IDENTIFYING AND MONETIZING CARBON FINANCE ASSETS IN COMMERCIAL REAL ESTATE

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1 Page 174 IDENTIFYING AND MONETIZING CARBON FINANCE ASSETS IN COMMERCIAL REAL ESTATE By Mark J. Bennett* and Stephen G. Palms** Green building has arrived in the real estate world. Owners and users of real estate are always seeking ways to reduce operating expenses and increase the number of dollars available from third party sources for the construction of new buildings or the improvement of existing buildings. The use of green technology and energy efficiency policies in a real estate context translates into both immediate and long term economic benefit to both the owner and the user of every type of building. The recent passage of the Michigan Clean, Renewable and Energy Efficiency Act 1 creates significant opportunities in the identification and monetization of renewable energy and energy efficiency resources as an entire new real estate asset class. In light of current recessionary trends in our economy, investments in energy efficiency related projects can provided much needed cash fl ow and economic stimulus if targeted wisely. Green Lease Mining, a process of identifying energy-related, win-win opportunities for both landlords and tenants, can provide further economic gain to enhance otherwise stressed property values. The purpose of this article is to review the current status of the rapidly evolving federal, state and local regulations associated with green building and sustainable development, and the opportunities as well as the risks these regulations present to owners, occupants and lenders. The stated policy inclinations of the incoming administration in Washington are likely to further accelerate these regulatory trends. Buildings use energy and other resources in very large quantities and therefore have a major impact on the environment. A report by the United Nations states that 30-40% 1 Enrolled Senate Bill 213 and House Bill 5524, as adopted on Sept. 18, of all primary energy in the world is used in buildings. 2 According to the most recent study available from the US Department of Energy (issued in 2005), buildings in the United States used 72% of all electricity generated and accounted for 80% of all electricity expenditures. 3 A 2004 study by the Environmental Protection Agency concluded that buildings account for 39% of total energy use, 12% of total water consumption, 68% of total electrical consumption and 38% of greenhouse gas emissions. 4 Sixty percent of the nation s electrical consumption is utilized to operate commercial buildings, including those used for education, retail, office, storage and warehouse purposes. 5 With the direct cost of energy escalating rapidly and with the growing indirect costs associated with carbon emissions, the economic benefits of increasing the efficiency of buildings and their use of energy, water and other resources increase every day. Simply stated, green buildings have reduced operating costs, which leads to a better return on investment and increases the value of the building. While green buildings cost more in terms of the initial investment, these costs are coming down, there are economic incentives to defray these costs, and the costs can be recovered through lower operating expenses during the life of the building. 6 2 U.N. Environment Programme, Buildings and Climate Change: Status, Challenges and Opportunities (2007). 3 U.S. Dept. of Energy, 2007 Buildings Energy Data Book (Sept. 2007), available at gov/?id=view_book 4 U.S. Environmental Protection Agency, Buildings and the Environment: A Statistical Summary (Dec. 2004), available at 5 See U.S. Energy Information Admin., Commercial Buildings Energy Consumption Survey, available at gov 6 CoStar Study Finds Energy Star, LEED Bldgs. Outperform Peers, March 26, 2008, available at Article.aspx?id=D968F1E0DCF73712B03A099E0E99C679 * Mark J. Bennett is Senior Counsel and Leader of Miller Canfield s Climate Change Practice Team. ** Stephen G. Palms is Senior Counsel and a member of Miller Canfield s Real Estate Practice Group.

2 Page 175 The term green building generally refers to a building that (1) optimizes site potential, (2) protects and conserves water, (3) optimizes the use of energy, (4) uses environmentally beneficial products to reduce air pollution, (5) enhances indoor air quality, and (6) optimizes operational and maintenance practices through innovation and design quality. The most commonly used standard for defining green buildings was established by the United States Green Building Council, a private non-profit organization based in Washington, D.C. ( USGBC ), in 1999, as the Leadership in Energy and Environmental Design, or LEED, system. 7 USGBC recently announced an overhaul of the LEED System in the form of LEED 2009, which incorporates several changes to the LEED process. Practitioners should monitor these changes as they will have significant impacts on how the LEED certification is obtained and thus should be incorporated into transactional documents. In light of the fact that the LEED standard has become the primary tool for the determination of whether a building qualifies for beneficial treatment as a green building, an understanding of each of the elements of the standard is critical. LEED rating systems exist for new construction (NC), existing buildings (EB), commercial interiors (CI), and core and shell (C&S). Standards are also being developed for schools, retail, healthcare facilities, homes, and neighborhood development. The LEED-EB standard is gaining increasing industry focus in light of the recent slowdown in the development of commercial real estate and the vast stock of existing buildings that can benefit economically from sustainability and energyrelated improvements, many of which can be attained with no or nominal capital expenditure. Some examples of the elements that define the LEED standard are as follows: (1) Optimizing Site Potential: If a building owner selects a brownfield site, a site that is located at least 100 feet from a wetland, a site that encourages the use of public transportation and fuel-efficient vehicle parking, or if a developer follows a site improvement plan that prevents the loss of soil during construction, prevents soil sedimentation from entering into storm sewers and streams and prevents air pollution in the form of dust or particulate matter, that developer/owner will receive points in this category. 7 Additional information about USGBC and LEED is available at (2) Water Conservation: Points for water efficiency will be awarded if potable water consumption for irrigation is reduced by 50%, and for the use of innovative wastewater technologies, such as using water-conserving plumbing fixtures or non-potable water to reduce the use of potable water by 50%. (3) Optimizing the Use of Energy: Energy points are awarded if the building systems meet minimal energy efficiency standards, if there are no chlorofl uoro-carbon based refrigerants, if renewable energy is used pursuant to an agreement with an energy provided, and generally if the building uses less energy than a typical building. Recently, this section has been further enhanced given the escalation of energy costs, which is expected to continue for the foreseeable future. (4) Minimizing Air Pollution: The use of recycled materials or locally manufactured environmentally responsible materials, minimizing construction waste or the reuse of existing materials in a renovation project, are the primary sources of points for the use of environmentally beneficial products to reduce air pollution. (5) Indoor Air Quality: Indoor air quality considerations include increased ventilation, avoiding building materials that emit formaldehyde or VOCs, the inclusion of individual lighting and temperature controls, maximizing the use of daylight and using low emitting materials, coatings, paints and finishes. (6) Optimizing Operations: The utilization of LEEDaccredited professionals in the planning and design process will earn points in the innovation and design category, as will the implementation of strategies that address sustainability in ways that are not included in the LEED guidelines or that substantially exceed LEED requirements. On a federal level, the government has implemented programs to conserve energy and resources in the buildings it owns and occupies and it has also passed legislation and issued executive orders in order to promote energy efficiency, to improve energy security and to reduce pollution in general. With respect to the buildings that the federal government owns, the best known initiative is the EPA s Energy Star program,

3 Page 176 administered by the Department of Energy ( DOE ) and the EPA. 8 Energy Star is a voluntary program to identify and promote energy efficient products and buildings in order to reduce energy consumption, improve energy security, and reduce pollution through voluntary labeling of, or other forms of communication about, products and buildings that meet the highest energy conservation standards. 9 Federal agencies may only purchase energyconsuming products that meet Energy Star or Federal Emergency Management Program specifications for energy consumption. The Energy Star program has been extended to cover new homes and commercial and industrial buildings, rating these buildings for energy efficiency and providing Energy Star qualifications for new homes that meet their standards for energy efficient building design. The EPA has created an energy rating system for commercial buildings, referred to as Portfolio Manager, which allows users to track and assess energy and water consumption as well as greenhouse gas emissions across their entire portfolio of buildings and compare them with other buildings of the same type and size across the country. 10 The next step is likely to be the requirement that every building obtain a rating certificate that identifies its energy efficiency and to require the disclosure of this information to lenders, investors and tenants. Both the European Union and the State of California have enacted laws that impose this requirement; other states and the federal government are probably not far behind. 11 In 1992, Congress passed the Energy Policy Act in an effort to reduce dependence on imported oil. 12 This Act requires states to establish minimum commercial building energy codes and it establishes efficiency standards for commercial heating and air-conditioning equipment, toilets, electric motors and light bulbs. As a result of the passage of this Act, the American Society of Heating, Refrigerating and Air-Conditioning Engineers ( ASHRAE ) created an energy conservation standard 8 More information about the Energy Star program is available at 9 See 42 U.S.C. 6294a(a). 10 Portfolio Manager is available at index.cfm?c=evaluate_performance.bus_portfoliomanager 11 Directive 2002/91/EC of the European Parliament on the Energy Performance of Buildings, as reprinted in the Official Journal of the European Communities L 1/65. This document is available at php?id=7&no_cache=1 For more information, see M. Bennett, The Evolution of Climate Change Due Diligence Standards, 231 Envtl. Due Diligence Guide Rep. (BNA) 1911 (Oct. 18, 2007). See also Cal Pub Res Code Pub. L. No , 106 Stat (1992). For a complete discussion of the Energy Policy Act of 1992, see Energy Law and Transactions Ch. 58 (David J. Muchow & William A. Model, eds., LexisNexis Matthew Bender). for commercial and other non-residential buildings; this standard is updated every three years. The current versions of LEED refer to this standard. The DOE also sponsored the establishment of a model energy code that contains energy efficiency criteria for new residential and commercial buildings and additions to existing buildings. Some states, including the State of Michigan, have adopted this code without modification; others have adopted it with modifications; still others have adopted it as a recommended practice, but without requiring that it apply to all new construction. 13 The Energy Policy Act of 2005 provides tax incentives and loan guarantees for energy production of various types. 14 Commercial buildings that make improvements to their energy systems are eligible for tax deductions up to $1.80 per square foot. The incentives focus on improvements to lighting, heating, ventilation and air-conditioning, as well as the building envelope. Many buildings are eligible for tax deductions for improvements completed within the ordinary course of business. The tax deductions can be used to improve the payback period of a prospective energy improvement investment. On January 24, 2007, President Bush issued Executive Order 13423, Strengthening Federal Environmental, Energy, and Transportation Management. 15 This Order directs federal agencies to implement sustainable practices for energy efficiency, greenhouse gas emissions and petroleum use reductions, renewable energy, the acquisition of recycled content, energy efficient, bio-based and environmentally preferable products and services, pollution prevention and recycling, reduction or elimination of toxics and hazardous chemicals, high performance buildings, vehicle fl eet management, electronics stewardship and water conservation. The Order requires each federal agency to reduce building energy consumption by 30% by 2015 (relative to a 2003 baseline), reduce GHG emissions by 30% by 2015 and reduce water consumption intensity 2% each year through New construction must be completed in compliance with the principles set forth in a Sustainable Buildings Memorandum of Understanding that was promulgated in 2006, which is, in essence, the LEED principles. 13 A full listing of states and what they require is available at Pub. L. No , 119 Stat. 594 (2005). For a complete discussion of the Energy Policy Act of 2005, see Energy Law and Transactions Ch. 59 (David J. Muchow & William A. Mogel, eds., LexisNexis Matthew Bender). 15 Executive Order (Jan. 24, 2007). A copy of E.O is available at releases/2007/01/ html

4 Page 177 The Energy Independence and Security Act of 2007 contains provisions designed to encourage the use of more energy efficient heating and cooling systems in buildings, including provisions that (a) establish green building standards for new federal buildings, (b) require federal buildings that are remodeled or constructed to reduce fossil fuel-generated energy consumption by 55% by 2010 as compared to 2003 and 100% by 2030; (c) establish a zero-net energy initiative to develop technologies, practices and policies to reach the goal of having all commercial buildings use no net energy by 2050; (d) establish new incentives to promote industrial energy efficiency through converting waste heat into electricity; (e) reauthorize state energy grants to address states energy priorities and adopt renewable energy and energy efficiency technologies through fiscal year 2012; and (f) establish an Energy and Environment Block Grant to be used for seed money for innovative local best practices to fund local initiatives, such as home energy conservation programs, building retrofits to increase energy efficiency and alternative energy programs. 16 Additionally, all federal government commercial leases meeting minimum space requirements, with certain exceptions, are to be in LEEDcertified buildings beginning in Finally, the US Senate, in September, 2008, passed a bill extending tax credits for renewable energy, and providing incentives for industries that generate electricity through solar, wind, geothermal and other natural sources. In the House, passage of a broad energy bill that would extend tax breaks for renewable energy projects was also moving toward passage; it included an eight-year investment tax credit of 30 percent for solar and fuel cell projects, a threeyear extension of production tax credits for geothermal, biomass and hydropower, and a one-year extension for wind projects. 17 Turning to the State of Michigan, the recently adopted Clean, Renewable and Energy Efficiency Act creates significant opportunity for owners and occupants of commercial real estate in the form of renewable energy credits and the ability to sell excess energy through netmetering provisions. Statutes of this nature have been in place in more than twenty states over recent years such that routine forms of identifying and contracting to address these new opportunities will now become commonplace in Michigan real estate transactions. Businesses certified by the NextEnergy Authority that locate in the NextEnergy Zone, located in Detroit at the Wayne State University Research and Technology Park, to develop alternative energy technologies may claim certain tax credits. 18 There 16 Pub. L. No , 121 Stat (2007). 17 See Steve Tetrault, Senate Leaders Strike Accord for Green Energy Tax Credits (Sept. 18, 2008), available at com. 18 MCL ; MCL et seq. are a number of grant programs established by the State for the development of biomass technology, education programs to help consumers better understand energy efficiency and renewable energy options and energy efficiency for low-income clients. 19 In April, 2005, the Governor issued an Executive Directive establishing an energy savings target for all state buildings; the target is a 10% reduction in energy use by the end of 2008 and a 20% reduction by the end of 2015, as compared with the fiscal year ending September 30, An Executive Directive issued in 2007 requires that life-cycle cost and energy efficiency must be included in the determination of whether to purchase a given good or service by the state, that all new office equipment purchased by the state must by Energy Star compliant, and that the State should lease Energy Star-qualified buildings whenever feasible. 21 Under the provisions of the 2007 Directive, all capital outlay projects over $1,000,000 for buildings occupied by state agencies, departments, universities and community colleges are required to be designed and constructed in accordance with the LEED rating system, and that the Department of Management and Budget must ensure that all new construction and renovations of state buildings, including state leased buildings, strive to score at the LEED Platinum level on the Existing Building, New Construction and Commercial Interiors scorecards when attainable. Finally, in September, 2008, the State passed the Clean, Renewable and Efficient Energy Act, which, among other things, established a goal for the state to reduce energy purchases by 25% by 2015, when compared to energy use and energy purchases for the state fiscal year ending September 30, 2002, and extended the energy star assessment and rating program to all buildings owned or leased by the State. 22 A number of States, including Washington, 23 Maryland, 24 Nevada, 25 Colorado, 26 Florida, 27 New York See 20 MI Executive Directive No MI Executive Directive No Senate Bill 213; House Bill See Wash Rev Code 28A.150; 28B.10; A copy of the bill is available at aspx?bill= See Md Code Ann, State Fin & Proc See Nev Rev Stat See (Executive Order); ont3/20de9b ?open&file= SJR032_enr.pdf (Joint Resolution). 27 See eo_07_126.pdf (Executive Order). 28 Information about this initiative is available at ny.gov/governor/press/fl _ html

5 Page 178 and New Jersey, 29 have also passed legislation that mandates the implementation of green building standards in facilities owned or leased by the state and in statefunded building projects as well. Several states have gone beyond state owned, occupied or financed buildings, and established goals for certifying a specified number of commercial buildings to a green standard within a set period of time. New York passed a law in 2002 that required minimum standards of energy efficiency in new residential and commercial buildings. 30 Connecticut passed a law in 2006 that required the adoption of regulations that establish building construction standard that are consistent with or exceed a LEED Silver rating for new commercial construction and major renovation projects. 31 New York offers a tax incentive program for developers and builders of environmentally friendly buildings though its Green Building Tax Credit program, which was enacted in The program offers tax credits to developers of up to $2 million for using green building techniques. Maryland offers similar tax credits and also offers a sales tax exemption for certain energy efficient equipment. 33 Local governments have also joined the effort to encourage green development. These incentives include reducing the time requirement for zoning approvals, permitting and inspections; waiving or refunding permitting fees; waiving property taxes; or allowing greater density or size for green buildings. 34 Baltimore County, Maryland, for example, offers a 10 year property tax credit for a commercial building that achieves LEED Silver certification. 35 Honolulu provides a one-year exemption from real estate taxes for all new commercial, resort, hotel and industrial construction that achieves a LEED Certified rating. 36 Seattle, Nashville and Portsmouth, New Hampshire, among others, 29 See NJ Stat Ann 52: et seq. Text of the law is available at 30 Information regarding the ECCC is available at dos.state.ny.us/code/energycode/nyenergycode.htm 31 See Conn Gen Stat 1-205(b). 32 NY Tax Law Md Code Ann, Tax-Gen (income tax credit); Md Code Ann, Tax-Prop (property tax credit). 34 B. Rainwater, Local Leaders in Sustainability: A Study of Green Building Programs in Our Nation s Communities, American Institute of Architects (2007), available at aia.org/siteobjects/files/llinsustain(full)_final.pdf A listing of government LEED initiatives, which includes counties, cities and towns as well as states, is available at usgbc.org/showfile.aspx?documentid= Information about Baltimore County s property tax credit is available at economicdev/edd_brownfields.html 36 Honolulu s tax exemption is available at gov/refs/bill/text/2004/b069.htm have programs that reward projects that meet LEED standards with density incentives. 37 Chicago has adopted a program that includes direct subsidies for certain affordable housing projects, weatherization materials for housing units on Chicago s west side, energy and water audits for local industry groups and low-interest loans. 38 Boston announced in 2006 that it would require compliance with the LEED Certified standard as part of the private development process. 39 Montgomery County, Maryland, requires all non-residential and all multi-family buildings of at least 10,000 square feet to obtain LEED or equivalent certification. 40 Incentives and grants are also available from the private sector. Non-governmental entities and private foundations are offering grants or other subsidies in order to encourage sustainability. The Kresge Foundation, for example, awards grants in the planning and design phase and specifically references LEED as one basis upon which to qualify for such grants. 41 The Enterprise Foundation s Green Communities program offers grants to motivate sustainability effort in the affordable housing industry. The list of organizations offering financial incentives grows longer every day. 42 Financial incentives in the form of grants or tax credits are only one way to encourage building owners and users to embrace sustainability. Energy savings can also be used to improve cash fl ow and create higher property values. In an owner-occupied building, the calculation is simple: invest in equipment that reduces the cost of energy and calculate the payback period. In a building with tenants with gross leases, the calculation is the same. In a building that is leased to tenants with triple net leases, where the tenants pay for the energy costs, or if the tenants are paying for their own electricity, the approach is to renegotiate the lease to lower the tenants occupancy costs and increase the rent by an amount less than the cost savings; this enables the landlord to earn a fair return on its investment in upgrading the lighting, 37 Additional information about these incentives is available at PublicPolicyInitiatives/DevelopmentIncentives/default.asp 38 City of Chicago, Environmental Action Agenda: Building the Sustainable City 2006, available at org/webportal/cocwebportal/coc_attach/actionagenda. pdf 39 Boston s announcement is available at MeninoGreenBldgPR1206.pdf 40 Montgomery County s requirements for buildings over 10,000 square feet is available at montgomerycountymd.gov/17-06.pdf 41 See for additional information. 42 See for additional information.

6 Page 179 heating and cooling systems and reduces the tenant s overall occupancy cost. Lighting consumes 35-40% of the electricity in a typical commercial building. 43 A 40% reduction in the energy cost of lighting could mean a 14% reduction in building energy costs. If the landlord commits to the capital expenditure that generates the savings, and the tenants agree to increase their rent by an amount less than the cost savings but significant enough to repay the capital investment to the landlord plus a fair return on that investment, both parties benefit. The landlord has an added bonus of a more efficient building and the opportunity to convert that efficiency into value by the increased rental income that it will enable the landlord to generate. The risk to the tenant that the energy savings may be less than the increased rent can be mitigated by establishing the rent increase as a percentage of the actual reduction in the electricity costs. It is also possible, depending upon the language in the lease, for the landlord to assess tenants for capital improvements that will benefit all tenants. Assuming that the language in the lease permits assessments for improvements that reduce operating costs, assessing the 43 See EPA 430-B B, Dec tenant for a lighting upgrade, which will generally be amortized over a 10-year period, may be the preferred approach if a tenant will not agree to increase its rent in exchange for reduced electricity costs, and if the new improvements can be used by the next tenant in the space. The word green must have a prominent place on the checklist of every building owner and user as well as the lenders who finance real estate transactions. From a regulatory perspective, compliance with efficiency standards is or will be required in the very near future. Economic benefits in the form of grants, tax credits and other direct financial support are available to support real estate projects. With the new technologies, there is a real opportunity to reduce operating costs relating to energy, or at least to minimize increases in those costs despite increases in the costs of oil and gas. From site selection to building design to the language in the lease, the world of real estate is rapidly turning green, creating opportunities as well as obligations, and demanding attention from everyone involved.