2. Rationale for government intervention
This section considers why the presence of market failures means that government intervention can help improve the functioning of the private rented sector with respect to energy efficiency upgrades, with potential benefits not only for parties in the private rented sector, but also for wider society.
The first type of arguments consider various forms of market failure which mean that energy efficiency upgrades may not be installed even when the private net benefit is positive. The second type of arguments broaden the discussion to consider why market failures relating to wider factors such as greenhouse gas emissions and health mean that upgrades whose social net benefit is positive may not be installed. Distributional issues, i.e. the impact on the less well-off in society, further strengthen these arguments.
2.1 Misaligned incentives
In the private rented sector, landlords generally are responsible for paying for improvements to the dwelling, while tenants are responsible for fuel bills. This can result in a misalignment of incentives in relation to energy efficiency upgrades since the landlord is directly responsible for the cost while the benefits from reduced fuel bills flow directly to tenants. As a result, energy efficiency measures may not be installed even if the fuel bill savings over the lifetime of the upgrade would more than compensate for the capital costs of the upgrade.
However, the economic impact on parties is often not identical with who pays for particular items. In this case, the potential misalignment of incentives from parties being responsible for different financial elements can be mitigated if the landlord is able to capture some of the benefit to the tenant from lower fuel bills by being able to charge a higher rent for a property with a higher quality. Where the expected fuel bill savings over the lifetime of an upgrade are higher than its cost, it is possible for both landlord and tenant to be better off from installing the upgrade: the landlord from being able to receive an additional rent which more than covers the cost of the upgrade, and the tenant because the increase in their rent is less than the decrease in their fuel bills, reducing their total expenditure.
However, there are a number of factors set out below, such as imperfect information relating to the impact of energy efficiency measures and the difficulty which people experience in assessing a varying stream of benefits over time, which mean that in the absence of regulation the market will fail to provide the optimal level of energy efficiency upgrades. The more difficulty tenants have in valuing the benefits of energy efficiency, the smaller the incentive that landlords have to retrofit their properties.
2.2 Imperfect information
The market in energy efficiency measures in the residential sector may be hampered by imperfect information about the benefits of installing measures. To some extent, these can be mitigated by the availability of standardised reports such as EPCs. However, the savings from an upgrade also depend on the way that a given household uses fuel in a particular property – the energy savings in the same dwelling will vary depending on how many people are in the household, how long they spend in the house, which rooms they prefer to heat and to what temperatures, etc. Thus, apart from the issue of whether households are able to understand EPC reports so that they take the EPC rating into account when choosing a property to rent, there is the further issue that it may not be easy for them to know on the basis on an EPC – which uses standardised occupancy and use assumptions – what their actual fuel bill will be.
This effect is compounded by relatively short tenure in the private rented sector: as evidenced in section 4.2, around half of tenancies end within two years. Thus tenants are often moving into new properties, and it may take them some time to learn what their fuel bills will be in a particular house, especially as there is significant seasonal fluctuation in fuel use.
As a result, when comparing two properties, one with a lower rent but with worse energy efficiency, and another with a higher rent but with better energy efficiency, households may focus on the more visible and certain extra rent they will have to pay for the second property, as against the less visible and more uncertain savings from lower fuel bills in the first property, even if fuel bill savings are potentially significantly larger.
2.3 Failures of rationality
Empirical evidence suggests that people can have particular difficulties when weighing up the impact of factors which are spread over time. In the case of the benefits of energy efficiency upgrades, adding to the complexity is that the savings can be quite different over different points of time, due to the strong seasonal pattern of fuel use. The fact that savings will also depend on future trends in fuel prices may further increase the complexity of the calculation that the household must make.
2.4 Economies in the installing market
The introduction of regulation can help guarantee minimum levels of demand for energy efficiency upgrades. This can give installers confidence to invest in equipment and training to meet the demand, and a larger market may also provide efficiencies through economies of scale and learning-by-doing effects. If a trajectory is set to a D, around 83,000 dwellings will ultimately need to be upgraded by 2025 due to regulating energy efficiency in the private rented sector.
2.5 Securing permission from multiple owners
The introduction of regulations in the private rented sector may also make it easier to obtain agreement for the installation of energy efficiency measures which affect communal elements, where the approval of more than one owner is required. This may assist social landlords who are attempting to reach the Energy Efficiency Standard for Social Housing, as well as assist owner-occupiers, who voluntarily wish to undertake energy efficiency upgrades, where their properties form part of mixed-tenure blocks which include private rented dwellings.
2.6 Greenhouse gas emissions
The case for regulation is further strengthened by taking into account the costs imposed on society from the greenhouse gas emissions produced by fuel use. Since the costs to society from climate change caused by greenhouse gas emissions are not fully reflected in the price of carbon-intensive fuels, the social benefits from energy efficiency upgrades are even larger than the private benefits from lower fuel bills.
As a result, even for dwellings where, due to their particular characteristics, the net private payoff from upgrades may be marginal or even negative, from a social point of view upgrades can still have a positive net benefit once the social benefits from reduced emissions are taken into account.
The analysis undertaken for the Climate Change Plan has shown that conservation measures in the residential sector form part of the least-cost path to society for achieving the greenhouse gas emissions reductions required by legislation.
2.7 Distributional impacts
The amount of energy consumed is a relatively fixed component of households' monthly spend, and accordingly expenditure on energy bills typically consumes a greater percentage of income for lower-income households than for higher-income households. This can result in these households facing a trade-off between paying for adequately heating their homes and spending on other basic goods and services.
By overcoming market failures in the private rented sector, and thereby increasing the energy efficiency of homes and reducing fuel bills, regulation can help improve the well-being of some of the more vulnerable households in Scotland.
2.8 Health and wellbeing impacts
In the private rented sector, around 7% of households report that their heating never keeps them warm in winter and a further 19% that it only sometimes does. The corresponding rates for all Scottish households are 4% and 14%.
Living in these low indoor temperatures may pose a risk to health due to the range of negative morbidity and mortality impacts associated with exposure to cold and damp conditions. The 2011 Marmot Review Team report, the 2012 Hills Fuel Poverty Review and the 2013 Cochrane Systematic Review set out the significant body of evidence linking low indoor temperatures to these poor health outcomes, particularly for those most vulnerable to the effects, i.e. young children, the elderly, and people with physical and mental health conditions.
The Scottish Government commissioned an evidence review from Aether covering the potential wider impacts of climate change mitigation in the built environment, which was published in January 2017. The review highlighted the impact which a range of building fabric improvements can have upon the health of residents of the building. Notably, studies have found that "improvements in insulation can result in direct effects on winter mortality and potentially morbidity as well as indirect effects e.g. through reductions in mould growth" (Wilkinson, 2009). In order to obtain the health benefits from energy efficiency upgrades, the measures must be installed, operated, and maintained correctly, e.g. to avoid issues such as mould growth arising due to insufficient ventilation when insulation is applied.
In addition to physical health benefits, the evidence review by Aether highlighted research showing that fabric improvements to improve energy efficiency can offer a range of mental health benefits. These mental health benefits are often related to reduced stress from a reduction in fuel bills as a result of increased energy efficiency.
Studies show that improved housing conditions can also increase wellbeing, for example with regards to increased satisfaction with the home and reduced social isolation (Grey et al, 2017; Willand et al, 2015).
These potential health benefits, both physical and mental, further support the case for regulation, particularly since market failures relating to imperfect information (section 2.2) and failures of rationality (section 2.3) are particularly likely to apply to a household's ability to assess these long-run health impacts. Health impacts also strengthen the arguments based on distributional impacts (section 2.7) because they are most likely to be significant for vulnerable households. Finally, the costs to society resulting from greater demand for public sector services such as the NHS are analogous to the types of costs to society from greenhouse gas emissions discussed in section 2.6, and offer a further argument in favour of regulation.