Over the past few months there has been much publicity about the Carbon Reduction Commitment (CRC). A large number of companies have now pushed the CRC further up their agenda and are starting to think in more detail about what they need to do. One area that has not been looked at in much depth until recently is the impact of the CRC on the traditional landlord and tenant relationship.
In this article we will look briefly at the basic structure of the CRC and then focus on several issues that arise for landlords and tenants who are affected by the scheme.
What is the CRC?
The CRC is a new, legally binding, emissions-trading scheme that will apply to large businesses and public-sector organisations with effect from April 2010. It is effectively a tax on CO2 emissions produced by properties (priced in £/tonne) and is a key part of the government’s aim to reduce carbon emissions.
The scheme will run on an annual basis (1 April – 31 March). CRC participants will be required to forecast their energy use for each year and buy sufficient emissions allowances to cover this usage. In forecasting levels of energy usage participants must endeavour to make their estimates as accurate as possible. As data is self-certified, a risk-based audit of 20% of CRC participants will take place each year, and strict civil and criminal penalties will apply for non-compliance.
At the end of each scheme year actual emissions have to be reported and sufficient allowances surrendered to cover the organisation’s CO2 output. Any remaining allowances can be carried over to subsequent years. It is hoped that organisations will try to reduce their energy consumption to reduce the number of allowances they require.
In the introductory phase (April 2010 – April 2013), an unlimited supply of allowances will be sold at a fixed price of £12 per tonne of CO2. From April 2013 a limited number of allowances (decreasing each year) will be sold by auction and allowances will become freely tradable. It is anticipated to work in a similar way to the unregistered secondary market that has developed out of the EU Emissions Trading Scheme (ETS) with a market of derivatives and specialised brokers. You should note that the CRC does not overlap with the EU ETS or any Climate Change Agreements, so any emissions covered by either of these are exempt.
Organisations that achieve a reduction in energy consumption will both reduce their energy bills and have to purchase fewer allowances. As the scheme is designed to be revenue-neutral for the government, any revenue raised will be ‘recycled’ to participants. A public league table will be established ranking participants’ emissions performance, with those higher up the table receiving the largest recycling payments. Performance will be judged using three differently weighted criteria:
- the change in annual emissions of each participant relative to its average emissions over the preceding five years;
- a measure of action taken prior to the start of the scheme to reduce CO2 emissions; and
- the change in emissions per unit of turnover (private sector) or revenue expenditure (public sector).
Who will be affected?
An organisation will be caught by the scheme if its 2008 electricity consumption exceeds 6,000 MWh on half-hourly metering. This equates to an annual bill of approximately £500,000. It is the person or organisation that actually pays the bill to the electricity company that will be the ‘CRC participant’.
Landlords and tenants need to ascertain whether they qualify as CRC participants. The scheme affects organisations as a whole, so the highest parent company will be the CRC participant for its group. Organisations will therefore need to take into account all the properties for which they (or their subsidiaries) paid the electricity bill in 2008. If they exceed the threshold in aggregate then they will need to register.
In future years, once the scheme is fully established, landlords will also need to calculate their required level of allowances for any properties that will either leave or join their portfolio during the scheme year.
Who has responsibility under the CRC will be clear in certain circumstances and not in others. For example, a tenant of a whole building that pays its electricity bill directly to its supplier will be responsible for CRC compliance rather than its landlord. Conversely, where a tenant pays its landlord for electricity consumed at the premises (either as a proportion based on floor area or based on sub-metering) the landlord will be responsible for CRC compliance in relation to the premises. If the landlord also provides electricity to common parts, it will be responsible for CRC compliance in relation to this consumption.
Can landlords recoup the costs of CRC compliance from their tenants?
If a landlord has responsibility for CRC for either occupied premises or common parts, they need to consider whether they wish to (and whether they are able to) charge their tenants the costs associated with CRC compliance. These costs could be substantial, depending on the number of properties involved, and may include the costs of forecasting, monitoring and complying with reporting obligations under the CRC, and obviously the cost of purchasing the allowances.
The CRC regulations do not, unfortunately, specify how costs should be apportioned between landlords and tenants. It will therefore be a matter for individual landlords and tenants to resolve. Existing leases, which will have been drafted without any express provisions relating to the CRC, will need to be interpreted to establish the extent to which the landlord is able to recover its CRC costs. Some landlords may wish to persuade tenants to formally vary existing leases to expressly deal with these issues.
Landlords will also need to think about whether and how their tenants should benefit from any recycling payments received or contribute to any penalties if they are imposed.
A Guide for Landlords and Tenants
Although the CRC regulations do not prescribe as to how to apportion costs as between landlords and tenants, a useful guide was issued in June that suggests some potential solutions. The guide was produced by a working party co-ordinated by the British Property Federation (BPF) and involved a wide range of organisations from the property industry, including the British Council for Offices, the British Council of Shopping Centres and the British Retail Consortium.
The guide suggests several ways that landlords could calculate (and potentially seek to recover) their CRC costs.
Scheme-year basis
The landlord effectively calculates and passes on to each tenant the average cost of allowances over this fixed period, apportioned across its whole portfolio on a floor-area basis. This would mean that payments and receipts in relation to the CRC are paid by the tenants that were in the building/portfolio for the relevant scheme year. This takes no account, however, of the performance of individual buildings and will not encourage tenants to become more energy efficient. A further disadvantage of this method is that as the dates of the scheme year are unlikely to coincide with those of the service-charge year, the service-charge accounts may need to remain open until each scheme year’s allowances have been finalised.
Building-by-building basis
Landlords could allocate costs on a building-by-building basis and set up a separate CRC fund for each building, in effect running several mini-CRC schemes. Each fund could be used to pay for energy-efficient improvements for each building and make payments directly to tenants in line with each tenant’s own energy performance. This may not be financially efficient for the landlord, as if the number of allowances required for a particular building has been estimated incorrectly any ‘spare’ allowances would not then be able to be transferred to other buildings within its portfolio or to other group companies. This method would also be administratively cumbersome for the landlord.
Cash basis
Alternatively, the landlord could charge the costs to the service charge when they are incurred, and any sums credited to the service charge when received, regardless of the scheme year to which they relate, and whether the tenant base has changed. This is likely to be attractive to landlords as it will be the most administratively straightforward method, although it is likely to result in unfairness for tenants.
A further issue arises if either the landlord or tenant wishes to carry out works that will result in improved energy efficiency of the premises. Should costs incurred in carrying out such works and individual energy performance be taken into account in allocating CRC compliance costs? Unless tenants receive a direct financial benefit for implementing energy efficiencies, it will be very difficult for landlords to persuade tenants to do so.
Current leases and the CRC
As previously mentioned, it is unlikely that existing leases will deal adequately with the complexities of the CRC scheme. Incorporation of drafting to deal with these issues should be considered on the grant of any new lease and may soon become an integral part of lease re-gear negotiations that are being commonly encountered in the current market.
In agreeing any such drafting, landlords should be careful to make the provisions dealing with the CRC as fair and reasonable as possible. If not, a well-advised tenant could raise the issue at rent review to seek a lower rent.
Changes of ownership and occupation
Both landlords and tenants need to understand the implications arising from changes in ownership and occupation in the context of the CRC.
From a landlord’s perspective, a non-CRC participant may sell a property to a landlord who is a participant. This sale could fall at any point during a scheme year and may not have been factored in by the buyer when assessing the level of allowances required to be purchased by it at the start of the scheme year. Further, potentially more expensive allowances may therefore need to be purchased by the new landlord in the secondary market. There would no doubt be resistance from any tenants being asked to contribute to this additional cost.
Once the scheme is in force, if a tenant is considering assigning or underletting their lease it is likely that landlords who are CRC participants will seek information about the energy efficiency of any proposed new occupier as part of any application for consent. Whether a landlord may reasonably refuse consent on this basis will depend on the terms of the alienation provisions in each specific lease.
In addition, if the outgoing tenant has contributed to CRC costs for a future period (or potentially could be entitled to a rebate as part of any recycling payment) they will need to consider agreeing an apportionment method with the incoming tenant to recoup part of this sum.
Action required now
Although the scheme does not commence until April 2010 it is imperative that organisations that will be CRC participants appoint an individual now with overall responsibility for CRC. Landlords will need to identify which tenants will contribute to their emissions for CRC, pull together information about energy use on a building-by-building basis, and try to understand in more detail each tenant’s business and energy-consumption requirements. This will allow organisations to more accurately forecast their emissions and consequently the number of allowances they need to purchase in the initial phase.
The service-charge provisions in leases will also need to be reviewed to determine if landlords will be able to recharge their CRC costs or whether tenants need to be approached now to suggest appropriate lease variations. Alternatively, depending on the size of the landlord’s portfolio, it may decide that the administrative burden of recharging its CRC costs across its portfolio is disproportionately high and consequently decide to absorb the costs itself and not recharge them at all.
Reducing CO2 emissions
The focus of the CRC scheme is to dramatically reduce greenhouse gas emissions from buildings, which account for over 50% of such emissions in the UK. The government has set a challenging reduction target of 80% by 2050. Landlords need to consider, especially in light of the potential impact of the public league table, how to make their buildings ‘greener’ and how to encourage their tenants to become more energy efficient, all at minimal cost in the current economic climate.
All parties need to work together to reach agreement on how to fairly tackle the issues arising from applying the CRC to the property industry, with the common goal of improving the energy efficiency of buildings across the UK.
By Leilah Rawle, associate, and Eleanor Joyce, associate, CMS Cameron McKenna LLP.
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