Here’s a challenge: Say you own a business, and you have huge assets that are expensive to maintain. Your engineer tells you about an energy conservation measure (ECM) that has a simple payback of less than four years, and you have the capital necessary to implement the measure. When might it make good business sense not to do the project?
Answer: When you pass along your operating costs to your clients.
This is the reality in many commercial building leases, especially with respect to energy costs for base building systems such as heating, ventilation, air conditioning, elevators, and common-area lighting. As a result, landlords often, and understandably, pick profits instead of energy-saving projects. They simply cannot apply operational savings to justify the capital expense. This is often called the "split-incentive" problem, and many landlords say it inhibits them from investing in such projects.
Given that there is money to be saved through reduced energy costs, it seems possible to craft an agreement that would incentivize both landlord and tenant. But how?
In 2010, the New York City Mayor’s Office decided to attack this problem. Officials there knew that if they succeeded, an energy-saving template would be available for a variety of emerging green leasing options. They assembled a working group of experienced real estate professionals representing all roles in the industry with the objective of conceiving a solution to the split-incentive problem and writing a model clause for a commercial lease.
The group quickly identified the needs of the landlord and the tenant. Landlords want certainty on the payback period of an investment; they do not want their payback to depend, literally, on the weather. Tenants do not want to assume the risk of higher costs; the last thing they want is a clause that could result in spending more on operating costs. Another key contribution to the solution is engineering know-how: in the vast majority of cases, experienced engineers are able to predict an ECM’s cost savings within a 20 percent margin of error.
The group established by the NYC Mayor’s Office came up with a solution called the "energy aligned clause" (EAC) for commercial leases that gives both parties something
Under this clause, and with an ECM, tenants save energy costs and pay landlords 80 percent of the cost reduction predicted by the engineer. The tenants continue making the payments until their portion of the capital expense is paid off. Landlords are thus enabled to calculate a payback period based on the efficacy of the ECM, and they are more likely to execute the project. The landlord enjoys an improved asset and, once it is paid off, reduced pass-through costs that could improve margins. If the retrofit saves money as predicted, the tenant will enjoy 20 percent of the savings during the payback period. If it saves less than predicted, tenant savings are reduced. But as long as the engineering estimate is within the 20 percent performance buffer, the tenant stays ahead compared with the retrofit not having been implemented. If the retrofit saves more than predicted, the tenant enjoys more savings.
The clause creates two additional financial incentives for tenants, depending on the situation.
First, if the lease is still in effect when the payback period ends, the tenant enjoys all the energy cost savings from that time until the end of the lease.
Second, many leases require the tenant to pay for repairs. Should there be an old, inefficient base building system, landlords are often financially motivated to repair the existing system rather than perform a full retrofit because repair costs can be passed along to tenants. With the EAC in place, landlords are more likely to spend the capital. Thus the tenant would enjoy reduced energy costs in lieu of a repair expense.
A key attribute of the EAC is that the pass-through costs are based on predicted savings, not actual savings. This is especially attractive because calculation of energy savings can be fraught with debate. Under an EAC, both parties agree on an energy specialist upfront and, accepting the specialist’s ability to determine savings within the 20 percent margin of error, they avoid what can be some very difficult accounting.
Urban Green Council, the New York chapter of the U.S. Green Building Council, is concluding a six-month outreach effort to landlords, tenants, brokers, and attorneys in commercial real estate with the overarching objective of changing the conversation. They do not want to let the split-incentive problem be the last word on a potential energy retrofit project. Instead, they want the discussion to shift to the EAC, which can ultimately lead to more ECMs.
Silverstein Properties, a full-service real estate firm based in New York City, used the EAC twice in 2011—
for the New York City offices of law firm WilmerHale (Wilmer Cutler Pickering Hale and Dorr) and of MSCI Inc. Since the outreach began, the city of New York signed two leases including the EAC: in July, for a 285,000-square-foot (26,500 sq m) space, and in August, for a 21,600-square-foot (2,000 sq m) space, both in New York City. The city plans to use it going forward wherever it has the split-incentive problem. Also, a major multinational corporation (that does not want to be named) has recently incorporated the EAC into its preferred leasing language wherever it is the lessee. In addition, many companies and agencies are now conducting due diligence on the EAC, and it is expected the uptake will accelerate.
Clearly the energy aligned clause constitutes a win for the landlord, the tenant, and the environment. Ignoring cost-effective energy conservation measures was the wrong business paradigm. The EAC finally fixes this.
Paul Reale is a special consultant to Urban Green Council, the New York chapter of the U.S. Green Building Council. Urban Green Council’s mission is to advance sustainability in urban buildings through education, advocacy, and research. For more information about the energy aligned clause, visit urbangreencouncil.org/EnergyAlignedClause.