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Split Incentive Series: Market Structure Solutions (II of V)

Written by: Daniel Handal

Our first blog of this Split Incentive series began the discussion on the challenge of implementing energy efficiency in the commercial real estate (CRE) market. Continuing the discussion, this blog covers how to navigate through the differing motivations and incentives of CRE stakeholders to spur the adoption of energy efficiency. In short, the market structure solution is to understand and appreciate the roles of various stakeholders at the building level and allocate the value amongst them in different but applicable ways.

Stakeholder Motivations

To influence what happens in individual buildings, especially large buildings, successful commercial energy efficiency programs need to influence the following stakeholders: the entity that controls the leasing arrangements, the one that owns the building, the building engineering and operations staff and the tenants, and potentially a range of other individuals contracted by the building for specific purposes. Each stakeholder has their own business model to value the investment which must be considered. In short, to implement a Tenant Improvement (TI) project successfully, the key is to understand how each stakeholder’s interests align and overlap early in the process as shown in the figure below.

Energy Bills

Understanding a particular owner or tenant’s lease situation can greatly aid the case for energy efficiency. Many tenants have individual utility meters and pay their own energy costs. If a building is master-metered, the building owners may pass on the energy costs to tenants on a fixed cost per square foot, as a pro-rata share of the total utility bill or may pay the utility bills themselves. This is contingent on the structure of the leases in the building. If tenants have (and pay) their own utility meters, or if the utility cost is passed on to tenants, then owners do not receive direct operating cost savings from any capital improvements, including energy efficiency measures.

Lease Types

Moreover, in the leased commercial office market, most tenants fail to ask about operating costs, including energy bills, when they are looking for leased space and often consider these to be fixed costs. Accordingly, non-optimal leases for allowing energy efficiency improvement are typically adopted initially. Most leases are also difficult to amend mid-contract, which makes improvements to occupied spaces difficult. Thus, the timing of engaging tenant spaces is critical: before the leases are signed, or at the lease renewal, are the best times to influence future efficiency decision-makers. Incorporating a green lease clause to help align incentives is a good way to do so.  Many stakeholders equate “green” to costing more and do not factor the longer term total cost of occupancy.  However, green leases range in complexity from basic sustainability clauses (e.g., recycling) to cost pass-through clauses.

For more information on mitigating market structure barriers, please visit our platform and Connect Program pages. Stay tuned for our next blog in the split-incentive series on tackling financial barriers in the CRE market.


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