CRC: Recovery of CRC costs from tenants - will it be easier now?

Practical Law UK Legal Update 6-503-9037 (Approx. 10 pages)

CRC: Recovery of CRC costs from tenants - will it be easier now?

by PLC Property, PLC Environment and PLC Tax

Background

Terms that appear in capital letters in this update are defined in Practice note, CRC Energy Efficiency Scheme: PLC glossary and abbreviations.

The CRC Energy Efficiency Scheme (CRC) was introduced under powers granted in sections 44-55 of the Practice note, Climate Change Act 2008. The CRC is a UK-wide, mandatory, "cap and trade" emissions trading scheme for large businesses and public sector organisations. It came into force on 1 April 2010. The details of the CRC are set out in the CRC Energy Efficiency Scheme Order 2010 (SI 2010/768) (CRC Order). Participants in the CRC must purchase and surrender Allowances, to cover every tonne of carbon dioxide (CO2) emissions associated with their energy consumption in the buildings that they own and occupy.

Originally, the CRC was intended to be revenue neutral to the government. The revenue raised from the sale of Allowances was to be recycled to Participants, who would each receive a Revenue Recycling payment every year. The Revenue Recycling payment received by a Participant was offset against the cost of the Allowances and other costs of complying with the CRC. Indeed, it was possible for a Participant to recover more in Revenue Recycling payments than they paid for their Allowances. This gave Participants a financial incentive to improve their energy efficiency, which would be reflected in their performance in the League Table. In turn, this determined the amount of their Revenue Recycling payment.

In certain circumstances, the CRC makes landlords responsible for purchasing the Allowances required for the tenanted areas of their building (as well as for the common parts). The CRC Order does not prescribe whether or how these landlords may recoup from the tenants of those areas the costs which the landlord incurs under the CRC. For more details of the range of these costs, see Varieties of CRC cost below.

Until October 2010, many landlords took the view that, so long as the net cost to them was low (because the Allowances were relatively cheap and they were likely to recover a significant proportion of the costs by way of Revenue Recycling payments) they would not seek to recharge CRC costs to their tenants. Another factor that weighed against recharging CRC costs to tenants was that to do so fairly would require complex lease drafting, which was potentially damaging to tenant relations. For further details, see The Carbon Reduction Commitment Energy Efficiency Scheme: A guide for landlords and tenants: Second edition (August 2010).

In the Spending Review on 20 October 2010 (SR 2010), the Government announced the abolition of Revenue Recycling payments. This will increase substantially the cost to Participants of compliance with the CRC as they will no longer receive a sum to offset against their CRC costs.

Where the landlord is responsible for purchasing Allowances to cover CO2 emissions from tenanted areas in the building, it will have a far greater incentive now to recharge its CRC costs to the tenants. Otherwise these costs will be a drain on the investment income from the building, which will adversely affect the yield and thus the value of that investment.

Landlords will, therefore, look at the terms of the occupation leases to see whether they permit recharging of CRC costs. The most likely clauses are those known as the "rates and taxes clause", the "common outgoings clause" or provisions in the service charge schedule of a lease of part of a building.

Does the abolition of Revenue Recycling payments mean CRC costs can be recovered more easily?

Commentators have suggested that the abolition of the Revenue Recycling payments means that the CRC is no longer revenue neutral to the Government and that the cost of Allowances is now akin to a tax. As a consequence, they believe that CRC costs will be much easier to recharge to tenants under existing lease clauses, since these generally make tenants responsible for the taxes charged on their premises.

This view is oversimplistic. This update examines why.

Does it matter whether CRC costs can be classified as a tax?

The simple answer is, not necessarily. It depends on the wording of the clause. There are several relevant questions to consider:

Which types of CRC cost is the landlord trying to recharge to the tenant? See Varieties of CRC cost below.
Does the clause refer to taxes at all?
If it does, does the clause extend to future or new taxes? See Does the clause cover new taxes below.
Does the clause list other types of expense which the tenant must bear? See Even if CRC costs are not a tax, they may still be covered by the clause below.
Are these expenses to be paid by the tenant only if they are incurred in some way in relation to the demised premises or the building of which they form part? See The relevant lease clause may require a link between the payment and the property below.

Varieties of CRC cost

Where the landlord is a Participant (either directly or as part of a Group, where the Highest Parent Undertaking is responsible for registration and compliance with the CRC) any or all of the following costs may be incurred by the landlord or the Highest Parent Undertaking:

The cost of Allowances required to cover emissions of CO2 from:
- the common parts; and
- the demised areas (where the tenant is not responsible for its energy supplies. For more information, see Practice note, CRC Energy Efficiency Scheme: overview: When are you "responsible for an energy supply"?).
Costs of initial registration as a Participant.
Administration costs relating to the Participant's trading account at the CRC Registry, for example the initial fee for opening the account and the fee for changing Account Representatives.
The annual charge to maintain registration as a Participant.
The costs of collecting energy information and data, and monitoring energy consumption.
The cost of preparing the Footprint Reports and Annual Reports required under the CRC and collating the supporting evidence in an Evidence Pack.

For more information about the costs that can be incurred complying with the CRC, see Practice note, CRC Energy Efficiency Scheme: charges and other costs: Charges levied under the CRC Order.

Does the relevant lease clause cover new taxes?

Even if the clause makes the tenant responsible for taxes, this may not be enough to recharge those CRC costs to the tenant. Ancient case law (Brewster v Kitchin [1698] 1 Ld Raym 317) says that an obligation to pay "all taxes" will be looked at in the light of the types of taxes envisaged at the time the clause was drafted. Novel or future taxes would not be picked up by that wording. CRC costs could well fall into the category of a novel tax.

This is why many clauses refer to payment of "all present and future taxes". Such wording would be enough to prevent argument that CRC costs, even if a tax, were not recoverable because they were a new kind of tax.

Even if CRC costs are not a tax, they may still be covered by the relevant lease clause

Most clauses which are designed to make the tenant pay the expenses of the property will refer not only to taxes, but also to a long list of other types of payment. For example, the clause may also refer to rates, assessments, levies, impositions, duties or charges. It may even mention outgoings.

The cost of purchasing Allowances is certainly a charge. Section 21(1) of the Finance Act 2008 gives the Treasury the power to "impose charges by providing for carbon reduction trading scheme allowances to be allocated in return for payment".

The cost of purchasing Allowances may also be an imposition. Outgoings has an even wider meaning and may cover other types of CRC cost. It is impossible to be certain, as case law on interpretation of this type of wording is old and inconsistent. For example:

A covenant by the tenant to pay "rates, taxes and assessments" has been held to cover only those of a recurring nature (not one off payments) (Wilkinson v Collyer [1884] 13 QBD 1).
A covenant to pay outgoings, duties, burdens or impositions was held to cover expenditure of a non-recurring nature (Aldridge v Ferne [1886] 17 QBD 212).

There is also a general rule of construction (known as the ejusdem generis rule) which says that items in a long list will be construed as being of the same nature as the item that starts the list. So if the list starts with "taxes", the subsequent items in the list may add nothing to the nature of the recoverable sums. This rule does not apply where the drafting makes it clear that each item is to be construed in its own right - perhaps by adding "of whatever nature" at the end of the list.

The relevant lease clause may require a link between the payment and the property

Often such clauses protect the tenant by requiring it to pay only the taxes or outgoings which relate to the property. For example, the obligation may be to bear those costs:

Charged on the property.
Levied on the property.
Incurred in relation to the property.
Incurred in respect of the property.
Incurred with reference to the property.

It is not clear how these formulae would be applied to CRC costs, and they may apply differently to each type of CRC cost.

The cost of Allowances

If the landlord has only one building, then the entire cost of the Allowances it buys will relate to that building. However, where a landlord has more than one building, the Allowances must be bought in respect of the emissions for which it is responsible as a whole across the portfolio. They are not charged on the building itself, nor are they bought "per building". It is true that it is possible to work out how many are needed for any particular building within the portfolio, because this would be linked to the building's relative energy consumption and related emissions.

The position is even more complex where the landlord is part of a Group Participant. Here it is the Highest Parent Company which is obliged to buy the Allowances for the Group as a whole, for emissions from all the relevant properties in the portfolios of all the companies in that Group. There is no obligation to earmark particular Allowances for particular buildings.

At its simplest, the tenant may argue successfully that the cost of Allowances was not charged on the property but on the landlord's (or its Group's) emissions and therefore falls outside the clause altogether. Tenants may draw strength for this argument from Allum v Dickinson (1882) 9 QBD 632 which said that a covenant to pay sums charged "upon the premises or upon the occupier in respect thereof" did not cover charges that were imposed on the landlord rather than on the premises.

Wider wording (such as payments charged "in relation to/in respect of or with reference to" the property) should be satisfied by a more indirect relationship between the payment and the property. As the energy consumption in each property in the portfolio will be recorded, the CO2 emissions from it can be calculated, and therefore the number of Allowances required. Arguably, this should satisfy the test of relationship to the property. However, we foresee at least two ways in which tenants may argue that CRC costs do not satisfy the test:

If the CRC continues to allow Participants to purchase their Allowances at any point during a Compliance Year and at different costs (depending on when and where they are purchased) it will be impossible to identify particular Allowances (and thus particular costs) as having been bought for any one building in the portfolio. The Participant can choose its own method for division of the costs of the Allowances between the companies in its Group (if it is a Group Participant), and then between the buildings. A tenant may suggest the method adopted breaks the required link between the particular building and the price of the Allowances allocated to it.
The pricing structure and mechanism for sale of Allowances may be reviewed, following the consultation on simplifying the CRC that is to take place soon. If so, this argument may become irrelevant.
Where the landlord is part of a Group Participant, the tenant may argue that the Allowances were bought to discharge the obligations of the Highest Parent Company to surrender Allowances sufficient to cover the conglomerate emissions of the Group and that they were not bought in relation to any particular property.

Other types of CRC cost

The costs of registration and other administration charges are incurred by the Participant in discharging its duties on behalf of itself or its Group and all its properties as a whole. These are duties imposed on it as a Participant. It is very difficult to suggest that they have been incurred on a building-specific basis (except in the circumstances where it is the landlord that is the Participant, it only has this one building, and it is the emissions from that building which required the landlord to register as a Participant in the CRC).

For example, if the Participant has engaged an energy consultant to organise the collection and recording of energy consumption data across its buildings, it is likely that this service will be charged for as a whole, not per building.

So it seems much less likely that these types of CRC cost will fall within a clause that requires the tenant to pay sums which are linked to the property.

Are CRC costs now a tax?

In limited circumstances, it may be critical whether the CRC costs can now be classified as a tax. This will be the case if the only suitable clause in the lease to justify billing CRC costs to the tenant permits only the charging of taxes, present and future.

The conventional characteristics of a tax are that:

The payment is compulsory (the first characteristic).
The obligation to pay is imposed by parliamentary statute (not a local act or statutory instrument) (the second characteristic).
The payment is due to, and retained by, a public authority (the third characteristic).
The payer obtains no asset or benefit directly in return for the payment (the fourth characteristic).

For more discussion of these issues see the cases of Farlow v Stephenson [1900] 1 Ch 128 (paragraph 12.092) and Aston Cantlow v Wallbank [2003] 3 All ER 1213.

The following features of the CRC are relevant in determining whether the CRC is a tax:

The obligation to pay for Allowances.
The obligation to surrender Allowances to cover CO2 emissions.
Whether revenues from the allocation of Allowances are retained by the government.

The first characteristic

This characteristic is satisfied if a Participant is responsible for energy supplies because then it must surrender (and therefore purchase) Allowances equivalent to the corresponding CO2 emissions. While it is true that it is possible for the Participant to reduce the emissions, and thus the amount it must spend on Allowances, this is also true of other established taxes (such as VAT) which are charged on consumption. It does not make the payment any less compulsory.

The second characteristic

It is not clear whether this requirement is satisfied.

Section 21 of the Finance Act 2008 permits the Treasury to "impose charges by providing for carbon reduction trading scheme allowances to be allocated in return for payment" (section 21(1)). It indicates that such charges may be imposed by regulations (section 21(2)). Therefore there is clear statutory authority to impose a charge for the allocation of Allowances.

Article 53 of the CRC Order, made under powers conferred by the Climate Change Act 2008, requires a Participant to surrender Allowances at least equal to the Participant’s CO2 emissions for the relevant year.

Both section 21 and article 53 were in place before the government’s announcement that Revenue Recycling payments would be abolished. The prevailing view before that announcement was that because revenues from the allocation of Allowances would be recycled (and not retained by the government), the CRC was not a tax. There was, however, nothing in the legislation or the CRC Order which obliged the government to make Revenue Recycling payments.

Convention suggests that, when Parliament imposes a tax, it does so in clear terms. For example:

Stamp Duty Land Tax (SDLT): Section 42(1) of the Finance Act 2003 provides that "A tax (to be known as 'stamp duty land tax') shall be charged in accordance with this Part on land transactions".
Capital Gains Tax: Section 1(1) of the Taxation of Chargeable Gains Tax Act 1992 provides that "Tax shall be charged in accordance with this Act in respect of capital gains...".
Landfill Tax: Section 39(1) of the Finance Act 1996 provides that "A tax, to be known as landfill tax, shall be charged in accordance with this Part".

One view is that the cost of Allowances is already imposed by Parliament (and therefore satisfies the second characteristic) by a combination of section 21 of the Finance Act 2008 (which authorises the imposition of a charge for Allowances) and article 53 of the CRC Order (made under powers conferred in the Climate Change Act 2008) which requires the surrender of those Allowances. Although it may be usual for legislation imposing a tax to refer to it as a tax, Parliament is sovereign and may call a tax whatever it likes. Existing legislation does not require Revenue Recycling and, therefore, Parliament has already given power for revenues to be retained by the government.

The contrary argument is that convention dictates that Parliament only authorises the raising of taxes through clear language and the current wording only permits the raising of a charge. However, following the SR 2010 and the promised consultation on the CRC (expected in 2011) it seems likely that there will be some amending legislation. If so, the opportunity to set out, in clear statutory language, that the CRC is a tax may be taken. This could be done in a future Finance Bill, a new piece of primary legislation, or by amendment of the Climate Change Act 2008.

The third characteristic

This is satisfied where the Allowances are bought from the government. It seems most unlikely to be true of Allowances bought from third parties (perhaps Participants who have surplus Allowances). As the CRC is currently designed, Participants can buy Allowances from other Participants or third parties. For more information, see Practice note, CRC Energy Efficiency Scheme: overview: Buying and trading of Allowances.

This may change as a result of the forthcoming consultation on simplifying the CRC. For more information on the consultation see Legal update, CRC: Environment Agency sends letter to participants about changes announced in the Spending Review 2010.

The fourth characteristic

Many would argue that, in paying for Allowances, the landlord acquires an asset (chose in action) which has a value and can be sold to others and so the fourth characteristic of a tax is not satisfied. This is true, under the current version of the CRC, where there is expected to be a Secondary Market in which Participants can sell their surplus Allowances at the market price, or purchase additional Allowances. For more information, see Practice note, CRC Energy Efficiency Scheme: overview: Buying and trading of Allowances. However this may change as a result of the forthcoming consultation on simplifying the CRC. For more information on the consultation see Legal update, CRC: Environment Agency sends letter to participants about changes announced in the Spending Review 2010.

If the CRC is changed so that a Secondary Market does not develop, or trading between Participants is not permitted, then payments made for Allowances may well satisfy the fourth characteristic.

Some commentators would say that, where Allowances are bought in order to meet the obligation to surrender, the Allowances are the "currency", nominated in the legislation, which must be used to meet the liability created by the CRC. Looked at together, this means the Participant is not, in any real sense, obtaining a benefit or asset in return for the payment to the government.

At a Department of Energy and Climate Change (DECC) stakeholder event on simplification of CRC Energy Efficiency Scheme on Thursday 3rd March 2011, DECC indicated that HM Treasury are treating the CRC as a tax.

Contra proferentem rule of construction

If the clause is unclear about whether the tenant should pay CRC costs (of a particular sort or in general), then the usual rules of interpretation will apply. The contra proferentem rule will mean those ambiguities will be resolved against the interests of the party that drafted the clause (generally the landlord), and some or all of the CRC costs may be held to be irrecoverable. Only a crystal clear clause will work reliably to permit the pass through to tenants of CRC costs.

New leases

This update has concentrated on assessing whether existing lease clauses will place the burden of CRC costs on tenants. The same issues will arise when drafting new leases.

What is needed is a comprehensive clause which places an obligation on the tenant to pay all costs incurred (of all varieties, and whether incurred by the landlord or the tenant) under the CRC in relation to the consumption of energy in and the related emission of CO2 from the demised premises. In a lease of part, there would need to be a matching obligation (probably through the service charge) to contribute to the CRC costs incurred by the landlord in relation to the common parts of the building.

This could be done by expanding the common outgoings clause and (where relevant) the service charge heads of expenditure. Where included in the service charge, the landlord can require the payment of advance charges, based on an estimate of the final CRC costs. There is no longer any need for convoluted drafting to credit back to the tenant a fair share of the Revenue Recycling payment (which was the feature of CRC which made drafting a clause to share CRC costs and Revenue Recycling payments so difficult).

However, tenants will easily spot such a clear clause. If they are in a strong position, they may well resist it. At the very least they should ensure that the clause includes a mechanism to ensure that the CRC costs they may have to pay are those which are fairly attributed to their building. This will need to take account of a number of features, including the allocation (between the companies in the Group, and between properties in the landlord's portfolio) of the costs of Allowances which were bought at different times and prices. For more discussion of the issues to consider, see The Carbon Reduction Commitment Energy Efficiency Scheme: A guide for landlords and tenants: Second edition (August 2010).

The practical implications

When is this issue relevant?

The commercial imperative to recover CRC costs from tenants is much greater since the abolition of Revenue Recycling payments. However it will apply only where the current landlord (or a prospective purchaser from it) actually incurs CRC costs. In situations where the landlord is neither a Participant, nor part of a Group Participant, it will not incur CRC costs. Similarly, if the tenant is responsible for the supplies to the property (which can be the case whether it has a lease of the whole or part of the property) then it (not the landlord) will incur the CRC costs and no question of reimbursement will arise.

Is review of all existing lease clauses worthwhile?

Even where the landlord will incur CRC costs, if it has a large portfolio, it may not be worth incurring the legal costs of a review of the relevant clauses in the existing leases. Unless the landlord has used a standard (and unamended) form of lease, there will be no clear message as to whether the CRC costs are recoverable from tenants, in part or full, on all the properties. The analysis may differ for leases in the same building. This exercise will not, therefore, help a major landlord develop a standard approach.

Some landlords may recharge the CRC costs through the service charge regardless

It seems quite likely that, with existing buildings and leases of part, which provide for a service charge, the landlord may simply put the CRC costs through the service charge account and wait for the tenants to object to this approach. If the amounts are small, tenants may not notice or care. If they do notice, they may believe the landlord's explanation that the existing clauses cover CRC costs (perhaps as a tax or another imposition or outgoing).

Landlords may speed up the move to separate supplies of services to tenants

Where the sums at stake are larger, and the tenants more vigilant, it may be worth deflecting the argument over whether the CRC costs are to be paid under this type of clause. If the tenant is responsible for the supply, the issue does not arise. Where possible (and this is partly a function of the physical layout of the property and partly a function of cost) the landlord may be encouraged to arrange for energy supplies to be altered, so that the tenants are responsible for the energy supplies to their demised premises. This would leave the landlord to recoup (or pay itself) only the cost of Allowances needed to cover CO2 emissions from energy consumption in the common parts.

Landlords and tenants will be keener to cooperate over reducing energy consumption

Whether it is the landlord that ultimately pays for the CRC costs, or the tenant who has to bear them, both will have an interest in reducing energy bills and CRC costs by reducing energy consumption and the related CO2 emissions. This should improve their desire to cooperate with each other (whether under formal provisions of the lease, a memorandum of agreement, or just ad hoc) in ways of economising on energy consumption. For more information about green lease clauses, see Practice note, Green leases: list of materials.

CRC: Recovery of CRC costs from tenants - will it be easier now? | Practical Law