Promoters of real estate funds considering upgrading from Article 6 to Article 8 of the EU’s Sustainable Finance Disclosure Regulation (SFDR) need a clear plan on how the fund will promote environmental or social characteristics to ensure it complies with the requirements of the Article 8 designation.

Under SFDR, Article 8 portfolios should promote, “environmental or social characteristics, or a combination of those characteristics.” But what does this really mean?

It’s possible for a fund to promote “sustainability” without making any “sustainable investments” as defined in the SFDR. This can be accomplished as long as there is the promotion of environmental or social characteristics. For example, a fund can consider principal adverse impact indicators (PAIs) and integrate sustainable risk indicators in its investment decisions while not investing in “sustainable investments”.

But for funds focussed primarily on real estate investments, what it means to invest “sustainably” is defined in a more tangible and measurable manner than other asset classes, allowing real estate funds and their investments to demonstrate their compliance in a simpler manner. Promoters may, for this reason, choose to commit a fund to investing partially in “sustainable investments” to showcase their sustainability credentials, although this is not strictly required to achieve an Article 8 designation.

If a fund promoter voluntarily commits a fund to holding a minimum proportion of “sustainable investments”, consideration must be given to the composition of the existing portfolio of investments, as well as its future composition, to avoid violation of this threshold upon upgrading and any unintended restrictions on future investments. Key to this is carefully defining which assets can be considered “sustainable investments” at any point in time, and any metrics that apply.

Within the context of the SFDR, a “sustainable investment’’ is considered “an investment in an economic activity that contributes to an environmental objective… or an investment in an economic activity that contributes to a social objective… or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices.”

When thinking about activities that contribute to an environmental objective, it’s useful to refer to the EU Taxonomy for examples. It has defined 102 qualifying economic activities that contribute to six environmental objectives. In the context of real estate, these activities include the construction of new buildings with high-grade energy performance, the renovation of existing buildings to reduce energy waste, the acquisition and ownership of buildings with high-grade energy performance, and the installation, maintenance and repair of energy efficiency equipment and renewable energy technologies.

However, it’s important to bear in mind that to qualify as a “sustainable activity” under the EU Taxonomy, an activity must not only comply with a strict set of technical screening criteria but also “do no significant harm” to other environmental objectives defined by the regulation. For example, in construction, the Taxonomy explicitly prohibits the use of certain pollutant chemicals so as not to harm the objective of pollution prevention and control.

Fund promoters may choose, for this reason, not to go as far as claiming compliance with the EU Taxonomy but instead use it as a guideline to define what might constitute a “sustainable investment” within the parameters of the SFDR.

While there is also a requirement under the SFDR to demonstrate that “sustainable investments do not significantly harm” any environmental or social objectives, the requirements are less prescriptive, and can be attained by ensuring the investments do not contribute to a limited number of PAIs listed within the SFDR as being applicable to investments in real estate assets.

These PAIs include negative impacts on land artificialisation, waste production, energy consumption, greenhouse gas emissions and exposure to fossil fuels. The fund promoter must make its own assessment that any “sustainable investments” meet the “do no significant harm” test at the point of investment. 

The fund must also disclose how its sustainable investments are aligned with the OECD Guidelines for Multinational Enterprises (MNEs) and the UN Guiding Principles on Business and Human Rights.

In real estate, the investments themselves are not considered MNEs so disclosure in relation to OECD Guidelines on MNEs can be limited. For example, investments may contribute to economic, environmental and social progress with a view to achieving sustainable development, encourage local capacity building through close co-operation with the local community, or seek to improve environmental performance at asset level.  

In terms of alignment with the UN Guiding Principles on Business and Human Rights, consideration must be given to the risk of potential adverse human rights impacts arising from business relationships linked to the construction or operation of the real estate assets. For example, through development contractors or service providers to the properties. A commitment should be made to prevent and mitigate potential adverse human rights impacts.

Fund promoters must also consider how they will measure the attainment of the sustainable characteristics promoted by the fund ‘holistically’ as part of the overall investment strategy of the fund and it may be necessary to appoint a third-party data provider to collect the data required for the fund to comply with required transparency reporting obligations under the SFDR.

Finally, changes to the investment strategy of the fund will be subject to investor approval and these should be drafted in a way that are transparent and easy for investors to understand to support attainment of this approval.

From Kamahn Lee-Barron of TMF Group