This is a guest post by Milton Bevington, a UMass-Boston Lecturer affiliated with SERC, and who has been closely engaged with the Clinton Climate Initiative. He is also a member of the City of Cambridge Climate Protection Action Committee.

I recently released a study of innovation in energy efficiency project finance, the culmination of five years’ effort in over twenty global capitals on more than a hundred projects. The report describes successful pilots, lessons learned, and implications for a broad acceleration in energy efficiency investment worldwide. Significantly, the report confirms the recent emergence of a new Asian center of innovation in energy efficiency project finance. The paper, entitled Making Energy Efficiency Bankable: Lessons Learned from a Global Market Transformation Effort, is co-authored with Christopher Seeley of the William J. Clinton Foundation, and will be presented at the 2012 ACEEE Summer Conference on Energy Efficiency in Buildings

We know that the cleanest, safest, and least costly energy is the energy we don’t use. Analysts have concluded repeatedly that investment in conservation is perhaps the most cost-effective alternative source of energy. Yet, despite decades of progress in building technology, surveys of energy efficiency investment have shown it repeatedly falling short of rational expectations.

Not long ago, a DOE report noted that U.S. investment in energy efficiency was no more than the total of budgeted efficiency programs funded by consumer electricity surcharges. Another report estimated the impact of utility-sponsored efficiency programs to be less than one-half of 1% of total building energy use in the past 20 years. Significantly expanded authorizations now coming online might raise that amount to a little over three-quarters of 1% in the next decade. Apparently, there’s more to creating a market for energy efficiency than some new technology and economic pump priming. Based on recent experience, the answer may lie in everyday commercial practices – that is, contracting, underwriting, funding, and debt servicing associated with energy efficiency projects.

Question: What is the significance of innovation in energy efficiency project finance? Answer:

I=Kr +Te +De

Innovation in building energy efficiency results from the interplay of Knowledge from research, Technology from engineering, and Delivery to market from enlightened entrepreneurship. A common problem arises when a promising idea reaches a stage known as the “Valley of Death” — that is, when the idea is not yet perceived as workable in practice or at scale and is therefore considered too risky by traditional investors (read building owners and real estate lenders in the case of energy efficiency). Crossing the valley requires some kind of convincing demonstration of economic feasibility which in turn requires financial resources, hence the dilemma.

With a sound knowledge base and considerable proven technology, energy efficiency nevertheless suffers from a delivery gap attributable to widespread perceptions of financial risk and uncertain performance. While a number of seemingly practical project finance prototypes exist, to date there has not been sufficient commercial-scale demonstration of those models to confirm their economic viability – that is, profitability at acceptable risk.

Under these circumstances, loan investors are deterred from providing capital, bank regulators are not supportive of the risk, and investment portfolio managers have little access to energy efficiency returns. If nothing changes, energy efficiency will remain stuck in the Valley of Death for a long time to come. What is required is a way to cross the valley and expand large-scale delivery of energy efficiency to the global marketplace.

In May 2007, former U.S. President Bill Clinton launched an ambitious energy efficiency best practices effort. The Energy Efficiency Building Retrofit Program explored ways to make efficiency retrofit projects more bankable with unsubsidized, commercial lending models applicable in a variety of countries and considerably more scalable globally than current regulated and legislated models tied to local jurisdictions. The author was one of the guiding lights of that program, and his report, in cooperation with Clinton Foundation colleague Christopher Seeley, describes the innovative pilots undertaken, lessons learned, and implications for a broad acceleration of energy efficiency investment worldwide. It also confirms the emergence of a new Asian center of innovation in energy efficiency project finance.

Between them, the authors delivered pro bono advisory services to building owners for five years in over twenty large cities worldwide, negotiating technical and financial performance terms on more than a hundred building retrofit projects. Their experience suggests that, when contracting and lending are properly coordinated and deployed, their model has the potential to transform the market for energy efficiency. Here are the model’s distinct aspects.

Energy performance lending

For mortgaged properties with limited refinancing options, a new form of collateral and underwriting process for energy efficiency projects. Common real estate lending practice complicates energy efficiency projects because it can be difficult to add debt without refinancing a property completely. As proponents of PACE finance (both residential and commercial) have learned, the rights of first mortgage holders cannot be easily ignored.

Energy performance lending uses underwriting criteria which lean on energy efficiency project cash flows to secure loans. An analogy is the way that a drilling project is secured using the expected cash flows from oil. When used in conjunction with an enhanced contracting model, projects underwritten in this way can coexist with senior debt without affecting prior security interests.

Managed utilities service agreements

For multi-tenanted buildings, a special entity structure that removes a significant decision hurdle by eliminating split incentives between owners and leaseholders. In many tenant occupied buildings, because of the way leases are written, owners lack proper incentives to make energy efficiency investments in common areas of their building. Managed utilities treats energy use as an outsourced service, transferring project debt to a special purpose entity and converting repayment obligations to operating expense passed through to tenants under the terms of their lease. Tenants are protected against rent increases by savings guarantees in the contract, and rents decline at the end of the performance period with ongoing savings to tenants.

Energy performance contracting

An enhanced design-build approach to contracting energy efficiency retrofit projects which is the sine qua non of energy performance lending, effectively turning energy savings guarantees into a true credit enhancement. Owing to the generally strong credit of governments and bank willingness to offer favorable terms for government debt, performance contracting thrives in the U.S. public sector, but not in commercial real estate or other parts of the world. The energy services industry concluded uniform contract terms with the Clinton Foundation, delivering more credible savings guarantees and making third-party financing more attractive.

Municipal leasing

For local governments, capital budget competition and concerns over limits on agency bonding capacity can constrain energy efficiency investment. Yet with its high transaction costs and inflexible terms, bonding is in some ways ill suited for naturally smaller energy efficiency retrofit projects unless implemented as part of a much larger capital project.

Fortunately, virtually any essential-use energy efficiency project can be financed using a municipal lease, usually at a cost comparable to bonding. Depending on the project, the total cost of lease financing is often not greater than bonding because slight cost-of-funds premiums are offset by lower transaction costs and by flexible takedown and payment terms. Legal opinion holds that leases are not normally subject to the same borrowing caps as bonding, and the absence of high transactions costs make smaller projects more attractive.

Tax-exempt equipment leasing

Nonprofit institutions in the U.S. are partnering with public finance agencies, outside accountants, and credit rating agencies to create a new class of energy efficiency projects not subject to normal borrowing limits or rating concerns. Institutions rely on state financing agencies for tax-exempt borrowing as states alone have the authority to issue tax-exempt bonds, and all states have at least one agency that can bond on behalf of tax-exempt institutions. However, institutional borrowing can be limited by an institution’s balance sheet and possibly their credit rating.

Institutions have begun using a tax-exempt project finance structure linked to a performance-based contract that qualifies for off-balance-sheet treatment. The bonding agency agrees to hold title to the project during the performance period. With constraints eliminated, institutions are freed to undertake energy efficiency projects based on their inherent economics rather than competing for limited capital funds.

Conclusion

Evidenced by successful prototypes and pilots in Asia, it appears energy efficiency can be financed independent of local regulatory regimes and special-purpose incentives. The twenty-first century requires more such models to meet the challenge of low-carbon economic development. It’s conceivable that innovation in project finance can do for building efficiency in the coming century what 30-year mortgages did for home ownership in the last.

The refereed research, entitled Making energy efficiency bankable: Lessons learned from a global market transformation effort, will be formally presented at the biennial conference of the American Council for an Energy Efficient Economy (ACEEE) in August. Interested parties can download the paper for review beforehand or contact Milton Bevington (milton@mbpartners.org) for more information.