Environmental, social, and governance (ESG) regulations will increasingly impose obligations (and, likely, new costs) on commercial buildings. Such obligations typically include or expand upon current energy reporting and disclosure requirements, as well as building emission standards targeted to carbon reduction goals or specific building emissions benchmarks. Failure to comply with emissions standards or to accurately report data may result in costly fines or other penalties.
Avoiding fines and penalties is a critical management/ownership responsibility, and it can be managed through responsive strategies for these regulations and deadlines, such as updating building leases to ensure compliance and appropriate expense pass-throughs and recaptures.
ESG Compliance and Capturing ESG-Related Costs and Expenses
ESG regulations (and their impact) will vary based on jurisdiction and are typically dependent on a building’s age, infrastructure, uses, and tenants. Owners and managers should revise leases, occupancy agreements, and amendments for new transactions to include specific ESG provisions for overall compliance, and to recapture related expenses and obtain reporting data. This includes provisions governing maintenance, alterations and improvements, taxes and assessments, data collection and reporting, and operating costs and expenses to recover the expenses of compliance and required capital improvements.
New costs and expenses as a result of reduced carbon emissions may not be captured in current leases or occupancy agreements. Such expenses include the need for building improvements, third-party consultants, supplies, etc. Owners can include such costs and related economic considerations as additional rent in their leasing calculus and adapt leases as necessary. Non-capital improvements, such as maintenance, repairs, renovations, etc., can be billed as long as the applicable lease or other agreements contemplate a comprehensive array of operating costs, as many commercial documents are already broadly crafted to do so. Including specific compliance costs is a good idea, as capital improvement costs are often limited to certain categories that will need to be revised to include ESG infrastructure improvements. Capital costs will likely be required to be amortized over an acceptable period with the yearly amortized portion included in operating costs for the building passed through to tenants.
Older buildings present a unique set of challenges in reducing carbon emissions. Fortunately, several ESG programs offer owners alternative compliance options in the form of payments or various power purchase options. Alternative payments, such as taxes or other municipal assessments, need to be reviewed to determine whether they can be passed through to tenants via existing operating expenses or the “tax” provisions. Otherwise, building owners should consider updating lease provisions to include such payments and purchases.
Definition of Building “Owner”
Some ESG regulations may define the building “owner” or applicable responsible party to include a large, long-term tenant, allowing the actual owner to designate a building tenant as “owner” where a lease assigns maintenance, regulatory compliance, and/or capital improvement costs to the tenant(s). Some regulations also require a long lease term, for example, up to 30 years.
Reporting Requirements
Many ESG regulations require building owners to report periodically on energy and water use, building primary uses, applicable renewable energy credits (RECs), and substantive energy purchase terms. Compliance may require landlords to obtain this information from their tenants (or provide landlords with access to tenants’ utility data). Lease provisions must require tenants to deliver data (or access to data) related to their premises within a sufficient time frame to allow timely reporting, and to engage third-party verification providers, as necessary.
Leases should appropriately allocate costs and expenses for reporting, certifying, and bringing the building into compliance over time. Violations of reporting procedures may result in daily fines for noncompliance. Building owners can consider making such fines or penalties a reimbursable expense or an event of default if a tenant fails to comply with ESG requirements.
Specific Lease Provisions
Tenant alterations provisions require work to be performed per sustainability laws, practices, and ESG requirements, as well as to meet compliance measures that may change from time to time. Additional prerequisites and landlord approval rights for third-party professionals, whom the tenant may engage during design or construction of alterations, allow a landlord to confirm that plans, procurement of materials, and waste management conform to sustainability and ESG requirements. To comply with applicable ESG requirements during the construction process when procuring furniture, fixtures, and other materials and supplies, landlords may decide to include specific tenant obligations.
Waste management provisions may also require updates and revisions to meet certain ESG requirements. If a building owner is required to set up building-wide infrastructure for recycling or waste removal in addition to the direct additional contractor cost, management may need to provide bins and products to effect the program, and tenants must comply with (and pay for) the program. This can include recycling protocols and/or separate waste stream disposal as designated.
In addition to a typical “compliance with laws” provision, owners can consider adding a comprehensive ESG provision that consolidates, both generally and specifically, all of the ESG regulations in one place.
Conclusion
Building owners and managers will continue to be required to vigilantly review all aspects of their buildings to ensure compliance with the evolving regulatory framework, and to ensure that leases and occupancy agreements contain appropriate provisions to capture the intended economic dynamics of any transactions.
