Scottish Pubs Code and related regulations: business and regulatory impact assessment

Annex A

Methodology Underpinning the Cost and Benefit Estimates in the Scottish Pub Code Regulations 2024 BRIA

MRO Leases

Background

The Tied Pubs (Scotland) Act 2021 provides that the Scottish Pubs Code must require pub-owning businesses to offer a Market Rent Only (MRO) lease where a tied pub tenant requests it, except in specified circumstances.

An MRO lease is a lease where the rent is set at an amount agreed between the tenant and the pub-owning business or, failing agreement being reached, at the market rate for the property. It does not include any product or services ties.

An assessment of the costs and benefits of different options set out in this BRIA (see table 1) to deliver the MRO lease requirement of the Scottish Pubs Code is set out below. The assumptions, reasoning and methodological underpinning of this assessment is set out in this annex and is divided into the following parts:

• Transfers of profits from pub-owning businesses to tenants.
• Costs arising to tenants and pub-owning businesses due to a lack of an investment exemption.
• Costs to tenants and pub-owning businesses arising from independent assessments of MRO options.

The focus of the analysis has been on costs and benefits to tenants and pub-owning businesses. Further consideration of benefits and costs to other groups and other uncertainties are also considered.

Transfer of profits from a pub-owning business to a tenant

In principle, we assume this policy has no impact on the profitability of pubs overall (at least in the short run). All else being equal, profits of tied pub tenants that exercise their right to request an MRO lease under the code will be transferred from pub-owning businesses to tied tenants. This is presented as a benefit for tenants and a cost for pub-owning businesses in this BRIA. There may be some longer-term net costs associated with some options assessed in the BRIA arising from impacts on investment that are examined separately below.

To reflect uncertainty in the level of transfer of profit from pub-owning businesses to tenants we establish an upper and lower bound for the level of the potential financial transfer. An upper bound for the level of transfer is established by supposing a scenario in which all 700 tied pub tenants in Scotland are disadvantaged and will therefore gain the maximum transfer of profits when moved to an MRO lease.

For the purposes of calculating the upper bound, in this scenario we assume the following:

• ‘Dry rent’/Property rent unchanged: it is common practise in the sector that, as a part of a tenant’s tied lease, the rent which tenants pay on the property – referred to as ‘Dry rent’ – is set at a discount, relative to that paid by an equivalent free-of-tie tenant. This discount is due to the tie obliging tenants to purchase tied products which are typically priced above the market rate. Within this upper bound scenario, however, it is presumed that the property rent paid by a tied pub tenant would not differ to that paid by a free-of-tie pub, as it’s assumed no discounts in practice were given to the tenant in the form of reductions in ‘Dry rent’ by the pub-owning business. This would infer that there are no associated costs (or loss of benefits) from a tenant choosing an MRO lease in this scenario as there is no dry rent discount.
• Loss of Special Commercial or Financial Advantages (SCORFA) benefits: As part of research^[38] commissioned by the Scottish Government in 2016, CGA produced estimated values of SCORFA benefits. Annex 7 of the report outlines the full BBPA list of definitions for the SCORFA benefits. A range was produced reflecting differences in views between pub-owning businesses, tied-tenants, and Independent Free Trade (IFT) pubs. These total estimates ranged from £3,700 to £18,600 per year per pub. As such it is assumed that, for an average tenant choosing to move to an MRO lease, they would lose out on benefits valued at around £4,600 (the average total, based on responses from full-tied pub tenants). Adjusting this figure, to account for changes in price since the source data was published, it is estimated that the same value in 2023 price is around £5,700. The deflator used in this instance is ONS’ annual GDP Implied Deflator^[39], reflecting the average rate of inflation across the UK economy.
• Cost of tied products/‘Wet rent: In switching to an MRO lease, tenants would not be required to pay ‘Wet rent’ to their pub-owning business. Estimates published as a part of the Office of Fair Trading (OFT) final decision^[40] to the CAMRA super-complaint, indicated that the average price charged by pub-owning businesses to tenants for draught beer was around 40% to 45% higher than the price paid by free-of-tie lessees to the major UK brewers. This equated to an average difference of around £19,000 to £21,000 per year per pub for beer. As such it is assumed, in this upper scenario, that this £21,000 would represent a benefit to the tenant when choosing an MRO lease. Adjusting this figure, to account for changes in price since the source data was published, it is estimated that the same value in 2023 price is around £29,500. The deflator used in this instance is ONS’ annual GDP Implied Deflator, reflecting the average rate of inflation across the UK economy.
• Deposits and repairing responsibilities: It is assumed that there will be no substantial increases in deposits or repairing responsibilities.

In assuming the above, it would be thought that, under this upper bound scenario, the tenant in a tied pub lease is up to £23,800 worse off than those tenants free-of-tie^[41]. Taking this figure and multiplying by the estimated 700 tied pub tenants within Scotland currently (and assuming no change in the near future), gives an upper estimate for the transfer of around £16.6 million.

Conversely, a lower bound for the level of transfer can be established by supposing a scenario in which no tenants are financially disadvantaged relative to those free-of-tie on MRO leases. In this scenario, the policy would have no effect on the profitability of a pub, as no tenant would opt for an MRO lease given the perceived loss of SCORFA benefits and perceived increase in rents that could potentially offset savings from reductions in wet rent. As such, there would be no transfer of profits under these conditions. Alternatively, tenants may value the flexibility of an MRO lease as important and valuable in and of itself, even if the potential profitability of such a lease compared to the status-quo was doubtful.

The above looks to demonstrate the perceived two extremes of scale for the level of transfer for a typical tied pub. The true level of transfers between pub-owning businesses and tenants will likely lie somewhere in-between these estimates on a case-by-case basis. However, due to a lack of evidence and the effect of individual circumstances, it is not possible to provide a more precise estimate.

Costs arising to Tenants and Pub-owning businesses from a lack of an investment exemption

It is recognised that, particularly under Option 4 in this BRIA where an MRO lease request is available to tied pubs at any time (including material changes of circumstances), there is scope for the MRO lease request to disincentivise and reduce investments made by pub-owning businesses, as the MRO request could put at risk returns to the investment through lower revenue streams from wet-rent.

As a part of the consultation on the Scottish Pubs Code, proposals were included to specify circumstances where an MRO lease option need not be offered by the pub-owning businesses. These circumstances included circumstances in which the pub-owning business had invested significantly in the tenant’s pub.

The determining feature of impact for such a policy decision, is the level at which such a threshold is set – both in terms of monetary value and the length by which such an exemption would be in place. As part of engagement and related consultations, three options were proposed by stakeholders and policy officials:

• Equivalent to 1.5 times the annual rent over 5 years.
• Equivalent to 2 times the annual rent over 7 years (to match that which is in place in England and Wales).
• Equivalent to 10 times the annual rent over 7 years.

The Scottish Government’s preferred option is 5 years from the date an investment agreement was agreed, where the pub-owning business is investing in capital improvement works to the pub of to the sum of £35,000 or 1.5 times the annual rent of the pub or more, whichever is the greater.

In general, there is a lack of data available by which we can look to comprehensively understand the current level of investments made by pub-owning businesses, the drivers of such investments and the speed/ability for pub-owning businesses (and tenants) to realise their returns.

This is partly to be expected, given the varying nature and scale of any such investments within business. The impact of this policy, at an individual lease/pub level, will be dependent upon what circumstances otherwise would be. Noted in evidence given to the OFT ^[42], pub-owning businesses will offer very different levels of support and investment, and the extent of support/investment that each pub-owning business offers will differ from pub to pub. Some pubs may receive no investment in years while others may receive a significant amount of investment. For instance, in Admiral Taverns public report, they invested £10 million into 138 pubs across their group (includes pubs across GB) in the first half of 2023, with several pubs seeing investments of several £100,000s^[43]. Comments given by the SBPA^[44] also highlighted that, of its members, one in six tied pubs had received annual capital investment of around £70,000. Conversely, in response to a Committee survey^[45] in 2020, multiple tenants whose pub-owning businesses are not known stated that they’d received no investment in the pub they rented.

It is anticipated, however, that any regulatory thresholds – be the ones proposed or alternates – may result in unintended consequences, as the regulation directs (to varying degrees) investment decisions. For the following section, an illustrative example is used, assuming a threshold of £35,000 over 5 years is in place.

• Pub-owning businesses would likely be disincentivised from making investments which, combined, amounts to less than the set threshold – particularly as the amount tends towards it (£35,000 in this case). This is because it is assumed that the pub-owning business risks the possibility of not being able to realise adequate returns on investment of less than £35,000, prior to a tenant seeking an MRO lease option. Similarly, it might be expected that pub-owning businesses will reduce their level of investment which, otherwise, would have been only marginally over the exemption threshold.
• Conversely, it is possible that such a threshold will incentivise additional investment. If a pub-owning business deems that the cost of additional investment is less than or equal to the benefit – both monetary and non-monetary – that they would realise by guaranteeing a tenant maintains their tied-lease, they would be expected to invest further. Here it might be assumed that the pub-owning business had previously invested £30,000 per every 5 years. By then investing a further £5,000, they would qualify for the exemption criteria, would not be required to offer an MRO lease option and would not risk ‘losing’ their tied tenant to an MRO lease.
• Finally, we might expect that, with a single tier investment exemption, significantly larger investment might also be disincentivised. This being that, while both tenant and pub-owning business would realise benefits from the investment, the exemption period is deemed insufficient by the pub-owning business (in their decision-making process) to offset the risks associated with a tenant opting for an MRO lease option. Once again, it’s unclear as to what this upper limit might be or how applicable it is. For example, if it is deemed that investments in excess of £100,000 prove too risky but if this only occurs in one or two occasions, the overall effect is less substantial.

Conversely, it might be expected that, through the availability of an MRO lease, investment within pubs might increase, or reductions in pub-owning business funded investment could be partially offset, by tenants investing in the pub themselves. This is because tenants would benefit by retaining a greater share of any additional turnover and profit levels generated by the investment. The scope of this, however, is expected to be small as larger scale investments often depend on access to commercial finance and the cost may be prohibitive for many small pub-businesses.

Beyond the anticipated impact that an exemption threshold might have on the level of investment made by pub-owning businesses, what can also be expected is that such a policy has scope to increase the demand for independent adjudication, where pub-owning businesses and tenants disagree on the level of the investment made into the pub. Once again, the frequency of such occurrences and the scale of this cost is particularly challenging to predict.

Costs to Tenants and Pub-owning businesses arising from independent assessments of MRO options

In instances, where the tenant and pub-owning business are unable to agree on the terms of an MRO lease, it is possible that it will be referred to the Adjudicator for Independent Assessment. In these instances, there will be an associated administrative cost, composed of the anticipated cost on an Independent Assessor being appointed and the frequency at which one will be needed.

As an indication, guidance shared on the Pubs Code Adjudicator in England and Wales suggest that the fees of an appointed Independent Assessor will range between £3,000 to £6,000^[46] - subject to an agreed structure, which is banded - based on the annual rental value of the pub.

Whereas, as a part of the Tied Pubs (Scotland) Bill Financial Memorandum and based on the Pubs Code Adjudicator (PCA) for England and Wales Arbitration data^[47], it was estimated that there may be an average of 23 MRO requests in total^[48]. A proportion of these would likely trigger an independent rent assessment. Based on research commissioned by the PCA in England and Wales in 2021^[49], we estimate around a third of cases (approx. eight per year) may seek an independent assessment as part of the MRO process. This gives a lower estimate of the expected cost of £24,000 and a higher estimate of £48,000 per year. The rent assessor’s fees are to be split equally between the pub-owning business and the tenant.

It should be noted, however, unlike in England and Wales, the right of tied pub tenants to request an MRO option in Scotland will largely be automatic, although it is subject to some exemptions. This may mean that there are proportionally higher numbers of requests to exercise the right to request an MRO option in Scotland. This may in turn mean that the numbers of MRO related arbitration referrals, such as for independent assessment, to the Scottish PCA are higher than the figures estimated above.

Limitations of analysis

‘Dry rent’/Property rent – Within the OFT's response to the CAMRA super-complaint, they set out that estimates (provided to them by certain large pub companies, and publicly available data regarding property rents), suggested that tied tenants benefit from rents that are approximately £10,000 to 12,000 per annum lower than rents for free-of-tie tenants.

Whilst intelligence gathered from the consultation and subsequent discussions does point towards the level of ‘Dry rent’ discount decreasing, it’s less apparent that it has reduced to zero, as it is assumed within the upper bound scenario analysis above.

The ‘Dry rent’ that a tenant pays their pub-owning business will be dependent upon several factors (i.e., location, business performance, etc.) and will vary on a case-by-case basis. Owing to this and other drivers, the discount which tenants are offered by the pub-owning businesses, if they are to enter into a tied-lease, will also vary.

‘Wet rent’ - The ‘Wet rent’ will vary between the pub-owning businesses and between pubs within companies. The range provided, based on analysis completed by OFT in 2010, has limitations both in terms of the assumptions made within its calculation and coverage. Within the OFT’s analysis, it is recognised that average prices estimated for individual free houses (the counterfactual) may understate the prices actually paid (thereby exaggerating the difference between the prices paid by tied pubs and free houses).

SCORFA benefits – Similar to ‘Wet rent’, the SCORFA benefits will vary between pub-owning businesses and between pubs within pub-owning businesses. Additionally, it is noted that the value of these benefits to tenants is highly subjective and there is no agreed consensus. Within the research conducted by CGA, its apparent that the value placed on the SCORFA by agents varies significantly – both in terms of the overall value and individual components.

Changes to pub profitability – In the analysis we assume no change in the overall profitability of a tied pub under any option. During the consultation, however, it has been raised that by tenants choosing an MRO lease and to go free-of-tie, that a pubs profitability could either improve through greater autonomy of the tenant or worsen through the loss of economies of scale.

Change in pub-owning businesses behaviour – Based on responses to the consultation, it is apparent that pub-owning businesses will seek to change their business operation in response to some aspects of the code. Where a tenant moves to an MRO lease, there will be a subsequent impact on the pub-owning business’s revenues and costs. On the one hand, they will no longer need to provide services to the tenant or arrange for distribution of tied goods. On the other, the pub-owning business will lose revenue through the loss of ‘Wet rent’ as the tenant sources their beer from the open market. The pub-owning business will also receive a different ‘Dry rent’ from the tenant. This then may result in the pub-owning business seeking to:

• Sell on pubs that have gone free-of-tie, which it no longer considers viable.
• Alter agreements with existing tied tenants to offset increased marginal costs.

Additionally, with the policy offering tenants the option to request an MRO lease at any point within the lifespan of a tied pub lease, it was argued within consultancy responses that this could disincentivise pub-owning businesses investing significantly in the associated pubs – arguing that they would be unable to realise the returns on such investment. These impacts may also be faced by tenants who do not wish to request an MRO lease, as pub-owning businesses may pre-emptively take action to reduce uncertainty and risk of tenants choosing to go MRO at some point in the longer-term.

Change in tenants’ behaviour – When a tenant chooses to request an MRO lease option, it does not necessarily mean that they will eventually accept the associated offer. Instead, the prospect of a tenant choosing an MRO lease option could result in some pub-owning business choosing to offer improved terms for the tenant to choose to remain tied. Likewise, there is scope that tenants will seek an MRO option as a means to assess the fairness of their existing lease.

This is borne out in figures on the adoption of MRO options in England and Wales, reported by BBPA^[50]. Of the 1,381 MRO notices which have been received and where an outcome has been reached between 2016 and 2023, 26% resulted in a free-of-tie agreement, whilst 58% resulted in a new tied arrangement being agreed. It should however be noted that take-up of MRO leases in Scotland is expected to be higher than it has been in England and Wales.

Additionally, whilst it has been stressed that the tenant’s choice to move to an MRO lease would discourage pub-owning businesses from investing in the associated pub(s), it is likely that it would encourage tenants to invest in their businesses, as they would benefit by retaining a greater share of additional turnover and profit levels generated by any investment programme.

Independent assessment and take-up of MRO leases – In the above calculations, it has been assumed that the proportion of Scottish MRO negations that go into independent assessment closely mirrors the percentage of MROs that go into independent assessment in England and Wales. However, it is expected that the take-up of MRO leases will be higher in Scotland than in England and Wales, with less restrictions and an automatic right to the MRO option for tenants. Therefore, it may very well be that the incidence of independent assessments in Scotland will be higher than in England and Wales. Nonetheless, with absence of further evidence, it is difficult to provide a better estimate.

Age/Suitability of data – Some of the data used within the above analysis can be considered out-of-date and that the associated figures fail to capture the current situation. However, without more current data available it is not possible to infer what more up-to-date figures would look like. To address this, additional insights from key stakeholders would be required, to provide new, more up-to-date estimates or context as to how the markets have developed over the recent past. The statutory review of the Scottish Pubs Code and the Adjudicator, expected in 2026 may provide a further opportunity to collect new information.

Costs and benefits which are not quantified in this BRIA

Costs to consumers – Reported low profit margins for pubs would suggest that there is limited capacity to absorb new costs and, as such, new costs would be passed on to consumers. If the policy was to result in additional costs, there is scope that these will be passed on to consumers.

Benefits to brewers – As tenants choose an MRO lease and go-free-of-tie, they have the ability to source their beer free from the restrictions of a tie. Within this there are two possible responses with implications for brewers:

1. The tenant may choose to source some/all its supply of beer from their pub-owning business. Whilst this would not offset the loss in ‘Wet rent’ (given the aforementioned price differential) for the pub-owning business, it would offset some of the lost revenue.

2. The tenant may choose to source some/all its supply of beer from another brewer/wholesaler. Holding all else constant, this would represent an increase to the brewers’ revenue streams.

The scale of these, however, whilst difficult to estimate, is also highly uncertain both in terms of how many tenants go free-of-tie and how their respective pub-owning businesses will behave as a consequence.

Burden of risk – The tie can be perceived to act as a risk-sharing mechanism, as total rent paid to the pub-owning is dependent upon the profitability of the pub. If a tenant has a ‘good’ year, they will pay more ‘Wet rent’. Conversely, in ‘bad’ years they will pay less. By a tenant choosing an MRO lease, the tenant will retain more of their profits. However, they will be more exposed to market fluctuations than they would under a tied agreement. As such, it can be considered that the tenant will shoulder a greater share of these risks in such a case, whilst the opposite will be true for the pub-owning business.

Improved certainty for market agents – It has been noted in several discussions, by various stakeholders, that the prospect of a Scottish Pubs Code being introduced, with uncertainty of what the code would entail or how it would be enforced, have resulted in certain pre-emptive behaviours (particularly by pub-owning businesses) to manage associated and anticipated risks. These include the cessation of investment and short-term new leases. Regardless of which option is taken, it would provide the sector with greater certainty about the detail and likely impact of the code on business.