Let me first apologize to my readership. I have been very dilatory in getting this commentary done and this topic is… a bit daunting. In my defense, working for a living can get in the way of thinking and writing. In any event, I have been doing some considerable reading about Environmental, Social and Governance (ESG) issues recently. It had not really been on my screen, in a big way, but has been bubbling along as a thing, important to some, but not so much for us denizens of the commercial real estate finance space.
Now, perhaps with an assist from Uncle Joe’s new administration and broadening engagement across stakeholders and constituencies, it is about to become much more than just chatter. Dechert has a team focusing on ESG issues across multiple business sectors and a lot of work is getting done. Ratings agencies and other purpose-built advisory groups are pressing ahead with advisory services and scoring systems. The NASDAQ is proposing new ESG disclosures from listed companies, the SEC recently announced the hiring of a senior policy advisor on ESG issues and is organizing a “Task Force” to monitor disclosure violations. Yikes! Our principal trade organizations (CREFC, MBA and SFA) are also trying to put a stake in the ground here and sort out what our industry should do, endeavor to be helpful and endeavor to shape the discussion.
Moreover, much of the investor marketplace seems to be pivoting to treat ESG issues seriously. How much of that is a perceived causal link between ESG and credit and how much is about public virtue and, to by cynical, how much is about virtue signaling? Not clear, but for my purposes not relevant either.
The question is, what do we do? And by “we” here, I am speaking very narrowly of the commercial mortgage finance industry. I’m going to get there, but let me start off by sharing some of my undoubtedly impressionistic observation about ESG in the here and now.
“…the climate scenarios (or Representative Concentration Pathways) RCPs, describe possible pathways of greenhouse gas (GHG) emissions and were produced by the intergovernmental panel on climate change (IPCC) and used in its fifth assessment (AR5)”
So, with all that said, what do we do? Short answer, we need to embrace ESG sensitivities in credit ratings and investment decision making.
So, first step; don’t fight the tape. Yes, we can be aware of all the intellectual vulnerabilities, elisions, assumptions and basic guessing in the structure of the ESG ratings process. Work with it. Engage, don’t carp. Having an ESG score on your deal will not be an option. Some of the agencies now, and certainly all of them shortly, will simply provide ESG information in connection with every rating they do, and they will present it in a more unambiguous and unhighlighted manner. Already we can see this in the presales. The other agencies don’t have Fitch’s cute color-coded system superficially suggesting certainty, but the information is there. The analysis will get sharpened and at some point, I would expect to see subtext attached to credit ratings indicating relevant ESG compliance.
The industry should engage, through our trade organizations and otherwise, with the ratings agencies, investors, the freestanding ESG rating institutions and organizations and other constituencies to try to reduce the chaos here. We need to get to an agreed upon taxonomy, much like the IRP as soon as possible and agree on what data needs to be harvested and how it should be presented and delivered. We’ve seen this movie before. To the extent we don’t make this happen, we leave it to others who don’t understand our industry to make it up and do it to us. That can’t be a good thing.
Moreover, let’s not wait upon a completely agreed upon ESG taxonomy, it’s time to begin engagement on disclosure and structure in our transactions now. Note that ESG is both a shield and a sword; demonstrating alignment can be economically positive. As no one is sure what inputs are critical and no one has real visibility into the relationship between inputs and outputs, industry participants are free to develop their own views here.
Should risk factors be enhanced along ESG axes? Certainly. Given that in the typical CRE securitization offering document we solemnly tell investors that there’s risks associated with investing in real estate, we surely can find space in our 80 or 90 single spaced, turgid pages of risk factors, a place for a robust discussion of ESG.
Inoculate yourself against risk by disclosing in the risk factors any identified issues. To the extent there is inadequate information to make an assessment of ESG, perhaps we should say that. Perhaps we should highlight questions asked but not answered. We can and certainly should indicate that while the sponsor attempted to identify positive ESG inputs, we can provide no assurances as to whether value along the various ESG axes will be delivered from those inputs.
On the flipside, let’s tell investors where alignment is good. To the extent investors and other stakeholders are looking for ESG alignment, and an alignment is largely assumed based on a compilation of ESG inputs, the path forward is clear: Invest in diligence, up the input count and disclose. Develop an ESG profile for your transaction.
Can we highlight or establish how certain assets have positive (or negative) externalities regarding local communities, particularly economically disadvantaged communities? Can we identify governance issues in our deal sponsor? Is there diversity in deal sponsor management and perhaps even major tenant management? Look, there is a remarkably large amount of literature out there suggesting connectivity between the characteristics of the transaction and social justice issues that can be mined for inputs and potential relationships. Can we map transactions to applicable scoring methodologies? Certainly, that can be reverse engineered.
Look, right now, this is largely about accumulating good inputs. The more the better. The more the higher the score. Many of these things don’t actually cost money. The fact that we can’t replicate outputs or even agree on what the outputs are from the inputs, doesn’t matter; it’s a function, and as long as we can have visibility into the inputs, we can create value here.
And finally, let’s go all in with deals that are specifically designed around ESG goals and therefore can be branded as deals designed around ESG goals. This, of course, is already happening, so get on the board and get a green deal done. Green is perhaps the easiest thing to engineer within this ESG framework.
It’s still early days. This is a thing and the governments’ regulators and investors will increasingly care about ESG and increasingly care about documentable evidence of ESG compliance. Might we get a premium for really good ESG scores? Maybe, but more certain is that negative scores won’t be helpful in selling securities.
Not to be cynical, but like any complicated set of rules, protocols and procedures, there will be opportunities to create value from clients where the value of compliance demonstrably exceeds the costs of compliance. That’s a math we can solve.