How letting and asset management can support net zero real estate

Out-Law Analysis | 06 Sep 2021 | 9:13 am | 13 min. read

If the property industry is to align with the climate targets that the UK is seeking to achieve, introducing requirements as part of the new build process is only part of the solution.

Landowners and occupiers also need to consider how buildings are occupied and used and explore steps that can be taken in relation to existing building stock. This is in many ways the much bigger challenge.

Driving change: regulation and collaboration

The concept of ‘green’ leases is not new – the idea of landlords and tenants making “sustainable” commitments in a lease or separate memorandum has been around for some time. However, in practice, the introduction of sustainable lease obligations has tended to be limited – either to leases of recently developed or refurbished buildings, where the lease terms are an extension of the sustainable principles that have already been considered as part of the build process, or to reflect the approach taken by a particular landlord or occupier looking to improve the energy efficiency of a building.

However, there are several factors driving a change in approach. The increased legislative and reporting requirements are two such factors. The increased focus on climate change and environmental, social and governance issues is also driving a change of approach at board level and in personal expectations. Occupiers with their own reporting requirements and environmental policies and targets want the buildings they occupy to meet those requirements. Increasingly landlords and tenants are discovering that they need to work together to meet their respective goals.

There are several examples of how the impact of increased regulation and the drive to collaborate is affecting how properties are let and managed.

Marketing to new tenants

Minimum energy efficiency standards (MEES) in England and Wales already require all private rented buildings, both residential and commercial, to have a minimum EPC E rating subject to certain exemptions. The recent government announcement of a minimum EPC B rating by 2030 for rented commercial buildings, and a proposed EPC C rating by 2027, together with the consultation proposing a requirement of an EPC C for new residential tenancies from 2025 and all residential tenancies from 2028, mean landlords are going to have to look at how to meet those requirements – not just for new build developments but also for existing buildings.

Regulation may be pushing landlords to make changes to achieve a higher EPC threshold. However, it is not the only driver.

At a time when the greater use of technology, remote working and Covid-19 closures have led to increased vacancy rates – particularly in the office and retail sectors – it is becoming increasingly important to find new differentiating factors, and strong “green” credentials are another way to distinguish a property from its competitors. Tenants are also looking to occupy buildings that reflect their environmental commitments. It is not surprising therefore that we are increasingly seeing references to “net zero” and “carbon neutral” mentioned in letting marketing materials and heads of terms. Raising these issues at marketing stage also sets the expectation that both landlords and tenants are committed to a sustainable agenda, which should support future discussions.

Lease drafting for the net zero carbon journey

Landlord works

EPCs take into account a number of factors – for example, the age and type of building, its construction and its insulation and heating systems. As the minimum rating for an EPC on letting rises, there is going to be an increasing focus on works that are carried out to the building and which could affect the rating both before and during the term of a lease. This has implications for both landlords and tenants.

One area where there are implications is in relation to access rights: if a landlord is considering undertaking works during the term of a lease, it will need appropriate access rights and any other rights that it requires to undertake those works, for example where the works might cause some interruption in services. Some landlords have looked at including additional rights in leases to allow a landlord to carry out works to improve the environmental performance of a building or to install energy efficient measures such as onsite generation.

There are also questions to address in relation to the cost of works: the parties need to consider whether those works should be a landlord cost or one that that the tenant should be contributing towards. That point should be addressed in the lease drafting to avoid unexpected consequences. For example:

  • One of the current exemptions that landlords can claim under MEES is where a landlord is unable to obtain consent from a third party to do the work required to increase a building’s rating to the required threshold. This exemption would include consent from a tenant. If the landlord is able to obtain consent, or does not need consent because it has the necessary rights in the lease, then after 2023 the landlord must do any qualifying works required or face a significant fine. Such works will be at the landlord’s own expense unless the cost can be recovered from the tenant;
  • On the issue of whether tenants should contribute to the energy performance of a building, the “split incentive” may be relevant – namely that landlords are reluctant to bear the costs of such improvements from which tenants benefit through reduced energy costs whilst tenants with short terms leases are reluctant to contribute to the cost of the improvements works which benefit the building. The MEES requirements are subject to an exemption where the cost of the works would not meet a seven-year payback test. Where tenants will not agree usual service charge recovery for the cost of energy efficiency improvements a fair compromise may be a contribution to the costs commensurate with the cost savings the tenant will enjoy during its lease term.

Landlords will need to think carefully about how they use MEES exemptions. There has been criticism of the exemptions to the current MEES regulations, and it is clear from the latest consultations that the scope and recording of exemptions generally is under review.

Even where tenants will not agree any cost contribution it may still be important for the landlord to have a right to carry out relevant improvement works to avoid the lease acting to perpetuate sub-optimal energy performance. If the lease is clear about the how landlords and tenants intend to approach the issue of any works required and how costs should be apportioned, this would have significant benefits in the reduction of emissions.

Points to consider in leases:

  • Do landlords need additional rights of access or to carry out works – for example, to inspect or to carry out works to improve energy efficiency or to install equipment such as smart meters or to install on site renewables?
  • Who should pay the cost of any works required to improve the energy efficiency of the property – landlord, tenant or both? If the tenant is to contribute, should that be towards the entire cost of the work or only to the extent that the tenant achieves cost savings as a result?
Tenant fit out and alterations

It is increasingly common to see controls in new leases which restrict tenant alterations that would adversely affect the environmental performance of the building or reduce the rating of an EPC that has already been obtained. Where a new EPC is required because the tenant has undertaken alterations, landlords may also want to consider providing for any EPCs to be obtained by an assessor approved by a landlord and for the tenant to meet the costs of the landlord obtaining the EPC for the premises.

If a landlord is looking to maintain or improve environmental standards in its buildings, it may also wish to include specific environmental requirements as part of any tenant repairs or alterations. This could include, for example, a requirement to use energy efficient, recycled, non-polluting or local materials, or to follow sustainable methods of work, for example, reducing waste.

One area that is a particular focus in the latest consultation on implementation of the EPC B target in non-domestic buildings is the challenge of buildings that are usually let in “shell and core” condition and which are then fitted out by tenants. To meet MEES requirements, landlords can face a situation where they are legally required to install measures that will immediately be replaced. One way of managing this currently is through an agreement for lease, with tenants contributing towards installations that are installed before the lease is granted. However, that may not be acceptable to all tenants. The government proposes to deal with this issue by moving the enforcement date for MEES to a point six months after the tenant has commenced occupation via a new form of temporary exemption for “shell and core” properties.

Points to consider in leases:

  • If the building is being let in shell and core condition, is an agreement for lease structure required in order to comply with MEES and avoid the higher emissions of wasted landlord works?
  • Should there be restrictions on the tenant’s ability to obtain an EPC, for example only with landlord’s consent or from a nominated assessor?
  • Should current restrictions on the tenant undertaking works which adversely impact on EPC ratings extend to other ratings (e.g. BREEAM or benchmarks such as GRESB)?
  • Are there any requirements that should be included in relation to works by either party – for example, in relation to materials used, targets on waste, water or energy emissions?
  • Should there be obligations on either or both parties to consent to alterations that will improve energy efficiency?
  • Should either party be under an obligation to notify the other of matters – for example, disrepair that could adversely impact on the energy efficiency of the property or improvements that could assist energy efficiency?
  • Should alterations take account of the circular economy and be recyclable?
Reinstatement of works

If a tenant has carried out alterations which improve the environmental performance of the building, it may want confirmation that those alterations will not need to be reinstated at the end of the term. Similarly, landlords may be concerned that tenants do not carry out full reinstatement where works that have been undertaken improve environmental performance – particularly if reinstatement may result in a building failing to meet the minimum MEES threshold. A more thoughtful approach to reinstatement consistent with minimising embodied carbon is required.

Points to consider in leases:

  • Are there any specific works or types of works that should not require reinstatement or only partial reinstatement?
Data collection and reporting

There are already metrics to benchmark operational performance of buildings. Two of the most widely used by landlord investors are the Real Estate Environmental Benchmark and GRESB.

The GRESB Real Estate Benchmark takes account of operational energy, greenhouse gas emissions, water consumption and waste as part of the scoring. The recently launched NABERS UK building rating provides building ratings based not just on the modelled performance of a building but also on its operational performance of a building. Initially this is designed for use for office buildings only, but we may see this type of rating rolled out further.

We also now have the long-awaited consultation on a mandatory performance-based rating system for commercial and industrial buildings. The government’s proposal to introduce mandatory reporting covering scope 1, 2 and 3 emissions, aligned to the standards created by the Task Force on Climate-related Financial Disclosures (TCFD), will also involve landlords reporting on tenant’s fuel and electricity use.

For owner occupiers and whole building tenants, data relating to energy, emissions, water and waste is easily accessible, but for landlords, this requires access to data about their buildings that may be more difficult to capture. We are already seeing the collection of energy data playing out in a number of ways.

On the ground both landlords and tenants are looking to introduce more sub-metering of utilities in their premises so that separate energy use can be captured. Technology is also playing a part in the sharing of data. Some companies are already marketing technology solutions that will capture utilities data remotely without having to rely on that data being collected by a tenant and passed to a landlord. For both landlords and tenants, increased reporting is not limited to energy data. Businesses are also looking to capture information on the way that buildings are used – for example, data on water use and waste management, data on emissions and even information on suppliers.

At present most landlords and tenants are having to rely on informal routes to obtain information from each other as leases do not tend to provide mechanisms for data sharing. However, some of the practical solutions being proposed on data sharing raise issues of access, data protection and confidentiality.

As data sharing becomes increasingly important, we should expect to see greater focus on provisions in leases or accompanying documents to support landlords and tenants to share data that they hold on environmental performance in order to compile statistics or to meet disclosure obligations.

Points to consider in leases:

  • Obligations on tenants, and landlords, to provide information about operational energy and water consumption and waste disposal;
  • Rights for landlords to monitor environmental performance;
  • Smart metering – rights for landlords to install smart meters or for tenants to request meters. Who should meet that cost?
  • Confidentiality – how will that data be used and shared?
Energy efficiency obligations

More ambitious lease provisions, where a landlord and tenant are prepared to make those commitments might include obligations on one of both parties to reduce the energy intensity of areas of which that party has control with incentives or sanctions applied based on performance against agreed targets, or obligations to purchase energy from renewable sources – although this may be subject to competition issues.

Landlord and Tenant Act 1954 renewals

Where tenants seek to renew leases on the same terms as their existing leases and those leases do not contain terms which promote the reduction of carbon emissions or the energy efficiency of the building, landlords should consider whether to seek those terms in any renewal lease.

Despite the disappointing County Court judgment in the recent case of WH Smith Retail Holdings Ltd v Commerz Real Investmentgesellshaft, where the court refused to allow the inclusion of new provisions permitting energy efficiency works by a landlord and service charge recovery for the cost of such works, in our view there are compelling arguments to justify the inclusion of such provisions, especially where they result in no increased cost to the tenant.

Retrofitting and wider initiatives

As regulations become tighter and reporting obligations increase, property owners are increasingly likely to consider altering existing assets to improve their sustainability performance, and their ability to actually make those changes will come into sharper focus.

Traditionally, an investor might only make minor upgrades to buildings whilst occupational leases are in place, but this is likely to change as owners take a more pro-active approach to making improvements without waiting for buildings to become vacant. Owners may wish to take the initiative and carry out works to their assets to improve their sustainability such as installing more efficient glazing or cladding or upgrading the monitoring and evaluation systems within the building or they could look to install electric vehicle charging points or solar or other alternative energy sources. Property owners may also look to collaborate with owners of neighbouring properties in relation to shared energy sources or heating and cooling systems.

Though landlords can take advantage of the current exemption to the obligation on them to carry out improvement works to ensure that a building complies with MEES regulations, they need to strike a balance between preserving their ability to benefit from the exemption and their ability to implement any initiatives that they may choose to roll out across their portfolios. We expect that an increasing number of landlords may look to address the issue head on by including drafting in their leases to enable them to elect to carry out improvement works notwithstanding that this could exclude them from claiming an exemption under the MEES regulations.

If landlords want to retain the ability to implement wider initiatives, such as the installation of electric vehicle charging points or solar panels, then they will need to retain a sufficient degree of control over the relevant areas. It may be that simply reserving rights over the premises demised to occupiers is sufficient. However, we may see that landlords prefer to retain direct control by excluding car parking or landscaped areas or the roof-top space that would traditionally have been included within the tenant’s demise of a whole building. In the case of roof top space, excluding such areas from the demise may have wider implications – for example, the parties would need to consider issues such as how the lease deals with repair liability.

In some cases, there could be benefits for owners of neighbouring buildings to collaborate, especially in relation to shared energy sources. For example, it may be that a combined energy plant in the basement of one building could also serve its neighbours. Legal considerations that the parties will need to think about will include issues of ownership and control over the relevant areas, the rights and easements that the premises that benefit from the relevant plant will need to ensure a continuous and uninterrupted power supply, as well as ensuring that the shared plant does not prevent the future redevelopment of any building or land within which it is located. These structures are much easier to put in place when developing a new scheme, but there is no reason why they should not be retrofitted into existing assets provided that careful thought is given to the legal framework.

There could also be cases where a data trust may be worthwhile – these are set up to act as the ‘data steward’, much like a management company can be set up to act as the steward of the public areas on an estate. The approach to a data trust is up to the parties involved – it could be solely to seek to profit from the amalgamation of data, for the public good, or a combination of these and other purposes. It will need strong governance and rules, to establish what data it collects, who it discloses it to and the uses for it. A data trust could, for instance, collect data on energy use, utilities, sources of energy, from electric vehicle charging points and a battery storage unit, and then analyse this data together to much more impact, for instance to seek incremental improvements in energy usage or carbon emission reductions.