NREP on changing the ESG paradigm

For real estate to meet net-zero targets by 2050, the industry needs a change of philosophy, says NREP partner Gustaf Lilliehöök

This article is sponsored by NREP

NREP, the largest investment manager in the Nordics, with €12.5 billion of assets under management, has been a leader in ESG investment, but it is accelerating its progress, says partner Gustaf Lilliehöök. He believes that not only does real estate need to invest in sustainability and in technology, it needs to think differently about value and time horizons.

What commitments has NREP made toward net-zero carbon in its real estate portfolio?

NREP’ has always been about identifying that gap between how things are and how they could be, and then creating value by doing something about it. Our ambition is to become the first international real estate investor with a carbon-neutral investment portfolio by 2028, well ahead of the IPCC’s target date of net zero by 2050. We have near-term goals for delivery by 2023 of reducing upfront embodied carbon by up to 33 percent from 2020 levels on new NREP developments and reducing at least 50 percent of operational carbon emissions from 2020 levels. And we’ve set ourselves the goal of being fully carbon-neutral with regard to both embodied carbon and operational carbon – without external offsets – by 2028.

That is a hugely ambitious target. Can it be done?

In the Nordics, we can’t really change global outcomes when it comes to CO2 levels and the atmosphere. The role we can play is to prove what can be done. If our solutions influence the behaviors of larger markets, or get adopted by players in larger markets, we can make an impact. So, we need to set much higher ambitions for ourselves, to move much faster to get where we need to be in time.

Thus, we’ve set extremely ambitious targets, but pledges alone aren’t enough – we need substantially more decisive action to protect our planet from the urgent environmental pressures it faces and invite partners to join us in this movement toward making decarbonized cities a reality.

From the largest Nordic rooftop solar program to pioneering low-carbon heating solutions and construction with upcycled building materials, NREP has always pushed the boundaries when it comes to ESG innovation and investment, and we’ve no intention of slowing down. To achieve the ambitious targets we’ve set, many technologies need to be deployed in parallel and at scale, and we’re determined to demonstrate to the industry how this can be done.

We need to prove that existing green building technology has the potential to be scalable, and also that it’s as good or at least nearly as good as traditional standard solutions from an economic, a process risk and an end-user perspective. If we don’t fulfill those three criteria, then the methods will never get adopted by the broader industry. We’re also investing in the search for new technologies which have the potential to really make progress.

Is the approach dependent on technology, then?

Continued development of better technology is crucial to move all the way to where we need to get to, but as an industry we must not wait for future technologies but also focus on getting much better at adopting existing good technologies at scale. That means thinking differently about the real estate value chain and how you underwrite assets and sustainability qualities. It means working differently, which is tricky because we’re in an industry that has tended to be behind the curve with regard to tech and resistant to change.

You need to think differently about how you develop. For example, simply doing a life cycle assessment (LCA) to calculate the embodied carbon of your building on a backward-looking basis does not make any difference to greenhouse gas emissions.

In contrast, if we do an LCA scenario analysis at the very initial scoping stages, then we often find that we can save 10-30 percent embodied carbon without significant economic trade-offs. Typically, 70 percent, if not more, of the environmental impact is locked in during the first 10 percent of the development process for a property. So, it’s about having really thought through the key questions upfront and coming into a project with a clear understanding of what we want to achieve.

We must be able to engage with all the value chain participants before we lock ourselves in to design and processes. And we need to look beyond single projects. The standard modus is that for almost every project, a new constellation of parties comes together to produce a unique product, but the effort and cost required to push new sustainable solutions will not make sense unless we can replicate those solutions across many projects. By working together with trusted and willing partners and suppliers on a repetitive basis, we enable collaboration for better and more sustainable solutions. We can’t be held back by trying to do this with parties which are not willing. The real estate value chain needs to work in a fundamentally different way; in a more trusting and integrated way.

Obviously, there are costs involved in changing the approach, so how do you persuade the industry to make the investment?

The benefits of green values don’t play out over a one-to-two-year horizon; they play out over a seven-year, if not significantly longer, time horizon. However, over that time horizon the pressure from tenants, from capital markets, from regulators, to be greener will be even greater, so the demand for green real estate will increase.

As supply is inelastic, the rents and values of green buildings will rise. So, today we need investors to underwrite that green premium and, once they do, there is a different budget for creating green buildings. It is not unreasonable to underwrite those future expectations, in the same way we might underwrite today based on forecasts for urbanization or tenant demand.

And this is needed in order to have a real impact. Over the past 10 years, there’s been a strong push back against sustainability certifications and initiatives based on the argument that it increases costs, but there’s been a very poor appreciation of the value benefits, resulting in an underinvestment in sustainability.

There’s a huge responsibility sitting with the investors and owners of real estate to change the way they look at real estate underwriting, in order to push the green agenda forward. We’re the part of the value chain that will capture the future increase of green premiums, and we have a position in the value chain that allows us to materially influence the rules of engagement, the economic boundary conditions and more sustainable decision-making by everyone else.

What else does real estate capital need to do to be a force for sustainable real estate?

Investors need to build the knowledge and capacity to upfront articulate the specific sustainability qualities they want. Simply demanding sustainability certifications of properties is not enough, as that will typically result in developers simply going for the cheapest certification points.

We also need to look at the whole life cycle of a building and at how to extend it, as obviously the best buildings are those we build today and never have to tear down. If you looked at a 100-year horizon, investments in sustainability would seem very small. Small additional investments can create large values for a broader set of stakeholders over the lifetime of the building, but many of these ’right’ decisions do not get made because of agents in the value chain that are plagued by narrow short-term incentives.

Given the financial incentives, it’s no wonder that some developers and construction firms typically focus on minimizing costs, meeting minimum standards and offloading the asset as soon as possible after completion. But the long-term price of that is very high. Again, the responsibility is with long-term owners of real estate to underwrite over a minimum 10-year perspective.

So, even if NREP ends up having a shorter holding period, we always underwrite 10 years or more.

A lot of real estate investors come in two groups: the dealmakers that make money from flipping assets, and the pools of institutional capital that see real estate as a substitute for fixed-income products, where the best properties are those you buy and then they simply produce a rental cashflow every month without a need to ever engage with tenants.

Neither of those mentalities will drive change in how we produce or how we use real estate or how we improve it. We need to shift from seeing real estate as a financial asset to seeing it as a product, which we need to maintain and improve in order to serve our customers.

Most of the world’s buildings are older and less sustainable. What are the challenges in improving them?

The demand for green buildings, from all sides, will outstrip supply, so there will be opportunities to make strong returns by making legacy buildings greener, but some are easier than others. At one end of the spectrum, we see buildings that perform poorly by environmental measures but are in strong locations, where the city has grown around them. There is sufficient future economic value potential and environmental improvement opportunity to make an easy case.

A more difficult value proposition are buildings that have lower economic value potential and are sort of okay from an environmental perspective, but not great.

Many lighter initiatives typically make sense, but today the cost-benefit balance of deeper improvement measures are often more difficult to justify, not just because it‘s more difficult for these assets to carry the cost, but because the environmental outcomes are more marginal. That said, if current regulatory and market trends continue then the economic incentives to significantly improve these buildings may be much stronger in the not-too-distant future.

Venturing into green tech

NREP’s approach to technology is twofold – to work with existing tech to make sustainable real estate scalable and viable, and investing venture capital in new technology which could accelerate the greening of the industry.

Earlier this year, the investment manager launched 2150, a sustainability technology venture firm, which closed its first fund in October, raising $312 million from investors including Credit Suisse and the BMW Foundation.

The fund has made a number of investments already, in startups like CarbonCure Technologies, which lowers the CO2 footprint of concrete, Normative, which tracks the full carbon footprint of supply chains, and Ampd Energy, which helps decarbonize construction sites by powering cranes with a battery-driven generator.

NREP hopes the technologies being created by 2150’s portfolio companies can contribute to alleviating the worst effects of climate change. Fortunately, 2150 is not alone. The amount invested in climate tech startups increased from $418 million in 2013 to $16.3 billion in 2019, according to a 2020 report from PwC.