This article forms part of a wider series, The ESG Collection, by our cross-sector team covering current themes and topics high up on the ESG agenda for businesses. In part one we will unpick the environmental pillar of ESG, including topics focused on climate change, energy use and efficiency, and nature. Looking to the real estate sector, with the socio-economic drivers behind responsible capitalism greater than they've ever been, we're seeing increasing numbers of clients interested in green leases. Here Clare Harman Clark, Senior Counsel – knowledge, considers the whats, hows and whys of green leases.
The UK government has set a national legislative target of a 78% reduction in greenhouse gases by 2035 and a net zero target by 2050, and (perhaps not unfairly), responsibility for a large portion of the necessary action will inevitably fall on the real estate world. According to the UK Green Building Council (GBC), the built environment contributes a massive 40% of the UK's total greenhouse gas emissions. But it's not simply generated by construction - most of our bricks and mortar isn't going anywhere fast. The UK has some of the oldest housing stock in the world in fact, and it's further estimated that 80% of buildings that will exist in 2050 have already been built.
These figures are surprising in a macro sense, but in a micro sense it can be hard for the individual owners and operators of real estate to know how to make the most positive difference. And while navigating ESG ambitions is generally challenging, it's especially complex for property. Much like the three little pigs, clients are facing down big bad wolves of government regulation, market rules and client ambitions, all of which are huffing and puffing at their doors.
For all the media attention on net zero, financial disclosure standards are limited now (see our previous article in this series), but expected to increase dramatically over the next few years. Meanwhile, plain vanilla regulation for the real estate arena focuses on the production of Energy Performance Certificates (EPCs), and their subsequent impact on lettings via Minimum Energy Efficiency Standards (MEES). EPCs rate buildings A-G depending on their energy efficiency. From April 2023, it will be unlawful to continue to let property with a substandard EPC rating of E or F. With the median EPC rating in England and Wales reported to be a D, the numbers affected are considerable. Moving forward, there are government pledges and - as yet unanswered - consultations focused on reaching a minimum MEES rating of B by 2030.
Why green leases?
Almost every business will need to operate from commercial premises, and even with limited prescribed regulation on operational efficiency, many firms are finding that these spaces offer real opportunities to deliver on ESG policies and demonstrate sustainable values. Tenant clients may well have an eye on the operational cost savings driven by improved energy efficiency, but they are also focused on attracting and retaining the best talent. In this context, the building's environmental functionality is often key to enhanced employee wellbeing.
Meanwhile, landlord clients might start from prosaic goals of basic regulatory or legislative compliance, but the most forward thinking are also responding to tenant and investor demands for sustainable buildings. The idea is certainly bedding in from a capital allocation perspective. As the commercial property market talks less about green premium and more about brown obsolescence, steps taken now will almost certainly protect or improve asset capital and rental values in the longer term. It can certainly be expected to reduce the chance of greater costs caused by the physical and transition risks of climate change. For those more engaged businesses, green leases - or even a green memorandum of understanding (MoU) when there's no opportunity to change an existing lease midterm - are providing a fantastic opportunity to have the conversations and build the operational relationships to last.
So what is a green lease?
Conceptionally speaking, green leases aren't new. The idea is in fact at least a decade old. The Better Buildings Partnership (BBP)'s Green Lease Toolkit has been freely available for use since 2013, aiming, in a non-prescriptive way, to promote professional understanding and stimulate market transformation, thus improving "the sustainability of existing commercial building stock". Key property owners such as NHS England have meanwhile published a standalone suite of sustainability provisions "to help organisations to improve the green credentials of their leased estate". And the latest incarnation of the Model Commercial Lease (MCL) suite in June 2021 incorporated a sustainability schedule for the purpose of “facilitate[ing] a discussion between the parties about these issues”.
Most recently, the collaborative initiative The Chancery Lane Project (TCLP) has published a raft of new contractual clauses to cover a variety of ways property agreements and leases can place obligations on parties to use their properties in an environmentally conscious way. Its Net Zero Toolkit contains, for example, "Hannah's clause" to consider green service charge provisions. Meanwhile "Aatmay’s clause" (which Taylor Wessing was involved in drafting) incorporates sustainable and circular economy principles into repair and alterations provisions.
What might a green lease cover?
The upshot is that while there is no market standard green lease, a combination of ambition and expectation are evident in some key principles:
MEES regulation
The largest green lease theme is undoubtably the simplest: clauses which seek to protect each party's position under the MEES regulation. Routinely, tenants are not permitted to propose works or install plant that might impact (negatively) on environmental performance or the existing EPC rating. They might also have to liaise with the landlord in the event they are legally required to obtain a new EPC, a move that could inadvertently drag a landlord within the auspices of MEES breach. The landlord may meanwhile want to reserve rights to enter tenanted areas and carry out energy improvement works. Some landlords in fact create detailed EPC policies, specifying a choice of assessor and pathways to registration, etc.
Service charge and costs recovery
While there may be a corollary outcome that increased efficiency means reduced tenant outgoings, there could well be a scrap over the capital cost of improvement in the first place. The ability of a landlord to recover these sums via the service charge will likely come down to the negotiating power of each party. In the meantime, parties might use efficiency or circular economy principles on the use of goods and materials in the common parts, or costs capture for measuring/benchmarking environmental performance in the building.
Yield up
There can be negative environmental consequences and waste generated by a tenant having to reinstate at the end of the term. Some landlords will therefore agree to waive reinstatement obligations where the tenant's works have improved environmental efficiency, or where reinstatement would impact adversely on environmental performance.
Co-operation on environmental performance
Another big theme is co-operation between landlord and tenant to improve environmental performance. The landlord and the tenant might agree a series of KPIs and goals on energy use upfront, or they may merely confirm a joint wish to promote and improve environmental performance and pledge to co-operate (without legal obligation) to identify appropriate strategies.
A multi-tenanted estate might justify the creation of a quasi-formal "environmental forum" that will bring landlord and tenants together regularly to review existing environmental performance plans and agree targets and strategies moving forward. To date, the obligations for this seem largely based around creating a safe space to discuss issues (possibly with the managing agents) without creating legally binding requirements.
Crucial to the performance of any forum or performance initiative is going to be data, and many green leases therefore contain agreements on regularly sharing the "environmental performance data" that each party holds for the property. This could mean allowing access to meter readings, or submitting rafts of other operational/performance figures. There can be tensions here relating to confidentiality, but clearly drafted protections for third party disclosure and use can alleviate such concerns.
Operational regulations
Of course, maintaining a certain EPC rating is only half the story for actual operational performance. Landlords might therefore import circular economy principles into repair/decoration covenants, restrict changes of use that may adversely affect the energy performance, or simply draft new building management obligations to require switching lights off or recycling.
Other ambitions
Clearly the reference to "green" is made in the context of the environmental pillar of ESG, but as notions of sustainability mature it's likely that lease parties will think more about their property's social or governance credentials. Many clients have one eye on a rating from GRESB, for example, an industry-led provider of transparent ESG data to financial markets. GRESB specifically asks for evidence of "social initiatives" when applying ratings. Such things do ask a lot from a standard leasing arrangement, but landlord and tenant relationships, particularly on an estate, might well look to improve the wellbeing of occupants or surrounding communities (for example opening up ground floor circulation space or setting up education initiatives). We'll be looking to the social pillar of ESG in more detail in a future series of The ESG Collection.
Getting your (straw/stick/brick) house in order
The contents of any green lease will clearly differ quite dramatically depending on asset class and property layout. However, before the wolf huffs, puffs and catches property owners out, it will pay reputationally - and in operational efficiency terms - to get ahead of the game by prioritising sustainability in property leases.
For more information on how green leases could support your business's sustainable values, get in touch with a member of our team.
