Efficiency in Buildings: Beginning of the end of the “payback period”?

Last week we reported on the EU’s plans to toughen up the law on the energy performance of buildings by passing a Recast Energy Performance of Buildings Directive. We promised to provide further detail on a number of potentially important discrete changes proposed in the Recast Directive. One of these changes relates to the financial modelling of measures designed to increase the energy performance of buildings.

Payback Period

There is a fair amount of sentiment (in most parts of the real estate sector) in favour of increased use within buildings of more efficient materials, building management systems, and technology such as thermal solar, photovoltaics, wind, biomass and heat pumps. However, very often actual installation does not pass a financial model, which is often called the “pay back period”. In short pursuant to this model the installation costs are divided by annual savings in energy costs, to produce a pay back period, usually expressed as a number of years. If the payback period is perceived to be too long, installation of the efficiency measure may not get the go ahead.

Inherent conflicts

The “payback period” has the very clear benefit of sheer simplicity. However it is rudimentary and open to abuse and manipulation. The model comes under considerable criticism from very many quarters (including accounting, technical, policy and environment) and is seen as a very significant hurdle to the take up of energy efficient methods and technology within the real estate sector. It is said to be a significant hurdle not only because of its inherent flaws but (and perhaps more so) because it highlights a conflict within the real estate sector. Many commentators maintain that it is this conflict that acts as a principal barrier to the take up of energy efficient methods and technologies. In essence the conflict lies between the interests of the developer and the employer and the landlord and the tenant. The developer and the landlord will be reluctant to invest in efficient methods and technologies if the resultant benefits in energy savings are to be reaped by the employer/tenant. The developer and landlord could be out of pocket.

EU proposal – “cost-optimal level” not “payback period”

The EU accepts that a balance needs to be struck. However the EU starts from a wholly different perspective. The EU is not looking at the balance between developer and employer or landlord and tenant. Its starting point is more fundamental. The balance for which the EU intends to legislate, is the balance between the costs of implementing measures to increase the energy efficiency of buildings and the energy that is ultimately saved. Thus from the EU’s perspective the starting point is how efficient could the building reasonably be, rather than how quickly would the investment be repaid?

Recital 10 of the Recast Directive sets out in very simple terms the EU’s intentions. It states that “Member States should set minimum requirements for the energy performance of buildings. The requirements should be set with a view to achieving the cost-optimal balance between the investments involved and the energy costs saved throughout the life-cycle of the building”.

Article 4(1) provides that Member States shall take the necessary measures to ensure that minimum energy performance requirements are set “with a view to achieving cost-optimal levels”. This is to be based on methodology set out in the Recast Directive. Obviously “cost-optimal level” is an important term. It is expressly defined to mean “the lowest level of costs during the life-cycle of a building, which are determined taking into account investment costs, maintenance and operating costs (including energy costs), earnings from energy produced, where applicable, and disposal costs, where applicable”. Clearly the EU is to impose life-cycle costing as the financial model. The “payback period” is nowhere to be seen.

Some Member States are likely to have to amend their current requirements to meet this obligation. As the draft Recast Directive currently stands, these requirements will need to be amended in domestic law by 31st December 2010 for buildings occupied by public authorities and by 31st January 2012 for other buildings (Article 23).

EU lack of confidence in Member States

Article 5 is also of importance. Like the original Energy Performance of Buildings Directive, the Recast Directive works on the basis that each Member State will amend its domestic laws to incorporate the purposes and objectives of the Recast Directive. Thus in principle, each Member State should amend its minimum energy performance requirements, by the dates set out above, to include the changes made by the Recast Directive, including the requirement for life-cycle costing.

However the EU is concerned that the various minimum energy performance requirements set by Member States to date vary considerably and many are far from cost-optimal levels. The EU also thinks that there is a lack of ambition in some Member States. Reading between the lines the EU is not confident that Member States will purposively implement the amendments set out in the Recast Directive. Thus in the Recast Directive the EU is seeking to ensure that over a transition period (see below) Member States align with cost-optimal levels. Article 5 provides that by 31st December 2010, the EU Commission will provide a comparative methodology for calculating cost-optimal levels (which levels may differ between new and existing buildings and between different categories of buildings – indeed looking at the language used in the primary text (i.e. the Recast Directive itself) which could be better drafted, do not be surprised if confusion creeps in with respect to what is required for new build and what is required for retrofit).

By 30th June 2011, each Member State must calculate (and report to the EU) the cost-optimal levels in its jurisdiction using the comparative methodology and benchmark these calculations against the minimum energy performance requirements which it (the Member State) has laid down in domestic law. Having made such benchmarking analysis if the Member State falls short in its requirements, Article 4.4 provides that from 30th June 2017 (i.e. the transition period) the Member State will be required to begin to amend its national standards to meet those set out in the comparative methodology. Thus in amending its energy performance requirements, if a Member State fails to benchmark favourably with the comparative methodology, it will have to amend the requirements again.

Ramifications

The Recast Directive is still in the legislative process and it may be that some of the drafting and dates will change. Some Member States are, for instance, concerned by some of the implementation dates and other matters. There are also aspects of the draft Recast Directive which lack clarity, however the gist of what the EU is proposing in respect of life-cycle analysis is clear (save perhaps for the point raised above in connection with new builds and retrofits). There does not appear to be much reported concern from Member States over this aspect of the Recast Directive.

Whilst there will be a transition period to allow Member States to put their domestic law into order, it may be prudent during this period (1) for the real estate sector to accelerate its thinking on how life-cycle costing might be implemented within the context of developer/employer and landlord/tenant relationships and (2) for intelligent dialogue to be undertaken between the real estate sector and the cleantech sector.

Whilst this is not an immediate issue for legal due diligence, it is not inconceivable that these changes will become part of the fabric of commercial due diligence in transactions involving real estate. This could be (and perhaps, should be) the case even before laws are finally implemented at national level.