Commercial sustainability: green bonds

Can green bonds flourish?

18 April 2017

Standardisation is needed if green bonds are to align the interests of tenants, commercial real-estate companies and global investors successfully, argues Michael Wilkins

In a speech to the UN General Assembly in April last year, Bank of England Governor Mark Carney made the point that green bonds – debt instruments whose proceeds are used to fund environmentally sustainable projects – have the potential to align the interests of issuers and investors.

This is particularly true for real estate. Green bonds can allow commercial real-estate firms to acquire funds for developing assets such as office blocks and residential buildings, and improve the sustainability of their portfolios, while they also make for reliable investments that contribute towards a green economy.

Yet despite the benefits, green bond issuance in real estate has so far been limited. This is a result of lack of formal standardisation and the absence of a coherent set of defining procedures for bond governance and use of proceeds, which has been hampering confidence.

Increased standardisation, going beyond the positive contributions already made by frameworks such as the International Capital Market Association’s Green Bond Principles, should therefore be established for such bonds to fulfil their potential.

Tenant demand

An increasing number of commercial real-estate tenants – mostly large international corporations – are looking to rent sustainable property. There are several reasons for their interest.

According to the UN Environment Programme, buildings consume about 40% of energy, 25% of water and 40% of resources globally, as well as emitting around a third of the world’s greenhouse gas emissions. So it is not surprising that a growing number of commercial tenants are looking for economically sustainable properties that will reduce their energy bills and other operational expenses.

Occupying environmentally sustainable property not only enables corporate tenants to reduce their costs, but also shows their dedication to tackling climate change goals and building a sustainable economy. In fact, most large companies now incorporate their green credentials into regular reporting and consider environmental factors as part of their global strategy.

The CBRE European Occupier Survey 2015/16 also found that, among 120 European global corporations, sustainability and environmental concerns rank equally with geopolitical issues in terms of future operational concerns, higher than currency fluctuations and emerging market competition.

Sustainable portfolios

To meet rising expectations from tenants, commercial real-estate companies are increasingly looking to implement stronger sustainability measures for the buildings in their portfolios.

As of December 2015, most of the commercial real-estate companies that S&P Global Ratings assesses report that a majority of their office portfolio is certified as green by various energy efficiency and environmental awareness labels, with the aim of certifying more assets over the next 2 to 3 years.

Figure 1

Figure 1: Percentage of office portfolio certified in terms of floor area

Figure 1 illustrates how leading European commercial real-estate companies have increased – and are further aiming to increase – the green certification of their portfolios.

In addition, S&P Global Ratings has found that sustainable properties attract more reliable tenants, which in turn helps commercial real-estate companies collect steady, adequate rents while reducing vacancies. Moreover, high occupancy and creditworthy tenants are beneficial for such companies’ competitive advantage and credit rating, as they enable predictable cash flows.

Stronger market position

The 'greenness' of real-estate assets can also be a distinguishing factor in oversupplied markets where tenants are more aware of environmental factors.

Paris is a good example; French commercial real-estate company Société Foncière Lyonnaise, for instance, has a relatively small number of assets, but can boast high energy efficiency across these because it views green certification as necessary to demonstrate the superior quality of its holdings.

For markets that are undersupplied in higher-quality green assets, including Madrid and Barcelona, certification is also a way for commercial real-estate companies such as Merlin Properties to affirm market leadership.

In the London real-estate market, however, there has been less of a focus on green certification than in continental Europe. Put simply, attracting tenants has historically proven less difficult in London than in other European cities. For this reason, UK commercial real-estate issuers such as Derwent London have focused on improving the sustainability of future assets rather than existing ones.

Yet, should the London rental estate environment turn sluggish in the light of Brexit, buildings’ green qualities may come to play a larger part of UK real-estate investment trusts’ strategies.

Access to the bond market

S&P Global Ratings has found that, for the pool of green bond investors to grow, clarification of and standards for the market are necessary.

Currently, issuers are responsible for documenting and reporting the 'greenness' of the bonds they issue. This can come at a high cost, including fees for external reporting and third-party certifications, which could pose a barrier to green bond expansion in the long run. Moreover, bond documentation typically includes commitments to use proceeds for environmentally sustainable projects, which can restrict the flexibility of the issuer in terms of property management.

As a result, green bond issuance has thus far been limited to a group of large issuers of high-quality credit that can afford these extra costs and absorb the proceeds without disrupting their operational strategy. This issue seems to stem from the lack of a sector-specific framework for the green bond market, which would unify green bond criteria and preserve the issuers’ flexibility in terms of property management.

Currently, the sector benefits from various established methods of certifying the 'greenness' of buildings: the Building Research Establishment Environmental Assessment Method (BREEAM), High Environmental Quality (HQE) and Leadership in Energy and Environmental Design (LEED) certifications. Each assesses buildings by indicators such as carbon emissions, water efficiency, waste management and construction materials.

However, the future success of green bonds in real estate will most likely rely on introducing standardisation. To help increase momentum, S&P Global Ratings plans to release a green evaluation product before July, to assess the governance, transparency and environmental impact of a green bond in real estate as well as in other sectors. The ability of investors to benchmark the 'greenness' and credit quality of their bond portfolio should lead to greater transparency and ultimately bolster market growth in this nascent sector.

Michael Wilkins is Head of Environment and Climate Risk Research, S&P Global Ratings

Further information

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