Cost model: Energy savings

Global warming has become the single biggest environmental issue of the 21st century. The recent separation of the Larson B shelf in Antarctica – a piece of ice nine times larger than Singapore – and the melting of the Himalayan glaciers show the scale of the problem.
Emission of heat-trapping greenhouse gases by the industrialised nations is believed to be the main cause of global warming. On 11 December 1997 in Kyoto, Japan, 171 countries ratified an international agreement to reduce greenhouse gas emissions in recognition of the problems global warming could cause.
The UK is one of the key supporters of the Kyoto Protocol and has agreed not only to reduce emissions by 12.5% from their 1990 level between 2008 and 2012, but to move beyond this legally binding target and achieve a 20% reduction on 1990 levels by 2010.
One significant step to assist commercial enterprises in reducing greenhouse gases has been the introduction of the enhanced capital allowances scheme.
ECAs are given for Department for Environment Food and Rural Affairs-approved expenditure on energy-saving technologies.
The scheme offers tax relief to encourage businesses to make energy-saving investments in specified technologies, which include the following groups:

• Boilers
• Combined heat and power
• Lighting
• Pipework insulation
• Motors and drives
• Refrigeration equipment
• Thermal screens
• Heat pumps*
• Radiant and warm air heaters *
• Solar heaters, specifically thermal systems *
• Energy efficient refrigeration equipment, including display cabinets and compressor equipment *
• Air compressors (electronic drain taps and conditioning monitoring control systems) *

The original scheme came into force on 1 April 2001, when it was available to a limited number of taxpayers. However, since this year’s budget on 17 April, ECAs are now available to all businesses regardless of size, industrial or commercial sector or location. From a property point of view, this means they are now available to most building owners and occupiers who are taxpayers.

<B>Doesn’t the government already run a system of relief for expenditure on plant and machinery?</b>
Yes, expenditure on qualifying plant and machinery is normally given at a rate of 25% a year on a reducing balance basis and is deducted from taxable profit.
This allows the benefit to be spread over a number of years. For example, for a 30% corporation taxpayer, £100 expenditure incurred on qualifying plant and machinery would equate to a £23 tax saving over the first five years.

<B>Why are ECAs of benefit if tax relief is already available ?</b>
ECAs enable businesses to obtain relief on the full cost in the first year, accelerating the relief traditional capital allowances offer. Thus, the £100 expenditure on energy-saving technology would now provide a £30 tax saving in the first year. Assuming a discount rate of 6%, this equates to a 17% improvement in net present value (comparing the value of money now with the value of money in the future).
The main benefits of ECAs for commercial property-owners are:

• Affordability of energy-saving technology that is typically more expensive than non-energy-saving technology.
• Reduced energy consumption costs.
• Reduced emission of greenhouse gases.

<B>What do ECAs actually mean to the property industry?</b>
As with the introduction of any new legislation, it will be several years before live cost information becomes available identifying the ECAs available in various buildings types.
In addition, determining the amount of ECAs that are potentially available to a particular building type is not particularly straightforward. This is because the approved energy-saving technology group lists are still being built up as more and more technologies are becoming government-approved.
It is also only since the April budget removing the leasing trade restrictions that ECAs have become of interest to taxpaying landlords.
Before this, only owner-occupiers and tenants benefited from ECAs.
Therefore, in the interim, commercial property owners and their advisers will be asking the following questions:

• Does the initial capital and whole-life cost of energy-saving technologies offer cash savings to property owners in the form of accelerated tax relief and reduced energy costs?
• Will the additional cost of energy-saving technologies negate the tax saving potentially available and actually cost more?
• If the above advantages do occur, how much tax relief and savings in energy costs, including the climate change levy, are potentially available in a building?

Until commercial property owners have answers to these questions and have developed a more detailed understanding of the issue, it could be many years before ECAs are fully adopted by the property industry.
We have therefore undertaken a case study examining the affordability of energy-saving technologies for a common commercial property. A modern office building was selected and the cost implications of specifying non-energy-saving technologies and government-approved energy-saving technologies were compared.

<B>ECA case study</b>
The first part of our study was to prepare a traditional capital allowances assessment of the plant and machinery allowances and tax relief available on the basis that non-energy saving technologies were included in the building specification. This is shown in the table on page 51 (Office building component costs) and a building specification and capital allowances overview is shown in the table on page 52 (Which bits qualify).
The second part of the study involved revising the project costs to reflect the inclusion of approved energy-saving technologies in the specification. This resulted in construction costs increasing by £132,000, as some of the approved technologies were more expensive than the non-energy-saving ones. The specification and cost differences are described in the table on page 53 (The cost of going green).
ECA tax relief and energy cost savings over the whole life of the building at years five, 10, 15 and 20 are included in the third table. The subject is a 10,000 m2 B1 office building with surface car parking.
It is important to note that any capital allowances claim would be subject to negotiation and agreement with the Inland Revenue.

<B>Case study summary</b>
ECAs offer an incentive for the property industry to invest in DEFRA-approved energy-saving technologies, making them more affordable and financially viable. In this example, additional expenditure of £132,000 on approved technologies generates an accelerated tax saving of £136,000 and cumulative net present value energy cost savings of £210,000.
However, the accelerated tax savings barely cover the extra capital cost of the energy-saving technologies. If the government is serious about giving taxpayers an incentive to invest in these technologies, it needs to increase the tax relief.
It is important to note that even though a technology is DEFRA-approved, the Inland Revenue may reject a taxpayer’s claim for ECAs unless it can be proved the technology is needed to meet the particular requirements of their trade.
In this case study, DEFRA-approved lighting is listed as qualifying for ECAs because it satisfies the lighting-fitting efficiency codes given on the ECA website. However, the Inland Revenue may not consider the lighting to be plant and if the ECAs for lighting are deducted from our study, the net present value of additional cash saved is actually less than the additional cost of the energy-saving technologies.
Given that lighting is generally the most significant electrical element in a building in cost terms, and accounts for 20% of all electricity use in the UK, the government should consider amending the tax legislation to include ECA-approved lighting as qualifying plant.

<B>So who will benefit most from ECAs?</b>
Most owner-occupiers and building tenants will benefit directly from the accelerated tax relief and energy-cost savings available for purchasing approved energy-saving technologies.
A landlord whose tenant pays the energy costs under the terms of the lease will only benefit from the accelerated tax relief. They should, however, benefit indirectly from the energy savings as the building should be more attractive to a potential tenant.
The value of ECAs potentially available depends on the building type and function. For example, supermarkets where significant expenditure is incurred on qualifying technologies such as refrigeration display cabinets, will attract significantly higher ECAs than an office building.
In the end it is an individual corporate decision to install energy-efficient technologies in commercial properties. Purchasing these technologies generally becomes financially viable when the tax relief, energy cost and climate change levy savings are taken into account.

<B>So how are ECAs claimed?</b>
There are major obstacles to be overcome.
A company may think it has purchased energy-saving plant and machinery, but if the product is not listed on the DEFRA energy technology product list, the relief is unavailable.
The list is published on the ECA website, www.eca.gov.uk. The energy-saving plant or machinery must be unused and not second hand, and, in the case of expenditure on premises other than shops, showrooms, hotels or offices, must have a useful economic life of less than 25 years.
The claim must be based on the costs incurred, which include the cost of the DEFRA-approved technology, transportation and installation costs, professional fees and the cost of alterations to an existing building to install the technology.
Determining the cost of the energy-saving technologies is not straightforward. For example, where it is incorporated into a large item of plant, such as pump and air-handling unit motors, only the proportion of the total plant cost that relates to the particular energy-saving technology will qualify for ECAs.
Specialist advice is required, not only in identifying costs that relate to the energy-saving technologies and their associated project “on costs” but in negotiation of the ECA claim with the Inland Revenue and/or the Valuation Office.

<B>How does a manufacturer get its energy-saving technologies on the DEFRA-approved list?</b>
Because the legislation is relatively new and because of the delay before manufacturers have their technologies approved, the energy-saving technology group lists are limited at present.
However, given the tax savings potentially available to property owners, manufacturers are now falling over themselves to have their products added to the list, positioning themselves to sell energy-saving products and related services to a captive audience.
Energy-saving technologies are not added to the list automatically. Specialist advice is required to ensure the particular technology obtains safe passage through the DEFRA accreditation process. The manufacturer will then receive a letter of acceptance and such products will qualify for ECAs from the date of the letter.
If a product is rejected, the manufacturer will be provided with the reasons and will be invited to resubmit a product for reconsideration. DEFRA also has the right to notify a manufacturer of the removal of a product from the list, for example if it does not actually meet the technical specification on which approval was granted.