Are Our Pensions Founded on Sand?

Posted on August 17, 2013 by Doug King

We are used to seeing environmental protection at the centre of sustainability arguments. We are not so used to thinking about the economic sustainability of what we do in construction. I believe that we may need to rethink the economic model behind commercial construction in the UK or face some dire consequences. Let me explain:

Back in 2009/2010, early in the recession, I was seeking new premises for my business. I identified a recent development in Bristol which was still unoccupied several years after completion. Normally, we would not have been able to afford city centre rents, but I thought that this building should have been ripe for negotiation, having no tenants. However, when I approached the agents I found that commercial property rent is not subject to the usual market forces of supply and demand. The agents gave me the following reason for being unable to reduce the rent. The asset value of the building is determined by the anticipated rental yield. Having purchased the building at a value based on predicted rent the landlord will not reduce the rent in order to attract tenants as this would reduce the asset value leaving them with a loss on their balance sheet. Apparently the paper value of a building is more important than it actually generating revenue. Why would this be?

Well, consider our typical commercial development model. A developer borrows money from the banks in order to construct a building which nobody actually wants. In order to maximise the potential return, the building is constructed to the lowest acceptable specification for its target market. Shortly after completion, the building will be sold to a landlord, typically a pension company. The pension company uses the asset value of the building to underwrite its future pension commitments. The pension company appoints an agent to market the building and then largely forgets about it. Rental revenue pays for the operation of the building. The developer repays the bank loans and pockets the profit.

So, now I understand. The pension companies hold these buildings on their books as assets on paper. It is these paper assets that underwrite the security of my (and your) future pension. However, it seems to me that this is based on the premise that:

the asset will generate revenue;
the asset will appreciate in value.

If the building does not have tenants and is not generating a revenue then what value does it actually have? Consider this other example:

Green Park is a business park development near Reading originally owned by Prudential. The park, which was valued at £500M – £600M in 2008, was held in the Prudential’s Life Fund. Green Park’s principle claim to fame is its highly visible wind turbine next to the M4. Green Park’s other landmark, 450 South Oak Way, the building facing the M4 motorway, together with its sister, 400 South Oak Way, have sat empty since completion in 2002.

450 South Oak Way has sat empty for 10 years, consuming capital rather than generating revenue.

These buildings were leased by Cisco shortly before the dotcom crash and never occupied. Cisco has been trying unsuccessfully to find alternative tenants since. Now, in order to prevent the building fabric from deteriorating, it must be the case that basic heating and cooling systems are kept in operation and basic maintenance is carried out. This will not be cheap considering the buildings’ fully glazed south facing elevations. So, without tenants, these buildings are consuming capital rather than generating revenue. How does that affect the asset value held on Cisco’s books? Well, Cisco gave up and surrendered their leases in July 2012.

So now the cost of maintaining these empty buildings falls once again on the landlord. Interestingly, by now, Prudential had also gotten out of Green Park, selling to Oxford Properties, the property arm of a Canadian pension fund, in 2011 for £400M (a loss of at least £100M for the Pru, such are the shenanigans of the property world). So the costs of maintaining these “assets” must now be borne by Canadian pensioners until tenants are found. I wonder if they will fare any better than Cisco or Prudential did.

In the past, commercial property has clearly been a good investment for pension funds as the assets typically always appreciated. However, this paradigm is changing. As regulations on building energy consumption are continually drawn tighter, underperforming commercial buildings will quickly become obsolete. Commercial tenants are beginning to demand energy efficiency in buildings and, further, from 2018 landlords will be unable to offer for rent any building with an EPC rating lower than E. 450 South Oak Way is Band D according to the agent’s particulars and so it is not in immediate danger of becoming obsolete. Nevertheless, the longer that buildings such as this sit empty the less likely it becomes that they will ever find a tenant, as newer buildings come along with substantially better energy ratings. Do we face the prospect that recently constructed buildings may even be demolished without ever having generated revenue? I wonder what this does to the asset value recorded in the pension fund’s books. Will we find ourselves in a few years time faced with pension funds loaded down with a whole load of toxic assets as bad as the sub-prime mortgage situation?

I’m not an economist and don’t know the answer to this question, but I do know that if my business does not produce revenue then it has no value as an asset and cannot be used to underwrite borrowing or liabilities. It worries the hell out of me that my pension might be underwritten by assets with no value other than paper. Does anyone else have any insights on this situation?

Zero Carbon or EcoBling?

Posted on August 8, 2013 by Doug King

By now, everyone should be aware that the UK is committed to reducing carbon dioxide emissions 80% below 1990 levels by 2050. Most people reading this blog will also be aware that carbon dioxide emissions arising from energy consumption in the buildings accounts for around 45% of the total.

Thus, one of the headline policies in the UK is that all new buildings should be constructed to zero carbon standards by 2020. However, by the time 2050 comes around new zero carbon buildings will only account for around 20% of the building stock, the remaining 80% are already in use today. The low carbon refurbishment of some 20 million existing buildings presents an even greater challenge for the construction industry than that of zero carbon new buildings. Further, in order to meet the commitment we will need to deliver over 2,000 low carbon building refurbishments every working day starting today.

Unfortunately, a number of recent studies of both low carbon housing and low carbon non-domestic buildings have shown that there is still a wide performance gap between the expectations of the construction industry and its clients and the ability to deliver real carbon savings. It is therefore vital that we embark on this journey of decarbonising the built environment with a clear understanding of what it will involve and which approaches deliver the best abatement at the lowest cost. Otherwise, we risk wasting time and money on initiatives that fail to achieve the end goal of reducing the overall amount of carbon dioxide emitted to the atmosphere.

Recently, the conjunction of local planning policies demanding on-site renewable energy generation and the generous financial incentives available for these technologies have created a perverse new market for small scale generation in urban locations. The most common approach now being taken to low and zero carbon housing is to use an electric heat pump in the winter and then provide the building with sufficient renewable generation to offset the electricity consumed by the heat pump over the course of the whole year. What we are seeing at the putative cutting edge of new building design will no doubt become the default approach for refurbishment too unless we do something about it.

Incentives encourage the installation of renewable technologies even where they are inappropriate.

In some instances I am even hearing now of projects that are abandoning super insulation and other passive energy conservation measures in order to pay for the revenue earning technologies. Under the right circumstances an owner could now be paid to generate heat that is wasted in a less well insulated building and paid again to generate renewable electricity to offset the wasted consumption and still qualify as zero carbon.

Subsidies aside, this approach to zero carbon, whether applied to new build or refurbishment, may not actually lead to zero emissions, as the assessment of carbon abatement does not take into account the different times at which the generation and the demands occur. The carbon intensity of grid-supplied electricity varies depending on the mix of generation required to meet demand. Generally, in the winter the carbon intensity is higher as more fossil fuel generation is brought into the mix to match the demand, whereas during the summer, when building attached renewables will be generating at their peak, the carbon intensity is low anyway.

Taken to the extreme, if we try to address low carbon refurbishment to meet our national targets using a mix of heat pumps and small scale renewable generators then we will simply exacerbate the problems. As more and more renewable generation is added to buildings, the carbon offset available for each individual generator will get lower and lower. On the flip side, a wholesale move to electric heating in the winter, even with the purported efficiency of heat pumps, will require a vast increase in generation capacity. Even if a substantial proportion of this demand can be met from large-scale renewables there will still be a requirement for backup generation to cover the intermittency of the renewable generators.

Then we need to consider the actual performance of heat pumps in practice. Ground source heat pumps provide pretty consistent performance throughout the year, but are expensive and require large areas of land for heat extraction. The performance of the more popular air source heat pumps depends on the external air temperature. The performance figures that are typically used to assess the carbon abatement potential are seasonal averages corresponding to outside air temperatures of 5°C to 7°C. With well designed, well insulated buildings there should be little demand for any space heating at these temperatures. In the future, heat pumps will be required to work mostly at outdoor temperatures below 0°C, when their performance drops rapidly. Thus, the instantaneous electricity demand from heat pumps during the winter could be much higher than anticipated at a time when the grid has higher carbon intensity.

A further problem with adopting small-scale renewable heat technologies to refurbish British buildings is that we have a history of building buildings that leak. The UK’s relatively benign climate means that, historically, we never really had to bother with insulation before energy conservation became such an issue, whereas our damp weather quickly leads to mould problems in buildings without good ventilation. Our standards of construction therefore reflect these very real drivers. However, this means that our buildings are generally too expensive to heat continuously, as the heat just escapes. Consequently we have adopted a pattern of intermittent heating following occupancy in homes and non-domestic buildings alike.

Intermittent heating requires a high intensity heat source such as a gas boiler, and a heating system that responds quickly, such as the traditional radiator. Low carbon and renewable heating systems work best when they are configured to deliver low intensity heat continuously to a well insulated, airtight building. To size a heat pump to deliver similar peak output to a boiler would be prohibitively expensive and lead to significant problems in its operation.

Dealing with the poor state of the fabric of our buildings must be the priority in refurbishment, before we ever start to think of bolt-on technologies. Insulation and airtightness do not have the “EcoBling” attraction of small scale renewable energy, but will require just as much thought and ingenuity if we are to get it right.

When we try to retrofit high levels of insulation and air-tightness to traditionally constructed British buildings we can quickly run into problems with indoor air quality, condensation and even rot within structural timbers, not to mention bronchial health problems relating to mould. Improvements to insulation and airtightness therefore need to go hand in hand with provision for protection against condensation and controlled ventilation with heat recovery. Thus, an apparently simple measure actually introduces a whole family of additional requirements in order to maintain a safe and healthy internal environment. Is a serious mistake therefore to try and skimp on consideration of issues relating to the building fabric in order to pay for the low carbon technologies.

Therefore, when it comes to retrofit, we must not allow ourselves to become distracted by the apparent financial attractiveness of bolt on renewable energy technologies. It is conceivable that the conjunction of zero carbon buildings, the feed in tariff and renewable heat incentive could actually lead to higher emissions overall, whilst not addressing the root of the problem. The approaches we take in order to meet policy goals in the short term may not in fact be the most sustainable approach in the long term.

The problems facing us in dealing with the building fabric issues in our stock of existing buildings will require considerable effort, expense and innovation. Failing to deal with the building fabric issues will result not just in higher than expected emissions, it could exacerbate health problems and other social issues such as fuel poverty. We need to be aware that the directions we are taking now through expedience may not lead us directly to our hoped for destination and that we may have to change direction several times before we can reach our ultimate goal.

We would be much better off focusing our efforts on building refurbishments that address the fundamental issue of consuming less energy to create comfortable and productive internal environments, rather than continuing to delude ourselves that we can simply bolt expensive technology on top of already failing buildings. That way, the cost to decarbonise our energy supply, the only real way to achieve a low carbon economy, will be reduced in line with the energy we save.

Race to the Bottom

Posted on June 19, 2013 by Doug King

The built environment is of vital importance to the creation of a sustainable society and construction needs to be considered as being for the public benefit. Decarbonising the UK building stock will not be easy or cheap and it requires concerted effort and co-operation across the supply chain. The capitalist free market is no longer an appropriate mechanism for the construction industry if we are to deliver the new paradigm.

Despite numerous spectacular failings in the delivery of IT and defence projects, our political leaders persist in their faith in the free market. Thus least first cost tendering is now applied across all aspects of public procurement for construction, from initial design right through to the regulatory functions. Where the Government leads the private sector will surely follow.

Open competition certainly does drive down prices but it is equally clear that it does not deliver real value or quality.

Any student of economics can tell you that people respond to incentives and that competition creates perverse incentives. Consider the case of the exam board official caught out last year feeding prior knowledge of exam questions to teachers at a training event. When schools are judged by exam results and exam boards compete to attract schools to use their examinations, they will do whatever is necessary to capture business. The market has created an incentive for perverse behaviours by exam boards including dumbing down the questions and advising teachers which areas to focus on during revision.

Nowadays even Local Authority Building Control has been forced into competition with approved inspectors. There is no longer any protection for the regulatory function. Developers will select their inspection services based not only on fees, but also on who is likely to give them the easiest route to compliance. So, just as with the competing exam boards, there is an incentive for building inspectors to be lenient in order to encourage future business. Any inspector who rigorously applies the regulations is likely to be quickly out of work. How can we therefore expect the statutory regulation function to be rigorously and impartially executed?

So, if our system of statutory oversight is compromised, can we rely on the supply chain to deliver the quality and performance improvements we need? I don’t think we can, as I said in a previous article ‘The Root of the Performance Gap’.

When I started as a young engineer, the practice I worked for had a policy of disregarding the lowest tender when we were evaluating mechanical and electrical subcontracts. You could almost guarantee that the lowest bidder had cut his cloth too thin and that performance on site would suffer, leading to poor quality and a continuous battle over proper completion of the works.

These days however, I find that clients not only appoint the lowest tenderer for every service, but that they also try to negotiate the price even lower. Yet it is clear that lowest cost tendering incentivises suppliers to deliver the lowest level of service that they can get away with. I contend that this actually leads to increased overall cost due to the additional management and supervision required to ensure that the bare minimum requirement of the specification is fulfilled.

However, given the urgent need to decarbonise the UK building stock, simply achieving the bare minimum of the specification is not enough. Every party in the construction process needs to deliver over and above. We need an industry in which every individual actively contributes to achieving a long-term vision rather than being focussed on short term financial goals. We need an industry in which selection is on the basis of performance and lifecycle value.

I suspect however that the public sector is still wedded to competitive tendering and we won’t see the necessary leadership for some time to come. In the interim, a step change in construction performance and value could be achieved by simply changing tender rules. There are lots of clever ways to structure competitions to achieve best value rather than lowest cost. However, a simple first step would be for the public sector to commit to taking the second lowest bid in any tender. At a stroke this would remove the incentive to bid at unrealistically low levels. The construction industry would then be able to concentrate on delivering value rather than recouping its losses.

The Root of The Performance Gap

Posted on June 18, 2013 by Doug King

A number of comments made during an industry dinner last week have crystallised a new understanding for me about the real root causes of the building performance gap that we now hear so much about.

The performance gap is the difference between the notional energy performance of a building predicted by its designers and the actual out-turn energy consumption once occupied. When you eliminate the obvious impact of regulated versus unregulated energy then there is often still a disparity between design and operation. In many cases this is due to failings in the design or construction, but equally often there is a failure in the management and operation of the finished product.

As is usual in the construction industry, blame for the performance gap is being attached to individual parties in the supply chain. However I now realise that the real problem is structural and embedded in the nature of supply chains themselves. Design and continuous improvement is a circular process, but the supply chain is linear. It is like that because procurement and project managers have made it so. Nowhere within the supply chain is any one party responsible end to end for the building performance.

The project manager who implements last minute omissions from the ‘expensive’ metering and control system is rewarded by the client for bringing the project in on budget. Facility Managers who reduce operating cost by disabling systems or purchasing the cheapest replacement parts are awarded bonuses for achieving financial targets. The chances are that neither party will even be working on the project when the consequences of such decisions come home to roost.

Further, at each link in the chain, we create incentives that promote short term thinking rather than action for the long term outcome of better building performance. Most client organisations separate those responsible for capital investment from those responsible for operations. They reward the procurement teams for achieving the lowest capital cost. Thus procurement is through competitive tendering which provides a clear incentive to do as little work as possible whilst achieving an acceptable, rather than exceptional, outcome.

The consultants need to win work at the lowest cost which constrains the time spent on design. The contractors need to make profit to pay shareholders so will select products on the basis of cost not performance. The Building Control Officers need to win future work and are unlikely to tell unwelcome truths about the building performance. The facility managers survive on their meagre fees by not spending money on extensive maintenance and quality replacement parts.

Even within organisations the way people are employed impacts on outcomes. Employees’ performance in regard to promotion and reward is often measured against annual or even monthly financial targets. When you combine this with a project based workload you create a clear incentive to move on to the next project as quickly as possible, rather than spend more time on delivering one project really well. People are then often ‘too busy’ getting work and doing work to plan the future of their business and still less the future of construction.

It is telling that the RIBA survey of chartered practices found that 62% do not have a business plan. I’d be prepared to bet that the most common reason for not having a business plan is being too busy to create one. Having worked in and run small businesses myself I am well aware of the pressure simply to keep turning over the work.

The building performance gap is not the ‘fault’ of the construction industry or the occupiers. It is a product of the systemic failure of procurement, management and operation of buildings.

More thoughts about the impact of procurement on construction value in follow up article ‘Race to the Bottom‘

Low Carbon People

Posted on March 8, 2013 by Doug King

MP Don Foster announced at Ecobuild this week, funding for a programme by the Zero Carbon Hub to investigate why energy consumption in low carbon dwellings is higher than expected. The answer is apparent in evidence also available at Ecobuild pointing to the obvious, which the industry and policy makers continue to fail to recognise.

On Tuesday, Ed Davey defended the Green Deal in the face of poor take up and a recent YouGov survey which revealed that the majority of householders have little interest in energy conservation and believe instead that the energy companies should be forced to lower their charges.

In the Edge Debate on Politics of Carbon Measurement, on Wednesday, Lynne Sullivan showed that actual energy consumption in Passivhaus dwellings is 90% below the average and substantially below the best of the rest.

So the reason for the performance gap between prediction and actual outcomes in low carbon homes should be obvious to all:

Passivhaus homes are voluntary. They are built or commissioned by individuals who are already concerned about their carbon footprint and are therefore pre-disposed to a low energy lifestyle.

The Code for Sustainable Homes, Building Regulations Part L et al are well meaning in intent, but the people who will buy the homes are no more interested in energy conservation than the average Briton. They will happily leave the heating on and open all the windows.

Studies of low carbon refurbishments by social housing landlords have already shown the vast variation in energy consumption in identically refurbished flats that occurs simply as a result of lifestyle. In some cases this variation is so great that it actually masks the improvement in efficiency achieved in the refurbishment.

The message is clear. Personal preference and individual behaviour is what drives energy consumption or conservation, not fantastic building fabric energy efficiency standards, nor regulation or checklists and not energy bills (at least yet).

When are politicians going to finally wake up and admit that the climate change and energy crisis is down to the way in which we all behave, not the buildings we behave in. If we want to make any substantial progress on sustainability it is time to start apportioning blame where it really belongs: the workmen (and workwomen) not the tools. Then we need to get on with changing people’s attitudes towards energy.