Improvements will have to be made to some commercially-let premises in order to meet minimum energy efficiency standards starting from 1 April 2018. The government is consulting on the detail of the proposed regulations.
- Why is legislation necessary?
- Powers in the Energy Act 2011
- What is the scope of the non-domestic regulations?
- Which buildings are not affected?
- When will the rules come into force?
- Which types of transactions are affected?
- If a property is caught, what has to be done?
- Who will bear the cost of improvements?
- Minimum energy efficiency standards and the contents of a commercial lease
- Forward trajectory
- What should landlords be doing now to prepare?
- Consultation - next steps
Why is legislation necessary?
According to the consultation document, energy used in heating and powering non-domestic buildings accounts for around 12% of the UK's CO2 emissions. Around 60% of today's non-domestic buildings will still exist in 2050, but to achieve the UK's legislative targets, CO2 emissions from all buildings must be close to zero by that date.
Some 18% of non-domestic properties currently have an Energy Performance Certificate (EPC) rating of F or G. There is clearly a gap, in energy performance terms, between where the current stock of real estate is, and where the government would like it to be.
Powers in the Energy Act 2011
The government acknowledges that emissions from the non-domestic rented sector are already covered to some degree by other policies, e.g. the Carbon Reduction Commitment (CRC) Energy Efficiency Scheme, and Climate Change Agreements. However, these do not cover all properties.
To address this, the Energy Act 2011 requires the government to bring into force regulations ("minimum energy efficiency standard regulations") to improve the energy efficiency of rented buildings in England and Wales, in both the domestic and non-domestic sectors. Here we consider the proposals relating to the non-domestic regulations. A separate consultation has been issued in relation to domestic buildings, which are outside the scope of this alert.
What is the scope of the non-domestic regulations?
The regulations will affect:
- non-domestic buildings, i.e. those which are not dwellings (separate proposals apply to domestic buildings; see above)
- situated in England and Wales
- with an EPC under the Energy Performance of Buildings regulations
- where the rating on that EPC is F or G
- and which are let out, or which are proposed to be let out
Which buildings are not affected?
It follows that the following properties will not be directly affected by the regulations:
- Owner occupied properties. The regulations only apply to property which is let, and so do not directly affect owner-occupied property (i.e. where the freeholder - or possibly a long leaseholder (see below) - owns and occupies the property). However, it may be that in time there is a knock-on impact on the marketability of such properties where the potential for letting is restricted
- Properties with an EPC rating of E or above. However, the methodology used to calculate EPCs has been tightened up over the last few years, with the result that when an EPC is renewed following its expiry date, its rating may decrease. Property owners who are "safe" now should therefore be prepared for a downgrade in the future, which may then bring them within the scope of the regulations
- Properties which do not require an EPC. A building for which no EPC is required, such as a building which is to be demolished and meets the statutory criteria, will not have to comply with the minimum energy efficiency standard regulations. The consultation states that this is the case even if the property in fact has an EPC, e.g. because one has been obtained voluntarily, although the position on voluntarily obtained EPCs does seem to differ through the consultation document (see the next bullet point)
- Properties without an EPC. A property which does not currently have an EPC is not within the scope of the regulations. A property may currently be let and still legitimately not have an EPC if, for example, it was let before 2008 when the EPC regime came into force. This rule may be most relevant if the regulations are introduced by way of a "hard start" (see below)
However, if and when such a property is let in the future, an EPC will usually have to be obtained, which will then bring it within the regime. Owners without an existing EPC may have no idea of the potential rating of their property and therefore whether it may at some point be caught by the regulations.
Somewhat confusingly, while the consultation initially suggests that the regulations will not apply to properties that do not require an EPC even where an EPC has nevertheless been obtained voluntarily, it later refers to the difficulty of framing a workable exemption for such circumstances. This seems to suggest that building owners who have voluntarily obtained an EPC when they did not need to (such as a landlord who chose to commission EPCs for its entire portfolio) may, nonetheless, fall within the regime.
It is hoped that if a property does not have an EPC, but should have one under the EPC regulations, it will be caught - but this is not expressly spelled out in the consultation paper and may be at odds with the enabling provisions in the Energy Act 2011.
When will the rules come into force?
Three alternatives are proposed:
- Retrospective: A "hard" start. The regulations would apply to all buildings where there is a lease in place on 1 April 2018. In other words, they would affect existing, as well as future, leases. This would mean that works would have to be carried out with a tenant in situ. The impact of this may be mitigated to some degree by one of the proposed exemptions which would apply where the tenant's consent to the works cannot be obtained (see below). In addition, if the property does not currently have an EPC, it may be exempt on this ground (see above)
- Prospective: A "soft" start. The regulations would apply to buildings where a lease is granted to a tenant on or after 1 April 2018. On this proposal, buildings subject to existing leases on this date would not be affected until later re-letting
- Phased introduction: As for the soft start, but with a backstop of 1 April 2023. This is the government's preferred option. All let buildings, including those let on existing leases, would be required to comply with minimum energy efficiency standards by the backstop date (or demonstrate an exemption). 2023 has been chosen on the basis of research indicating a current average commercial lease length of just less than five years. This would - in theory - allow such a lease to expire before the backstop date, thus allowing the landlord an opportunity to carry out the works with vacant possession
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Which types of transactions are affected?
Although an EPC has to be provided on both sales and lettings transactions, the minimum energy efficiency standard regulations only apply to lettings. If a letting would require an EPC to be provided under the EPC legislation, it would also trigger obligations under the proposed regulations.
Government guidance provides that certain types of lettings are currently exempt from the requirement to provide an EPC; one of the most common being a lease renewal. The government is consulting on whether minimum energy efficiency standards should, nonetheless, apply to lease renewals. This is a difficult area as, in some instances, a landlord has no choice about whether or not to renew, such as where a lease is protected by the Landlord and Tenant Act 1954.
There are other commonly encountered types of letting transaction which would not typically be thought of as a "new" or "consensual" letting. These include:
- Where there is a pre-existing obligation to grant or take a lease. For example:
- Pursuant to an agreement for lease or contractual right to renew
- Where a lease is granted to a guarantor following the insolvency of a tenant
- The grant of an overriding lease to a former tenant under the Landlord and Tenant (Covenants) Act 1995 (where the current tenant has defaulted, a former tenant who has guaranteed their obligations may be entitled to call for a new lease)
- A lease which arises because of a variation to an existing lease (e.g. an extension to the term) which has the effect of an implied surrender and re-grant
- A periodic tenancy, which "renews" at the end of every period unless and until notice to quit is given
The consultation does not address these transaction types. It should be noted that even if the transactions above are caught, an exemption may still be available where tenant consent would be required for the works to be carried out or for the Green Deal charge to be added to the electricity bill (see below).
The government is also seeking views on whether very short leases (of six months or less), and very long leases (99 years or more) should be excluded from the regulations. The former is on the basis of feedback that short, flexible leases are often used by small and medium-sized businesses and should be excluded. Anti-avoidance provisions would be included so that this provision would cease to apply in the event of multiple renewals of short term leases to the same tenant. As for very long leases, these are more akin to a sale than a letting - and the minimum energy efficiency standard regulations do not apply to sales.
The regulations would need to be complied with by a tenant wishing to sub-let its space - although such a tenant may be constrained as to what they can achieve by way of improvements within the scope of the property demised to them, and may well be able to take advantage of an exemption (see below).
There is no suggestion that the grant of an arrangement which, properly construed, was a licence (as opposed to a lease) would be caught.
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If a property is caught, what has to be done?
The intention is that if a property is caught by the regulations, it should not be let until the necessary energy efficiency improvements have been made to bring it up to standard, unless an exemption applies (see below).
However, this rule is heavily qualified by the fact that the only improvements which have to be made are those which could be made at no upfront cost to the landlord, for example through a Green Deal finance arrangement. The Green Deal works by accredited providers funding qualifying energy improvement works. The cost is recouped in instalments through the electricity bill for the property. Works will only qualify if they meet the "Golden Rule" that the repayments for improvements (including the interest charge) must be the same or less than the expected energy bill savings from the improvement.
Where a landlord has undertaken those measures possible within the Golden Rule (or where no measures pass the Golden Rule test), the landlord will be permitted to let the property, even if the property remains below an E rating. However, this exemption would expire after five years. The landlord would then either need to demonstrate that the exemption still applied, or meet the minimum standard. It appears that it would still be necessary to revisit the exemption in this way even in the event of a purely "soft" start, i.e. where no other trigger has occurred to comply with the regulations.
A landlord would not be compelled to take out Green Deal finance to undertake the works: the landlord may simply use a Green Deal assessment and quotations to identify a Golden Rule-compliant package of measures, and then pay for the improvements through any means it chooses. However, the advantage of Green Deal financing for landlords is that repayments are made by the person responsible for paying the electricity bill - which means that the costs may (but not necessarily) end up being borne by the tenant (see below).
The government is also consulting on whether, as an alternative to obtaining Green Deal quotes, landlords could independently demonstrate reasonable levels of investment in energy efficiency improvements to obtain an exemption. This would apply where all the measures which fall within a maximum payback period (to be specified) had been undertaken. A Green Deal assessment may still be required in order to identify appropriate measures.
The Green Deal therefore underpins the minimum energy efficiency standard regulations. The difficulty is that the Green Deal Finance Company is not currently offering Green Deal finance on non-domestic properties. This being the case, if the regulations were to come into force today on the basis proposed, they would appear to be of no practical effect, as no improvements would have to be made. The consultation states that the government expects that other companies may be interested in offering finance in the non-domestic sector. Securing this would seem to be critical to the success of the regulations.
Who will bear the cost of improvements?
Where a landlord has used the Green Deal to finance improvement works, the question of who will ultimately bear the cost depends on (i) how the electricity metering arrangements work at the property, and (ii) the terms of the lease.
If a landlord plans to use the Green Deal to improve a building which is let as a whole to a single tenant, but the tenant pays the electricity bill, the Green Deal charge will be added to the tenant's bill - but only if the tenant consents. (If the tenant does not consent, the landlord will not need to carry out the work - see below). However, if the works are to the common parts of a multi-let building, the Green Deal charge is likely to be added to the landlord's electricity bill. The way the leases are drafted may not permit those costs to be passed through to the tenants. Even if the Green Deal charge is added to the tenant's electricity bill, the landlord will become liable to pay the Green Deal instalments during void periods between lettings.
Where a landlord has used its own funds (or non-Green Deal finance) to carry out works, the cost may not be recoverable from tenants under the terms of existing leases, which usually only permit the recovery of repairs, rather than improvements, to the building fabric, plant and machinery.
In addition to the cost of the works themselves (and any linked financing costs), there will almost certainly be other direct and indirect costs associated with carrying out the works, which are likely to be borne by the landlord. These include:
- Building surveying and project management costs
- Compensation for tenant disturbance
- Legal due diligence
- Loss of income while the property is empty
- Empty property business rates
- The cost of preparation of a further EPC to demonstrate that the rating has been improved
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Works will not need to be carried out to bring the property up to the minimum standard if, and for so long as, an exemption applies. The proposed exemptions are:
All improvement works which meet the Golden Rule have been carried out
See "If a property is caught, what has to be done?" above.
Third party consent is required
Various consents may be required in order to comply with the regulations. For example:
- Consent from a tenant, superior landlord or mortgagee to the carrying out of the works themselves (depending on the terms of the lease, superior lease or mortgage deed)
- Consent from a tenant to add the Green Deal charge to the electricity bill (where the tenant is the billpayer - see below)
- Planning permission
Where a third party consent is required, the landlord must actually seek that consent. If consent is not obtained, or is given but subject to unreasonable conditions, the landlord will not have to carry out the works. In these situations the landlord will be permitted to let the property, notwithstanding that it falls below an E rating.
The exemption at the second bullet point above may apply where a landlord plans to use the Green Deal to improve a building which is let as a whole to a single tenant. In this situation the tenant's name is likely to be on the electricity bill. If the tenant refuses to consent to the addition of the Green Deal charge to that bill, the landlord will benefit from an exemption and will not need to carry out the works for so long as the exemption lasts.
However, this exemption is capable of producing what could be seen as some rather arbitrary results, for both landlords and tenants. For example, where the works are to the common parts of a multi-let building, the Green Deal charge is likely to be added to the landlord's electricity bill (not the tenant's). The leases may or may not permit that charge to be passed through to the tenants. Either way, the landlord will not qualify for an exemption under this head. Similarly, if the landlord prefers not to use the Green Deal and finances the work itself, the fact that the cost of the works cannot be recovered from the tenant (if this is indeed the case) will not mean that the landlord can take advantage of the exemption.
The third party consent exemption would last for five years, or, if sooner, (where the tenant had refused consent) when the tenant moves out of the property. At that point the landlord would either need to comply with the minimum energy efficiency standard, or demonstrate an exemption applies again.
The improvement works will result in a net material decrease in a property's capital or rental value
To make use of this exemption, an assessment would need to be carried out by an Royal Institution of Chartered Surveyors (RICS) valuer. The consultation states that the valuer would need to balance any potential negative impact on value (for example due to reduced floor space as a result of the works) against benefits such as an improved EPC rating. The government is seeking views on whether "material" should be defined (e.g. as a percentage of the property's capital or rental value), or whether it should be left to the valuer (and ultimately a court) to determine.
It is not clear, but it appears that the five year rule outlined above would also apply to this exemption.
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Minimum energy efficiency standards and the contents of a commercial lease
The consultation contains very little on matters which should be considered in commercial leases as a result of the regulations, presumably because this is viewed as a private matter between landlord and tenant.
However, it does suggest that a landlord may wish to include restrictions in the lease on the ability of a tenant to remove parts of the property which may reduce its EPC rating to below the minimum permitted standard. Some leases may already include such a provision, but in practice most landlords should be protected through a standard alterations clause which requires their consent to alterations. Although consent cannot usually be unreasonably withheld, it is argued that a landlord would be acting reasonably in refusing consent to an alteration which would decrease an EPC rating for the building, particularly if it would take the building below the minimum standard.
The consultation also suggests that a tenant could agree to undertake certain works, for example as part of its fit-out, to ensure that the property's EPC rating meets the minimum standard at the point at which the lease is completed.
This draws out another issue not made explicit in the consultation, which is the precise point in a letting transaction at which the regulations will apply. It seems the government's intention is that this should be when the lease is granted, so that it would be possible to (i) market a property which was not yet compliant and (ii) enter into an agreement for lease conditional on the necessary works being carried out. However, there are references in the consultation suggesting that the relevant date to assess compliance may in fact be the date on which the tenant occupies the premises - which may be before or after the grant of the lease. This will need to be clarified by the regulations.
There are other aspects of a typical commercial lease which may be affected by minimum energy efficiency standards.
A tenant who wishes to sublet its space will be caught by the regime. However, tenants of part of a building may not have the necessary building components within their lease which need to be upgraded and such a tenant would find it impossible to comply without being granted rights over other parts of the building. The government believes that this will be dealt with by the consents exemption - in other words, the tenant would not need to comply with the regulations where the landlord's consent could not be obtained.
However, a landlord may take the view that it would be in its interests to consent if this meant that upgrade works could then be carried out at little or no cost to the landlord. Presumably it is not the intention that a tenant of part of a building should be responsible for upgrading the entire building. One way around this might be for the tenant to obtain a separate EPC just covering the part being sub-let, as opposed to relying on the EPC for the whole building.
Some commentators had been concerned that a property let on an existing lease with an EPC rating of F or G would generate a zero value at rent review. This is because rent review clauses usually calculate the new rent by reference to the grant of a hypothetical lease. If the hypothetical premises are not capable of being lawfully let, so the argument goes, no tenant would be willing to pay for them.
Given that the sanctions for a breach of the regulations appear to be a financial penalty imposed on the landlord, rather than any effect on the validity of the lease itself (see below), this concern would appear to be unfounded.
The fact remains that a property below an E rating may not be capable of being sub-let without improvement works being carried out, which could have a depressing effect at review. Some rent review clauses may circumvent this by including an assumption that the property complies with all legal obligations and/or that it may be lawfully let.
Tenant's obligation to comply with laws
Most leases will include an obligation on the tenant to comply with legal requirements relating to the property. Whether such a clause will have the effect of requiring a tenant to carry out improvement works to the property depends on how it is drafted (for example, whether it includes an obligation to comply with laws which relate to the letting or continued letting of the property). If the regulations are brought into force by way of a soft start, then a property which is already let will not need to be upgraded - and so there will be no legal obligation which requires compliance - until that property is next let again (e.g. if the tenant wants to sublet, or the landlord needs to re-let at the end of the existing lease).
Tenants of an internal-only demise (which is usually the case with a lease of part of a building) would face the same difficulties here as to control and access rights as mentioned in the context of sub-letting above. Many landlords would prefer to retain control over improvement works which affect common areas.
Most existing service charge clauses will not permit the landlord to recover the cost of works which are improvements, as opposed to repairs. Similarly, one of the issues which is being debated is whether an additional Green Deal cost added to the landlord's electricity bill would fall within a tenant's standard covenant to pay for utility charges.
Legal advice should be sought before making amendments to leases as a right of recovery is of little practical use without a right of access to carry out works, and there may be consequences for both parties to the inclusion of such a right (see below).
Rights of access etc
The landlord may wish to reserve a right in new leases to enter the property specifically to carry out energy efficiency works. It should be noted that the inclusion of such a right means that the tenant's consent to carry out the works may not then be needed, and so the landlord would not be able to benefit from the third party consents exemption. Indeed, existing leases may contain more general wording (such as a landlord's right of entry to carry out works to the common parts) that could potentially have the same effect.
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The regulations will be enforced by Trading Standards Officers, who will have the power to impose a civil penalty for breach. There is no suggestion that the validity of the lease itself would be affected by a failure to comply with the minimum energy efficiency standards. Indeed, the consultation states that "the penalty regime will never require that a landlord remove their tenant in order to comply with the regulations".
Although the consultation does not make this clear, it would appear from the Energy Act 2011 that only the landlord (and not the tenant) will be liable to comply with the regulations. The regulations will need to address whether a breach will be once-and-for all, or continuing, such that a purchaser of a non-compliant property would inherit liability. This may depend on whether a "hard" or "soft" start is adopted.
The level (and method of calculation) of the penalty is one of the topics on which the government is seeking views as part of the consultation. Payment of a penalty would not absolve a landlord from needing to comply with the regulations - the landlord would have six months in which to comply or face another penalty.
This may be just the beginning…
The consultation raises the possibility of setting a "forward trajectory" (or at least of establishing the principles underpinning such a process) for standards beyond 2018. The clear suggestion is that the current regulations may be just the beginning, but the concern is that unless a clear future pathway is indicated, the industry may be faced with 'moving' standards which are difficult to predict. The criteria to meet an 'E' rating may well become stricter as time passes and there is also the possibility of the government deciding in the future to raise the bar to a higher minimum (e.g. a 'D' rating). It is important that the government is transparent about how minimum energy efficiency standards may evolve over time.
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What should landlords be doing now to prepare?
- Review portfolios and identify any properties with an EPC rating of F or G
- Ascertain which properties (lawfully) do not have EPCs (as these may not need to comply, at least initially)
- Identify properties with EPC ratings just above the 'E' threshold, particularly where the EPC was obtained some time ago (in view of the possibility of later downgrading)
- Consider forthcoming lease expiries for affected buildings (including any break options) to identify the likely trigger point for required improvement works, should a "soft" start be adopted
- Once the outcome of the consultation is known, review with legal advisers whether to include any additional provisions in new leases
Consultation - next steps
It should be emphasised that these are the current proposals, and they may change, depending on responses received to the consultation.
The consultation period is short, and ends on 2 September 2014. Responses to the consultation can be sent by email to firstname.lastname@example.org.The government states that it plans to issue its response, and lay the regulations before Parliament, by the start of 2015, to give the industry time to prepare. Government will also undoubtedly be mindful of the deadline presented by the approaching General Election.
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