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SEGRO - Can we meet this EU energy challenge?

19 June 2013
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Slough-based property company SEGRO and The Business Magazine gathered sector experts to discuss the implications of the 2011 Energy Act, which aims to help the UK meet its EU commitment to reduce CO2 emissions by 34% by 2020 – but also brings major ramifications for landlords and occupiers of commercial property. How major? Within the European Union’s directive on Energy Performance of Buildings the UK has committed to significant improvement of its built stock. By 2018, the letting of buildings with an Energy Performance Certificate (EPC) rating of F or G will be outlawed. Buildings will need to be future-proofed. Those who delay will find themselves with commercially obsolete assets or an unexpectedly large bill for upgrading their portfolio

Journalist John Burbedge reports the roundtable highlights

The roundtable focused on recent SEGRO-commissioned research by the CoreNet Global UK Chapter on the 2011 Energy Act.

This research, predominantly among owners or occupiers of corporate real estate, highlighted:

  • Poor sector awareness of the Act’s far-reaching implications
  • Ambiguities and confusion for those who were Act-aware
  • No concerted industrywide drive or timetable to upgrade buildings.

Beginning the discussion, David Murray asked the obvious question . . .

Did the results of the research surprise us?

"Sadly, No." was the consensus Roundtable response.

CoreNet’s Robin Harris admitted that the research confirmed his opinion that “most people aren’t sure what the Act is all about and how it might affect them. Even now, having read the report, I am still struggling as to who pays the bill for Green Deal funding – the occupier or the landlord. I think it is all a bit complicated.”

Kate Dean was also unsurprised by the lack of awareness and understanding because the Act had not been well publicised – despite its potential implications for the property sector. “Property is not a vote-winner,” she noted.

James Finnis said Energy Performance Certificates (EPCs) were not high profile with occupiers. “Their current focus is the overall occupational cost of the building and the ability to attract the right talent to drive their business. Inevitably, if occupiers go into a new building it is likely to have a good EPC rating, but whether its an EPC rating of say C or D is not currently the fundamental decision-making factor, the actual in use energy spend is far more valuable.”

Nick Coote, who advises on corporate real estate and is a member of CoreNet, agreed: “It is not on the radar of occupiers. They are driven primarily by the needs of their people.” Ironically, trending towards modern workstyles was leading occupiers to find better EPC-rated premises.

Coote explained that many occupiers now want to be on one floor, with an efficient open not cellular layout, which reduces the amount of space they need. “When an occupying business relocates from a 1990’s building, they choose premises to fit that modern profile and these tend to be newer, higher specification buildings with higher EPC ratings. The occupiers are not actually motivated by the EPC. It’s just the current reality of the market.”

However, Lambert Smith Hampton now always flagged up EPC ratings to clients. “If it is a low E then we tell the occupier the possible consequences. Elevating from a low E upwards may well cost far more than a high E for instance.”

Richard Griffiths pointed out that 2018 was not far off in commercial lease terms, and he believed EPC legislation was being considered in many property negotiations. “Only yesterday an investment transaction, I was aware of, fell through because the building involved was poorly EPC rated.”

The elephants in the room

Throughout the roundtable discussion two topics kept recurring:

  • The lack of clarity and detail about the Act
  • The potential inadequacy of EPCs as a legislative measure.

… as you will see from the conversations below.

Clarity is coming

Griffiths, of the UK Green Building Council, which is assisting the Government’s working group for the Energy Act, explained that only primary legislation has yet been tabled. The working group is now defining the detailed nature of the legislation, and the statutory importance of specific EPC ratings.

He explained that a wide range of roughly 20 organisations are represented on the working group, including owner and occupier professional bodies through which lobbying can be channeled. The working group will produce a proposal paper, for ministers, before wider issue for public consultation in late summer or autumn.

Robin Harris said he would ensure the SEGRO research and CoreNet’s views were made known to the working group.

Pointing out that some premises, such as listed buildings, will be exempt from the Act, Griffiths accepted the Roundtable concerns about the need for clarity and detail: “There is a big material risk to an occupier who finds himself in a building with an EPC rating worse than E, if the final legislation ends up demanding that the building is unfit.”

Finnis noted that the Act remained unclear and highlighted the risk of this legislation being a blunt instrument in a complex market.

M&E engineering consultant Matthew Jones mentioned the uncertainty brought to the sector by the “disorganised and shambolic” introduction of legislation in 2006, 2010 and 2013. “We are currently designing buildings valued at £20-£40 million that will fall under 2013 legislation and we still don’t know the full legislative position. Talking about statute for 2018, I am not surprised that we don’t know the details. We will probably still be having this conversation in 2017.”

Architect Chris Castle agreed that uncertainty was no friend to long-term planning, or complex design projects. “To be sat here with this panel of industry experts discussing what is going to happen in five years without clarity of the target, is in itself a significant problem.

“As designers, we always strive for best practice, sustainability and flexibility within buildings, but if they are going to set hard targets for five years time then we really ought to know what they are now. We are operating in something of a vacuum at the moment.”

SEGRO’s Dean mentioned the challenges of the proposed EPC legislation for owners and landlords in transferring occupational responsibilities to others, particularly in multi-let office buildings. “It’s not clear who is responsible. Is it the landlord or the tenant? We are all waiting to see the detail of the secondary legislation. It definitely needs a lot of finessing.” There might also be a need to lobby the Government, she added, to get “some clarity around the ambiguity that we are working with at the moment.”

EPCs: A flawed method of measurement?

EPCs were introduced in August 2007, but several Roundtable members were still not convinced about their true value within the legislation.

Nigel Pavey explained that EPC assessment software was never meant to be a design tool, but, because of its link to legislation, it will now influence design. “You can improve a building’s EPC – get a biomass boiler or connect to a local heating network – but you don’t have to change the building design at all.”

Matthew Jones: “It is certainly flawed. It is not an empirical instrument but a very blunt tool that gives an order of listing for various buildings.”

Pavey claimed that when EPCs were launched the methodology was so simple that EPC assessors in England and Wales could complete the rating procedures while on their holidays, having never even visited the buildings concerned. “When the EPC concept was brought out they opened up EPC assessment to the market. Anyone could do it with a little training.” (A different system was set up in Scotland using qualified professional assessors.)

Assessments have been improved since the early days, but even so many existing EPCs, valid for 10 years, could still be questionable, he suggested.

Coote said his firm’s building surveyors had not undertaken EPCs when launched because they realized that the open-to-all assessment process would lead to a flooded commoditised market based on the lowest cost – making the assessment role commercially unviable if carried out with proper professional diligence.

Griffiths acknowledged that historically the launch of EPCs had been somewhat undermined by early poor assessment standards, but the Government had quickly recognized that and improved the assessment process – and would continue to do so with the new legislation.

Should the new legislation be based on EPCs?

Castle: “The evidence of the past five years shows that EPCs are not exactly accurate and that is problematic. Where buildings have received EPC ratings, there can be a huge gulf between a building’s actual energy performance in use and its EPC anticipated at the construction phase. We need to measure what we need to know about, and measuring projected energy through EPCs is not really useful.”

Pavey questioned the validity of EPCs as a statutory measure. He suggested the calculation methodology of an EPC rating could be “quite flawed.” Display Energy Certificates (DECs)* that measure the actual energy use of a building could be extremely different to the EPC rating, hence EPCs will get challenged.

(*The Government introduced the requirement of a DEC (Display Energy Certificate) for public buildings in October 2008.)

Griffiths said that EPC recognition and use within various sectors made them the best option for the legislation to be based upon. “There is nothing potentially better at present and we can at least focus on EPCs and improve them. This is a real opportunity for EPCs to be made into a robust tool.”

Castle queried if EPCs could be used in conjunction with another measurement device to produce better benchmarking. Griffiths felt EPCs would be the sole tool adopted by the legislative working group.

Pavey noted that EPC assessment relies heavily on the fabric of a building, and planners, through the building regulations, are now focusing on the fabrics of new buildings and refurbishment projects. “I think this legislation is linked to EPCs not DECs because the landlord has responsibility for the fabric of the building, not the tenant. That’s the mindset of where they are going.

“Maybe they have got it right to go towards EPCs, but either way it is a big task to change a building fabric-wise – and expensive.”

We’ll see you in court

With leases and service charge provisions commonly including landlord-supporting catch-all clauses such as ‘complying with statute’ and ‘doing works in the interest of good estate management.’ Coote predicted the new legislation would provoke legal test-case activity, especially in multi-let scenarios. “In some contexts there will be legal challenges, such as when a landlord upgrades the EPC, and puts the building costs through the tenancy service charge.”

Such aspects were now being far more closely considered by tenants’ advisers, he noted.

Finnis claimed the legislation could have a radical market impact simply through the ‘law of unintended consequences’. “The idea behind the legislation makes sense but the question is ‘Where do you draw the line?’” Hence, five years away from the legislation coming into operation, buildings slipping down the EPC ratings were already becoming less popular, simply because of their inability to be let in due course.

Also, with leases spanning the 2018 deadline, landlords are increasingly being asked to specify their future plans to upgrade low EPC-rated buildings.

Another concern was the effect of upgrading works on business occupational continuity. “To replace an air-conditioning system in a multi-let building is very challenging and capital intensive. Refurbishing a building with a tenant in occupation is not impossible, but it is difficult and expensive. And this difficulty further exacerbates the issue of who pays for the work. It is very possible that disputes here will end up in Court.”

Investments were also being affected, with fund managers now very aware of the capital costs of refurbishing buildings. “Changing a building from an EPC of G to D is expensive; to get it up to a C or B will be a very large capital number.”

Will EPC ratings add to property obsolescence?

Coote raised the concern of obsolescence. “The Thames Valley has about two million sq ft of Grade C properties and more than half of them are locationally or physically obsolete, with very low EPC ratings. These need to be converted – perhaps becoming hotels or residential – otherwise they will just sit empty in a Grade C bucket.”

Harris noted that the same could be said for the rest of the country.

Dean pointed out that SEGRO was constantly upgrading commercial premises on its Slough trading estate to meet client requirements and EPC ratings. She suggested 8% of the Slough stock might require EPC upgrading, but SEGRO was already tackling the challenge as an ongoing process.

Coote suggested that poor floorplates and floor-to-ceiling heights make buildings obsolete rather than poor EPC ratings. “Modern workplace occupiers don’t need so much space, about 40% less, but they do want it of a higher quality and that exacerbates the obsolescence problem.”

Finnis doubted the effective implementation of the legislation deadline. “I think it will be very challenging to maintain the current deadline. The stock replacement rate in the Western Corridor market is at an all time low and a proportion of the stock is obsolete in the context of this legislation. A hard deadline will create a fundamental issue and potential lack of supply by saying that space worse than an E rating cannot be let/sub-let.”

Griffiths stated the legislation would definitely include an economic feasibility test, so if a building cannot economically be brought up to the correct EPC level, it will not necessarily be termed unlettable.”

“But what will that economic level be?” asked the Roundtable.

Griffiths said he believed it would based on the interest costs of taking out government-backed Green Deal funding to re-engineer the building, compared against the overall energy saving costs likely to be achieved.

‘Hermetically sealed boxes’ put Thames Valley at risk

Finnis pointed out that 20% of all UK stock is EPC rated at F or G – and the Thames Valley might be at a potentially greater EPC risk than other regions. “Our research shows that more than 90% of western corridor stock is more than ten years old. A lot were produced in the 1990s as hermetically sealed glass boxes with old-fashioned air-conditioning systems that use a lot of electricity.

“As these buildings come to the market to be let or sub-let, I fear EPC issues will arise because these buildings are expensive to run in energy terms..”

Harris remarked: “If 20% of UK stock is F and G rated, is the Government saying one fifth of buildings will have to be bulldozed? That’s impossible.”

People in glasshouses . . .

“I don’t think the Government will want to go that route,” Coote confidently predicted. According to his research, several offices currently occupied by government departments in Reading were EPC rated at E or below – including the Environment Agency housed in a G-rated building.

“So this legislation could be successfully blighting the Government’s own stock?” queried Murray.

Coote: “I’m not aware of any government initiative to address the EPC issues of their own occupied properties.”

Murray: “Perhaps they should be leading by example.”

Possibly, someone at the Roundtable mentioned glasshouses . . . .

Refurbish, re-engineer or demolish?

Dean revealed that SEGRO had spent £5.5m at IQ Winnersh to take one building from EPC rating F to B. “But now we have a Grade A building rated BREEAM excellent, with a 25-30 year lifespan, a generous parking ratio and an occupier prepared to sign up to a 10-year certain term. It often makes much more sense to recycle buildings rather than knock them down and redevelop.”

Finnis stated that the western corridor replacement rate is under 1% within an 85 million sq ft market. “That means only 450,000 sq ft is being constructed that will be delivered this year. To replace the stock at issue is going to take us 50 years. That’s a fundamental problem coming at us like a train.”

While people might be focusing on EPC E-ratings for 2018, Griffiths pointed out that the government’s long-term ambition was clear and consideration should be given to more stringent EPC ratings in the future. “So, there may be a business case to do more significant investment now rather than later.”

Architect Castle agreed that undertaking extensive upgrading work in one go was not only cost-effective but a sustainable approach, “rather than throwing away some of the kit every five years.”

Finnis revealed that Jones Lang LaSalle had recently been working on long-term portfolio analysis for clients. Buildings without suitable specifications for cost-effective refurbishment or re-engineering were being spotlighted with specific advice being provided to clients to optimise capital spend on uprating EPCs.

Castle said it could be a fine balance between re-engineering or demolition, but sustainability-wise demolishing buildings was undesirable. “We know that it is possible to intelligently re-engineer or refurbish upwards to a decent EPC rating. It can be done, but it needs commitment from the client, investment and strategic management to future-proof a property portfolio.”

Appearances can be deceptive…

Dean felt the appearance of buildings might be one reason that occupiers are not focusing on the Energy Act’s EPC issues. “Their building is modern and still looks lovely, so there is an assumption that it operates efficiently in energy terms. But, it’s EPC rating could be a difficult occupational cost message for the property director to tell to his finance director.”

Coote agreed, mentioning a Grade A central Reading headquarters-style building with an EPC rating of F. “I couldn’t believe it, and nearly fell off my chair. Fortunately that one is going to be refurbished.”

Jones: “Over the past 20 years our industry (design and engineering) has changed beyond recognition. Our driver in the ‘90s was maintaining working conditions, but now it‘s all about energy consumption. About 80% of our work involves managing margins. The building might look the same, but what we do now to create it is a world apart.”

Castle agreed modern looks could be deceptive. “Today, it is about quality design; integrating the energy uses, fundamental geometry, and systems within the building. It is now a highly complex structure, in which even desk layouts might have a significant effect on the energy use. You might get very different ratings per floor dependent upon the types of occupation.”

Cast a fresh light on energy use

Castle pointed out that developers and landlords often invested much time and money in premises to achieve high EPC ratings, but such ratings could be largely irrelevant depending on whether the occupier adopted a responsible approach to energy use. Maybe tenants should be incentivized to use energy wisely, he suggested.

Coote suggested they could be taxed on the differential between the building’s EPC rating and their actual energy use recorded by a premises DEC.

Finnis felt tenants were already incentivised nowadays by their payment of ever-rising utility costs which flows through to their running costs or service charge bills.

Pavey stated lighting was one of the biggest energy triggers for EPC ratings. “Up to 50% of energy usage can be office lighting.” Optimising natural light through the office layout or good use of LED energy-efficient lighting could bring significant advantages, he suggested.

Coote: “Not only can you drive around at night and see office blocks lit up, but it is contributing to environmental light pollution in urban areas.”

Funding the upgrades and the Green Deal initiative

Dean mentioned that the Government’s Green Deal funding was launched in February to encourage people to upgrade their buildings before 2018. “I suspect that nobody is applying for Green Deal money in a commercial environment because of the costs (7% interest rate), and it appears the Government is doing little to target commercial occupiers and owners.”

Coote: “Aspects of the Green Deal seem incredibly complicated in commercial terms.

If an occupier does take it on the energy costs of that building after he has gone may continue to be much higher. I don’t know how that works from a landlord perspective, trying to re-let the property. There is the potential of loading comparative costs on a building and blighting it commercially.”

Roundtable discussion followed which revealed much confusion about Green Deal funding in relation to EPC upgrading. One person even suggested the Green Deal would generate more legal-tests through the courts.

All were agreed that most large commercial occupiers would get finance elsewhere, and the Green Deal would only be of interest to smaller occupiers at the lower end on the market

Dean highlighted that 60% of SEGRO’s occupiers are SMEs, so high uptake of Green Deal financing could present the company with significant issues, particularly when re- letting. “When tenants come back we refurbish and upgrade the quality of the stock, but sole occupiers could secure Green Deal funding and when they come back we are left with inflated costs.”

Griffiths suggested landlords could alleviate such concerns by providing acceptable alternative funding options for occupiers, and then it would be reasonable to refuse Green Deal financing within leasing agreements.

Dean: “It’s all about what is ‘reasonable’ and ‘acceptable’, and that could lead to more case law examples.”

Coote felt the Green Deal option at least enabled landlords and tenants to discuss EPC issues as an ‘energy event’, much in the same way as lease events.

Murray queried if occupiers would try to leverage the EPC issue to negotiate more favourable terms with landlords.

Finnis: “Corporate occupiers are always seeking to de-risk, so they will want works to be undertaken before they take occupation. They will be looking for a landlord to invest in the building today so that they can take on a new commitment going beyond 2018.

“In terms of leveraging, it’s simply a line in the sand, not a sledgehammer that either side can particularly use,” he added.

Responsible occupiers wanted

Apart from the problems of designing in a vacuum of uncertainty, Castle raised the architectural challenge of designing for irresponsible occupiers.

“The main thing about EPC ratings is that they are not a true reflection on how buildings are occupied. The Government wants us to reduce energy use, so as an industry we have to find a mechanism to incentivise the occupiers to be responsible in how they use the building.”

“As architects we constantly put in the best systems and adopt green engineering, heat recovery etc, but if the building is not occupied properly then we might as well not have bothered, and that’s one thing the Government has not logged onto yet.”

Jones said Hoare Lea had noticed that universities, with their changed funding structures, had gone through a sea-change and were no longer paying lip service to controlling energy usage.

While DEC displays within public buildings were at least raising the public profile of energy use, Castle wondered if DEC and EPC differentials might be used to ‘name and shame’ those buildings that should be doing better. “The future task is to get everyone working to achieve the true energy potential of buildings.”

Jones was heartened by energy and sustainability now getting traction on corporate CSR agendas. “Companies need to be seen to be occupying buildings that are more energy efficient. Having said that, government buildings are procured in the worst possible way. The focus is skewed to minimum costs and accordingly you get a minimum standard product.”

Griffiths admitted the UKGBC was a standard bearer for DECs. “We are very keen for them to become more widespread and part of the toolkit to report corporate energy use, which will be required under Article 8 of the EU Energy Efficiency Directive.”

He noted that Australia had adopted a DEC-like methodology to measure the environmental performance of all types of buildings. It is widely respected, even boldly referenced in advertising and marketing to show buildings’ status. “They have got this buildings’ rating scheme right and it has absolutely transformed their market.”

Ironically, the scheme is called the National Australian Built Environment Ratings System …. NABERS.

Will our energy performance affect us internationally?

Murray queried if unclear energy performance ratings would affect the UK adversely in international commercial property markets.

Dean suggested it would depend upon the size and nature of the corporate occupier. “It is certainly on the CSR agendas of the American companies who are very advanced in their requirements, and incentivised to get such ethical matters right. It does come across more in negotiations nowadays, along with BREEAM and the US green building equivalent LEED.” But, EPC doesn’t rate within such negotiations as a deal-breaker, she added.

Griffiths suggested that as owners make sure their buildings comply in EPC terms, it will improve their portfolio stock quality overall, making it more attractive to occupiers wherever they come from.

Finnis: “It will make buildings more efficient, but efficiency can be delivered in different ways – occupation density, aesthetics, and EPCs. But, assuming the landlord has the capital to invest in the stock, then the stock overall should upgrade.”

Coote said that was a good thing because occupiers are now “gravitating up the food-chain” looking for quality buildings able to offer modern workstyles and an improved corporate image.

Does the legislation need a compliance champion?

Dean said many large property corporates and owners would already have someone taking up such a role for their organization. However, a sector ‘champion’ might help create more awareness among occupiers in general about the Energy Act and EPCs, and also drive worthwhile ideas for improvement or necessary government lobbying.

Finnis said several big corporate occupiers were actually already analyzing their leased properties, thinking of their EPC risks well beyond 2018.

Coote pointed out that EPCs were still far down the agenda for many corporates and smaller occupiers, but such matters should come to notice on any deals involving a proper due diligence process.

What do we tell the Government?

Dean: “Everyone knows we have got green issues with global warming and climate control, but we do need better drafting of necessary legislation and initiatives. This Government has been plagued by poor drafting, so I would advise them to tighten up what we’ve already got, and listen better to future feedback and consultations.”

As a former civil servant, Griffiths advised the Roundtable not to wait until the Government’s consultation paper comes out, but to voice its industry views now. “This legislation needs to work for occupiers and landlords, but they are also the people who will make the legislation work.”

Participants

Kate Dean: Regional director, SEGRO

Robin Harris: Board member, CoreNet UK Chapter

Chris Castle: Equity director, EPR architects

Matthew Jones: Partner, Hoare Lea

Nigel Pavey: Director of engineering, ChapmanBDSP

Richard Griffiths: UK Green Building Council

Nick Coote: Head of Thames Valley team, Lambert Smith Hampton

James Finnis: Head of the South East office agency team, Jones Lang LaSalle

David Murray: Managing editor and publisher of The Business Magazine, chaired the discussion


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