Energy Act 2011: the new law on energy efficiency may be good for the environment, but it could bite landlords, write Nicholas Dowding QC, Barrister at Falcon Chambers and David Gilbert, Director and Head of professional standards and practice at LSH.

Costs of energy production are spiralling and traditional fossil resources are diminishing rapidly. Finally, however, it seems that the government is taking appropriate action to force property owners to make buildings more energy efficient. At the forefront of the government’s energy policy is the Energy Act 2011 (the Act), which received royal assent on 18 October 2011. The Act has major implications for commercial property: owners, tenants and lenders all need to start thinking about it now. The two aspects of the Act that will have the greatest effect on commercial property are the Private Rented Sector Regulations (PRSR) and the Green Deal. Although these are dealt with separately, they are interrelated. The Green Deal has been portrayed by the government as the hero of the story; the carrot to the stick of the Act’s villain, the PRSR. Once the PRSR is in force, no later than 1 April 2018, buildings must be raised to a minimum energy efficiency rating before they can be rented. Much of the detail is to be set out in regulations, and none have yet been made in relation to the private rented sector.

Preparation needed now

However, it is expected that the required level of energy efficiency will be identified by reference to the energy rating of a building as determined by its energy performance certificate (EPC), which the vast majority of commercial buildings are already required to have before they can be sold or let. This is assessed by reference to government-approved software, which is periodically revised by the Department of Energy and Climate Change (DECC). In many cases, this makes it harder to achieve higher EPC ratings over time. The current DECC website and Green Deal Impact Assessment indicate that the threshold will be an E rating. Thus, landlords with buildings that have F or G ratings will not be able to let them from 1 April 2018, unless sufficient efforts have been made to reduce the rating to the lowest possible level. Some 18% of rented non-residential buildings are thought to fall into this category. The consequences for the market are therefore profound. Until the ensuing regulations are issued, the effect will be hard to assess, but immediate action is needed to prepare for April 2018.

Contingency plans are required to deal with the risk that current proposals are implemented in full. In considering its contingency plans, the property industry must factor in the provisions of the Green Deal, which provides the funding mechanism to ensure that any works required to raise the EPC rating of a building can be implemented without an upfront cost to the landlord. This is achieved by providing for the cost of the works plus finance charges to be recoverable through the energy bills for the property rather than from the party that instigated the works.

The intention is to avoid the situation where landlords or occupiers fail to carry out energy efficiency works because the payback period is too long in comparison to the planned occupation. The government’s “golden rule”, much touted by the politicians, is that the expected financial savings must be equal to or greater than the costs attached to the energy bill, so that, in principle, the expected energy savings must not be less than the cost of the improvements. The DECC website suggests that a landlord who has carried out the maximum package of measures funded under the Green Deal (or Energy Company Obligation) will not fall foul of the restrictions on letting even if this does not take the property above an F rating.

The question is: will it work?

The government recently announced its decision to delay the roll out of the Green Deal for business following widespread concern as to the complexity of the commercial property market. One problem for commercial property is that the improvements that are anticipated can be very costly. Research by Cyril Sweett (see www.sweettgroup.com) suggests that, as regards fabric measures, the only type of commercial property that is likely to meet the golden rule is 1960s industrial property (by virtue of poor fabric and a high level of energy consumption). This research suggests that savings from improved services are likely to be insufficient to cover finance and capital costs for a much greater range of properties. Another potential problem is where the works are carried out by a tenant under a Green Deal plan, but the lease ends before the period of the plan has expired, in which case the landlord will have to meet the payments himself until he relets. All of those in the commercial world will be well advised to review their portfolios now and consider what action they should take. At the very least, knowing the current EPC rating of buildings held or occupied is critical. This must be followed by a review of potential options for improving the energy rating and minimising potential problems. At the simplest level, a decision may be made to dispose of poorly rated stock in favour of that with higher energy efficiency. Buildings that are retained (for example, because they fulfil a long-term strategic position) may have to be improved to ensure their lettability in 2018. In any event, there is no “do nothing” option.

Mortgage security

A critical point for lenders is that any loan for five years will mature before the restrictions on letting bite. In circumstances where the lender is expecting its money back, it will expect a property to be fully marketable. A property that currently falls in bands F or G may be less marketable – whether for a letting or sale – and that is only likely to get worse as April 2018 approaches. This therefore goes to the root of the security even if not necessarily its present value. To maximise asset value, significant expenditure may be required by the mortgagor to bring the property into band E. It seems reasonable for the lender to question how this will be funded during the loan term, whether that be through the Green Deal or otherwise. For example, lenders should be asking if the cost has been factored into the borrowers’ business plan. Some lenders have not woken up to this problem on new lending, let alone existing lending.

Conversely, those lenders who have considered the point may be faced with customers who do not seem to appreciate the scope of the problem, but merely regard it as yet another excuse for the lender not to advance funds. In simple terms, both borrower and lender should be facing this problem square on and working out a strategy for dealing with it, especially if upfront funding is required to implement improvements between now and 2018. There seems little sense in a borrower walking headlong into a situation where it has no strategy in place to ensure that it has a lettable asset when the time for repayment of its loan arrives.

Service charge management

The implications of the Act are likely to be acutely felt in the management of properties, particularly around the interpretation of how the legislation effects service charge management. Over the past decade the greater awareness of environmental issues, the pending legislation and the increasing absolute cost of utilities has lead to some leases incorporating “green” clauses, which require better environmental management of a building. A typical clause may read: “The landlord shall use reasonable endeavours to minimise energy use and water consumption, giving consideration to use of renewable technologies and energy (where appropriate for the building) in providing services pursuant to this lease.”

It is doubtful that anyone would disagree with the sentiment of this style of clause; driving lower utility consumption is common sense, after all. Landlords may be encouraged to make capital expenditure in new plant and machinery in order to deliver this benefit. In many cases, however, the work will not be covered by the service charge provisions, because it is not “repair” and it does not come within any other head of charge. The property manager is likely to face resistance from tenants asked to pay for the work, on the ground that it represents an improvement outside the terms of the lease, even if the repayments are made through energy bills. This promises a lot of lively occupier and landlord discussion and argument until the regulations are clear and case law sets precedents.

However, many commercial leases contain a “sweeper” service charge clause, for example, a provision entitling the landlord to recover the cost of providing such services and carrying out such works as it may consider necessary in accordance with the principles of good estate management. Depending on the wording of the particular provision and the particular facts, there may be a case for saying that work carried out to improve the energy performance of a building falls within such a provision, and so is a recoverable charge regardless of whether it represents “an improvement” to the building.

Conversely, tenants will argue that, absent clear words, they should not be responsible for meeting the cost of dealing with an asset that is outdated and that does not meet the regulations. The Act will also have significant ramifications on complex buildings where there are many shared services and close dependencies between the common parts and demised areas.

Aged air conditioning plant can, for example, be a major factor in driving EPC ratings into the lower F and G categories. Therefore, imagine a scenario where a dated air conditioning system in an office block is maintained by the landlord and it serves both common parts and the occupiers’ demised areas. The landlord may wish to, or be forced to, upgrade the air conditioning plant in the whole building owing to the interdependency of the plant across the common areas and demised areas. Only by so doing will it command a rating above the F and G banding to make any voids capable of letting and occupation. This will affect the whole building, being to the long-term betterment of its occupiers, but tenants may well regard it as an improvement and argue that it is not recoverable as a legitimate service charge expense. This is just one example of the thorny dilemmas that will occur, particularly in multi-let buildings. Such problems will no doubt test the drafting of the Act and the regulations in the run up to 2018, and the courts beyond. Already we are seeing drafting by tenants in new leases that attempts to remove any liability on their part to pay for upgrades to the landlord’s asset to achieve improved energy performance. Contracting parties therefore need to consider the problem now, not in five years.

Find out more: David Gilbert has written a number of articles on the Energy Act for leading trade publication, Estates Gazette. To read more tooling up for the Energy Act, download the PDF. To read more about how the new laws on efficiency may be a wolf in sheep's clothing, download the PDF.