Investors are growing increasingly aware of ESG and sustainability-related risks in the property sector against the backdrop of accelerating climate change. In the following insight, Parik Chandra, Partner and Head of Specialist Lending at Downing LLP, and Roger Lewis, Head of Responsible Investment explain how the growing adoption of sustainability-linked loans (SLLs) and related frameworks can help to raise ESG standards in residential property development.  

ESG-focused institutional investing is emerging as a major theme in residential property development. A recent Downing property report highlighted that 76% of the surveyed pension schemes expect a greater focus on ESG over the next three years.

The report also found that nine out-of-ten pension funds believed that lending to support residential property developers will play an important role in helping defined benefit schemes meet their ESG goals and tackle net zero challenges.  

Tackling the whole of the problem

Achieving net zero carbon by mid-century will require an ambitious economic transition, involving every company, lender, insurer, and investor. From residential homes to commercial real estate, the buildings hold a significant amount of carbon, both from powering and heating (or cooling, especially as the world warms), and locked-in or embodied carbon. Estimates suggest up to two-fifths of emissions globally are from buildings, split three-quarters operational and one quarter embodied. This means being realistic about a long-term strategy for achieving net zero. It also means targeting the whole of the economy, and all types of carbon.  

This shows the potential reach of SLLs compared with directly financing green projects. Institutional investors and developers are beginning to take note, as SLLs provide another tool for tackling the challenge of reducing embodied carbon in new schemes.

Deconstructing net zero

To achieve carbon neutrality by 2050, the role of lenders as the link between institutional investors and developers will be crucial in the transition.  

But there are major challenges. The Environmental Audit Committee (EAC), a group of parliamentarians, warns that, to date, there has been a lack of government impetus or policy levers to assess and reduce these emissions. The EAC believes a carbon tracking requirement should be fully incorporated into building regulations.  

While there are hurdles to overcome on top-down policy progress, investment managers are responding in two ways. First, SLLs can support positive ESG outcomes and enhance risk-adjusted returns. For example, through our SLL framework, we apply externally recognised principles and conduct target-driven dialogue with our borrowers. Second, through systemic stewardship and advocacy through engaging with policymakers – for example by responding to consultations – on areas like green homes.  

Shades of green

SLLs are loans where the interest rate is linked to the borrower's ability to meet pre-defined sustainability targets. Unlike a ‘green loan’, the project that achieves funding doesn't have only one main sustainability objective for its use of proceeds.  

Instead, SLLs provide a general-purpose facility. For Downing, we have referenced the ICMA SLL principles in creating our framework and the overarching objective of our SLLs is to incentivise and reward the borrower’s achievement of ambitious and pre-determined sustainability performance objectives.  

We base this on a borrower’s sustainability strategy, targets and objectives, which are linked to an ESG scorecard; this comes after a discussion on the subject in all initial loan conversations. Relevant ESG factors need to be material, measurable and benchmarked – and we require the disclosure of the calculation methodology. The ESG scorecard also refers to the UN sustainable development goals. Once the scorecard is completed, we assess it to determine an expected sustainability score at practical completion. Feedback will be provided where we highlight potential improvements to the score. For the verification SLL principle, once the scheme has been completed, a third-party assessment of ESG data provided in the scorecard will be undertaken by a specialist sustainability monitoring surveyor.

Sustainability Performance Targets

ESG integration includes both minimum standards and aspirational targets. Sustainability factors covered are climate risk (physical impacts), carbon emissions (embodied in materials and operational e.g. energy, renewables & efficiency), water & waste management, any biodiversity initiatives, examples of engagement with community and staff, and any certifications and memberships.

At the core of what we do is creating a dialogue with the borrower for positive sustainability outcomes. Within the loan structuring, a framework is constructed, where there are specific sustainability performance targets per KPI.

This framework measures ambition and performance, which includes a timeline for achieving objectives. Loan economic outcomes are linked to sustainability performance targets (SPTs) and the loan interest reduces where borrowers satisfy pre-determined SPTs and KPIs. Reporting outcomes and impacts are the important final step.  

SLLs in action

Our goal is to enable investees and borrowers to realise their growth plans by providing flexible solutions for their capital needs. Engagement focuses on assisting our partners by leveraging our extensive sector knowledge, including material ESG factors, to support enhanced value creation.  

We are committed to raising ESG standards over time within the smaller end of the UK development sector. We keep pace with policy and changing building regulations, technology, market sentiment and planning requirements - which includes net environmental gain, green buildings and the UK’s net zero strategy. We strongly believe that SLLs will emerge as a powerful instrument in this challenge.  

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