forrest through the trees

My roommate pointed out re: this post that there are a number of different EE financing models currently being developed and recommended Capital-E’s incredibly detailed summary of the current EEF landscape. To process it all, I’m breaking the learning process down into digestible chunks. 

Mortgage-backed Energy Efficient Financing (EEM)

The overview for EEMs is very simple. A property owner can roll their EE project into a new or refinanced mortgage to gain a number of benefits: the repayment period is matched with the length of the mortgage, effectively amortizing costs; energy savings are assumed to exceed the amortizing costs, increasing the borrower’s ability to pay and lowering their risk of default – this in turn can justify a lower interest rate; and the combination of EE and mortgage financing significantly reduces transaction costs. 

Maine, New York, and Colorado each have ENERGY STAR Mortgage programs that buy down associated interest rates, but government involvement is not strictly necessary for EEM to be an effective tool for increasing residential energy efficient.

(The ongoing mortgage crisis will have a smothering effect on the refinancing side of things for the foreseeable future.)

Preferential Terms for Green/EE Buildings

In an ideal world, EE building would receive preferable terms for loans and mortgages since they have:

• lower operating costs;
• lower risk of default;
• lower chances of building system failures, shutdowns;
• higher operating incomes;
• higher asset values;
• and higher health/productivity benefits for workers. 

Making this a reality means collecting a wide body of evidence to that effect. That’s a tall task, but the upside to this strategy is that it doesn’t require new programs or bureaucracy, just the attention of investors. 

State/Municipal Loan Programs

Similar to on-bill financing in that home-owners can pay back EE loans via their utility bills, these programs typically originate at the local level and are funded by a combination of federal grant money, rate-payer funds, bond issuance, and systems benefits charges. If states and municipalities can achieve the necessarily high degree of collaboration across departments, agencies, program administrators, and private contractors, this approach can concentrate expertise, opportunity, and funding in a single place — DOE and EPA can offer key technical assistance in this regard. Close coordination can integrate significant job creation while certain program structures also facilitate access to outside capital.

Excellent examples include Portland’s Clean Energy Works Program (CEWP), Pennsylvania’s Keystone HELP, and the Texas LoanSTAR program. (The LoanSTAR link is particularly persuasive.)

The big knock on this approach is the frequently temporary nature of its funding — see: ARRA — though New York’s successful and evolving utilization of a Systems Benefit Charge (SBC) shows how this hurdle might be overcome since SBCs remain stable apart from year-to-year fluctuations in state funding (18). For example, NYSERDA’s New York ENERGY STAR Homes Program had accounted for 24% of new homes in the state as of September 2010 after an initial market penetration of 1% in 2001 (Appendix B, 11).

Sustainable Energy Utilities (SEUs)

Delaware’s SEU is the go-to model, so let’s start there:

The most important feature of the SEU is that energy users can build a relationship with a single organization whose direct interest is to help residents and businesses use less energy and generate their own energy cleanly. Directly put, the SEU becomes the point-of-contact for efficiency and self-generation in the same way that conventional utilities are the point-of-contact for energy supply.

• The SEU does not supplant other private-sector activities, but complements them by providing a focal point for energy efficiency and renewable energy information, expertise, and incentives. The SEU model will encourage inventors, adaptors and entrepreneurs to bring their innovations to the marketplace.

• The SEU is a public/private partnership that uses public funding sources and consumer savings, combined with private sector funds and management skills, to address the shortcomings of traditional approaches. (2)

The SEU takes care of pre-screening projects, establishes measurement and verification practices, and covers the incremental cost between conventional and EE projects. The project’s ESCO then contracts with the customer to repay the loan, typically over 3-5 years. 

SEUs are particularly promising thanks to their compatibility with secondary capital markets. In Delaware, the SEU worked with Citigroup to pool many of these projects and leverage the state’s AAA rating to issue the nation’s first EE tax-exempt bond. This prompted secondary investors to collectively invest $72M in the bond. 

It seems like this model could enjoy wider adoption in better economic times, once state legislature’s a more willing to commit to new state-wide bond authorities.

Carbon Market Funding

This model, predicated on the existence of a carbon market like the Regional Greenhouse Gas Initiative (RGGI) or California’s pending market, would allow property owners who invest in EE projects to monetize the resulting CO2 reductions via the carbon market. It relies heavily on intermediary energy management and demand response firms like EnerNOC; because they already facilitate the measurement and aggregation of data on reduced emissions, the strategy envisions qualifying these DR firms to broker their customers’ carbon offsets on the market. Aggregating data from many individual EE projects through a handful of qualified firms would ensure the savings, validate their market value, and provide the customer an immediate return on their EE investment. 

Property Assessed Clean Energy (PACE) - Commercial

Where authorized by state law, local governments can fund EE projects for commercial, industrial, and 4+ family residential properties with long-term loans secured by a lien on the property and paid via a property tax surcharge. 

Cap-E also cites the regional approach to PACE being explored by the Carbon War Room in which:

• a Project Developer receives exclusive rights to market PACE financing within a particular jurisdiction;
• a Credit-worthy Contractor implements an EE project and ensure the savings in conjunction with;
• a 3rd Party Insurer who underwrites an insurance policy to back the guaranteed savings;
• and a Capital Provider finances the projects with low interest-rate, short-term loans that can be bundled into long-terms bonds and sold to institutional investors.

They estimate that this regional approach, being tested in Sacramento and Miami, will finance around $650M in EE projects over the next few years (24).

The upside: because PACE attaches loans to properties, they can transfer with ownership and extend for longer terms, in turn allowing for more favorable terms and easier refinancing options down the line. Lower rates and longer terms also make these projects more cash flow positive. Sufficient scaling of commercial PACE projects could attract significant funding from institutional investors. And there are no FHFA run-ins because mortgage consent is required.* 

The downside: mortgage consent can be difficult to secure and the program is only available to property owners. There are significant setup costs incurred by the municipality in establish PACE, setting a high bar for project costs ($2,500+, 25). In many instances, Class A building owners prefer self-financing.

*PACE residential went kaput thanks to FHFA protestations over the prioritization of liens.

My roommate pointed out re: this post that there are a number of different EE financing models currently being developed and recommended Capital-E’s incredibly detailed summary of the current EEF landscape. To process it all, I’m breaking the learning process down into digestible chunks.

Energy Services Agreements (ESAs)

ESAs combine a traditional power purchasing agreement (PPA) with the creation of a special purposes entity (SPE) to finance large commercial/industrial EE projects while limiting risk. Under an ESA, the customer contracts with an investment fund to facilitate all aspects of an EE project in exchange for payment of a fixed or floating portion of the energy savings over the duration of the contract. The investment fund establishes an SPE that is capitalized by itself and third-party investors, pays all project costs through an ESPC/ESP, and retains ownership of project equipment. 

 

(14)

This has a number of benefits for the commercial/industrial customer: there are no upfront costs; the contract payments are treated as an operating expense and can be passed on to tenants, resolving the split incentive; payments as an operating expense also keep the costs off balance sheet, removing complications re: credit risk and prior financing; and the customer gets to outsource their EE project to a developer that already knows what it’s doing.

At the same time, SPEs make this model particularly attractive to specialized investors and their prospective partners by cordoning risk by individual project investments. Many projects yield equity rate of returns, and any tax benefits or incentives garnered by the project pass to the investors, as well (9). If the model can be brought to scale, risk could be further reduced across a wide of array of projects and sold to institutional investors. 

But all of this hinges on the ESA’s ability to keep project financing off balance sheet as an operational rather than a capital lease. Financing Efficiency has a good explanation of why this is important and how proposed changes could handicap this approach, but the takeaway is that off balance sheet financing “allows organizations to install energy efficiency retrofits at no up-front cost and without impairing their existing debt picture, or market value.” 

They estimate that just 5% of EE projects are currently structured off balance sheet. Development of an assured ESA framework could greatly increase that number if standards continue to accept this operational approach.

My roommate pointed out re: the last post that legislation is but one of a number of steps that must be taken in order for on-bill financing to be a scalable driver of energy efficient renovations, and that OBF is but one of the many financial models currently being developed to address different building sectors [(R)esidential, (C)ommercial, (I)ndustrial, (M)unicapilities (U)niversities (S)chools (H)ospitals], include different players, and take advantage of different loan repayment types.

He also recommended Capital-E’s incredibly detailed summary of the current energy efficiency financing landscape but warned against “falling too far down the EEF rabbit hole.” Clearly I didn’t listen. For each section or rereading, there seem to be a dozen new directions or white papers to check out. In order to process it all, I’m going to try and break the whole learning process down into digestible chunks, starting with…

Energy Savings Performance Contracting: ESPCs

A property owner – typically in the MUSH market – works with an energy services company (ESCO) to develop, find financing for, and implement an EE project. The ESCO determines baseline energy use alongside projected energy savings, and the contract terms and length (10-20 years) are set so that the energy savings outpace the loan repayment schedule. The ESCO monitors and maintains the project installations over the life of the contract and typically guarantees prescribed savings to the customer, creating a financial commitment from the ESCO to make sure the project is successful. The savings are split between the customer and the loan repayment until the end of the contract, at which point the customer retains all residual savings. 

Everything about ESPCs is done on a large scale: 

• the customers are traditionally large MUSH market entities; 
• the projects are comprehensive, encompassing multiple EE approaches; 
• the funding can come from a variety of sources ranging from debt and tax equity to utility incentives, government grants, and state revolving loan funds; 
• the contract term is typically at least ten years; 
• and the development period can be protracted owing to the complexity of blend funding and credit assessments. 

The 30-year track record of successful ESPCs also yielded the International Performance Measurement and Verification Protocol (IPMVP) whose standardized terms and best practices can facilitate further scaling of this model.

Furthermore, there are benefits to the ESPC approach that are particularly appealing to the MUSH market. Third-party financing curtails the amount of time it would otherwise take to get a large, public project approved and completed. The ESCO selection process emphasizes high qualifications rather than low bids, as with design, bid, bill (DBB). And the ESCO’s full assumption of accountability reduces customer risk should problems arise (4). 

ESPCs, however, are not as yet suited for smaller projects. They are cost- and time-intensive, making smaller projects less appealing for ESCOs. ESPC projects are incredibly varied, making standardization of financing and the establishment of a secondary market difficult. And the Dodd-Frank Act will also impact the role ESCOs play in energy savings performance contracting, as summarized by Senators Landrieu and Coons here.

—-

In 2006, 82% of ESCO industry revenues came from the MUSH market with the remainder divided among the Commercial (9%), Industrial (6%), and Residential (3%) sectors, and yet C/R/I accounts for ~80% of energy use in the United States (19). Which suggests why ESPCs are such a natural starting point…

ESPCs offer a good starting point for a number of reasons. Their established history offers insight into the way customers, providers, financiers, and policymakers come together to approach a particular set of EE questions.

They touch on a number of the issues — regulation, aggregation, securitization, lien priority, sufficient data collection, transaction costs — hindering other forms of EEF.

But most of all, those 2006 numbers indicate the tremendous growth potential that can be unlocked by further innovation in energy efficiency financing.