Mind the Green Funding Gap

As the scale of the UK government’s strategy to reach net zero emissions by 2050 sinks in, we need to consider how it will be funded. In the commercial real estate market there is already a strong and growing appetite for lending where energy efficient buildings are provided as security. But is the data readily available to understand not only the energy efficiency profile of that security but also the impact on value and liquidity available for buildings that do not fall within the proposed energy efficient standards.

As highlighted in our article 'Leased buildings – who pays the price for net zero?', this is not just a funder and borrower relationship – it involves tenants too. Most commercial space is leased, so whatever the solution is' it will require collaboration between all three parties, as called for by the UK Green Building Council. Lawyers can, of course, pour over facility agreements and leases to give an opinion on legal liability, but there is a wider commercial question around who is the right person to bear this cost.

With the ratchet on EPCs looking likely to be implemented from 2025 through to 2030 when the B rating requirements will apply to space to be let, funders need to be considering both an action plan now for existing portfolios but also how to address what is coming down the track for new funding. The risk of inaction now will increase the likelihood of unoccupied buildings and stranded assets in the future.

The extent and therefore the cost of works required to improve the energy efficiency of buildings will differ wildly. Knowledge is key and what we need as a priority is a detailed understanding of the current state of buildings from an energy efficiency perspective, the costed options of works that are possible to improve that efficiency to the required standards and also to understand what is not possible. As part of most new lending decisions, a standard building survey is required, but the inclusion of energy efficiency analysis will necessarily take the standard of such building survey to a completely different level. One crucial question is whether the surveying industry has the capacity to provide that level of support when it is confronted with a deluge of building owners and investors who want to understand how energy performance can be optimised.

On new financing opportunities, lenders may look to include a certain level of energy efficient improvement works through additional capex obligations on the borrower to fund from equity, but this may not always be viable from an equity perspective and we may begin to see green capex lines being included in loans going forward, with a clear business plan as to what must be done and when.

Traditional development finance would normally come with a higher margin until the works have been completed and it may be that green capex lines are also funded at a higher margin. However, there is competitive drive in the market place to be seen to fund green and this may well drive down margins for this type of funding. Funders will of course be heavily invested in wanting a clear exit strategy on assets that are currently below par and will be highly motivated to ensure that capex is directed at energy efficiency improvements to achieve the required values for sale/refinancing. Imposing additional capex obligations is clearly a more straightforward exercise for new funding but is far more challenging for existing loans, particularly where such a loan is in practice performing in line with the metrics originally agreed.

Will we see a huge growth in funding defensive green capex to counter deterioration in values? Depending on the source of that funding, some traditional lenders may need to consider a standard intercreditor arrangement that could be agreed to bring in second funders to advance these capex lines, where those traditional lenders cannot or do not want to fund. Certain investors, such as closed funds, will not have the capex lines available to fund these improvements. It is therefore looking likely that we will see a new market for funders to provide that defensive green capex funding. Second funders may in these circumstances demand a higher level of priority than is usually the case.

But are we also going to see a new type of distressed asset coming our way with LTV covenants being challenged? This will not be driven by lack of liquidity and normal market drivers; instead, the new market may value energy efficiency alongside traditional valuation. We could see more use of insolvency procedures for energy inefficient assets or portfolios, with obvious financial consequences for lenders. There is no doubt that opportunistic investors/developers with the expertise to take on inefficient buildings at a discount will be watching carefully as this evolves. Certain funders may specifically choose to support investors by providing finance on underperforming portfolios, based upon an investor's clear exit strategy with a clear costed business plan and target end values.

Ashurst are working with industry bodies, funders, owners and occupiers to:

• identify opportunities to develop business plans in order to facilitate energy efficiency improvements;
• develop innovative solutions for funding the green capex;
• agree funding documents that cater for the green capex, allow for the sharing of data and set a clear business plan;
• work with funders and borrowers to find solutions within the framework of existing funding structures.

So what challenges will need to be navigated going forward?

• The lack of capacity in the market in the coming years for professional advice to identify the current energy efficiency of buildings, the works required and options available and cost to feed into any business plan.
• The potential for there to be a split in the market between buildings with lower energy efficiency and those that make the grade. Will the latter come to market at a "greenium"?
• Existing facility agreements will not allow funders to impose business plans on borrowers to improve the energy efficiency of assets. Collaboration is key.
• For new funding on buildings which are not already energy efficient, there will need to be a capex line of lending for these works with a clear business plan.
• There is there a risk that we will see "stranded assets" which will simply not be capable of achieving an EPC rating of B by 2030