Paying for Green Retrofits of Commercial Buildings with On-Bill Financing and ESAs

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.

Conclusion

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.

New ADA and Energy Use Disclosure Requirements for Commercial Property Owners

Beginning July 1, 2013, owners of commercial property in California will need to comply with new disclosure requirements when entering a new lease, amending a lease, or when owners sell or finance a commercial building.  The first disclosure requirement relates to disability access and the other requirement relates to a building’s energy use and consumption.

Certified Access Specialist Disclosure

Under California SB 1186, commercial property owners must include a disclosure in all commercial leases or lease amendments stating whether the property has been inspected by a certified access specialist and, if so, whether the property is in compliance with construction-related accessibility standards.   A certified access specialist (also known as a “CASp”) is a professional certified by the State of California to assess commercial properties and their compliance with federal and state disability-related laws and regulations.  After an inspection, the specialist issues a report which identifies areas of non-compliance with accessibility standards.  The report can be used by property owners to create a practical and financially reasonable plan for fixing problems in advance of litigation.

While the CASp disclosure in leases and lease amendments is mandatory, property owners are not required obtain such inspections.  The new law provides incentives, however, to having the building inspected.  Property owners who timely correct ADA violations identified in a CASp report or have had their property inspected by an approved inspector prior to being served with a complaint by an ADA plaintiff can be eligible for reduced statutory damages or a 90 day stay of proceedings in the event of a lawsuit.   The stay is granted to give the owner the opportunity to correct accessibility issues and dismiss the lawsuit.

Energy Use Reporting

Another California law, known as AB 1103, provides that prior to the leasing, sale or financing of an entire commercial building of more than 50,000 square feet (the requirement hits smaller buildings in 2014 – all the way down to 5,000 square feet on July 1, 2014!), the landlord, seller or borrower is required to disclose energy use data for the building for the prior 12 months, together with information regarding the building’s operating characteristics and ENERGY STAR Energy Performance Score.  To comply, building owners are required to open an account for the building at the ENERGY STAR Portfolio Manager Website, operated by the US EPA, no later than 30 days prior to the date the disclosure is required.  Under the law, once an account is opened, utility companies are required to provide energy data within 30 days of the date of the request.   Then, the owner must log back in to the account, complete a compliance report, and download certain Energy Use Materials for disclosure to the prospective tenant, purchaser or lender.   The disclosure requirement applies to virtually all commercial building use types.

The ENERGY STAR Portfolio Manager is a free online software tool that allows property owners to track and evaluate energy consumption in light of the occupancy of the building in specified land use categories.  A building is given a score on a scale of 1 to 100.  A rating of 50 means that the building performs at the midpoint when compared with similar buildings.  The Portfolio Manager uses national weather data to compare buildings in similar climates, so that buildings in locations that have snow in the winter and high humidity in the summer are not are scored against buildings in temperate climates. A building that scores 75 or above qualifies for an ENERGY STAR certification.  Because the consequences of having a poor score can have consequences in attracting tenants that have green building requirements, it is important for property owners to retain knowledgeable staff or consultants to handle the inputs into the ENERGY STAR database.  Even small mistakes can affect an overall score considerably in the wrong direction.

The new law will allow tenants, buyers and lenders to compare a building’s  performance with other similar buildings.  In addition, the disclosure requirement provides more information than a disclosure of monthly utility bills, as is typical when tenants evaluate utility pass through expenses, buyers estimate future operating costs in their pro formas, or when lenders evaluate which assets have a better ability to maintain profitability and support loan repayment.  On the other hand, the cost and expense of complying with the law’s new disclosure requirement is an added cost of doing business as a commercial property owner in California.