Buildings consume 40% of the energy used in the United States, with commercial buildings accounting for just under half (18%) of that total. 2/3 of the energy is used in the building systems (HVAC, lighting, water).

Energy efficiency improvement projects in existing buildings generally show very favorable return on investment, often with shorter payback periods and higher certainty than other uses of capital. But they aren’t happening in commercial buildings at anywhere near the pace these favorable financials would indicate.

One of the primary obstacles is the so-called split-incentive. The owner of the property has to make the investment, but the tenant gets the savings, because under many commercial leases, the tenants pay for the utilities.

In some cases, the owner can pass through the cost of capital improvements, but the amount that can be passed through to the tenants is typically based on amortizing the cost of the improvement over the useful life of the improvement. The useful life of such improvements (for example, a replacement boiler, new windows, upgraded light fixtures) is typically very long. Extending the payback period well beyond what it would be based on the energy savings is a significant disincentive to making the investments.

A solution takes shape – the “green lease”

A solution to the problem is conceptually quite simple – align the incentives. Here’s how it works:

  • An independent engineer certifies that a specified energy efficiency improvement project will reduce utility consumption and provides an estimate of the yearly savings.
  • The owner (lessor) finances and carries out the project.
  • The tenant (lessee) passes the energy savings back to the owner (lessor) during the payback period, until the cost of the project is paid back. From that point forward, the tenant reaps 100% of the savings for the rest of the term of the lease.

Building science and energy efficiency engineering can now predict energy savings fairly reliably, but there are still uncertainties. Creating mutually-acceptable, legally binding language tying required payments from lessees to lessors based on those estimates required time and some compromises.

Three years after the National Resources Defense Council convened a forum in New York on this problem, the New York Mayor’s Office announced the signing of the first “green lease” on April 5th, 2011.

Here’s how the New York “energy aligned” model lease dealt with the uncertainties:

  • The payments from the tenant to the landlord are based on the estimated savings, not measured savings.
    • This simplifies the language and reduces complexity, but it reduces the incentive to measure costs accurately and to follow operational procedures that may be required to get the full benefit of the energy reductions.
  • The payback period is extended by having the tenant pay 80% of the estimated savings over 125% of the payback period
    • Extending the payback period slows the return to the owner and slightly increases costs (because the cost of financing is not passed through).
    • The tenant still pays 100% of the cost, but does see a cash flow benefit immediately (20% of the savings) rather than having to wait for payback to be completed. The tenant is also shielded from any impact if the actual savings are lower than expected, even temporarily.

Even with these compromises, the green lease is a powerful tool to increase the rate of energy efficiency improvements in existing commercial buildings. New York City has embraced it as an important tool in the city’s sustainability strategy. Others should follow.


The split incentive problem in commercial energy efficiency upgrades