ESG In Real – Estate And The Role Of Internal Audit

Introduction

Early adopter of Environmental, Social and Governance (ESG) practices have been rewarded with strengthened financial performance, approval and acceptance from key stakeholders and the community, effectively managed risk and building resilience, and developed and retained diverse talent. Increasing investor demand for ESG performance metrics coupled with new SEC rules for climate related disclosures, real estate companies are able to take the lead in evolving ESG practices.

In the United States, commercial and residential buildings account for approximately 40% of total energy consumption. Historically, ESG efforts have focused on reducing energy usage and associated emissions. As cities continue to adopt more stringent emissions reduction targets, more real estate owners and operators are integrating environmental performance as part of their business strategies. Furthermore, investors are paying attention to ensure they invest in companies that integrate environmental factors. Looking beyond investor demand, environmental performance can help attract lucrative tenants who are increasingly seeking efficient, healthy, and green certified buildings. Incorporating these environmental performance factors can lead to increased profitability through higher property values, tenant attraction and retention and improved return on investment.

In addition to investor and tenant driven demand, successful ESG programs optimize operational performance, identify and mitigate risks and gain a competitive advantage in the industry.

Real estate companies today are now incorporating ESG components into their long-term sustainability strategy, driven by regulation, intrinsic behavior or requirements from investors and debt providers. This fuels the need for ESG disclosure and data management to measure relevant KPIs, perform benchmarks between assets and portfolios, and report on ESG performance.

Components Of Esg

Environmental

This incorporates climate change, natural resources, pollution, recycling, and waste. In real estate terms, this primarily focuses on the energy efficiency and emissions of buildings which are increasingly determined and assessed against “green” rating systems such as BREEAM, LEED, WELL, as well as the use of Display Energy Certificates and Energy Performance Certificates.

Social

This incorporates human capital and social opportunities. In real estate terms, this focuses on a building’s impact on society, for example, the health and wellbeing of tenants and the local community. It is driving demand for larger public green spaces, frictionless (no-contact) building access and support for local enterprises, such as cafes and shops.

Governance

Governance includes board composition, executive compensation, and other hard to quantify factors such as reputation, which are applicable not just to the property owner but also to tenants, management companies and other on-site staff.

The Reit Industry At A Glance

REITs are improving ESG data and disclosures, strengthening board oversight of ESG, and implementing programs that prioritize the health and wellness of stakeholders.

Risk Management

The impacts of climate change have already influenced real estate markets on a global scale. Thirty-five percent of real estate companies are exposed to climate hazards. Of these, 17% of properties are exposed to inland flood risk, 6% to sea level rise and coastal floods and 12% to hurricanes. Successful ESG programs enable real estate portfolios to better identify and manage risks, particularly those posed by climate change, and make more informed investment decisions based on their findings.

Additionally, successful ESG programs incorporate a proactive approach towards regulatory compliance, as energy and water benchmarking requirements are adopted in more cities on a national scale. Portfolios with a comprehensive sustainability strategy and data management platform are positioned to be ahead of the curve and readily able to adapt to meet local environmental regulatory compliance standards and avoid fines and penalties and potential reputational risk.

Operational & Financial Performance

Operational performance including energy and water consumption, greenhouse gas emissions, indoor air quality, safety and waste management are material factors to measure sustainability in the real estate sector. Companies with a comprehensive ESG strategy equip investors and real estate managers with quantifiable data to measure performance. This provides actionable opportunities to prioritize assets for energy studies, capital upgrades, retrofits, green building certifications, and more. ENERGY STAR, LEED, and GRESB provide standardized frameworks to/ prioritize relevant metrics, monitor, evaluate and report ESG performance, and contribute to increased transparency across the real estate sector.

Internal Audit’s Role In ESG

The Internal Audit function can add significant value to an organization’s ESG program and disclosures. Internal Audit can proactively advise line management responsible for managing an ESG program on governance, risks, processes, and internal controls. With direct reporting to the Audit Committee, Internal Audit can relay the appropriate messaging to assist with the risk management of ESG programs, helping to ensure timely allocation of resources and action plans.

Common consulting or assurance roles Internal Audit functions can assist with:

• In its consulting role and responsibilities, Internal Audit can be involved in a rollout of an ESG program and its company’s ESG governance and strategy, identifying potential risks so that proper risk mitigation procedures are included in the ESG program. Internal Audit can conduct gap assessments against industry and/or company frameworks to identify applicable areas of improvements.
• Many companies implement applications to manage an ESG program. Internal Audit can review the specifications and requirements of such implementations during the preimplementation phase and advise on appropriate controls to build into these programs.
• ESG procedures of a company can involve significant data collection from various sources and its summarization. The accuracy and completeness of the data for key metric calculations, and the reporting of such data come with their own set of risks, requiring a need to establish proper control mechanisms to prevent or detect any errors in a timely manner. Internal Audit can provide reasonable assurance on the data and data collection procedures and provide recommendations to improve such procedures.
• Internal Audit can perform focused reviews in connection with the company’s ESG policies and procedures, including providing assurance over the design and operating effectiveness of the various key elements of the ESG program.
• Internal Audit can assist management and the external auditors in an examination of a company’s ESG disclosures through the testing of systems and internal controls. This allows management to make appropriate representations and allows external auditors to rely on Internal Audit’s work product, resulting in additional efficiencies.

What Does The Furture Hold?

There is a clear relationship between successful ESG strategies, financial performance and the increasing demand from investors and tenants to support the business case for ESG integration.

In the real estate industry, environmental initiatives such as reducing energy or water usage have historically been attractive to asset owners because of their tangible financial benefits, such as reducing operating expenditures. However, as the industry moves forward, companies need to think longer term. While reducing operating expenditures is important in the short term, considering future risks such as energy and water price risk, climate change related risks, and reputational risks due to social or governance issues is what will truly bring long term sustained performance.

Real estate companies of all sizes will eventually be required to disclose it ESG practices. Creating robust programs with Internal Audit’s assistance will mitigate the risk of inaccurate disclosures. Incorporating ESG risks into annual risk assessments and_ performing ESG-focused reviews is a best practice that should immediately be implemented.

About DLA LLC

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