With this installment, we turn to a transcript that was first published in the Project Finance NewsWire in February 2013 written by James Berger, an associate in our project finance group.
ObstaclesHowever, there are several obstacles to such investments.
One obstacle is the high upfront capital costs. More efficient equipment is often more expensive than less efficient equipment. Retrofitting a building can be prohibitively expensive for the building’s owner. Many homeowners or building owners are reluctant to make investments that can take years to show a return or else they have higher priority uses for their capital.
Another obstacle is uncertainty about the amount of savings. While it is easy to calculate how much energy a piece of equipment or a building uses, it is much more difficult to calculate how much energy has been saved as a result of an energy efficiency upgrade. Standardizing protocols and models for accurately predicting and measuring the energy savings of different energy efficiency investments is important to create accurate financial models.
Another obstacle is most energy efficiency investments are illiquid. The lack of an easy or quick exit prevents many would-be investors from participating in this market. Tradable financial assets backed by energy efficiency improvements might be able to find a more ready market than direct investments in the underlying energy efficiency improvements.
Another challenge is scale. Upgrading the energy efficiency of a whole commercial building will always be a smaller investment than building a utility-scale wind or solar project. The low-hanging fruit of energy efficiency could provide billions of dollars of investment opportunities and very attractive returns, but it will require taking a page out of the books of residential solar companies that package portfolios of small rooftop solar installations to finance in master financing facilities in order to lower transaction costs and reduce risk through diversification.
Several different strategies for financing portfolios of energy efficiency investments have emerged.
PACEResidential PACE (or property assessed clean energy) financing is used to install renewable energy systems such as solar panels on a residential roof and make energy efficiency improvements in a home.
Pursuant to special legislation, a local municipality borrows money in the capital market by issuing bonds. The municipality then lends the proceeds of the bond offering to homeowners who want to install renewable energy equipment or make efficiency improvements. In some cities, water conservation measures can also be funded. The homeowner repays the loan through a special property tax assessment that attaches to the property.
This addresses the problems of high upfront costs as a deterrent to make improvements. Loans to homeowners can run as long as 20 years. The loans are also on favorable terms because the municipality can borrow more cheaply than the homeowner can. The loan amount is based on the tax capacity of the property rather than the homeowner’s credit.
The obligation to repay the loan transfers to a purchaser if the property is sold. This allows a homeowner to decide whether to make improvements without worrying whether they will pay off before selling the home.
PACE loans effectively subordinate all other lenders’ security, because the PACE loan is repaid as part of the property tax assessment, which is superior to all other obligations. This means that mortgage lenders end up subordinated to the municipality.
In 2010, the Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, issued a statement indicating that it would not allow PACE loans to take priority over mortgages that are federally insured. Most PACE programs have had to be suspended as a result. Some states have subsequently passed legislation that removes the senior lien status and leaves PACE loans in a subordinated position to mortgage holders.
Currently 28 states and Washington, DC have passed legislation permitting PACE financing.
Commercial PACE programs have been implemented in California and Colorado. The structure of the commercial programs is similar to the residential programs: a municipality issues bonds and the proceeds are borrowed by building owners to install renewable energy systems or make energy efficiency upgrades. A key difference is that mortgage holder approval is required. In addition, the Federal Housing Finance Agency’s stance on residential PACE programs does not apply to commercial PACE programs.
The financing potential for commercial PACE is huge, with an opportunity to invest $88 to $180 billion in improvements to large commercial buildings alone.
There are three types of bonds that can be issued under commercial PACE programs. A pooled bond is where applications are aggregated and a revenue bond is issued to fund proposed projects. A stand-alone bond can be used for very large projects. This is when a revenue bond is issued to fund an individual project or a small number of substantial projects. Finally, an owner-arranged bond is where an owner arranges project financing with a private lender and the lender accepts a PACE-like repayment arrangement.
Only a limited number of residential and commercial PACE bonds have been issued to date in California, Colorado, Minnesota and Ohio in amounts ranging from $40,000 to $9.75 million. Resolving the subordination issue and the Federal Housing Finance Agency’s objections, as well as increasing awareness and the volume of issuances is important to this market. Commercial PACE can expand once more states pass the appropriate legislation.
SecuritizationDespite securitization’s bad reputation in the wake of the financial crisis in which securitized residential mortgages played a large role, many types of loans, such as auto and credit card loans, are still regularly securitized and sold to investors. There has been talk for months about the securitization of residential solar system leases and power purchase agreements.
Some investors are now looking at securitizing portfolios of energy efficiency loans, including PACE loans.
Securitization of such loans would work like any other traditional securitization. First, a bank or other financial institution would pool energy efficiency loans by purchasing them from lenders. Next, the bank would engage a loan servicer and segregate the pool of loans into discrete pools of assets that reflect differing categories of risk. Notes secured by the receivables from these pools of assets would then be marketed and sold to third-party investors. This model could give large investors a relatively safe investment that returns a specified interest rate while also giving the original lenders new capital with which they can make new loans.
Securitization of energy efficiency loans may remove some of the obstacles associated with investing in energy efficiency. First, securitization would make a fresh source of capital available to lenders. Second, it would provide a liquid market for investors, which could attract more capital to the market.
Determining the risk of default of the underlying loans is a hurdle that must be overcome. The risk associated with PACE loans is low in cases where the loans have a senior lien on the property associated with the loan. For non-PACE loans that do not have a senior lien, the risk of default would have to be based on the creditworthiness of the borrowers. There are not enough years of data on default rates.
Because securitized energy efficiency loans will be backed by the receivables of many different loans, creating standardized protocols and methods for determining the savings from certain energy efficiency investments is very important. The securitization model rests on being able to pool loans based on risk and return.
Some bankers expect that the first round of securitized energy efficiency loans will hit the market in 2013.
Fund ArrangementsLarger projects are needed in which to invest to provide the market with opportunities for scale. With fewer and larger projects, there will be lower transaction costs and, theoretically, a higher return.
Investment funds, which can aggregate tens or hundreds of millions of dollars of investable capital, can make large energy efficiency investments using one of two similar arrangements.
One arrangement is an energy savings performance contract where an investment fund serves as an intermediary between a building owner and a service provider who installs and, to the extent necessary, operates and manages energy efficiency upgrades. The investment fund provides the financing for the improvements and owns them, usually through a special purpose entity used for a specific energy efficiency project. This only works for large projects.
The building owner agrees to pay the investment fund a regular service charge that will repay the investment as well as provide a return on the invested capital. The service charge is an amount per unit of avoided energy. This arrangement protects the building owner from ever paying more per month for energy than before the parties entered the contract.
The investment fund enters into an agreement with a service provider that will make the energy efficiency upgrades and be responsible for ongoing monitoring and maintenance. Continuous monitoring is needed to measure the energy savings. In some transactions, the agreements with service providers include a performance guarantee to ensure specified energy efficiency targets are met.
An alternative to pricing based on energy savings is to use a managed energy services agreement where the investment fund pays the building owner’s on-going utility bills directly and charges the building owner a fixed monthly fee equal to the building’s historical energy rates, adjusted for occupancy and weather-related variables, both of which must be negotiated and agreed upon prior to entering the transaction. Obviously, the fee charged must be less than what the building owner is paying currently for utilities for the arrangement to be attractive.
The investment fund generates revenue by capturing the difference between the building’s old energy costs and its decreasing energy costs as the building is made more efficient over time.
An advantage of a managed energy services agreement is that it reduces diverging incentives in multi-tenant buildings where the building might have an incentive to pocket the savings from the efficiency improvements while charging tenants full cost for utilities. This will not maximize reductions in energy usage. In addition, because repayment in managed energy services agreements is tied through the utility bill, the risk of tenants or building owners failing to make a payment is reduced (when compared to energy savings performance contracts) because the tenant or building owner will have to pay the bill to keep the lights on or the hot water running.
Both types of arrangements typically provide an option for the building owner to purchase the equipment or other upgrades at the end of the contract with the investment fund. The owner of improvements can depreciate them, and many types of improvements also qualify for tax credits. The building owner cannot be expected at inception to exercise any purchase option or the investment fund will not be considered the tax owner of the improvements. The fund will also have a hard time claiming tax ownership of any improvements that cannot be removed and deployed economically at the end of the contract term. The contract must not be so long as to mean that the improvements have been dedicated to the building owner for substantially their entire economic life. Inability to claim tax ownership may not be fatal; it just affects the economics.
Both of the arrangements described earlier are new with only minimal track records. The kinds of investors that would invest in a typical investment fund may not be willing to invest in a fund that makes energy efficiency investments through these types of arrangements. Time will tell.