The government is looking to tighten minimum energy efficiency standards for rented commercial properties in England and Wales. On 15 October it published a consultation on how best to achieve this, proposing ambitious targets for energy efficiency improvements by 2030.

The consultation puts forward two alternative trajectories. The government's preferred option is that all commercial privately rented properties in England and Wales should be required to achieve a minimum energy efficiency standard of EPC band B by 2030. The alternative option is a requirement to achieve EPC band C by the same date.

The government's hope is that setting a clear trajectory to 2030 now will give landlords and tenants a long enough lead-in time to plan and carry out improvements, and give the energy efficiency market the certainty of demand needed to encourage growth and innovation.

What is the background?

Since 1 April 2018, under the existing minimum energy efficiency standards laid down in the Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 (MEES Regulations), landlords of commercial properties have not been permitted to grant a new tenancy, or extend or renew an existing one, unless the property has a minimum energy efficiency standard of EPC band E. This prohibition will be extended to existing tenancies from 1 April 2023.

Businesses and industry are responsible for over 25% of UK emissions, a significant proportion of which are created by the energy they use to heat the buildings they occupy. Improving the energy efficiency of buildings is therefore a key priority. In the Clean Growth Strategy published in 2017, the government said it aimed to help businesses to reduce their energy use by at least 20% by 2030. It has also made a broader commitment to achieving zero carbon emissions in the UK by 2050.

Progress has been achieved under the current MEES Regulations, but if the above aims are to be achieved then the speed of progress needs to increase significantly.

Government's preferred option for EPC band B by 2030

The government's preferred option is for buildings to achieve EPC band B, because the modelling carried out suggests that the alternative option will not deliver the energy and carbon savings required from the private rented sector to achieve the government's existing targets. Setting the minimum standard at EPC band B would bring 85% of commercial properties within the scope of the MEES Regulations, compared to 42% if the minimum standard were set at EPC band C.

Setting the minimum standard at the higher level would also have a significantly greater impact in stimulating demand for energy efficiency products and services and encouraging a competitive marketplace. Landlords and other businesses would then benefit from the cost reductions likely to follow.

Improving the relevant building stock to EPC band B is expected to cost about £5 billion between 2019 and 2030, compared to about £1.5 billion for improvement to EPC band C. However, the government also estimates that the annual benefits to businesses of setting the standard at EPC band B would be approximately double those which would be achieved if it were set at EPC band C.

Single implementation date or incremental milestones?

As well as seeking responses on the two alternative proposals the government is consulting on whether there should be a single implementation date or whether the new standard should be introduced in stages. The consultation contains various examples of how staged implementation could work and discusses the advantages and disadvantages of the two approaches.

The seven-year payback test

Energy efficiency improvements would only be required to the extent that they meet the seven-year payback test, as is the case at the moment. The test is met if the expected value of savings on energy bills over a seven-year period is equal to or greater than the cost of the improvements carried out. While there is no proposal to change the test, the government says it is committed to acting on any clear feedback that outlines ways in which the test can be improved in practice.

Where a landlord has carried out all the improvements that meet the payback test but the property still does not meet the minimum standard, the landlord would still be able to let or continue to let the property provided it registers the relevant exemption, as at present. However, exemptions only last 5 years. If the proposed changes stimulate investment in the energy efficiency market as the government hopes, faster technological change and increased competitiveness are likely to mean that improvements which did not originally meet the test will do so when the exemption expires. Landlords should therefore not assume that they will routinely be able to renew an exemption when it expires.

Exemptions, penalties and enforcement measures

Current MEES exemptions would continue to apply, as would the current penalties and enforcement measures. The consultation notes that effective enforcement will be key to the success of the current and future minimum standards, and our expectation is that the enforcement regime will be tightened.

Implications for landlords

The proposed increase in the minimum energy efficiency standard is significant. Landlords would therefore face substantially increased costs, which may in turn increase their need to borrow. Those landlords who are already highly geared may struggle to finance improving their properties to the required level.

On any sale of property, the proposed new energy efficiency standard would need to be factored in and is likely to have an effect on capital value, particularly where the property currently falls far short of the new standard.

The consultation identifies that there has historically been a "split incentive" between landlords and tenants, in that the cost of energy efficiency improvements typically falls on landlords while it is tenants that reap the benefits in the form of lower energy bills. The government's view is that in a well-functioning market the split incentive would not exist because rent levels would reflect the differences in energy efficiency of different properties. It remains to be seen whether the proposed significant increase in the minimum energy efficiency standard results in rent levels adjusting to better take account of actual energy costs. While the market may adjust over a longer period, this may be a somewhat unrealistic prospect in the shorter term, particularly in a climate where tenancy lengths are relatively short.

Implications for lenders

Lenders have existing concerns on MEES-related issues which will only be heightened by an increase in the minimum energy efficiency standard. A sub-standard EPC rating is already likely to affect the capital value, marketability and rental value of the lender's security. The larger the gap between the property's current EPC rating and any increased minimum standard that is introduced, the greater the lender's concerns.

The possible adverse effect of a sub-standard rating on rental value could affect the reliability of the borrower's income stream to service the borrowing, and/or the extent of the capital expenditure required to bring the property up to the necessary standard. Lenders will assess the implications of any higher energy efficiency standard in deciding whether to lend and, if so, what if any additional conditions to impose.

For our 2018 article on MEES considerations specific to lenders see MEES: considerations for lenders.

Responding to the consultation

The consultation closes on 7 January 2020. Landlords and other interested parties would be well advised to read the consultation and consider responding to some or all of the questions raised. In particular, they may have a view on which of the two options is preferable and/or whether the proposed changes would be better introduced on a single implementation date or phased in gradually.

The consultation can be found here.