This is the second of two articles on trends in ESG within the commercial property sector and will examine our own experience of how ESG principles are being introduced into leases and the resulting issues for landlords and tenants.
In our previous article we looked at how the Minimum Energy Efficiency Standards (MEES) Regulations and the Government’s Heat and Buildings Strategy (HBS) will affect landlords and occupiers and how many commercial leases now contain “green lease” clauses which seek to ensure that both parties work together to improve the environmental performance of the building and to identify strategies for the improvement of its environmental performance.
This can involve sharing information about energy consumption and occupation and requiring both parties to consider environmental good practice, energy and water efficiency and managing reducing and recycling waste. The lease can require both landlords and occupiers to try to use reclaimed, re-used or recycled materials in carrying out services, alterations and repair works.
Changes needed to be net-zero by 2050
In terms of physical changes needed to a building, how will landlords and occupiers implement changes to their buildings to stay on track with these proposals and who pays for the climb to the summit of net-zero by 2050? This will largely depend on the provisions already in place for an existing lease, the provisions to be included in a new lease or what can be agreed, by way of innovation, in a lease renewal to an existing tenant. It is expected that landlords will aim to pass at least some of the costs of improving their buildings’ EPC ratings to tenants.
For example, as a result of the HBS, gas boilers are likely to be replaced by electric heat pumps and the cost of these replacements will be expensive. Occupiers should check whether the service charge provisions in their leases contain significant safeguards against the recharging of such costs. Are improvement works/replacement works included in the service charge? If a boiler needs replacing and is not yet in disrepair, the service charge wording would need to allow for the landlord to recover the costs of improvements, as opposed to repair. Improvements are generally not allowed to be recharged to tenants.
Occupiers may be open to paying for an improvement if they have lower energy bills once the works have been completed, but conversely why should a tenant pay for the landlord improving the value of its investment, especially if the tenant only has a short term interest in the building?
While tenants are keen to demonstrate that they are responsible when it comes to ESG principles, they can be understandably cautious about new environmental efficiency clauses and will want to ensure that any works and environmental performance initiatives are in keeping with the age of a building and the length of their lease. If the landlords want to oblige the tenants to pay unknown future costs for improvements, any required works should only be undertaken after consultation with the tenant and at the tenant’s absolute discretion. Another solution may be to suggest a specific cap on such capital expenditure, be it annually, per item or over the term of the lease.
The tenant should ensure that, where a lease provision could clearly result in capital expenditure, it will have a say in that and, where provisions are more general, that the landlord needs to behave in a reasonable and commercially prudent way.
If the lease contains a landlord’s right to install metering equipment or to go into the tenant’s premises to carry out works to bring the premises above the relevant EPC rating, this should be at the landlord’s cost and the tenant should have the right to consent to or refuse access first, and maybe get something in return by way of rent concession.
Rent review clauses should also be checked for assumptions and disregards on matters relating to environmental performance. The inclusion of an assumption that the premises will have an EPC rating which is sufficient to allow them to be legally let during the whole lease term could result in the tenant paying a higher new rent than the premises should really achieve.
Tenants will want to see the landlords giving up the usual right to require reinstatement of alterations made by the tenant, where the alterations will improve environmental performance.
Tenants should be aware that on assignment of their lease or on a subletting, they will need to comply with EPC rating minimum standards at the time of disposal. Improvement works to the premises may be needed to bring the premises up to the required threshold before the transaction can go ahead and the landlord’s consent may be required.
On lease renewals under the Landlord and Tenant Act 1954 where the tenant is entitled to a lease on the same terms, unless a change can be justified by the party seeking to change the original lease wording, the courts will now have to look at innovative ‘green’ clauses which are in dispute. An example of this would be to determine if the landlord can justify changes in the wording of the lease to protect the EPC rating of the building. Recent case law indicates the court would not be willing to impose excessive new duties on the tenant that are not in the previous lease, but that a clause requiring the tenant to return the building at the end of the new lease with the same EPC rating as at the start of the new lease should be allowed, as without the clause, the landlord would lack any real protection against inaction by the tenant, which could make the property 'sub-standard'. That could have significant financial consequences for the landlord.
Traditionally, landlords and tenants have had differing objectives in negotiating many lease provisions. However, when it comes to making their building environmentally sustainable, it may be time to adopt a more collaborative approach to hit net-zero on target.
Consistent with our policy when giving comment and advice on a non-specific basis, we cannot assume legal responsibility for the accuracy of any particular statement. In the case of specific problems we recommend that professional advice be sought.