From April 2018, new regulations will make it significantly harder for landlords to rent property with an energy efficiency rating below ‘E’. Warren Gordon looks at the lease drafting implications, and potential exemptions from the new requirements
The minimum energy efficiency standards (MEES) under the Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015, come into force on 1 April 2018 for the grant of new leases (including statutory renewals). The effect of MEES is that the grant of a new lease on or after that date will be unlawful if the property has a sub-standard asset rating, as shown in an energy performance certificate (EPC).
Recent government pronouncements (such as its ‘Clean Growth Strategy’) highlight that energy efficiency standards are likely to become stricter.
The current sub-standard rating is anything below ‘E’, but it may become stricter in the medium term. From 1 April 2020 (for residential property) and 1 April 2023 (for commercial property), continuing to let property with a sub-standard rating will be unlawful.
There are certain exclusions and exemptions when the new lease or continued letting will not be unlawful, but the exemption must be registered on the statutory register. The main effect of the lease being unlawful is that the landlord may incur potentially severe financial penalties. Landlords urgently need to determine which properties will potentially cause them to break the law, and to decide whether works should be carried out or exemptions registered to prevent this from happening. Solicitors should consider what advice to provide and what drafting to include for MEES in leases.
The purpose of ePCs
We are very familiar with the role of EPCs in property transactions, whether residential or commercial. An EPC is required if a property is being let or sold (unless there is an existing valid EPC), if a new building is constructed, or if certain modifications are carried out to an existing building.
The purpose of an EPC, which is produced by an accredited energy assessor, is to record the energy efficiency of a building. The certificate provides a rating from ‘A’ to ‘G’, where ‘A’ is very efficient and ‘G’ is very inefficient. Each energy rating, known as an ‘asset rating’, is based on the characteristics of the building itself, such as its age and condition, and its services, such as heating and lighting. The asset rating shows the building’s intrinsic performance, as opposed to the actual energy used.
The EPC provides prospective buyers, tenants, owners, occupiers and lenders with information to enable them to consider energy efficiency and fuel costs as part of their investment. However, it has been given a whole new lease of life with MEES.
The impact of MEES
Some property organisations have a very strong corporate ethos of promoting green issues, and introduce behavioural change in their portfolios without any element of stick being required. The government, however, considered that the pace of change for improvements to energy efficiency was too slow and more needed to be done. Legislation was enacted (the Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015), which created MEES. This new law will come into force on 1 April 2018 and the consequences of non-compliance mean that everyone in the property industry needs to focus on what their EPCs are saying now; if they say the wrong thing, radical action may be needed.
If the EPC for a private-rented property shows a rating of ‘F’ or ‘G’ – a ‘sub-standard rating’ – a landlord, starting on 1 April 2018 (subject to certain exemptions), is not permitted to grant a new lease, or extend or renew an existing one, of the property. From 1 April 2023 for commercial property and 1 April 2020 for residential property, this restriction is expanded so that a landlord is not permitted to continue to let such a property. This means that it will be unlawful for a landlord from those dates simply to allow existing leases to continue of a property that has a sub-standard rating. So if your property has a rating below ‘E’, the basic position is that you will not be permitted to let it. This is clearly a big deal, and if a landlord chooses to ignore the restriction and let the property, a not insignificant penalty could be coming their way.
For commercial property, if there is less than three months’ non-compliance from the service of a penalty notice by the local trading standards officer, the landlord will receive a penalty of the greater of £5,000 or 10 per cent of rateable value up to £50,000. If there is three months’ or more non-compliance, the penalty is the greater of £10,000 or 20 per cent of rateable value up to £150,000. A penalty is applied for each tenancy that is unlawful. The penalties are lower for residential property. There is also the reputational damage of guilty landlords being ‘named and shamed’. For many landlords, those penalties will be a significant financial disincentive to grant new lettings of properties with an ‘F’ or ‘G’ rating. However, it is curious that while the landlord may be penalised, the lease itself will be legally valid.
Recent government pronouncements (such as its ‘Clean Growth Strategy’) highlight that energy efficiency standards are likely to become stricter. There are proposals to consult in 2018 on raising minimum standards of energy efficiency for rented commercial buildings. In relation to residential property, the aim is for as many private-rented homes as possible to be upgraded to at least a ‘C’ rating by 2030, where practical, cost-effective and affordable.
Exemptions and exclusions allowing for grant of leases
In terms of how to respond to a property with a sub-standard rating, one approach might be to carry out works to the property to improve the rating to a lawful one. However, the property owner may be unable to recover the costs. Instead, the owner may seek to utilise a legislative exemption; if the exemption applies and it is registered on the statutory private-rented sector (PRS) exemptions register, it would not be unlawful to grant a lease on the property, even if its rating remains sub-standard. Such exemptions are time-limited and do not benefit successor landlords. The types of exemption include the following.
The consent exemption
This is available if, within the preceding five years, a landlord has been unable to increase the EPC to band ‘E’ as a result of the tenant refusing to consent to any relevant energy efficiency improvements, or the landlord, despite reasonable efforts, being unable to obtain the necessary consent of a third party, including for planning. This exemption accounts for why some landlords are introducing clauses in leases making the landlord’s rights to enter the property to carry out works related to MEES conditional on the tenant’s consent.
‘Relevant energy efficiency improvements’ are identified in the legislation, and for commercial property, qualify if they can achieve a simple payback within seven years. For residential property, landlords currently only need to carry out the improvements if they are at no cost to them, although the government is currently consulting on requiring a landlord of a sub-standard residential property to contribute towards the cost of improving its energy efficiency, capped at £2,500 per property.
The devaluation exemption
This is available if, within the previous five years, the landlord has not achieved band ‘E’ by making the relevant energy efficiency improvements, because the landlord has obtained a report from an independent surveyor which states that making the improvements would result in a reduction of more than five per cent in the market value of the property.
It is important to note that landlords can only rely on the relevant exemption where they have registered the information concerning the exemption in the PRS exemptions register. Registration has been open since 1 April 2017, although the register is still only in a pilot form.
There are also exclusions for properties that do not require an EPC, or, in the case of commercial property, for leases with a term not exceeding six months, or for 99 years or more. While MEES will apply to residential property let on an assured tenancy, certain other types of tenancy are excluded.
All this highlights the fact that a landlord may well be able to let an ‘F’ or ‘G’ property from April 2018 without incurring a penalty, but this is by no means a certainty: registering an exemption will not be easy. So how should property owners respond to the new legislation in terms of lease drafting?
Lease drafting for MEES
An important question is whether the cost of upgrading a property to at least an ‘E’ rating can be covered by the service charge. The answer is usually no. Many service charge provisions do not allow for the recovery of the cost of improvements. There also appears to be a prevailing view in the property industry that many tenants will not allow for the service charge to cover improving the property’s energy efficiency. They know that the landlord may well be doing this not to benefit the building, but because it wants to let without being penalised.
A key area of concern for landlords is control over the obtaining of EPCs for property. Producers of EPCs have varying degrees of expertise and knowledge of the property, and landlords would not want a less-expertly drawn EPC produced that shows an ‘F’ or ‘G’ rating. So when it comes to what drafting should go in leases, control over EPCs obtained by tenants is a big point. For example, the tenant should not obtain an EPC without the landlord’s prior written approval, not to be unreasonably withheld, to the energy assessor who will provide the EPC. The tenant should also provide a copy of the EPC and other relevant information.
‘Light green lease drafting’ that has found its way into leases in recent years may also assist with MEES; for example, a typical provision is that the tenant will not do anything that adversely impacts energy ratings.
One drafting change, for which caution should be exercised, is making the landlord’s right to enter to carry out MEES works subject to the tenant’s absolute consent. The model commercial leases adopt this approach, which seeks to utilise the consent exemption. Some landlords, however, will want to be able to enter to carry out works, and may be concerned about the reputational damage of being perceived to be seeking out ways not to implement environmentally-friendly legislation. What is clear is that MEES drafting is in a state of flux, and it will still take some time to establish market standard drafting.
MEES is having and will have a major impact on the property industry. The significant penalties will impact on the behaviour of property owners, and while the penalties may encourage the carrying out of works to improve energy ratings, they may equally lead to the registration of exemptions, and lease drafting that seeks to avoid those works, certainly those at the landlord’s cost.