An increasing number of developers, investors and occupiers are putting sustainability at the heart of their business plans and real estate strategies. Earlier this year, Theresa May's Government introduced a legal obligation to bring carbon emissions to "net zero" across the United Kingdom by 2050; and businesses across all industries are considering how this affects them, and crucially whether there is competitive advantage in moving early and substantially sooner than 2050.
For the past few years, a key component of Government's drive towards increasing the environmental performance of real estate has been the Minimum Energy Efficiency Standards (MEES). Just when commercial landlords and tenants had started to develop a strategy to deal with MEES, the goalposts are about to be moved. This will require a re-think in strategy for both landlords and tenants, and probably greater collaboration between them going forwards.
Even though the outcome of Government's current consultation is at this stage unknown, the direction of travel in law and policy - and increasingly in relation to occupier expectations - is clear, and it is never too early to start preparing.
The current position
The current minimum energy efficiency standard is an EPC rating of E or above. Properties below the minimum rating are sub-standard. Since 1 April 2018 it has been a breach of the MEES regulations to grant a lease of a sub-standard commercial property, unless an exemption applies. From 1 April 2023 the prohibition will extend to existing leases, and it will become a breach of the regulations to continue to let a sub-standard commercial property. (Domestic properties will be caught by the prohibition on continuing to let from 2020. This article considers commercial properties only.)
Various exemptions are available under the current scheme. These include an exemption where all relevant energy efficiency improvement measures which meet the "payback test" have been made, but the property still does not meet the minimum rating. The payback test is broadly that the cost of the energy efficiency measures is equal to, or less than, the energy savings generated by those measures, calculated over a seven year period.
Government had always flagged that the minimum rating was likely to increase over time. Some commentators had wondered whether Brexit would slow down or halt this policy. Government's recent consultation demonstrates that this is manifestly not the case, and that its ambitions are greater than many had perhaps anticipated. There is no reason to think that the imminent general election will result in a radical u-turn, given the need to meet environmental commitments.
The consultation sets out a target of a minimum energy efficiency standard of an EPC rating of B by 2030. Failing that, Government's fallback option is to fix the minimum at C by 2030.
Government estimates that an EPC B trajectory would bring 85% of buildings into scope, compared with less than half that number under a C trajectory. It suggests that 64% of buildings would be able to reach EPC B, and a further 20% would be able to reach EPC C (the remainder would be unable to reach a C rating).
The way to 2030
As the old adage goes, it is not the destination that is important, it is the journey. Whichever of Government's routes to 2030 end up being adopted will have a significant impact on the strategy that landlords and tenants will need to adopt in order to stay ahead of their competitors, meet their customers' aspirations and investors' expectations, and to comply with legal duties.
The basic choice facing Government is between a single implementation date on the one hand, and the use of incremental milestones on the other.
Single implementation date
Under a single implementation date, buildings could not continue to be let on and after 1 April 2030 unless they reach the minimum standard (of EPC B or C, as determined by Government), subject to the payback test exemption.
Under the single implementation date option, the 2030 deadline will apply to all tenancies - not just the grant of a new tenancy after that date. It will therefore not be an option for a landlord to grant a new tenancy of a soon-to-be sub-standard property in 2029, and metaphorically cross its fingers for a few more years. All tenanted non-domestic premises must be brought up to the new minimum standard by 2030, unless an exemption can be claimed.
Government recognises that, under the single implementation date route, there is a risk that most improvements take place close to the 2030 deadline. This could lead to capability and capacity issues in both the energy efficiency, and EPC assessor, markets in the immediate pinch point prior to 2030. In addition, if energy improvements are postponed until shortly before the 2030 deadline, the opportunity to reap the benefit of energy savings at an earlier date is lost.
As an alternative to a single implementation date, Government is also looking at achieving the end goal of EPC B/C by 2030 through the adoption of incremental milestones. The consultation sets out four possible stepping stones to 2030, depending on which end goal (B or C) is adopted. However these are not the only options, and Government invites views from consultees as to other ways in which incremental milestones could be used.
As illustrated by the timetables above, two of the trajectories apply different deadlines to the grant of new lettings from existing leases (similar to the 2018/2023 model under the current regulations). The other two trajectories are not structured by reference to lease lifecycles and simply regulate existing leases.
What strategy to adopt
Currently, a landlord's strategy to deal with MEES will depend on a number of factors. These include its own environmental and sustainability credentials, its relationship with its tenants, the terms left to run on existing leases (including any breaks), the energy efficiency levels and age of its building stock and the dates when existing EPCs will expire. A landlord may adopt different strategies in relation to different buildings to reflect these varying factors.
Many landlords are adopting a pro-active approach to MEES. This might take the form of planning in works to raise standards wherever possible. An equally pro-active, but very different, approach adopted by some landlords is to seek to pass on some or all of the costs of MEES to their tenants.
Other landlords may have chosen to adopt a strategy of "wait and see". This may be because leases are due to fall in, or buildings will require redevelopment, in the near future (and before 2023), such that there will be a natural opportunity to do any necessary work then. Alternatively, landlords may anticipate that their tenants will be looking to offload some space, and hope that an application to underlet may alter the balance of bargaining power between the parties as the MEES obligation is triggered earlier than it would otherwise have been.
A need to rethink?
The current consultation means that landlords should reflect on their existing strategies, and assess whether any changes are required to adapt to the new trajectory. While this is not straightforward given that the precise route forward is not yet known, the impact of different incremental milestones on a landlord's portfolio should be considered.
A trajectory with incremental milestones based on a lease lifecycle is likely to be easier for both landlords and tenants to work with than one where the incremental milestones also apply to existing tenancies. That said, it depends in part on the landlord's plans for funding any necessary energy efficiency improvement works (and on whether any tax breaks, grants or other government led incentives are available). Landlords who are willing to fund works themselves can review lease term dates - including possible breaks - in order to schedule in upgrade works at a time when the property is likely to be vacant. It may also be possible for energy improvement works to be carried out as part of an incoming tenant's fit-out (more on this below).
In contrast, if Government decides to proceed with incremental milestones based on a prohibition on continuing to let sub-standard properties, the need for landlords to act now in developing their MEES strategy is arguably even greater. A ten year lease of an "E" rated property granted in 2020 could fall foul of the ramped-up regulations as soon as 2025. In this instance, what the lease says about the landlord's rights of access to carry out works, service charge recovery provisions and rent review (among other clauses) will be thrown into sharp focus.
The transition through different EPC bands from E to an eventual minimum rating of B/C in 2030 also presents a basic dilemma. Should landlords undertake, up-front, all works necessary to lift the property to the 2030 rating…? From one perspective this is appealing - it is less disruptive, and more efficient, than carrying out multiple sets of works at different times. The overall cost, and potential for wastage of earlier measures installed, is also likely to be less. However, this must be balanced against other factors.
For example, a MEES trigger may be initiated by a tenant (e.g. because they wish to sublet), rather than the landlord. Although in this situation the landlord and tenant would appear to have equal interest in the property being made MEES compliant, the reality is that their interests may not be aligned. On the most common lease terms, the landlord is unlikely to be able to require the tenant to do more work than is actually required as a result of the trigger. This may end up being no works at all, if the payback test is not met (and the tenant can consequently claim an exemption). The landlord on the other hand may have an interest in a larger package of measures being carried out to uplift the property through several ratings in one go (which may then make the works cost-effective). Landlords may want to consider contractual lease terms which would apply in these circumstances to require the tenant to carry out additional works at the landlord's cost. Such an approach has not yet been tested in the market as far as we know.
The potential for tension between these competing interests reinforces the need for landlords to have a clear idea of their preferred strategy in advance of any lease events.
In addition, if landlords are to go for the "one hit" strategy of front-loading energy efficiency improvements to raise the EPC rating now to the 2030 minimum, Government must provide adequate reassurance that any changes in the EPC calculation methodology will not result in a down-rating of the property between now and 2030 (assuming that there is a trigger for production of a new EPC in that time). This is touched on in the consultation, which also mentions that Government is keeping under review whether the EPC is the correct yardstick by which to measure MEES in any event. Clearly these are risks which must be taken into consideration.
Use of exemptions
For some landlords, their current choice of strategy is to utilise exemptions wherever possible. Again, this strategy should be re-tested against the new proposals - particularly in light of the fact that exemptions only last for a maximum of five years.
Exemptions must be registered in order to be effective, and are personal - meaning that if the property is put up for sale, the incoming buyer/landlord will need to establish whether it can either comply with MEES, or itself meet the criteria for an exemption. Commercial property owners need to consider the existing ratings of properties that they may be planning to sell in the short to medium term: even if such properties are MEES compliant now, potential buyers will be conscious of the changes coming down the tracks, and this may have an effect on valuation.
While it appears that Government does not currently have any plans to abolish the existing exemptions, the nature of the payback test exemption means that it is responsive to both reductions in the cost of energy efficiency measures, and improvements in the energy reductions generated by those measures, over time. It is therefore possible that a landlord may find itself obliged to install a package of measures in 2028 that may not have been cost effective in 2023. Landlords should consider whether it may in fact be more convenient to carry out energy efficiency improvement works at an earlier stage, rather than rely on the payback test exemption. In this manner landlords may have more control over the timing and cost of the works. This factor may be particularly influential where a landlord is obliged to carry out some works now, with only a portion of the works being covered by the payback test exemption.
The date and lifespan of existing EPCs should already be a factor in a landlord's MEES strategy. An EPC currently lasts for ten years, unless works are carried out to the property which both change the number of lettable units within the property (whether an increase or a decrease) and affect the systems for heating and cooling.
This means that a property with an EPC of, say, C, issued in 2019, would under normal circumstances retain that C rating until 2029. That would meet the milestones under three out of the four possible trajectories above, meaning that the landlord may not be faced with a possible problem until the next time the EPC needs to be re-issued after 2029. Since an EPC only has to be produced when there is a trigger (on construction, on a sale, letting, or specific works as set out above), then depending on the term of any lease running at the time this may not be until 2030 or beyond.
However, Government is considering increasing the triggers for production of an EPC. This possibility must be factored into a landlord's strategy, especially if there is reason to think that a new EPC would produce a lower rating than the existing EPC (either because of works which have already been carried out at the property, or a change in EPC calculation methodologies during the intervening period).
For example, while refurbishment works would not currently trigger the production of a new EPC unless they met the criteria above, if the EPC triggers were amended then it is possible that a planned building refurbishment could result in the requirement to produce a new EPC. In these circumstances landlords would be advised to consider whether energy efficiency improvement works should be carried out at the same time as the refurbishment.
Landlords need to be particularly careful if new triggers for production of an EPC include the carrying out of alterations at the property. It is important that leases preserve the landlord's ability to control alterations - acting reasonably - so that the landlord can ensure that a tenant's proposed alterations do not result in any new EPC which is produced bearing a lower rating than the existing EPC.
The lifespan of an EPC also has the potential to take a property out of the scope of MEES. MEES only applies where the property has a valid EPC. For example, an EPC produced in 2015 will ordinarily expire in 2025. Changes in the minimum rating after 2025 will be of no impact (there is no valid EPC, so MEES doesn't apply), unless and until there is a trigger for the production of a new EPC (e.g. the property is marketed for sale or rent).
It is possible that Government may legislate to reduce the validity period of an EPC to less than 10 years, in which case (somewhat counter-intuitively) a property could potentially be taken out of MEES earlier than expected. Bear in mind though that, as outlined above, the triggers for production of a new EPC may be expanded in future.
Under the current MEES regulations, a property must meet the minimum standard before a new lease is granted. This can lead to problems where a building is to be let in a shell and core condition, on the basis that the tenant will install lighting, air-conditioning etc as part of its fit-out. Any EPC generated for the property in advance of the letting in these circumstances is likely to be sub-standard, as the Government guidance instructs energy assessors to adopt a set of assumptions based on the most energy intensive fixed services fit-out allowed under Part L of the Building Regulations. Similar issues can arise where a sub-standard building has heating and lighting already installed but these are to be upgraded as part of the tenant's fit-out; or where it makes sense for the landlord to schedule in energy efficiency works to be carried out at the same time as the tenant's fit-out.
In these circumstances, either a landlord must expend money on installing kit which is likely to be immediately replaced; or fit-out works must be carried out under an agreement for lease, and the lease only granted once the works have been completed (and either a new EPC issued, or evidence to demonstrate compliance with an exemption compiled). This may not be desirable from either party's perspective.
The Government consultation recognises that this situation is unsatisfactory. While it does not suggest altering the underpinning principle that responsibility for the energy efficiency of the building rests with the landlord, it is seeking market-led solutions to this issue. One possibility not mentioned in the consultation, but which might facilitate lettings, could be for Government to introduce an additional category of exemption. This could apply where under the terms of an agreement for lease, lease or other contractual arrangement a prospective tenant has agreed to be responsible for carrying out certain energy efficiency works to the property. The exemption would allow a certain period following lease grant in order for the property to be brought up to the minimum standard (as evidenced by a new EPC), or a different exemption claimed (e.g. where all cost-effective measures have been taken). By analogy with existing exemptions, a period of - say - six months could be permitted.
If this new exemption were to be introduced, getting the right balance of landlord plant and fixtures and tenant fit out to achieve the desired rating will be important. There will be an increased contractual requirement for collaboration. Landlords would also need to take steps to protect themselves contractually, including obtaining a tenant commitment to complete the works within the relevant timeframe, and step-in rights to complete the works (at the tenant's cost) should the tenant fail to do so. This is because the responsibility for MEES compliance would ultimately remain with the landlord after the expiry of the initial exemption period.
Tenants can expect an even more detailed grilling from their landlord about any works they plan to undertake at the property. Landlords will be keen to receive assurances on the effect of works on the property's energy efficiency. Any decrease in the EPC rating must be avoided.
Where the tenant's works are part of a collaborative arrangement to comply with MEES, if the likely outcome of the works is that the property will not be raised up to the minimum standard, the landlord will need to rely an exemption. The most likely exemption is that all the works that meet the payback test have been carried out. In order to claim this exemption strict criteria must be met, including the obtaining of at least three quotes. Tenants may not always be keen either to obtain this information, or to share it with their landlord. There is clearly a need for discussion and negotiation here.
Tenants must also consider whether they may themselves become landlords. In a market where space is becoming more and more flexible, tenants wishing to offload spare capacity may trigger the requirement to comply with MEES.
Time to respond to the consultation
The consultation does not close until 7 January 2020, so there is still plenty of time to respond. The issues Government is seeking feedback on include:
- The choice of a single implementation date versus incremental milestones
- If incremental milestones are used, which route to 2030 should be adopted
- How to deal with situations in which the EPC rating is to be raised through the tenant's fit-out works
- Whether Government's proposals are likely to increase void periods
- The key factors which determine the costs which landlords would seek to pass on to their tenants.
Future developments - operational performance
The existing regulatory framework, relying as it does on EPCs, focuses primarily on building fabric.
Government acknowledges that without ensuring that commercial buildings are operated in ways that maximise their energy performance, the gains in building quality will never be fully realised. In 2020 Government will consult on introducing mandatory in-use energy performance ratings for non-domestic buildings in the private sector. This is likely to have a greater impact on tenants, rather than landlords. Depending on how the new requirements work, this may also mean that tenants have a more vested interest in engaging with landlords on energy improvements to a building's fabric.
One thing is clear - Government is serious about driving energy efficiency in commercial buildings. Landlords and tenants who do not engage now with these initiatives risk being left behind.