The institutional real estate industry is urging regulators to introduce new product-label categories to the EU’s Sustainable Finance Disclosure Regulation (SFDR), a move it believes would encourage more investment in the decarbonisation of buildings and social impact strategies.
European real estate investment association INREV has submitted a model response to the European Commission’s current review of SFDR, highlighting how the regulation could better support the sustainability efforts of the asset class. Other real estate trade bodies, fund managers and organisations are expected to respond in line with INREV’s response, which has been seen by IPE Real Assets.
INREV has endorsed the first of two approaches proposed by the Commission (see box below) for the creation of a categorisation system for financial products – namely, creating new categories that are not based on existing Article 8 and 9 classifications, which have been problematic for real estate funds.
The association has told the Commission: “INREV believes SFDR and Article 8 and Article 9 are useful for regulating transparency and disclosure requirements and for fighting against greenwashing. However, they are not the best basis for formal product categories as they do not accommodate transition strategies well. Particularly for real estate.”
Real estate fund managers pursuing strategies to improve the sustainability performance of buildings have found it difficult to disclose under Article 9 – the highest sustainability classification under SFDR – because assets need to be sustainable at the point of purchase to be eligible. Earlier this year, INREV published a paper arguing that this could have the unintended consequence of diverting capital away from decarbonisation strategies.
Abigail Dean, global head of strategic insights at Nuveen Real Assets and INREV ESG committee chair, said: “The real estate industry has been faced with some particular challenges in the application of SFDR. We believe that the lack of recognition for real estate products focused on green transition could be limiting capital flows to sustainable activity.”
She added: “This consultation is therefore an opportunity for the real estate industry to give clear feedback on the changes that could be made to deliver better transparency and to allow investors to more easily identify products focused on sustainable activity.”
Aleksandra Njagulj, global head of ESG for real estate at DWS and INREV ESG committee vice chair, said: “Consultation on implementation of SFDR offers a welcome opportunity for industry to feed back to European Commission on practical considerations. For real estate industry, the key focus point is explicit SFDR recognition of ‘stranded to green’ asset refurbishment as a sustainable activity.”
Phase out of Article 8 and 9?
Last year, EU regulators warned that Article 8 and 9 classification should not be used by the fund management industry as a product labelling system, but in the current SFDR consultation the Commission acknowledges that Article 8 and 9 are “are being used as de facto product labels” and “there is a market demand for such tools in order to communicate the ESG/sustainability performance of financial products”.
In its consultation response, INREV has argued for the phasing out of Article 8 and 9. “It is crucial that a clear and well-defined categorising/labelling system is implemented,” the organisation said.
“The disclosure requirements of Article 8 and Article 9 should focus solely on disclosing the sustainability strategy of a fund, rather than describing it. We would therefore advocate eliminating Article 8 and Article 9 after a transition period. During the transition period, both systems could coexist but, in the long run, having SFDR stand alongside a categorisation based on the type of investment strategy would likely lead to two labelling systems and risk creating confusion for investors.”
The model response was produced after seeking input from other European associations, fund managers and service providers. Lonneke Löwik, CEO of INREV, told IPE Real Assets: “It’s vitally important that the real estate investment industry aligns our views on the important issue of how to improve on the current de facto use of SFDR article 8 and 9 as product labels.
“We believe adopting labels that clearly reflect funds’ sustainability strategies will be much better accommodate financing the transition of real estate assets to net zero as well as social impact strategies. It’s great that so many parts of the industry came together to develop a model response which clearly reflects our shared views on the issues in the Commission consultation.”
Collaboration with the UK’s SDR?
The consultation response comes several days after the Financial Conduct Authority (FCA) published details of the Sustainable Disclosure Requirements (SDR) – effectively, the UK’s equivalent regulation, which has been welcomed by the UK real estate investment industry and is expected to have some influence on the EU’s reform of SFDR.
SDR has four product labels, including “sustainability improvers” and “sustainability impact”, which the FCA has indicated could be applicable to real estate strategies that target environmental transition and social impact, respectively.
The EU has proposed four labels (see box below), which INREV has broadly welcomed (category C, which excludes “activities and/or investees involved in activities with negative effects on people and/or the planet” was deemed irrelevant to the asset class).
Melville Rodrigues, head of advisory for real assets at Apex Group and public policy committee member of the UK’s Association of Real Estate Funds, said: “SFDR has been a globally defining disclosure regulatory regime opportunity to encourage real estate fund managers to operate their funds sustainably. However, the regulation needs to be fine-tuned and made more appropriate to our real estate sector, especially in attracting institutional capital for net-zero transition strategies.
“These welcomed INREV responses will hopefully facilitate aligned responses from our real estate sector that will result in continuing constructive engagement with EU regulators to achieve more appropriate regulation. The INREV responses helpfully recommend that the European Commission engage with the FCA and take up the FCA’s offer to the European Commission as it develops a labelling regime under SFDR to achieve coherence with the UK’s SDR.”
INREV has told the Commission that SFDR’s principal adverse impact (PAI) indicators “are not fit for purpose and create confusion” and that “the biggest challenges are the lack of clarity on how to report against the fossil fuel exposure PAI” and SFDR’s reference to energy performance certificates (EPCs).
The association said “significant uncertainty remains regarding how to account for fossil fuels and how real estate assets located in countries where EPC labels are not used should be dealt with” It added that “requirements for EPC labels for real estate assets do not work well for funds with transition strategies that purposefully acquire non-sustainable assets with a view toward retrofitting them to be sustainable”.
Olivia Prentice, partner and head of impact at Bridges Fund Management, which launched an Article 9 real estate fund in 2022, said: “We’re generally supportive of SFDR, and we’re aligning our funds with it. Our concern is that the current drafting effectively disincentivises some of the most environmentally impactful real estate investments: ie refurbishing or renovating existing buildings to avert future carbon emissions.
“Although SFDR was never intended to be a labelling regime, funds like ours that are specifically focused on sustainability and impact have inevitably looked to align with what seemed to be the most sustainable category – Article 9. And based on the current guidance, buildings that are energy-inefficient at the point of investment – the ones we most need to decarbonise – will seemingly fail the ‘do no significant harm’ element of the Article 9 rules, because having an EPC of C or below is one of the PAI indicators.”
Some real estate fund managers “have tried to get round this by focusing on new development, or by arguing that a low EPC rating doesn’t necessarily constitute significant harm,” Prentice said. “Others have given up on Article 9 altogether. Either way, the current regime is clearly not incentivising investors to target ambitious sustainability thresholds.”
Prentice said Bridges was “encouraged” by the proposed classification – in particular, category D, “which specifically covers these ‘transition assets’ and seems well aligned with the SDR’s sustainable improvers’ category”.
The two proposed approaches to establishing an SFDR categorisation system
- Splitting categories in a different way than according to existing concepts used in Articles 8 and 9 – for example, focusing on the type of investment strategy of the product (promise of positive contribution to certain sustainability objectives, transition, etc) based on criteria that do not necessarily relate to those existing concepts.
- Converting Articles 8 and 9 into formal product categories, and clarifying and adding criteria to underpin the existing concepts of environmental/social characteristics, sustainable investment, do no significant harm, etc.
Proposed SFDR product labels
A: Products investing in assets that specifically strive to offer targeted, measurable solutions to sustainability related problems that affect people and/or the planet, e.g. investments in firms generating and distributing renewable energy, or in companies building social housing or regenerating urban areas.
B: Products aiming to meet credible sustainability standards or adhering to a specific sustainability-related theme, e.g. investments in companies with evidence of solid waste and water management, or strong representation of women in decision-making.
C: Products that exclude activities and/or investees involved in activities with negative effects on people and/or the planet.
D: Products with a transition focus aiming to bring measurable improvements to the sustainability profile of the assets they invest in, e.g. investments in economic activities becoming taxonomy-aligned or in transitional economic activities that are taxonomy aligned, investments in companies, economic activities or portfolios with credible targets and/or plans to decarbonise, improve workers’ rights, reduce environmental impacts.