Investing in energy efficiency can reduce greenhouse gas emissions even while saving money on energy bills. It seems like a no-brainer. Yet the one-third of northwesterners who live in rental housing actively avoid investing in energy efficiency. And their landlords also resist efficiency investments. What’s going on?

When it comes to rental housing, there’s a big market failure in energy efficiency. It’s a problem of “split incentives,” which we’ve written about here and here. Owners don’t make efficiency investments because it’s the renters who pay the energy bills. And renters don’t make investments in property they don’t own. The result is housing that wastes energy and costs more than it should.

One solution takes advantage of the lease or rental agreement: “green leases” enable owners to spend money on efficiency improvements and recoup their costs by raising rent by the same amount as the realized energy savings, minus a smaller agreed on amount which gets passed on to the renter. In other words, if an efficiency investment
to the renter’s unit generates $100 of monthly energy savings, the rent might go up $80 per month. Although the rent increases, the tenant’s total housing bill goes down by $20. It’s a win for both parties. The tenant would start saving money right away, and over time the landlord would recoup his initial investment (and even make money), through the higher rents. Plus, the tenant would be using less energy.

A typical example might be a refrigerator replacement. A tenant has little economic incentive to buy a new efficient (and more expensive) refrigerator because he’s unlikely to be around long enough to recoup the extra upfront expense through reduced energy bills. And a landlord might think she’s better off buying the cheapest model she can find because she’s not paying the bills for the fridge’s operations. A green lease might fix this problem by allowing the landlord to increase rent enough to pay for a more expensive and efficient model, but because of the lower energy bills, the tenant would actually save money even after the rent increase.

The challenge with green leases is creating a practical financing arrangement that doesn’t saddle landlords with too many headaches. And to make economic sense, efficiency investments would need to generate sufficient savings in a short enough time that the owner could pay back the bank, or herself, for the upfront cost of making the investment in the first place. So in order to know if an investment makes sense, both landlords and tenants will need a trustworthy assessment of the potential savings. Plus, they’ll need to resolve some other questions. What happens if the improvement fails to save the energy and money that it promises? What if it generates more savings?

If green lease arrangements sound complicated, that’s because they are. Green leases are already used in the US and Canadian commercial real estate rental sectors, but they are not sweeping apartment rentals. The legal complexities can make green leases challenging and uncertain. And both landlords and tenants dislike uncertainty. Like other kinds of financing ideas green leases are innovative and potentially promising, but they have yet to break through the barrier of the split incentive for multifamily rental buildings.

Governments tend to shy away from energy efficiency mandates, but legal energy performance standards might be just the thing to push both landlords and tenants toward saving energy and money. For instance, a city could require landlords to replace old appliances, but also offer a program, like the ones in Maine and New York State, to provide financing for landlords.  Mandatory efficiency programs might ensure fairness so that the efficiencies and savings are realized by lower-income tenants, who frequently live in the most energy-wasteful housing and can least afford higher bills. Without a mandatory program, there’s a risk that green leases will remain concentrated in the commercial sector and higher end housing where paid professional managers are increasingly aware of the economic benefits of energy efficiency.  But the dispersed and small-scale nature of residential rental housing means that some owners, especially in areas that serve lower income people, might never make the energy efficiency leap with out a nudge.