Carbon reduction and commercial leases in the UK

• Author: Susan Bright
• Position: Oxford University, Oxford, UK

Introduction

The CRC energy efficiency scheme

The UK took an important global lead in April 2010 by implementing a compulsory carbon trading scheme through the carbon reduction commitment (CRC) energy efficiency scheme order 2010 (the “CRC scheme”)[¹]. The government states that the objectives of the CRC scheme are:

[…] to encourage carbon savings within large organisations, primarily by driving uptake of cost-effective end use energy efficiency measures and fuel switching – in order to help the UK meet its medium and longer-term greenhouse gas emission reduction targets ( Department of Energy and Climate Change, 2010 ).

The scheme works by requiring qualifying organisations to register as CRC participants and to purchase annual carbon allowances to cover their anticipated emissions during each reporting year running from 1 April to 31 March. The CRC scheme applies to organisations whose total annual half hourly metered electricity use in 2008 was above the qualification threshold of 6,000 MWh; this roughly equates to an annual electricity bill of more than £500,000. Small energy users are excluded because the administrative and transaction costs of including them would outweigh any energy savings ( NERA Economic Consulting and Enviros Consulting, 2006 ). The Department of Energy and Climate Change estimates that around 5,000 organisations will qualify for full participation, and around a further 15,000 will have to make an “information disclosure” (which relates to metering and energy use). During the early years of the scheme the price of carbon is fixed, but from 2013 allowances will be sold on an auction basis and the imposition of a government cap will lead to a gradual reduction in overall emission levels. It is not only through the pricing and cap mechanisms that the scheme aims to drive down emissions; there are also provisions for the “recycling” of payments at the end of each accounting year, which will reward those organisations that have made the most strides towards improving energy efficiency. Performance is made transparent through the publication of a CRC “Performance League Table”. Although it has not been specifically designed to target emissions from the commercial built environment, it is clear that the CRC scheme will have a significant impact on the property sector.

The landlord-tenant divide

Of the 5,000 or so organisations that will be required to participate under the CRC scheme, many will be landlords of commercial property. If these organisations are to reduce energy emissions to reflect the goals of the CRC scheme it is therefore necessary that the structure and terms of leases permit appropriate abatement measures to be taken. It is, however, widely acknowledged that the majority of UK leases present serious barriers and disincentives to the implementation of energy efficient measures. This has been recognised throughout the policy history of the CRC scheme. In the first major publication to promote a mandatory cap and trade scheme, The Carbon Trust's, 2005 report on the UK Climate Change Programme, the “landlord-tenant divide” was identified as one of the key barriers ( The Carbon Trust, 2005 ). The challenges to the CRC scheme generated by the division of ownership and management responsibility within the landlord and tenant relationship and what is commonly referred to as the “split incentive” (which is explained below) have been referred to in all of the key policy documents since then. Notwithstanding this, the CRC scheme makes no express provision for landlords and tenants and the only indirect acknowledgement of the difficulties that there may be in delivery of the scheme in this context is the statutory imposition on tenants of what the government has described as a duty to cooperate with the landlord organisation for the purposes of complying with the CRC scheme ( Department of Energy and Climate Change, 2009 ). On what is a central issue, the ability of landlords to pass on the costs of participating in the CRC scheme to tenants, the government conspicuously decided not to legislate but to “develop voluntary ‘good practice’ guidance (in collaboration with both landlords and tenants)” ( Department for Environment, 2008 ). This work is ongoing, but as yet there is no sign of industry consensus on either the principle of whether tenants should be required to contribute to their landlord's CRC costs, or (if so) on how to reflect this in the leasehold drafting.

Much of the property industry is critical. Liz Peace, the Chief Executive of the British Property Federation (BPF) (the lead organisation representing property owners and investors in the UK) has said that:

[…] the scheme has not been properly thought through. Large areas of uncertainty remain over how you apply the CRC around existing leases. Landlords have no legal remit to influence how tenants use energy ( Property Industry Working Party, 2009a ).

This paper will consider the challenges in applying the CRC scheme so as to deliver the desired policy outcomes in the context of commercial landlord and tenant relationships. There is a subsidiary issue that is also very important in practice, to do with how the CRC scheme can be mapped onto the wording of existing leases, and provided for through the wording of new leases. This subsidiary issue will be touched on below but the primary focus of this paper is upon the challenge of using the CRC scheme to achieve serious energy reduction against the constraints of the traditional structure and pattern of commercial leases in the UK.

An overview of energy payment in UK commercial leases

The institutional lease and the net rent concept

Much commercial property in the UK is leased. It is difficult to find reliable figures, but a report of the Investment Property Forum (IPF) estimates that 43 percent of the total stock by value is in the “investment market”, comprising just over 60 percent of the retail and office sectors, but a little less than 25 percent in the industrial sector ( IPF, 2005, p. 51 ). It is also hard to find how much is let to more than one tenant, but one statistic suggests that 70 percent of tenanted commercial buildings are multi-occupancy ( NERA Economic Consulting and Enviros Consulting, 2006, p. 43 ). The IPF report is confined to “investment grade” property and although the commercial property sector is broader than this, CRC participants are most likely to be owners or occupiers of this level of property. Further, it is in this market that what is referred to as the “institutional lease” is dominant.

This idea of the institutional lease is important in relation to this paper for two reasons. First, the fact that for many landlords the lease is primarily an investment requires the lease to be readily marketable as an asset, and this is a driver towards investment leases taking a common format and not containing unusual provisions. As Williams and Eddington explain, standard lease terms carry the advantages of acceptability in the marketplace, easier negotiation and familiarity ( Williams and Eddington, 2009 ). Leases that reflect a standard pattern are much easier to attach a capital value to ( Edwards and Krendel, 2007, pp. 142-3 ). This leads to the second aspect of the institutional lease that is important. For an investor landlord the ideal is a lease that delivers a long-term secure income. One outworking of this principle, important in the CRC context, is that all unknown servicing costs (such as repair and insurance) are borne by the tenant. This means that the landlord receives a net rent, one that is not vulnerable to deduction of variable costs. In most cases, therefore, it is the tenant that pays for energy costs for the premises.

Although it is the tenant who will usually pay for energy, it does not follow that the tenant is in charge either of energy supply, or of how much energy is used. A sample of the variety of arrangements found in practice can be seen from looking at a case study based on the property portfolio of Land Securities, the UK's largest Real Estate Investment Trust ( Burges Salmon and Ecofys, 2008, p. 67 ). The summary below builds on this case study (making some further assumptions) to describe a range of tenancy and energy arrangements that exist:

The whole building is let to a sole tenant, which has its own energy supply.

Multi-let property scenario 1. The landlord supplies energy for the common parts and for heating and air conditioning throughout the property (with the costs being passed through to tenants by a service charge) but the each tenant has its own electricity supply to its premises.

Multi-let property scenario 2. All energy is supplied by the landlord (with costs passed through to tenants by a service charge and the tenant's share is calculated by reference to the floor area occupied by the tenant).

Multi-let property scenario 3. All energy is supplied by the landlord but there is sub-metering for tenants (and the energy costs are passed through by a service charge which takes account of each tenant's individual energy use within its premises).

Multi-let property scenario 4. This contains a mix of retail and office space. The retail tenants have their own electricity supply, but gas is supplied by the landlord. The office tenants have all energy supplied by the landlord (It is more...