Sustainable financial market: development and significance

Unlike traditional financial ratings, ESG ratings have not yet played a major role in public perception. Yet their influence on investment decisions has skyrocketed in recent years. What added value do ESG ratings deliver in practice - and where are the limits?

Climate change, scarcity of resources, and shortage of skilled workers: environmental, social, and governance factors are increasingly determining the economic success of companies. This is a key reason why many investors are now integrating sustainability criteria into their risk models and investment decisions. As a result, the market for sustainable investments has become a growth driver in the fund segment; ESG-related assets under management have reached dizzying volumes.

Quelle: Marktbericht nachhaltige Geldanlagen 2022. Deutschland, Österreich und die Schweiz. Hrsg.  Forum Nachhaltige Geldanlagen e. V., Berlin 2022, S. 12.

Regulation in many countries around the world - especially that of the EU ("Sustainable Finance") - has also contributed to this. The latter aims to systematically steer financial flows toward more sustainable business models. Now that financial market participants and financial advisors in Europe have to report publicly under the EU Disclosure or Taxonomy Regulation whether and to what extent they take sustainability criteria into account or whether they contribute to achieving sustainability goals, products without ESG components are likely to become a discontinued model in the long term.

However, investors face a key challenge in this regard: an objective and comparative ESG assessment of companies, funds or even individual properties is complex. In addition, the relevant players usually lack the necessary in-house expertise to carry out such analyses. Another complicating factor is that, due to the positive connotation of the topic of sustainability in public, very many companies and products advertise with this attribute - irrespective of the question of what their actual contribution is. The danger of greenwashing is great.

Specialized sustainability rating agencies have been providing a remedy for many years. What began on a very small scale and with a lot of idealism about 30 years ago has now become big business: The formerly small and rather nationally or regionally active providers have largely been taken over by conventional financial players such as credit rating agencies, index providers and stock exchange operators - typically from the Anglo-Saxon world. In "Rate the Rater 2020: Investor Survey and Interview Results," the following ratings used are cited, particularly with regard to ESG ratings at the corporate level: MSCI, Sustainalytics, Bloomberg ESG Disclosure Score, CDP, FTSE Russell's ESG Ratings, ISS, Robecosam Corporate Sustainability Assessment, and Thomson Reuter's ESG Scores. To meet the demand of asset managers and institutional investors, providers collect ESG data on thousands of companies worldwide and prepare it for the market in a variety of product solutions and services. ESG ratings are a key tool for measuring the performance and comparability of issuers of securities such as companies and governments, as well as funds.

Benefits and application of ESG ratings

SG ratings serve to reduce the complexity of ecological, social and governance-related interdependencies and attempt to simplify the multi-layered reality by means of models. In addition to evaluating an individual issuer of securities, the aim is to enable the most objective possible comparisons to be made between them, so that the "good" can be separated from the "bad" and investments can be made accordingly. To this end, countless sustainability information and data are aggregated as part of a system of indicators, weightings and assessments and summarized in a rating (represented as a number, letter or similar).

These rating results are used by investors, for example, to define minimum requirements for securities issuers (in the sense of a minimum ESG rating): Issuers that fall below a defined rating threshold are then not eligible for investment. As a rule, investors and asset managers combine rating strategies with other ESG instruments (exclusion criteria, exercise of voting rights, etc.). Investors and asset managers decide for themselves how to use ESG data and instruments in the specific investment process. On the selection criteria for a rating system, a statement by Robert Kitel, Head of Sustainability & Future Research, alstria office REIT AG:

"As a listed company, we are rated every year by various rating companies (S&P CSA, MSCI, ISS ESG, Sustainalytics, GRESB, CDP, etc.) according to ESG/CSR criteria. For us, this is a normal process and since we cannot serve all requests, we select the ratings (e.g. the best rated systems from Rate the Raters) with which we enter into a detailed exchange. The ratings we prioritize, are time-consuming to respond to and mean 6-8 weeks of effort. Therefore, it is important for us to receive feedback in order to learn from it and to be able to develop further. The feedback is also incorporated into our annual sustainability report and helps us to identify the current and material issues so that we can report on them. We avoid the ratings that don't give us that transparency and feedback."

 Different understanding of materiality

This naturally also applies to product and corporate communications. Even if this is often presented differently in advertising messages: ESG is always also a relative consideration. It is not usually about being able to distinguish sustainable from non-sustainable companies or products - very few companies and products are likely to actually be sustainable in the literal sense. Rather, ESG ratings are about determining what sustainability risks a company has or what impact it has. This is an important insight to avoid disappointment for the end customer.

Even though ESG rating providers today generally have a similar understanding of sustainability, research methods and also results are quite different. In terms of content, for example, some approaches deliberately limit themselves to a smaller number of rating indicators which, in the opinion of the providers, have a particularly high financial materiality in the short and medium term: Here, then, the focus is particularly on sustainability-based financial opportunities and risks for companies. Other approaches, on the other hand, follow the principle of double materiality and additionally include the positive or negative impact of companies on sustainability - with correspondingly broader and deeper content coverage.

Methodological diversity leads to divergent rating statements

Data collection and its evaluation are also handled differently: While some rating agencies perform purely relative evaluations (for example, compared to the best in the industry), others additionally define absolute requirements on which the evaluations are based. And while some rating providers explicitly consider only publicly available ESG data, others also use internal company data collected through interviews or written surveys, for example. However, a lack of ESG transparency in particular, which is often observed among smaller companies and in certain countries and industries, leads to ratings that are not very meaningful when limited to publicly available data. The current trend to fill such data gaps by extrapolation in certain cases appears to be only partially suitable for making statements on the individual sustainability performance of companies.

The result is that ESG ratings from different rating agencies come to different assessments for a product or company in detail, and sometimes even in principle. It is therefore of fundamental importance to familiarize oneself with the respective rating approach in order to be able to classify the results against this background. This basically applies equally to the end customer of financial products, although it is difficult to gain a deep insight in practice.

 Nevertheless, these different approaches also have their justification, as sustainability as a topic cannot be completely objectified and different perspectives and opinions can certainly be helpful. In addition, it is becoming apparent that ESG ratings also have a completely different function today due to the enormous increase in the importance of sustainable investments: They are an incentive and a means of pressure for companies to improve their ESG performance in order to continue to have access to the financial market and to (favorable) refinancing opportunities in the future.

As with other industries, this applies equally to real estate companies and their assets. Hardly any other industry has such a high CO2 avoidance and adaptation potential as the construction and building sector, which is why investors and asset managers are increasingly making their investment decisions on the basis of corresponding ESG performance data. ESG ratings are being used to systematically evaluate listed real estate companies and REITs around the world, and unlisted bond issuers and real estate investment trusts are also increasingly being covered. Attracting investor funds without a sufficient ESG rating is therefore likely to become increasingly difficult in this sector as well.


ESG real estate and portfolio ratings: objectives and places of application

While classical ESG ratings refer to companies or funds, ESG real estate or portfolio ratings allow the comparison of the sustainability of buildings and portfolios with each other or with an average reference building. ESG real estate ratings show sustainability risks and opportunities and are suitable for any real estate class (e.g. existing buildings, project developments, new buildings).

Where is such an ESG real estate rating used? An ESG real estate rating enables, for example, the asset manager or risk controller of a fund or real estate company to better assess and manage ESG risks and opportunities at the real estate or portfolio level. This is particularly relevant for purchase, refurbishment or sale decisions, in order to be able to assess with what effort a building and its processes can be optimized in terms of sustainability, or whether an improvement is difficult to achieve.

In addition to these control and benchmark aspects, ESG real estate ratings are also used as communication tools. This is useful, for example, to document and publish the status quo, development progress or compliance with an investment strategy. In addition to the individual sustainability criteria, the scoring models often also map a review of compliance with ESG regulation (e.g. taxonomy compliance). This makes the degree of achievement of the specific sustainability criteria as well as ESG compliance transparent for stakeholders.

The key differences between ESG real estate ratings and classic ESG ratings at the corporate level are, in addition to the aforementioned use, the data (sources) used and the "raters" performing the ratings: ESG real estate ratings are usually performed by the owners of a property or an actor in their property management. Thus, they are not conducted by an independent third party.

The technical framework for carrying out the rating is currently provided in particular on the basis of models developed in the context of voluntary associations of players in the real estate industry (see, for example, the history of the development of the GRESB and ECORE rating systems). The platform for carrying out the respective real estate rating sometimes offers an initial validation of the reported data after entry - however, this is not to be understood as a substantive, qualitative review. An additional external review of the ESG real estate rating is therefore regularly requested by the real estate owners before the results are communicated.


Real estate ratings as distinct from certification systems

In-depth knowledge of, among other things, consumption and emissions data, the process and governance structure of the real estate company, minimum exclusion criteria, the underlying sustainability strategy, existing (green) building certificates or green leases is required for the implementation (see also: The time required for initial processing is estimated to be high. Real estate ratings should not be confused with the already much more established green or sustainability building certificates (e.g. BREEAM, LEED, DGNB). These certification systems also contain criteria for assessing the sustainability of a property. What all certification systems have in common, however, is that they are audited and certified by specially trained external third parties. In addition, due to their comparably high costs, certification is particularly suitable for buildings that already have an elevated sustainability standard and where this quality in the status quo is to be externally confirmed for a specific purpose. Certificates are not an instrument with the help of which (even less sustainable) properties are evaluated across the board - it is much more likely to make special properties stand out from the crowd and thereby enable advantages, especially in financing, selling or renting.


Challenges of ESG real estate ratings

The limits of the informative value of an ESG real estate rating are currently in particular the data availability, the (international) comparability, as well as the disclosure of the underlying building information:

If only the result of a scoring and the underlying criteria are published, an external third party cannot derive any statements on specific sustainability criteria of the property or a comparability with another one. However, the owner himself has a valuable control and monitoring tool for possible improvement potentials due to the completeness of the registered information and the development of the scoring result over time.

In addition, the insufficient international alignment of ESG real estate ratings in particular is currently a weak point for the comparability, informative value and management of international portfolios. Unlike ratings at company or product level, ESG real estate ratings still have a comparatively short history nationally and internationally and a low but steadily increasing market penetration. The costs of using them are also currently still considered low. However, ESG regulation and the requirements for decarbonization of the building stock in particular have greatly accelerated and professionalized their development.

 The most difficult challenge, however, is the availability of data: it is not only when it comes to the topic of real estate sustainability that the data basis in the real estate industry can be considered poor. Currently, data in almost all areas of real estate sustainability measurement is being painstakingly built up and enriched by external data. However, it will be several years before this data is available across the board and in appropriate quality for ESG real estate ratings.

What developments are emerging in ESG ratings?

It is a fact that the term sustainability has a strong positive connotation. However, this has also made greenwashing a widespread phenomenon both in business and in the financial market. However, there are now various tools that can be used to conduct meaningful and comparable ESG analyses, also to counter the accusation of greenwashing. These include, in particular, ESG ratings for companies and real estate.

Unfortunately, neither the topic of ESG / sustainability nor the assessment tools of an ESG rating are trivial, so that one must deal with them in terms of content in order to understand their significance and be able to use them in a targeted manner.

While ESG ratings of companies are already established and widely used, ESG ratings of individual real estate / portfolios are a fairly young tool, which still has development potential in terms of international comparability and availability.

However, it is already foreseeable that the current ESG real estate rating models will face strong competition from the taxonomy compliance testing anchored in ESG regulation as a seal of approval for sustainable real estate.

And capital market-oriented ESG ratings of companies are also likely to be covered more by EU regulation in the future: As part of a consultation in the first half of 2022, the EU Commission has taken an overview of the functioning of the market for ESG ratings and the integration of ESG aspects by traditional financial rating agencies. The results will be incorporated into the upcoming decision on whether and to what extent the market should be more strongly regulated in the future in order to better achieve the goals of the EU Green Deal.

Unsere Autor:innen:

Matthias Bönning, Managing Director and contact person for private equity companies at GmbH:
Tel. +49 171 8170380 ∙

Piera Walter, Senior Consultant and Contact for ESG and CSR at Alpha IC: :
Tel. +49 151 422294-50 ∙ - a leading strategy consultancy for sustainability - and Alpha IC are cooperation partners. The basis is the common holistic understanding of sustainability. Thanks to the integral consulting approach from the strategic conception on the management level to the operative implementation on the concrete object, the benefit for the customers is potentiated. Here you can find more information about our cooperation, the consulting approach and the contact persons.

Future articles in the blog series: ESG in Real Estate Practice

Part 7: Roadmap for a new corporate culture

Part 8: Whitepaper: ESG in Real Estate Practice: 10 Tips to accelerat your ESG Transformation

If you would like to read the previous parts of the series, please feel free to click on the respective link:

  1. Part: ESG in Real Estate Practice. Status quo of a transformation process
  2. Part: ESG in Real Estate Practice. Perspectives and needs of the actors
  3. Part: ESG in Real Estate Practice. Challenges for development
  4. Part: ESG in Real Estate Practice. TDD and ESG DD
  5. Part: Digitization needs and ESG management.