The real asset industry is under increasing pressure from investors and stakeholders to improve environmental, social, and governance (ESG) practices.
According to BlackRock’s most recent Global Real Asset Outlook, the real asset sector received $203B of cash inflows in 2018. Infrastructure had its second consecutive record-breaking year with $85B raised. The growth in real assets is expected to continue due to the infrastructure sector’s strong fundamentals, with 50% of that growth attributable to power and renewables as the global desire to decarbonize the economy increases. While funding records continue, three key trends will emerge: 1) greater competition, 2) more international focus, 3) increased focus on asset resiliency, sustainability, and ESG in general. Many real asset fund managers not prioritizing ESG may be at risk of raising their last fund.
In response, managers across infrastructure, real estate, and other sectors have a desire to move away from “check the box” exercises and toward a systemic strategy to measure, improve, and report on ESG performance. However, based on our experience and hundreds of meetings with heads of ESG and other C-level executives, many of these companies are struggling to get an ESG plan started, especially mid- and small-market firms that fear they lack the resources to “do ESG right.”
The good news is that emerging technologies and best practices are making ESG more achievable for real assets. In our work over the last decade, the most important takeaway is that an ESG program must include strategy, technology, and process to be successful. In this piece, we summarize four key trends driving more firms to make ESG a core part of their business and lay out a roadmap to help aspiring ESG leaders begin their journey.
Key Trends in ESG for Real Assets
1. ESG can drive financial performance and mitigate financial risk
Market data shows that ESG can improve financial performance at the asset, portfolio, and company level. For example, in real estate, a wealth of recent research has shown that green buildings have better sale and rental premiums, lower operating costs, and higher occupancy rates. Interviews have shown that many infrastructure investors also consider ESG criteria to be a predictor of returns and return stability.
On the flip side, not taking ESG seriously can lead to both performance and capital markets risk. About 66% of investment firm board members would consider divesting from a corporation with poor ESG performance, and assets with poor ESG performance leave operating savings on the table while facing greater exposure to interruption, value loss, and illiquidity from climate change and other natural disasters.
2. Benchmarking and disclosure of ESG performance is rising rapidly
In just the past few years, we have seen a dramatic increase in the number of real asset funds reporting to the major ESG frameworks (GRESB, CDP, and PRI). Investor demand for transparency is driving much of this growth, but undertaking a benchmarking exercise also helps funds understand where they are performing well relative to peers and where they should focus improvement efforts.
The image below showcases this growth. ESG reporting and disclosure has reached the mainstream, with companies reporting to CDP now represent 56% of global market capitalization. Infrastructure reporting in particular has more than doubled since 2017, highlighting the burgeoning interest in infrastructure ESG performance.
3. Climate resilience is a major forcing factor
The real assets industry is being spurred to take a hard look at climate resilience by investors and policymakers, given the increasing frequency and severity of natural disasters. The last few years were historic for weather and climate related disasters, with damages in the U.S. alone exceeding $300B in 2017 (the worst year on record) and $90B in 2018. According to the IPCC, cumulative climate damages could exceed $54 trillion globally before the end of the century.
For real asset managers, climate change can directly impact your assets, but it can also destroy value by increasing insurance premiums, decreasing liquidity, harming local and regional economies, and ultimately making certain assets untenable in the most exposed areas (see figure below). Therefore, managing and mitigating those risks is an increasingly important fiduciary responsibility.
The Spectrum of Climate Risks to Real Assets
Source: Heitman on “Future Proofing Real Estate Investment: How Industry Leaders are Factoring in Climate Risk”
In response, the Task Force on Climate-Related Financial Disclosures (TCFD)—formed by the G20 Finance Ministers, Central Bank Governors, and the Financial Stability Board and led by Michael Bloomberg—has issued recommendations on how financial institutions should analyze and report on material climate risks to investors. More than 800 major organizations have expressed their support for TCFD, and many leading real asset investors are beginning to implement TCFD recommendations. For example, Principle Real Estate Investors has taken the first steps to tackling climate risk using the TCFD framework, including launching a pilot climate assessment, disclosure pilot, and building organizational capacity around climate resilience.
4. Infrastructure ESG is challenging, but best practices are emerging
Infrastructure represents a challenging asset class when it comes to measuring, managing, and improving ESG performance. Whereas real estate assets tend to be somewhat standardized in their structure and operation, infrastructure assets run that gamut from energy generation to transportation to telecommunications. This makes it difficult to determine which ESG metrics, disclosures, and improvements are material for any given asset. Infrastructure assets also tend to have long hold periods and inflexible operating requirements, which imposes some restrictions on the performance improvement measures available. And while there have been some attempts to estimate appropriate valuation of ESG performance in infrastructure assets, these analyses are still preliminary and generally conclude that use of ESG criteria in investment decisions varies widely.
However, best practices are beginning to appear. Social impacts, data management, and governance practices are three key areas where many infrastructure funds have made headway on ESG. Lessons learned from the last decade of ESG progress in real estate—where successful case studies of ESG in action abound—are beginning to transfer to the infrastructure side. There has been a recent wave of investor interest in climate resilience planning for assets in locations vulnerable to sea-level rise and other threats. In the next few years, we expect a flurry of activity as the infrastructure industry increasingly adopts ESG assessments, strategies, and programs.
Practical Steps to Achieving ESG Goals: Strategy, Technology, and Process
Our experience working with dozens of diverse real asset investment firms has shown that strategy, technology, and process form the pillars of a successful ESG program. Without any of these pillars, you may make incremental progress, but you won’t be able to fully capitalize on the trends above and create long-term value through ESG (see figure below).
What it is:
A coherent set of ESG goals, principles, and commitments to guide your efforts, gauge your success, and communicate your progress.
What it includes:
A successful ESG strategy should have the following elements:
- ESG principles, mission statement, and discussion of alignment with company-wide priorities
- ESG metrics and a plan for tracking them
- Goals for improving ESG performance
- Prioritized action list of low-cost and long-term measures to achieve those goals
- Market engagement plan, including industry memberships and networks
- Messaging plan and collateral to share successes to investors and stakeholders
Why you need it:
Without strategy, ESG has no direction. You need to be able to tell a consistent “ESG story” to staff and stakeholders, ensuring that your efforts on the technology and services front are prioritized toward a common objective.
What it is:
Technology helps organizations scale their processes efficiently, reduce risk, and establish a data-driven feedback loop to inform process and strategy evolution and drive a competitive advantage.
What it includes:
- Site Level Granularity – Ability to track site or asset level data (not just the fund level) is an increasing requirement from LPs, as well as tracking deal team and portfolio management ESG metrics in a unified system.
- End to End – Ability to track deal team and portfolio management ESG metrics in a single system. There is a symbiotic relationship sharing data across these two teams.
- Self-Configurable – ESG is in its early innings. ESG frameworks will adjust. Materiality metrics will evolve. Technology needs to be agile enough to meet the changing ESG landscape.
- Forward-looking analysis – Most technology platforms are static “rear-view mirrors”. Technology needs to report on not only the past, but also provide key insights into future scenarios to play a more vital role in reducing risk.
- Dynamic Workflow – You need accurate ESG data at the right time. Most investors still rely on manual processes and data inputs into Excel, email and PowerPoint on a regular cadence. Technology can streamline this entire process, obviating the low value, error-prone administrative work to enable more focus on analysis, planning, and sustainability impact.
- Self-Service Analytics and Reporting – The ability to report on it in multiple ways and in multiple formats (Word, PPT, Excel, PDF, mobile dashboards, etc.). In addition, there are multiple frameworks to report to like GRESB, PRI, CDP, SASB every year. Technology streamlines these manual reporting efforts.
Why you need it:
Without technology, ESG execution lacks scaling. ESG managers need an accurate way to collect data, control data quality, drive visibility to stakeholders, and prioritize opportunities for improvement.
Real-world example of real asset fund ESG dashboard
What it is:
A set of repeatable, predictable, and transparent actions and policies to drive execution of the ESG strategy throughout the organization.
What it includes:
- Clear staff responsibility, accountability, and alignment for each element of ESG
- Defined outcomes and key performance indicators for the ESG program
- Consistent incorporation of ESG into investment selection, development, management, partnerships, and contracts
- Documentation of ESG actions and standards
- Incorporation of ESG into staff training
Why you need it:
Without process, ESG has no teeth. While one-off successes make for good case studies, process is required to drive scalable progress across all departments and move the needle on ESG.
Example of process for developing an ESG program
So, what’s next?
Mercatus and RE Tech Advisors are working together to provide a best-in-class ESG solution for real asset investors that seamlessly integrates strategy, technology, and process.
For those investors interested in learning more, please:
1) Take this simple survey to help benchmark where you are in your ESG journey. It takes less than two minutes to complete and provides a real-time score once completed.
2) Email ESGtrifecta@gomercatus.com to set up a joint complimentary call with RE Tech Advisors and Mercatus to help evaluate your needs and recommend some actionable next steps.