Australia: Carbon price impact on lease transactions

Landlord and Tenant alert
Last Updated: 14 June 2012
Article by Rob Jarvin

Focus: Impacts of the price on carbon on leasing transactions
Services: Property & Projects
Industry Focus: Property

The price on carbon is coming in July. Although landlords and tenants are not likely to be directly affected, there is certainly a possibility that the price on carbon will indirectly impact leasing transactions, primarily through increased utilities costs. The question remains whether this will emphasise and reinforce the focus on environmental initiatives and improving energy efficiencies in leasing transactions.

The carbon pricing regime is often referred to in political debate or media comment as the "carbon tax". However, in the interests of maintaining neutrality, this alert adopts the language used in the legislation, being the "carbon pricing mechanism" (abbreviated to CPM).

Those who have been practising in the property industry for some time will recall that, in the period leading up to the introduction of the GST, some landlords attempted to draft new lease provisions to protect themselves from any adverse GST impacts. These clauses were varied in their scope and detail because, for the most part, there was a large degree of uncertainty about how the tax would operate, how it would be administered and the transitional arrangements.

The proposed CPM has seen some similar attempts to draft provisions which protect landlords. However, unlike the GST, the CPM is not a tax which will be levied against any particular supply under a lease transaction. It is a charge which will be imposed on around 500 companies that operate emitting facilities which generate over 25,000 tonnes of carbon dioxide emissions each year.

So, unless a landlord or tenant is one of those large emitting entities, the CPM will not affect them directly. However, the consensus in the marketplace is that those companies who do have to pay a price on carbon will look to pass that impact on, if they are able to charge higher prices for whatever goods or services they are supplying. The most obvious area to impact on landlords and tenants will be electricity and utilities prices, which are generally dealt with in a lease under the banner of outgoings.

Utilities prices

In most cases, a tenant will have its own arrangements for electricity supply. Any price increases imposed by suppliers who are paying the price on carbon will affect those tenants directly.

Where utilities are charged to the landlord, either because they are not separately metered to specific tenant's premises or they are supplied to common or shared areas, the lease will generally dictate who will bear the impact of any cost increases. Given that the vast majority of commercial and retail leases in Australia are net leases, a landlord will generally be able to pass on any increases in utilities supply costs to tenants.

Where a lease is drawn as a gross lease, that is, the outgoings are borne by the landlord, then tenants may be partially immune from any rising utilities costs. Similarly, where outgoings recovery is tied to an increase over a post-CPM base year or capped at a certain amount, landlords may not be able to pass on the full impact of any utilities increases resulting from the CPM.

However, some commentators suggest that the CPM will have a minimal impact on rising electricity prices compared to the investment in generation and infrastructure which will take place over the next few years. Given that the Australian Energy Market Operator (the market regulator for the national electricity market) mandates investment in generation and infrastructure once certain low reserve conditions are reached, it is argued that the cost of this investment will likely be passed through to the end customer and, particularly in Queensland and New South Wales, is likely to put greater upward pressure on prices than the CPM.

Increasing rent

Economists have foreshadowed that the CPM will have an upward effect on prices generally. The Federal government has suggested that in 2012-13, the CPI increase as a result of the CPM may be around 0.7 per cent. Those tenants whose rent reviews are tied to CPI are likely to experience greater rent increases than would have occurred had the CPM not been introduced.

It is also possible that parties to a lease and valuers may take into account the CPM in market rent reviews. But it is more likely that these cost considerations will more generally be wrapped up under a broader head of assessment of the building's energy efficiency and utility consumption costs when market rents are determined.

Retail leases

Those parties operating in the retail space will know that the various states throughout Australia have retail lease legislative regimes which focus heavily on disclosure. Landlords will need to assess their leases and their buildings and ensure that adequate disclosures are made to tenants regarding the possible impact of any utilities price increases as a result of the CPM. This will apply to new tenants (by way of a disclosure statement) and existing tenants (by way of an annual outgoings estimate).

Office leases

For office building tenants, energy consumption is likely to be one of the major components of outgoings expenditure, so the impact of utilities price increases will definitely be relevant. However, with the recent focus on NABERS ratings, Building Energy Efficiency Disclosure Act requirements, green buildings and green leases, office tenants are likely to be familiar with a range of energy efficiency controls and initiatives.

Although office tenants are likely to be sensitive to any flow on of increased utilities costs, at the same time, many office tenants are already assessing the green rating of the buildings they occupy (or intend to occupy) and implementing their own strategies to cut energy costs and usage. There is the possibility over the longer term to counter the effects of short-term price rises by generally reducing energy costs and putting pressure on landlords to improve the energy efficiency of buildings. However, this may have been somewhat complicated by the announcement in the Federal budget of the scrapping of the proposed tax breaks for energy efficiency upgrades of commercial buildings.

In reality, the overall impact of a range of government policies (including the CPM) is likely to affect office tenants in different ways across different markets, depending on their size, locality and access to funding/incentives for refurbishments and energy efficiency projects.

Shifting the CPM down the line

It seems that there will be a period of uncertainty while the economy comes to terms with the CPM and its impact on business in Australia. In the instance of net leases, any utilities price increases linked to the CPM are likely to either be borne directly by the tenant or passed on from landlords to tenants. The question for the short term will be whether there is any scope for tenants to pass those increased lease costs on.

For some businesses, dealing with increased costs may be a relatively straight-forward proposition. For example, airlines frequently cite rising fuel costs as a reason for increasing the cost of flight tickets. Similarly it is likely that the any increased costs as a result of the CPM will be passed on to travellers through fare increases. There are also reports that supermarkets will be significantly impacted by the CPM (for example, by rising fuel and transport costs) and it is likely that the impact will be passed on to consumers through increased grocery prices. So, where there is scope to do so, tenants may be able to pass on any increased lease costs to their customers.

However, some tenants in the retail and manufacturing sectors are already struggling. Retail tenants may not be able to maintain sales levels if they seek to pass on increased lease costs by increasing prices. For manufacturers, competition from overseas and tight margins are already pressuring profitability, and CPM flow-on costs may be another obstacle that impairs the manufacturer's ability to achieve economies of scale.

Going forward

So far as existing leases are concerned, there is little landlords or tenants can do to alter the impact of the CPM. The underlying question seems to be whether any increased costs can be passed on, either from landlords to tenants or from tenants to customers/consumers.

For leases to be entered into in the future, parties should give thought to the following issues:

  • for retail tenancies, landlords should be careful to update the information in their disclosure statements and annual outgoings estimates to take account of the expected increases in utilities costs
  • so far as potential cost increases are concerned, landlords and tenants should consider the options (and impacts) for risk allocation which are available by electing whether the lease is a 'net' or 'gross' lease
  • tenants may seek to limit their exposure to increasing utilities costs by seeking a cap on outgoings
  • when considering linking rent increases to CPI, tenants should be mindful of the expected upward pressure on prices generally
  • the parties should generally give thought to energy efficiencies and exploring opportunities of improving energy performance and controlling energy costs.

The reality is that the CPM will be with us in July and there is likely to be a period of uncertainty as the economy comes to terms with its impact. In general terms it would appear that the price on carbon will drive costs upwards in some areas which will, either directly or indirectly, affect the majority of commercial operations in some way.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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