How do you solve the problem of funding retrofit work?
To reach the Government's target of net zero greenhouse gas emissions by 2050, existing commercial and residential buildings will need significant investment.
This doesn’t just mean retrofitting measures to improve energy efficiency and move to low-carbon heating, it also potentially means upgrading power connections and making sure buildings are resilient to the effects of climate change.
Retrofitting is a huge and costly undertaking, estimates for housing alone is in the billions, so how will the work be funded?
It’s a pressing problem for real estate owners. Minimum Energy Efficiency Standards (MEES) are already speeding up the rate of building obsolescence. And from next year, businesses will be required to disclose climate-related financial risks.
Barriers to break down
The Government can’t foot the huge retrofit bill alone, not without a ‘magic money tree’. The recent announcement of £5,000 grant for homeowners to replace gas boilers illustrates the point. The average cost of heat pumps is currently £10,000. That’s just part of the work required to make homes greener and there are commercial buildings to retrofit too.
Alternative funding streams to support the work are needed and to do that, there are a number of barriers to break down.
Landlords need an incentive to pay for the work, but at the moment there are few.
Chris Paul, Partner at Trowers & Hamlins explains: "The issue is the split incentive – where the landlord has to spend the money while the tenant gets the benefit through reduced energy bills and a warmer home or place of work."
Commercial property rental growth remains flat at present, making it difficult to justify a green premium and charge higher rents to recover the necessary investment. Not unless it is something that a lot of asset owners start doing which collectively pushes up rents.
For social housing providers, rent caps make it difficult to recover investment through increased rents. One solution is allowing landlords to charge ‘warm rents’ on retrofit property – recognising that tenants get the benefit of warmer homes and lower energy bills.
For private funders, investing in retrofit work doesn’t present an attractive proposition because there is no obvious route to service the debt. Where does the additional revenue stream come from on existing properties to pay back the loan for the work? And most retrofit isn’t easily demountable if the customer stops paying.
Making retrofit an attractive proposition for private funding is critical, particularly if this work is going to be done at scale.
Creating a scalable funding model
Naomi Roper, Partner at Trowers & Hamlins, says: "At the moment registered providers are making small scale changes as part of a repairs programme or they might do a unit or two as a pilot project. But they need to be able to look at their portfolio, know what measures are needed, how that work will be delivered and how it will be funded."
This means devising funding models which work at scale. And that is tricky to do when there is uncertainty about what the Government’s plans are. Roper says: "Nobody wants to go out to the market and get £300 million and then find out a month later, the Government is offering another grant; everyone is waiting for the Government."
Paul agrees: "If you are trying to fund a model for retrofit work, you want to know what the Government is planning for the next 10 years, but we haven't got that clarity."
Funders also need to know that any income stream derived from retrofit work won’t be shut off if the asset ownership changes.
Solutions to the problem
So what is the solution? Roper says: "It's not going be a one size fits all approach, asset owners will have to look at multiple different streams of financing. And given there will be such high demand, it may mean a change in risk profile for funders or coming up with innovative pricing."
So the challenge is creating a suitable income stream. One option that is already available is charging for on-site generated electricity. In its simplest form, that could be power purchase agreements (PPAs) for the electricity generated by rooftop solar installations. Getting the tenants to pay the landlord for that power creates a potential income stream that could be used to service wider debt.
More sophisticated models are being pioneered by Energiesprong UK, an initiative aimed at delivering energy efficiency improvements on a large scale. Their model involves whole house retrofit, with an innovative mechanism for the landlord to recover the investment through charging a separate 'energy service plan' (covering guaranteed heating temperatures, hot water allowance and power bundle) alongside the rent. Tenants get the benefit of improved comfort for the same cost, but most importantly landlords get access to a new revenue stream.
However, this only works where properties remain in the landlord's ownership, so it can continue to recover the retrofit costs from the additional income stream. And becoming an energy provider has its own problems.
Paul says: "Being the energy provider may be an uncomfortable space for many landlords. It comes with potential regulatory obligations, and the majority of landlords will want avoid the risks."
Occupying a retrofitted low-energy building should be attractive, but it may require a change in mindset. Tenants may need to get more comfortable with sourcing heat and power from their landlord, without the ability to shop around.
Point of payment collection
For funders who stand to lose out on the income stream if an asset is sold, there is a solution. This is to have the debt running with the property. While it came with a lot of baggage, the Green Deal was set up to do something similar. The payments were tied to the energy meter and collected from the occupier by the energy supplier. This allowed the debt to stay with the property, meaning the arrangements could survive a sale or change of tenancy.
Paul says: "From a funder’s point of view, it’s even better if repayments are collected by central government, local government or an energy company because the counterparty risk is so much better."
It is a system that is used in the US, through the Property Assessed Clean Energy (PACE) model. This allows property owners to finance the costs of energy efficiency and renewable energy upgrades through an increase in the property tax bill. This stays with the property, meaning that owners don't have the concern about recovering the investment at the point of sale. A similar system could operate in the UK, suggests Paul, with payments recovered alongside business rates or council tax.
Having a local authority or government linked system would also help create a market and pipeline for retrofit work which is needed to push investment into skills, training and the supply chain. Such investment is critical to getting retrofit work delivered on scale.
Whatever the solution, it needs to be simple. Funders naturally want fail-safe documentation and security. "But the risk is creating something that is too complex, where landlords need costly legal advice before they're willing to commit," says Paul.
Collaboration and joined-up thinking
Such a big challenge will also require joined-up thinking. Roper says: “It isn’t a problem that one person can solve by themselves. What I think we're going to be looking at is blended finance which is a combination of government, public and private funding. "This is where we want to start moving the conversation; it's going to take a collaboration between different entities to try and solve this."
Collaboration will require good relationships between local government, housing providers and the private sector – a team approach.
While it is a huge challenge, retrofit is also a big opportunity because so much work needs to be done. Roper concludes: "Mark Carney said that the road to net zero was the greatest commercial opportunity for funders out there, and he is absolutely right.
"There is a massive opportunity to corner the market, it's about pricing it at a level that people are happy with."