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Expert Voices: Paul Reale, Urban Green Council (the New York Chapter of the U.S. Green Building Council)

Of all the ways commercial real estate owners can spend capital, those of us in favor of environmental initiatives hope that cost-saving “energy retrofits” are somewhere near the top of that list. Unfortunately, given the way many leases are structured, it’s not on the list at all.

The “split-incentive problem” has gotten in the way for a long time. That’s where owners pay for capital upgrades to base building systems (such as HVAC and elevators) and tenants pay their prorated portion of the energy bill. So, although the savings often justify the expense, it’s the tenant’s savings and the owner’s expense. As a result, often the project just isn’t done.

The good news is that there’s now a solution to the split-incentive problem, which is starting to catch on…

In 2010, the New York City Mayor’s Office of Long-Term Planning and Sustainability assembled a working group of commercial real estate professionals to solve the split-incentive problem. Not long after, in April 2011, Mayor Michael Bloomberg presided over a signing ceremony for the first lease that contained the working group’s solution: the Energy Aligned Clause (EAC).

Mayor Bloomberg joins World Trade Center developer Larry Silverstein to announce downtown lease for law firm WilmerHale that contains groundbreaking new “green lease” language that aligns incentives for energy efficiency improvements. April 05, 2011 (Photo Credit: Spencer T Tucker)

More than anything else, the solution hinges on the ability of engineers to predict the savings associated with an energy retrofit in a commercial building within +/-20%.

The EAC leverages that margin to encourage the landlord to spend the capital on the project and to protect the tenant from paying more than business as usual, i.e., if the project hadn’t been done. Better yet, the EAC reduces the tenant’s energy costs as soon as the energy retrofit is complete.

Here’s how it works: Suppose the annual energy cost is $6,000,000. An engineer proposes an energy retrofit that costs $4,000,000 to implement and is estimated to reduce the tenant’s annual energy cost by $1,000,000. The owner provides the capital, the work is completed, and the energy costs are reduced.

Using the EAC, tenants commit to paying 80% of the predicted savings. In this case, that’s $800,000 per year. So instead of paying $6,000,000 per year in energy cost, the tenant pays $5,000,000 for energy, plus $800,000 for the retrofit, or $5,800,000, thus saving $200,000 per year.

In this example, this keeps up for the five years it takes for the owner to recoup the $4,000,000 ($800,000 per year for five years). And of course the owner has an improved building.

Better yet, if he or she is still in the lease after the capital expense is paid, the tenant begins to enjoy the full $1,000,000 of annual savings.

If the retrofit performs better than predicted, the tenant saves more, but even if the retrofit underperforms by up to 20%, the tenant still ends up not paying more than if the retrofit hadn’t been done. That’s because the 20% performance buffer protects the tenant.

After the April 2011 signing ceremony of the first use of the EAC, there was little uptake. So an outreach effort executed over the past six months helped to educate New York City’s real estate industry about it. Urban Green Council, the New York Chapter of the U.S. Green Building Council, led the effort. Crucial support was provided by the New York State Energy Research and Authority, the Natural Resource Defense Council, the Real Estate Board of New York, the Environmental Defense Fund, and the City of New York.

Since the outreach started, the City of New York has signed three leases that include the EAC, and plans to use it wherever it faces a split-incentive problem. Two multinational companies and a large government entity haven’t made it official yet, but they are working to incorporate the EAC in their preferred leasing terms. Many presentations later, there’s now significant interest both inside and well beyond New York City.

In short, the Energy Aligned Clause is starting to catch on. And that means the beginning of the end to the thorny split-incentive problem.

Paul Reale was the Special Consultant for the PlaNYC Energy Aligned Clause at Urban Green Council. For more information on the Energy Aligned Clause, click here.