Split Incentives May Not Reduce Commercial Energy Efficiency’s Value

When landlords make decisions about energy efficiency but tenants pay the costs, this creates a motivational problem known as the “split incentive.” Split incentives result in smaller investments in energy efficiency than would be economically efficient otherwise. A working paper, “Energy Codes and the Landlord-Tenant Problem,” explored this issue in April.

For example, replacing a refrigerator from the early 1990s with a new ENERGY STAR model is an investment that will pay for itself within six years, on average. However, neither tenants nor landlords may be motivated to do so. The tenants may plan to move in the near future and not bring the refrigerators with them. The landlords may not believe that they can charge more rent after replacing the appliances. [[{"type":"media","view_mode":"media_large","fid":"2100","attributes":{"alt":"Office buildings","height":"300","width":"450","style":"float:right","class":"media-image alignright size-medium wp-image-17782 media-element file-media-large"}}]]

The working paper, published by Maya Papineau, assistant professor of economics at Carleton University, indicates that the split-incentive problem does not prevent the market from adequately valuing energy-efficiency investments in new commercial office building construction. This value is expressed through rent and sales premiums.

Papineau compared similarly located buildings constructed immediately before and after the local implementation of building energy codes. She took advantage of varying dates of state-level implementation of these codes to analyze a diverse dataset.

The efficiency of a building built under a new and more-stringent energy code is not easily observable by a tenant or purchaser. It is analogous to improved efficiency from investments a landlord might make independent of energy codes, Papineau said.

This is in contrast to the more readily-observable efficiency of a third-party-verified, green-labeled building. Accordingly, Papineau’s hypotheses test whether the market compensates owners of buildings subject to stringent energy codes.

The market could compensate a building owner in several ways for having built a building under a more stringent energy code.

Commercial leases vary in terms of which party is responsible for paying for utilities.

Under a gross or full-service lease, a tenant is not responsible for paying for energy costs. In this case, a landlord is compensated through a higher net income after paying reduced energy costs. Under a modified gross lease or a net lease, tenants pay for utility costs. In these latter types of leases, a landlord could charge a higher rent that would be offset from the tenant’s perspective by the lower energy costs. Last, a building owner could charge a higher price when selling a building. [[{"type":"media","view_mode":"media_large","fid":"2101","attributes":{"alt":"Market premiums for buildings constructed under more stringent building energy code","height":"287","width":"300","style":"float:right","class":"media-image alignright wp-image-17795 size-medium media-element file-media-large"}}]]

Papineau’s research indicates a building constructed under an updated building energy code commands a sales price premium of approximately 9 percent.

Further, the research indicates that in the subset of buildings analyzed in which tenants are responsible for utilities through lease structures, the rent premium is 6 percent.

The paper continues the analysis a step further and calculates that these market premiums are consistent with the premiums that would reflect a full capitalization of the energy savings from the applicable standards.

The conclusion is that the market does value buildings constructed under more stringent energy codes. Similarly, it would value independent investments in energy efficiency.

Papineau said, “The results suggest that in commercial buildings, we likely need not be overly concerned about the frequently-cited suggestion that asymmetric information between landlords and tenants mitigates the returns to energy efficiency and contributes to an energy-efficiency gap.”

However, the author said that many other potentially relevant market failures are outside the scope of the paper.

One example of a related market dynamic is the difficulty a building owner faces when attempting to make efficiency investments in buildings that are already constructed and leased. In these scenarios, existing long-term contracts with tenants can dramatically reduce a building owner’s ability to monetize an efficiency investment in an appropriate time period.

Many organizations, such as Building Owners and Managers Association International, Rocky Mountain Institute, and Natural Resources Defense Council, recommend lease structures that allow the building owners and the tenants to appropriately share in the value from any potential future efficiency upgrades during the terms of the leases.

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