Building owners evaluating a green retrofit should consider on-bill financing or efficiency services agreements to finance the work. These two financing strategies can help building owners pay the substantial upfront costs of energy efficiency upgrades. What’s more, these creative financing models may also place within financial reach more efficient upgrades that may have a higher up-front cost, instead of lower-cost equipment that may not have the same long term benefits. This article looks briefly at some of the economic reasons why building owners do not pursue green retrofits and then explores on-bill financing and efficiency services agreements as options to solve funding issues.
Difficulties in Financing Real Estate Energy Efficiency Measures
Commercial property owners typically set aside capital reserves for periodic replacement of major capital improvements, such as the replacement of a building’s roof, HVAC systems and repaving of parking lot. Funds are less commonly set aside for energy efficiency upgrades, particularly in older buildings.
Landlords also typically don’t pass on the costs of energy efficiency measures to tenants. Most commercial leases are drafted as so-called “triple net” leases in which tenants bear utility consumption costs directly, so landlords have less of an incentive to proceed with energy efficiency improvements. While “triple net” leases sometimes reserve the landlord’s right to charge tenants for the costs of green retrofits as a pass-through expense on an amortized basis, some landlords are also loathe to pass through such capital expenses under short term leases.
Finally, many landlords would prefer not to finance green retrofits through real estate secured debt. Recognizing a return on investment for a green retrofit is delayed if financing costs are included.
On-Bill Financing: Utility Companies and Property Owners Cooperate
Utility companies and building owners can work together to finance the improvements necessary to implement a green retrofit. Simply put, the utility company advances the costs of the improvement work and is repaid from the energy cost savings by the building owner. Financing is available to fund lighting, HVAC, electric motors, LED street and parking lot lights, refrigeration, food service equipment and water pumps.
Here is how the transaction is structured: The utility company and the building owner reach an agreement whereby the utility will advance the funds required to complete the construction work necessary to retrofit the building. The improvements are completed from the funds by the building owner, who hires a general contractor to perform the work. The general contractor can be selected by the building owner, but typically must be on an approved list maintained by the utility.
Once the work is complete, the utility inspects the work. Then, the funds advanced by a utility company are repaid by the building owner on a monthly basis at the time of payment of utility bills. The amount of the monthly repayments is structured to equal the difference between the amount that would have been paid for “business as usual” utility consumption prior to upgrade and the amount payable for post-retrofit actual utility consumption. In California, utilities offer loans with a zero percent interest rate, there are no lending fees and no prepayment penalties.
Utilities today are offering loan amounts from $5,000 to $100,000 per premises with a maximum available credit of $1,000,000 per customer. Repayment terms vary, but are typically 5 years. After the loan is repaid, the benefits of the new equipment and the reduced energy consumption costs belong to the building owner.
Efficiency Services Agreements: Private Financing of Larger Retrofit Projects
Efficiency Services Agreements, also known as Energy Services Agreements, (“ESAs”), are more complex arrangements that raise funds for major commercial or industrial energy efficiency retrofits, such as private universities, hospitals, corporate campuses, and other large scale facilities. The improvement costs for such projects usually exceed $1,000,000.
ESA agreements are proposed by an ESA project sponsor to a property owner, who is the customer. The ESA project sponsor offers to provide the customer with equipment and services to achieve the customer’s energy efficiency goals.
As part of the ESA agreement, the ESA project sponsor forms a single purpose entity (“SPE”) that will purchase and own the equipment on the customer’s property. The SPE also contracts with an Energy Service Company (“ESCO”) to install and maintain the equipment and perform monitoring and verification services.
Once the equipment is installed and the energy efficiency performance of the systems is validated, the customer pays the SPE for the energy saved (so called “negawatts”). The amount of the payment is calculated on the basis of demonstrated actual energy savings, either as a fixed dollar amount per kilowatt hour saved or as a percentage of the utility’s energy rates applicable to the customer. The SPE then uses the proceeds received from the customer to pay for services provided by the ESCO and for debt service on the installed equipment.
The SPE finances the initial purchase and installation of the energy efficiency equipment with funds obtained from private investors – both debt and equity. Investors are repaid from customer payments (passed through the SPE, as described above), as well as incentives and rebates received from public utilities and governmental authorities, if available.
In some transactions, investors may demand a financial guaranty from the ESCO or the property owner as a credit enhancement. In addition, investors may require the SPE to purchase insurance to manage the risk that the installed equipment, once commissioned, meets the promised energy efficiency targets.
ESAs have numerous benefits. First, property owners may be able to finance energy efficiency improvements on an off-balance sheet basis. Second, customers pay only for the actual reduction in their utility bills. Third, the risk that the purchased equipment does not perform as advertised is shifted to the ESA project sponsor and/or ESCO. Fourth, the operation and maintenance of installed equipment is the responsibility of the ESCO, who has the applicable experience and technical expertise. Fifth, tax benefits may be available to the project sponsor or its investors, depending on the structure of the transaction and any available rebates and incentives. Sixth, transactions can be structured so that “triple net” lease tenants are not adversely affected.
On-bill financing and ESAs are two available tools available to property owners considering a green retrofit. For smaller commercial property owners, the zero interest on-bill financing offered by utilities is very attractive. Larger green retrofit projects would appear to benefit from an ESA structure, because those projects have larger funding requirements. Both funding mechanisms solve the problem of inadequate capital reserves, giving building owners the ability to install more energy efficient measures.
Where a commercial space is leased on a “triple net” basis, both ESAs and on-bill financing can be structured so that a tenant pays no more than its “business as usual” energy consumption cost. Similar structuring considerations can benefit “base year” and “gross” leases, where the landlord pays all or a portion of energy consumption expenses. Overall, today’s commercial property owners have more flexibility than ever in implementing energy efficiency upgrades for the benefit of their buildings, their tenants and the environment.