ESG Provisions in Commercial Leases: Who Pays and Who Benefits?

As the business world continues to prioritize social responsibility and sustainability, commercial landlords are increasingly incorporating ESG (environmental, social, and governance) provisions into leases. While these provisions may seem beneficial for tenants seeking to reduce their environmental footprint and enhance their reputation, it's important to consider the potential costs associated and how they may affect your lease obligations. In this post, we'll expand on the growing prevalence of ESG provisions, their implications for tenants, and how costs are likely handled.

As a tenant, you may have recently noticed that any new lease or renewal amendment agreement suddenly includes an ESG provision.

Why are landlords inserting ESG Provisions into commercial leases?

ESG provisions in commercial leases have become increasingly more common in recent years as more institutional landlords and REIT's seek to highlight their focus on environmental, social and governance practices. For landlords, these provisions can sometimes offer a competitive advantage by attracting high-profile tenants who also prioritize sustainability. Additionally, there is a growing expectation from certain investors, lenders, and stakeholders that landlords/developers & property owners are being good corporate citizens.

It's important to note that these provisions are being drafted by landlord legal counsels. Therefore, the language can be very one-sided and landlord friendly.

Under the ESG provision, tenants may expect to see variations of the following items:

1. Landlords may request certain disclosures on demand.
2. Tenants are required to fully cooperate with any ESG initiatives at the landlord's discretion.
3. Tenants must encourage employees, service providers, and partners to adopt sustainable practices (beware of vague requirements).
4. Tenants should make an effort to utilize renewable energy sources when feasible.
5. If the landlord determines that a capital improvement will enhance their ESG initiatives, they have the authority to include the cost in common area expenses, ultimately passed on to the tenant(s).

As a tenant, it is essential to understand the possible implications of these provisions, as they can significantly impact your operating expense costs, operations, and requirements for fulfilling lease obligations and avoiding events of default.

Who is ultimately paying for any ESG related expenses?

Certain ESG investments can very well bring long-term sustainability benefits that can sometimes result in cost savings. However, these investments often require front-end capital improvement costs that someone, often the tenant, ultimately absorbs.

As most industrial leases are structured as "NNN" (landlord passes through taxes, insurance premiums, and CAM's onto Tenants), these ESG initiatives are more than likely being absorbed by the tenant(s) through higher rent or higher common area maintenance (CAM) charges. It is crucial for the tenant to negotiate and specify what is appropriate for the landlord to pass through. Additionally, any operating expenses exclusion list should include capital improvements related to ESG initiatives going forward.

In conclusion, as a tenant, it's imperative that you remain vigilant and fully comprehend the financial implications of ESG initiatives within your lease agreement. While these initiatives are increasingly becoming more popular, the immediate financial onus often falls disproportionately on the tenants. Protect yourself financially by ensuring you have a robust list of operating expense exclusions, audit rights, and caps on controllable operating expenses. It's important that the costs and credits of ESG improvements are fairly highlighted and distributed. Don't find yourself shouldering an unfair share of the investment, while the landlord reaps all the reputational rewards.