Reprinted with permission from the July 23, 2013 edition of The Legal Intelligencer© 2013 ALM media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 or firstname.lastname@example.org or visit www.almreprints.com.
By Brad A. Molotsky and Kenneth M. Kulak
Making buildings more energy efficient is often described as "low-hanging fruit" for achieving dramatic energy savings and reduced greenhouse-gas emissions. While many people appreciate the complexity of building new renewable energy projects or introducing electric or natural gas-powered vehicles, the building sector is widely perceived as rife with the potential to reduce energy consumption through the application of available, existing technologies but somehow unable to fully realize this potential to date.
As lawyers who have worked on energy efficiency in commercial buildings, we believe that the low-hanging fruit analogy is fundamentally sound. Many of the barriers that have frustrated large-scale energy efficiency investment are being lowered quickly by a new combination of policies, technologies, incentives and mechanisms for sharing successes and data. Amid all the focus on hydraulic fracturing and other sources of energy supply, we expect that the harvesting of energy efficiency benefits in the years ahead will also attract substantial new capital investment and deliver benefits across the commercial building sector.
In this article, we explore key features of the current landscape of energy efficiency in commercial buildings and discuss developments creating both a substantial need and new opportunities for lawyers schooled in the skills required for successful commercial building energy efficiency transactions.
Energy and the Commercial Building Sector
The U.S. Department of Energy estimates that about 41 percent of energy consumed in the United States is used in residential and commercial buildings (44 percent more than the amount of energy used in transportation and 36 percent more than industrial manufacturing). In 2011, United Technologies Corp. and the Rhodium Group found that the cost for powering U.S. buildings was $432 billion - about what U.S. employers spend on health insurance.
Because buildings are generally supplied with electricity produced in power plants, the fuel mix (and emissions) for energy consumed in making electricity in the United States is reflected in building consumption. Seventy-five percent of the energy used in U.S. buildings is derived from fossil fuels (coal, natural gas), with the remaining energy from nuclear generation (16 percent) and renewable sources (9 percent, including hydroelectricity).
Commercial buildings (such as offices) consume about 46 percent of the energy used by the entire U.S. building sector (including residential), and more than half of the commercial building energy consumption is for heating, cooling and lighting. Even as the average amount of space in offices decreases on a per capita basis, the actual space used and electrical demand continues to increase. The DOE projects that by 2035, U.S. commercial building sector energy consumption will increase an additional 22 percent over 2009 levels (in part as a result of a 28 percent increase in commercial building floorspace).
The Changing Landscape
Historically, large-scale energy efficiency investment has been frustrated by a number of factors. Building owners may lack the capital to invest up front in efficiency upgrades. "Split incentives" and existing lease arrangements can also undermine efforts to finance energy efficiency depending upon the setting (offices, retail, hotel, warehouses, etc.), as owners cannot always pass on costs to tenants that do not want higher rents and may not remain to realize long-term benefits. Efforts to "scale up" investment across multiple properties can be frustrated by individual building characteristics or an inability to obtain reliable data on different building performance and energy usage. Incentives available through the federal tax code or local utilities can still leave a funding gap, and many companies are inexperienced in long-term contracts with energy service companies where costs may be recovered through sharing in future energy savings. Stakeholders in the commercial building sector increasingly do not see these challenges as insurmountable in light of the potential returns.
One particularly visible example of recent successful retrofits is the iconic Empire State Building, which underwent $13 million of energy efficiency upgrades as part of a larger $500 million renovation. The retrofits included new windows, installation of insulation behind radiators and new control systems. The building is now realizing $4.4 million of annual savings with a return on energy efficiency investment of more than 30 percent and has been certified as an Energy Star building by the U.S. Environmental Protection Agency (equivalent to "Gold" under the U.S. Green Building Council (USGBC) Leadership in Energy and Environmental Design (LEED) program).
In new construction, "green building" growth has also been dramatic. The USGBC reports that more than 41 percent of all nonresidential building starts in 2012 were green, compared to 2 percent of such construction in 2005. And even the federal government is requiring LEED Gold certification for all new federal building construction (as well as requiring agencies to lease space in Energy Star buildings).
The Obama administration's "Better Buildings Initiative," launched in 2011, has an overall goal of reducing the energy intensity in commercial and industrial sectors by 20 percent by 2020 and has already engaged 110 organizations representing 2 billion square feet of building area to make similar commitments. The DOE and the IRS are also taking steps to improve the usefulness of existing tax deductions for energy efficiency upgrades, and federal agencies are seeking to facilitate energy investment by entering into construction contracts with energy service providers that use long-term energy savings to pay for initial costs, without taxpayer funds.
But developers, building owners, investors, entrepreneurs, environmental advocates and state and local policymakers are not waiting on the federal government. The Rockefeller Foundation and Deutsche Bank have estimated that scaling energy efficiency is a $279 billion investment opportunity with energy savings over 10 years totaling more than $1 trillion. United Technologies and the Rhodium Group project that a similar up-front investment in high-performance energy efficiency could be recovered in three to four years. A wide range of initiatives are converging to facilitate more investment in energy efficiency, including:
Understanding how efficient a building actually is remains a significant problem in attracting capital to finance energy upgrades. New initiatives in major cities, including New York, Philadelphia, Washington, D.C., Chicago, Seattle, Austin, Tex., Minneapolis and San Francisco, are requiring building owners to calculate building energy use by using the federal Energy Star program and publicize that information, facilitating comparison by investors as well as potential tenants seeking to understand their energy consumption and thereby reduce their own carbon footprint. More than 267,000 U.S. commercial properties (representing 28 billion square feet) are now participating in the Energy Star program, and those buildings that track their energy usage using the EPA's portfolio manager programs achieve a 7 percent reduction.
Property Assessed Clean Energy (PACE) bonds are an attractive new financing mechanism emerging in several states. Under this arrangement, the proceeds from bonds issued by municipalities are available to commercial building owners to pay for energy upgrades, with the payment obligations backed by property tax liens.
In recent years, there has been large growth in companies offering sophisticated building management systems that closely track energy usage and provide for real-time adjustments to reduce energy consumption. These systems offer building owners the ability to more easily centralize energy information across a portfolio of properties, as well as provide feedback directly to tenants that can adjust their energy usage.
As part of their own sustainability initiatives and investment priorities, pension funds and other institutional investors are seeking to improve the energy efficiency of their real estate investments and increasingly taking action as shareholders on energy efficiency. Ceres, a nonprofit organization focused on sustainability issues and investor groups, reports that the California Public Employees' Retirement System, with a real estate portfolio of more than $21.3 billion, worked with its investment managers to exceed a 20 percent energy reduction goal. Calvert Investments recently filed shareholder resolutions to establish energy use targets. More broadly, several institutional investors are seeking to create investment-grade energy efficiency opportunities and a secondary market for energy efficiency finance.
Understanding Legal Needs
In our experience, the increasing regulatory and transactional complexity of energy-related investment requires an expanded partnership between in-house counsel and outside counsel to help ensure successful results.
Energy efficiency investment often presents novel questions for an organization and may be driven by different organizational goals and constituencies. In-house counsel may need to spend extra time to ensure that management and commercial teams share a complete understanding of contractual and financing frameworks and the risk/reward calculus in a particular project.
Given the many moving parts of an energy efficiency investment, in-house counsel may also look to outside counsel for advice on legal issues that cross different practice areas, including the following:
Many energy efficiency projects require a solid understanding of federal and state energy regulatory provisions to validate project assumptions and identify risks associated with existing statutory frameworks and utility incentive programs. This is particularly true for projects that incorporate on-site generation (such as a solar system) where excess energy may be delivered back to the local electric grid.
Given the long-term structure of many real estate arrangements, existing leases may need renegotiation to better align interests of owners and tenants in energy savings, and new leases may need to incorporate green features and options that may emerge over a lease term to facilitate recovery capital costs. Provisions in energy savings contracts must be negotiated with care to ensure appropriate protections as well as remedies if energy upgrades do not deliver expected savings.
The increasing sophistication of building management systems (as well as their use of the Internet for systems control, data storage and reporting) requires careful analysis of installation and services contracts, including provisions relating to indemnification, intellectual property, ownership and protection of data (for both building owners and tenants), and standards for the performance of services.
As government and utility incentive programs and other mechanisms such as PACE develop, the complex arrangements underlying the financing for many commercial buildings must be integrated with new interests intended to secure energy efficiency investments without jeopardizing existing obligations or creating an adverse impact on the ability to sell a building in the future.
The growth in energy efficiency opportunities and interest has been a long time coming, but we are optimistic that in the years ahead the description of energy efficiency as low-hanging fruit will fade as the policies and practices to enable high-efficiency buildings will become as much a part of our landscape as the buildings themselves.
Brad A. Molotsky is executive vice president and general counsel of Brandywine Realty Trust, a real estate investment trust with properties aggregating 40 million square feet in select markets across the United States.
Kenneth M. Kulak is a partner in the energy practice of Morgan, Lewis & Bockius, where he specializes in energy regulatory issues and renewable energy transactions.