cross-border basis). Real estate fund managers that boast about their products’ sustainability credentials must ensure that they do in fact operate the funds sustainably (including with regard to emission efficiency).
Be prepared for SDR: sooner rather than later
The FCA indicates that fund managers can begin using the labels from July 31 2024, with disclosures 12 months after the label is first used. From December 2 2024, detailed on-demand disclosures should be provided to relevant clients.
The market can, of course, act in advance of these deadlines; and there may be good reasons for doing so in terms of institutional investor demand and market dynamics. Whether or not a real estate fund manager has to comply with SDR and/or SFDR, there may be a ‘pull’ and ‘push’ dynamics from institutional investors, particularly non-European global investors. It raises the interesting question going forward – what will institutional investors prefer: SDR or SFDR? There may be an investor market:
- SDR pull – they consider SDR investment labels user-friendly (in particular, embracing transition strategies), more precise, and offering clear and stable benchmarks when assessing whether to commit in real estate funds: commitments expected to apply on a medium- or long-term basis.
- SFDR push associated with:
- the problems of applying the EU’s SFDR to real estate funds.
- the uncertainty whether or not SFDR has accommodated strategies that transition existing assets from inefficient to efficient. However, it is encouraging that: the European Commission (EC) clarified on April 14 2023 that products with GHG emissions reduction objectives can meet SFDR Article 9 disclosure requirements; and ESMA on December 14 2023 has referred to an adaptation to transition approach in its guidelines on funds’ names.
- what the outcome of the current EC consultations (here and here) on how the SFDR regime is functioning will be.
SDR and SFDR comparison
In its consultation documentation, the EC has recognised that “The SFDR was designed as a disclosure regime, but is being used as a labelling scheme, suggesting that there might be a demand for establishing sustainability product categories” and states “The fact that Articles 8 and 9 of the SFDR are being used as de facto product labels, together with the proliferation of national ESG/sustainability labels, suggests that there is a market demand for such tools in order to communicate the ESG/sustainability performance of financial products.” The EC has consulted on whether the introduction of product categories should be accompanied by specific rules on how market participants must label and communicate on their products.
Hopefully, post-Brexit EU and UK regulators will be able to learn from each other. Their aim should be to achieve sustainability label and disclosure coherence between SDR and any reformed SFDR.
Following the outcome of the EC’s consultation, any SFDR legislative reform would take place via the EU’s legislative process. This would presumably follow the 2024 European Parliament election and legislation would therefore not be complete until 2025. Given that elements of the real estate market operate across the EU and the UK, it may be that the investor market adopts SDR investment labels in preference to labels linked to SFDR Articles 8 and 9.
However it is achieved, EU-UK coherence with regard to labels will facilitate consistency and efficiency in terms of sustainability reporting. This will be welcomed by managers, investors and other stakeholders – particularly in these financially straitened times.
Our sustainable future must address the challenge of climate change. According to the International Energy Agency, the operations of buildings account for 30% of global final energy consumption and 26% of global energy-related emissions. Capital and investment strategies are needed to drive greater sustainability in real estate and appropriate sustainability labels and disclosures will be crucial.
SDR is welcome progress. UK real estate fund managers: embrace SDR!
*This article was first featured in ESG Investor on January 5 2024.
