8.2 Different Financial Viewpoints and the Decision-Making Process

1. Introduction to financial viewpoints

All building owners are likely to ask some of the following questions:

• How much will it cost (usually referring to the capital cost of a whole building retrofit)?
• Will I have to pay all of it upfront – what about grants or financial incentives?
• Will I get my money back – and when?
• How much will it increase the value of my property?
• Is it a sensible investment?
• If I am acting altruistically – how much over what ‘stacks up financially’ am I paying?
• Is government policy likely to support deep retrofit in the future? (see Lesson 8.3 for the bigger issue of UK energy policy and the role of energy efficiency within it)

Every client needs to know how much the job is going to cost and make an assessment of its value – it seems a simple question, but different stakeholders will have different ways of assessing costs and value.

It is true that financial decision making – especially when concerning our own homes – is complex and not necessarily rational – this is not ‘bad’, but should be recognised. Also, despite the longstanding use of standardised investment appraisal methods in business, it can be hard, time consuming and expensive to meaningfully assess individual projects.

Some appraisal tools (such as those used in the short-lived government Green Deal programme) produce results too far from reality to be robust. They are increasingly seen as ‘unreliable’ and ‘unconvincing’ and this can undermine householder trust in energy efficiency work.

2. Homeowner decision making

Individual home owners’ decisions to make home improvement investments are affected by a wide range of factors including: regulations, fashion, comfort, energy prices, environmental consciousness, and perceived effect on house values, but the perceived financial returns from energy efficient retrofits are also likely to be an important factor.

Overall, the UK home improvement market is worth £14 billion a year *. Most of this expenditure is made without consideration of financial returns. There are no savings from a new kitchen or bathroom. The financial benefit may come in an increase in the value of the house but the real benefits are things that cannot be valued e.g. ease of use, comfort, sense of well-being, pride of ownership etc.

For advocacy groups or policy makers promoting energy efficient retrofits, it is important to understand why people choose to spend money on home improvements and also to understand that the natural refurbishment/ improvement cycle presents a point at which intervention may be effective.

2.1 Intervention points

It is important to understand that there are key intervention points at which an energy efficient retrofit may be easier to implement e.g. house purchase, undertaking an extension, or undertaking major refurbishment such as kitchens and bathrooms. It is more likely that an energy efficient retrofit can be implemented at these intervention points rather than as a stand-alone project. At any point of intervention, making a financial case for additional marginal expenditure on energy efficiency measures may be effective – although as we saw in the previous lesson, the marginal costs of deep retrofit can be quite high for some properties.

It may be possible to phase whole house retrofit work to fit with maintenance cycles i.e. the ‘step by step’ approach. It may be better, in order to encourage integrated measures rather than piecemeal, to think of this as a ‘package by package’ approach. For example in any particular area [ventilation + airtightness + insulation] should go together, i.e. even if not all insulation is placed in one go, whole house airtightness and ventilation should ideally be completed.

As a rule, homeowners tend to pay the property’s maintenance and energy costs and the capital expenditure and financing costs related to a deep retrofit. They will directly enjoy the benefit of improvements in comfort and health, benefit from (at least some of) the potential increase in property value, reduced utility bills, and if they stay in the property long enough, the eventual cumulative profit from year on year energy savings. Their interest in the property commonly lies between 10-30 years, occasionally longer.

Householders with a medium to long term interest in their homes appear generally willing to pay to improve their homes in all kinds of ways, be it improved decor, an extension or new kitchen – and it is quite likely that upgraded health, comfort and perceived wellbeing combined with lower maintenance and running costs will be a major criteria for economic decision-making. The health effects, particularly when there are young children in the home, are likely to be a major driver which is as yet under-exploited. Comfort and health benefits may also be key drivers for the elderly or less mobile.

2.2 Value Added Tax

VAT will play a significant role for private homeowners in financial decision making concerning retrofit investment. VAT, at full or reduced rate for some items, is not included in the economic assessments illustrated in this module (this facility does exists however within the CLR modelling tool) in order to align with standardised assessment methods.

For social or commercial property owners who can claim VAT back, this is standard practice. Including VAT (and at different rates) for assessments of private homeowners but not including for commercial and social property owners was seen by the CLR team to be likely to create confusion as a result of the large amount of additional material to illustrate. The main impact of governments continuiing to charge reduced VAT on energy efficiency measures combined with full VAT on related ‘consequential’ work will be to significantly increase the upfront capital costs: unless deep retrofit is near total demolition and rebuild, where a zero VAT rating can be claimed!

2.3 ‘Improving’ homes for early sale

A typical property owner improving a house for sale is less likely to favour a deep retrofit and more likely to miss the opportunities offered by the intervention point. This increases future marginal costs of retrofit or even may lock the house into long term poor performance.

Rather than argue to little avail for an immediate deep retrofit in the face of a determination to carry out minimum improvements necessary for sale (aka a very shallow retrofit), retrofitters could improve the situation by advising on carrying out a more focused and carefully considered package of repairs and improvements that future-proof a building for deep retrofit. Ideally a whole house retrofit plan would be prepared to guide this process.

The future-proofed, retrofit-ready improvements would deal with moisture reservoirs e.g. by blocking or isolating from ground moisture sources, adding diffusion open rain protection and roof membranes, potentially turning suspended timber floors over shallow crawlspaces into insulated solid floors. They could incorporate the basic, lower cost airtightness and ventilation measures that underpin future moisture robust low energy, high comfort performance. This form of ‘retrofit ready’ improvement, resulting in less draughty, drier and better ventilated buildings is a form of ‘shallow’ retrofit that could help pave the way for more extensive and cost effective future measures by the new owners.

2.4 Private investment in ‘negawatthours’ (aka ‘Negawatts’)

For an owner occupier, a deep fabric retrofit can be seen as a choice of where you buy your heating energy (thermal comfort). Instead of buying your thermal comfort (heat) from an energy supply company selling heating fuel or electricity, you buy much of it via the investment in upgrading the building itself. The owner becomes their own ‘heat supply company’ by investing in ‘generating negawatt hours’ i.e. generating a reduction every year in the heat supply needed. This can be measured if compared to a pre-retrofit consumption baseline or an agreed annual space heat consumption level for the house type (by unit floor area) – the latter is the CLR method.

Deep retrofit represents a long-term investment and inevitably has some risk: deep retrofits are affected by interest rates and heating fuel price changes, though sensitivity to these can be modelled to gauge the level of risk. Investment in safe (i.e. moisture robust) energy efficiency upgrades of houses, like other investments in land and property, tends to be considered a relatively low risk investment for homeowners. It can also reduce risks for mortgage providers. In the US a study of 71,000 mortgage-holders found that those in ‘Energy Star’ rated homes were 30 per cent less likely to default *. This potential driver of investment is also as yet under-exploited in the UK.

A carefully implemented retrofit provides all the co-benefits previously described in Module 1, with the most attractive part of the investment for an individual owner-occupier (and social landlords) most likely being the long-term access to a healthier, more comfortable and more financially secure environment.

3. Decision making by landlords

Many domestic buildings, both houses and flats, are owned by private or social landlords who will have to make investments in retrofitting but do not benefit directly from the resulting energy cost saving: this is the problem of the split incentive.

Landlords, whether private or social, considering programmes to encourage investment in retrofits, are likely to use Discounted Cash Flow (DCF) techniques to assess the financial viability of investments. In any DCF analysis it is important to include all cash flows which may include items (in the case of landlords) such as increased revenues due to the increased ability of tenants to pay rent.

(See Lesson 8.6 for details on DCF techniques)

While commercial property owners and social landlords will be more familiar with investment appraisal methods, they may be less clear on how and when to incorporate the value of co-benefits. One example of co-benefits is reduced health costs amongst people in fuel poverty due to warmer homes – these benefits have been evaluated in a few pilot schemes. Prescribing better insulation may be a cost-effective use of health budgets. In this example the investor would be the NHS.

3.1 Private Landlords

On the face of it, landlords have much less to gain from retrofit than do owner-occupiers: they don’t (usually) pay the bills and they don’t personally enjoy the newly comfortable living conditions. This is the problem of the split incentive which also applies to much of the commercial building stock.

However, as the National Landlords Association put it:

“Although often overlooked, making energy efficiency improvements help maintain the fabric of properties; damp, mould and frozen pipes are less likely in an energy efficient property and this should keep maintenance costs down. The improvements will also, hopefully, encourage tenants to look after the property.”

It goes on to remind landlords that they have a duty to provide an Energy Performance Certificate (EPC) before the signing of a tenancy agreement, in order for prospective tenants to have information about energy costs upfront. Landlords have until 2018 to ensure their properties have an energy performance rating of at least an E. These regulations, if properly enforced, could become a major driver of retrofitting activity, although deep retrofits will not result from this driver alone.

Source: http://www.landlords.org.uk/news-campaigns/campaigns/energy-efficiency-issue#sthash.P0QiaFMK.dpuf

3.2 Social Landlords

As with private sector landlords, social landlords are under an obligation to upgrade existing properties to an ‘E’ by 2018, a target that the Chartered Institute of Environmental Health and many others consider is insufficiently ambitious. Social landlords are more likely to include non-financial factors in their decision making, such as combatting fuel poverty, but are still required to make financial assessments and are likely to use DCF techniques. Registered Social Landlords (RSLs) are private and non-profit making. Their funding comes from rent income and they borrow money from the financial markets with the funds coming from banks, building societies, pension funds and increasingly corporate bonds.

In England social landlords have been upgrading their properties with government assistance to the ‘decent homes’ standard for many years now, but even though this is still not universally attained, ‘decent homes’ is now regarded as a very low benchmark and many social landlords are looking to improve the efficiency of their properties. Retrofits to either decent homes or to EPC “E” are likely to be shallow, and offer few energy savings once occupants in fuel poverty have increased their living temperatures.

In Scotland an EPC based energy efficiency standard for social rented properties already applies:

“The Energy Efficiency Standard for Social Housing (EESSH) has been developed to help improve the energy efficiency of the social housing stock in Scotland and we are working with the private sector too.”

Quote from: http://www.gov.scot/Resource/0044/00447123.pdf

“The EESSH will mean that in the main no social property will be lower than a ‘C’ or ‘D’ energy efficiency rating, meaning that tenants should benefit from a warmer home, which could mean lower fuel consumption, lower energy bills and less tenants in fuel poverty. ”

Quote from: http://www.energyefficientsocialhousing.org/read-more-home

3.3 Social Landlords (Wales)

Not yet researched

3.4 Landlords – summary

Thus landlords have various obligations by law to ensure a minimum level of energy efficiency in their properties, which will require retrofit in many cases. On top of this there are a number of financial benefits which the energy retrofit of tenanted properties can offer the building owner. Some were indicated by the NLA quote above, and apply equally to social landlords.

4. Government

There is an argument that retrofitting buildings should be a government infrastructure investment. This idea has many merits but any government expenditure on retrofit will depend on investment appraisal following government guidelines (the Green Book which is published by HMT*).

The UK government assesses investments using modified Discounted Cash Flow or DCF techniques and it is important that all cash flows, including co-benefits such as reduced health costs are included in the assessments.

Lesson 8.4 goes into detail on the UK wide perspective, and Lesson 8.6 defines DCF techniques.

5. Where are the potential ‘customers’ for deep retrofit?

The numbers of early adopters of deep retrofit are small and affected by the ‘austere policy and grant environment’ (as of December 2015). The demand for retrofit is also affected by the lack of easy and attractive retrofit services on offer. Nonetheless, champions of energy efficiency, warm homes and the concept of ‘negawatts’ are actively promoting the benefits and co-benefits of deep retrofit and making the most of the opportunities to demonstrate improved retrofit practice. Best practice retrofit exemplars at small, medium and large scale – invested in by the most progressive individuals and organisations will be crucial to create the confidence required for what surely, inevitably will be a huge, on-going market for skills, products and services over the next decades. As part of preparing for this future market it is useful to understand some of the key characteristics of building ownership and the UK dwelling stock (see Lesson 8.4).