There is no more important work being done in American infrastructure than energy efficiency.
Buildings use more than 70% of the electricity generated and more than 40% of the natural gas used in the U.S. The existing U.S. building stock is extremely energy- inefficient. The DOE’s Energy Information Agency estimates that 30% of energy used in commercial buildings is wasted. In a 2009 report, McKinsey & Company estimated that energy savings worth $1.2 trillion are available if the full amount of economically viable and commercially available energy efficiency projects is implemented in the U.S. through 2020. Achieving these savings would require an upfront investment of $520 billion.
Of course, not all economically viable and commercially available energy efficiency projects will be built, and it will take a number of years to approach the deep market penetration referenced in the McKinsey study. At the same time, energy efficiency technologies and applications are advancing at a rapid pace, resulting in an ever-growing market. As is often said in the industry, energy efficiency is the “low-hanging fruit that continues to regrow”.
The estimates of the current size of the annual building energy efficiency market vary depending on the definition of the market measured, but all studies indicate that the market is large and growing. Using a narrow definition of the traditional Energy Service Company (ESCO) market, Lawrence Berkeley National Laboratory (LBNL) estimates it at approximately $7 billion in 2011. This narrow definition does not include companies such as engineering and architectural firms, HVAC, lighting, windows or insulation contractors, and consultants that offer energy efficiency services but typically do not enter into long-term contracts that link compensation to the project’s energy savings and/or performance. Using a broader definition of the market, which includes the types of entities excluded from the LBNL report, FMI estimates the market at more than $20 billion in 2011. Regardless of the starting definition of the market, all studies point to continued growth over the next several years, most often 10% or greater. FMI’s current estimates show about a 15% compound annual growth rate through 2020.
Even with such a huge and obvious value-creation opportunity, certain obstacles limit the growth of this market. Typical growth constraints cited include:
- Lack of awareness and focus on energy efficiency opportunities
- Skepticism regarding the economics of energy efficiency opportunities
- Unduly complex, nonstandardized and expensive transaction structures
- Scarcity of skilled project development talent
- Lack of prepackaged, simplified project funding — particularly in the commercial real estate (CRE) sector
- Split incentives (e.g., in certain situations when a building owner, who will incur the retrofit capital expenditure, is not the building occupant, who will benefit from reduced operating costs)
Companies that lessen any of these constraints to the building energy-efficiency retrofit market should grow quickly and capture strong profits.
This article focuses on the project financing constraint mentioned above and how companies can work with third-party financiers to deliver a prepackaged financing solution to clients. More specifically, it will look at the project financing markets for four building energy efficiency retrofit verticals — federal, MUSH (municipals, universities, schools, hospitals), institutional, and commercial and industrial. Projects in each of these markets are financed differently.
A FINANCIER’S PERSPECTIVE OF ENERGY EFFICIENCY PROJECT FINANCING
Most energy efficiency retrofit projects funded by third-party financiers are considered performance contracts since the ESCO provides some form of guarantee regarding the energy savings (in units of energy, not dollars) that will be generated by the project.
The value proposition of a performance contract is simple. The net present value (NPV) of energy and operating savings, plus any rebates or incentives, must equal or exceed the total costs of the retrofits (i.e., the project must have a neutral or positive NPV). In essence, the upfront costs of Energy Conservation Measures and Facility Improvement Measures, plus the financing and certain other costs are “repaid” from the energy and operating savings, rebates and incentives generated by the project. As a practical matter, most projects are designed to be “cash-flow- neutral”, where the savings, rebates and incentives pay the principal and interest arising from the lease, loan or other financing structure used to fund the project. A simplified cash flow model for a theoretical $1 million energy efficiency retrofit project is shown in Exhibit 1.
There are numerous rebates and incentives as well as government and utility policies that must be considered when developing performance contracts. The website www.dsireusa.org, maintained by North Carolina State University, provides examples. The key is to reach out to the governments, utilities and Non-Governmental Organizations serving the applicable market. Learn how their programs work and approach the market with full knowledge incentives, rebates, policies and programs.
Financiers consider a number of risks when evaluating and structuring financing for performance contracts. The most basic risks include:
- Credit-Worthy Client — Is the client (the project host) financially capable of making its payments on the project? Is the client in a “financeable class” in today’s capital markets?
- Credit-Worthy ESCO or Contractor — Is the ESCO or contractor financially capable of completing the project and standing behind its savings guarantees? Does the ESCO or contractor have the skills and financial stability commensurate with the project?
- Quality Design, Construction, Operations and Maintenance, Measurement and Verification — Does the project use proven technologies and applications, and is the estimated savings reasonable? Does the ESCO have a strong reputation and deep experience in delivering similar high-quality projects? Are the operations and maintenance and measurement and verification plans for the project appropriate?
- Adequate Project Economics — Are the projected cash flows for a project accurate and appropriately conservative? Does the project generate sufficient energy and operating savings to repay the financing within an appropriate time?
- Properly Documented Project — Are all legal documents adequate and in place, including a strong performance contract? Are risks and scopes properly allocated among the contracting parties? Are energy savings clearly defined?
Unlike traditional retrofit or replacement financing for mechanical and controls systems, the biggest difference for the lenders providing financing in this market is the guarantee of savings and the performance of the Energy Conservation Measures and Facility Improvement Measures installed. Of course, lenders are not engineers, so they have a strong preference for ESCOs and contractors that have (1) a long history of successful projects and demonstrated technical competence and (2) the financial wherewithal to support the project and related guarantees. Furthermore, well-planned and deployed protocols for operations and maintenance and measurement and verification are imperative, given the long-term payback of these projects.
ESCOs and contractors who properly address the above risks when approaching project financiers will be positioned to obtain the best financing options available in the market for their clients.
ENERGY EFFICIENCY PROJECT FINANCING FOR VERTICAL MARKET SECTORS
Federal — The market for financing federal government performance contracts is established and well-defined, resulting in accessible capital for qualified projects. Projects are financed with 100% debt. The client (U.S. government) is one of the most credit-worthy counterparties available worldwide, and the projects use government-approved, standardized contracting vehicles under various federal government programs administered by the Federal Energy Management Program (FEMP). Awardees under these federal programs that develop good projects and have a strong reputation should have access to financing in this market.
Federal Energy Efficiency project options are limited for those providers who are not qualified under FEMP. Nonqualified entities can work as subcontractors to other entities that are on FEMP’s list. A firm can become a FEMP-qualified ESCO through a somewhat extensive application process.
MUSH — The MUSH market relates to projects for state or local government-owned facilities. These include municipal buildings of all types, state universities, community colleges, K-12 public schools, public hospitals and the like. Energy efficiency project financing for the MUSH market is well-developed, and projects are typically financed with 100% debt or lease structures. Clients (project hosts) are typically good credits, and projects are generally developed under government- sponsored contracting programs.
The MUSH market differs from other markets in that tax-free municipal financing is often used. Tax-free financing lowers the borrowing cost since the holder does not pay federal taxes on the interest income. Rates are similar to those in the muni-bond market.
Similar to the federal market, ESCOs often need to be certified or accredited awardees under state programs or otherwise qualified under state or local programs in order to participate in these markets. Programs and participation rules differ by state.
Institutional — The institutional market refers to large, private (as opposed to government-owned or affiliated), noncommercial entities, such as private universities, private hospitals and research institutions. These entities often have strong credit ratings, sizable infrastructure and significant needs for EE and infrastructure improvements. Financing markets are fairly well-developed, and the majority of the financiers to the federal and MUSH markets also provide capital for institutional projects. As noted, the client’s credit must be strong, the ESCO must be reputable, and the project must be well-formulated and documented.
Commercial and Industrial (C&I) — The C&I market is generally considered to be the largest potential and most underpenetrated building efficiency market. The current lack of abundant, prepackaged, low-cost and efficient financing solutions is the greatest barrier to growth in this market.
The C&I market actually functions as a number of smaller markets, and the approach to each submarket differs. At the low end (i.e., projects in the thousands to tens of thousands of dollars for small businesses), utility-sponsored demand side management (Utility DSM) programs are proving to be effective. Under these programs, small businesses receive rebates and incentives from the utility that significantly reduce the project payback periods, increase the financial returns and generally make it easier for a small business to implement efficiency measures. Some utilities also offer on-bill financing, providing the client with a prepackaged loan for the retrofit.
At the high end (i.e., projects in the hundreds of thousands to millions of dollars), no widespread, generally accepted financing model is dominant. Many entities are simply paying for the retrofits out of their capital expenditure budgets (whether financed through corporate loans or cash on hand). Of course, many fewer projects are getting done via this “client pay” approach than would be completed via a prepackaged, attractive financing solution.
One promising potential solution is Property Assessed Clean Energy (PACE) financing. Under PACE, a municipality issues long-term bonds and then makes the funds available to certain qualified constituents (i.e., commercial buildings, industrial facilities, etc.) for qualifying energy efficiency projects. The cost of the project is added to the client’s tax bill. This structure provides long-term, low-cost financing for value-generating efficiency projects. One current issue with PACE is that first mortgage holders object to new claims (i.e., the cost of the EE project) being senior to the existing mortgage lender’s claim (which occurs when the tax bill is increased). As a result of this and certain other issues, PACE has not yet become a widespread financing solution.
Another potential structured solution is to form an investment fund that holds a portfolio of energy efficiency projects. The investment fund is financed with a blend of equity (acting to “credit enhance” the portfolio) and debt blending down the cost of capital. By holding a portfolio of projects, the fund can aggregate projects and “make bulk,” diversify its holdings and “age” its portfolio of projects, thereby allowing access to cheaper capital and even selling off a bundle of projects. A similar approach is used in many other mature industries.
We expect the C&I energy efficiency retrofit market to grow rapidly as PACE programs, energy efficiency funds or similar financing solutions become more available.
The market for energy efficiency retrofits in U.S. buildings is large and growing rapidly. One material constraint on growth is delivering clients a prepackaged financing solution. Financing in each market — federal, MUSH, Institutional and C&I — works differently. Nonetheless, the core attributes sought by financiers are similar across markets — credit- worthy client, credit-worthy ESCO, quality project, good economics and proper documentation.
Working with the right project financier is imperative to success in this market. A list of performance contracting project finance firms can be found at the websites for the National Association of Energy Services Companies and the Energy Services Coalition.
There is no more important work being done in American infrastructure than energy efficiency. Working with a capable and experienced project-financing partner allows ESCOs to deliver larger and higher-value projects for clients and, in the end, get more work done. ■
David Clamage is president of Saulsbury Hill Financial, LLC. Saulsbury arranges energy efficiency project financing for ESCOs and contractors. David may be reached at 303.629.8777 or via email at email@example.com. Tim Huckaby is managing director of the Energy Services and Cleantech Group at FMI Capital Advisors, Inc. Tim may be reached at 303-398-7265 or via email at firstname.lastname@example.org.