As ESG steadily climbs up the priority list for corporates, investors and lenders alike, the Minimum Energy Efficiency Standards (MEES) Regulations have brought into focus the immediate need for energy efficiency in commercial buildings in the UK. From 1 April 2023, it has been unlawful to continue to let a commercial property with an ‘F’ or ‘G’ EPC rating, even if the lease was granted prior to the MEES Regulations coming into force in 2018. Penalties for breach include fines of up to £150,000 and reputational risks – the threat of being named and shamed on a public register. And this is just the start. It is expected that the requirements under the MEES Regulations will be tightened over the next few years, with government consultations already indicating an intention to raise the minimum standard from ‘E’ to ‘C’ by 1 April 2027 and ‘B’ by 1 April 2030.
Put simply, commercial real estate with poor energy efficiency rating has become unlettable and unfinanceable without significant capital expenditure, and before too long, properties that were once considered broadly acceptable will suffer the same fate. Avison Young have reported that they calculate the total cost for achieving the 2030 MEES requirement (EPC ‘B’ rating) for industrial stock in the UK will be approximately £30.5 billion, averaging £334,000 per building. Avison Young explain this substantial cost for investors is largely driven by the difficulty in retrofitting energy efficiencies into aged assets, and the fact that 80% of industrial stock in the UK is more than 20 years old.
The question, therefore, is whether the cost of undertaking energy efficiency improvement works to a property can be adequately set off against the rental increase that investors need having completed the works. The ‘green premium’ versus the ‘brown discount’ clearly differs across asset classes and regions, but a ‘green premium’ on best-in-class assets is already apparent across all asset classes and localities, and increasing year-on-year. Avison Young have reported that the differential on average rents between ‘A’ and ‘B’ rated assets increased by 2 per cent from 2010 to 2015 and 2016 to 2021, with a similar trend presenting as a ‘brown discount’ with ‘E’ and ‘F’ ratings. As the energy efficiency requirements tighten further, the premium and discount, respectively, are expected to continue to increase, creating a split market between buildings that conform to the new performance requirements and sub-standard buildings that risk becoming obsolete.
To understand the cost of improving an EPC rating, it is critical to understand how an EPC rating is calculated. An assessor will review the insulation levels, type of heating system, lighting installed, ventilation, age and construction of the building and whether renewable energy is used. Investors, therefore, need to continue to actively review their portfolios, particularly in light of updated EPC criteria. Where energy-efficient improvements to properties are required, it is clear that these need to be identified early and actioned so as to avoid the risk of enforcement action being taken. Investors need to also be aware of the limited, but important, exceptions and exemptions available to the MEES regulations, including licences or leases of less than six months or more than 99 years, and properties that do not require EPCs (religious properties, certain industrial sites and temporary buildings). Careful assessment of these exceptions and exemptions should be made, and reviewed regularly.
However, whilst regulatory requirements are critical in pushing energy efficiency up the agenda, it has been widely noted that enforcement of the MEES Regulations is going to be a challenge for already stretched local authorities. Whilst some funding from central government has been made available, it remains to be seen how much appetite local authorities will have to invest in enforcement. Luckily for the environmental agenda, market forces are a powerful tool - it is tenants who ultimately dictate what developers and investors need to provide. Voting with their feet, tenants, and particularly large corporates who themselves have ESG targets, are making active choices for high-performance buildings. In the context of offices, there is a trend post-COVID-19 for corporate tenants to be sacrificing square feet for best-in-class buildings. Whilst energy performance of these buildings only forms part of the attraction (the services and amenities offered in such buildings tend to be far superior to older, less energy-efficient buildings), tenants are now keen to work with landlords to agree ‘green clauses’ to ensure that the systems in place in buildings that they occupy continue to be energy efficient and in compliance with their own ESG agenda.
As we look forward to the end of this decade, all indications show that the trend towards increased energy efficiency and performance of buildings will only gain further momentum. For most investors, the expectation is that non-performing assets where required improvement works are not economically viable will become obsolete, and values will be amended to reflect this. For lenders, a key metric on valuations will continue to be the energy performance of the building, and much closer consideration will be needed for loans secured against assets that are currently compliant but may not be by the end of the loan term.