Buildings consume more than 40% of the world’s energy output and emit an equivalent amount of the carbon emissions into the atmosphere. Federal and state governments are responding to the calls to reduce global warming with subsidies and changes in the tax code, which subsequently attract businesses to create new products, jobs, and revenue to sustain the industry.
One of the primary tools to reduce energy consumption and carbon emissions is performance contracting. In performance contracting, the customer hires an energy service company (ESCO) to perform an energy audit to identify and recommend a package of equipment upgrades to their existing facilities. The energy conservation measures (ECMs) are designed to reduce energy consumption, maintenance cost, and improve operational efficiency. Upgrades include installing high efficiency lighting fixtures, HVACs, boilers, chillers, and controls. The customer and ESCO enter into an energy service agreement that outlines the project scope, equipment upgrades and subsequent energy savings. Many ESCO’s offer to guarantee the energy savings to the customer. The guarantee is facilitated by the ESCO measuring and verifying the project’s performance.
The Measurement & Verification (M&V) is provided annually for a fee. Should the project not yield the specified savings during this M&V period, the ESCO is required to pay restitution. The ESCO can provide compensation in the form of additional work at no cost or a cash payment at year end.
The graph below highlights the customer’s utility expense before and after the installation of the ECMs. Prior to installing the ECMs, the customer is paying the full utility bill. Post-project completion, the customer has reduced its energy consumption by 30%. The facilities are operating with new energy efficient equipment and the customer’s obligation is 70% of its original utility bill. The customer has freed up the 30% savings, which can be allocated to pay the debt service on the financing to fund the loan payments on the project. Upon repayment of the financing agreement, the customer pays 70% of the original utility bill and retains the 30% savings to their bottom line.
The municipal, university, state, and healthcare (MUSH) market is one of the largest in the US. It represents $4 billion – $6 billion in performance contracting sales annually.
Most MUSH market customer’s hire ESCO’s to design, implement, and M&V their energy conservation projects. This strategy saves time, transfers performance liability, and leverages the ESCO’S expertise.
The federal government, many states, and local utilities provide financial incentives in the form of grants and utility rebates to entice customers to energy retrofit their older facilities and investors to fund the projects. The grants and incentives are based on project size and the equipment installed. The larger the project, the greater the incentives. Typically, they are spread over 1-5 years to increase program participation and compliance.
Issue: City, USA would like to energy retrofit 15 city-owned facilities to reduce energy consumption and carbon emissions.
Solution: City, USA hires an ESCO to perform an energy audit to identify the energy conservation measures to reduce its energy consumption, carbon emissions, and lower its utility bill. The City and ESCO enter into a $5,000,000.00 energy service agreement to implement energy conservation measures at 15 city-owned facilities.
Assumptions: The project involves installing new high energy efficiency lighting fixtures, HVAC, boilers, and controls. The customer operates the building exactly in the same manner as prior to installing the ECMs. The upgrades are expected to reduce energy consumption by 30% per year. The ESCO will provide M&V services to guarantee the energy savings for the initial 10 years of the project’s 25-year useful life.
Financing: The city has decided to finance the project over 15 years with a tax-exempt interest rate of 4.00% and annual payments equal to $223,249.61. The financing will be fully amortizing with no residual at maturity.
Accumulated Cash Flow: The project’s annual savings will exceed the financing payments and generate positive accumulated cash flow of $2,167,147 over the life of the project.
Total program savings equals the summation of the utility and operational savings and utility incentives. The program cost includes the annualized financing payments and M&V cost. The program savings less the cost equal annual cash flow. The summation of the subsequent annual cash flows equals the net cumulative cash flow.
Although the conditions are valid for the example provided, total program cost can be affected by the project’s cost, financing amount, payment frequency, and market rates at the time of funding.
Although each state may have slightly different legal requirements, in most cases, the lender will be provided with a first priority and perfected lien on the capital equipment. As an alternative, the project can be secured by the customer pledging unencumbered essential purpose facilities, such as its city hall building, police station, fire station, etc. The value of the pledge facilities should be equal to or greater than the financing amount.
Private universities and not for profit hospitals and higher education institutions may secure the financing with a combination of a revenue pledge and equipment collateral. Occasionally, the financing will be secured by pledging an unencumbered essential purpose facility, but typically the security interest is granted by filing a UCC-1 and/or fixture filing, as applicable. The security interest may, in some cases where a weaker lessee and ESCO are involved, even be coupled with a pledge or assignment of the ESCO’s guarantee or a Payment and Performance Bond, which ensures the ability of the ESCO to complete the project and/or guarantee the energy savings.
State, municipal governments and public institutions of higher education typically utilize tax-exempt lease purchase agreements to finance up to 100% of the project cost and spread the payments over 5-20 years. Tax-exempt rates offer lower payments than taxable financings, thus reducing interest expense and overall program cost.
Capital Leases: The financing is structured as an annual appropriation lease or an abatement lease. The abatement lease can be utilized in CA or IN only. The non-appropriation lease is used in all 50 US states and it territories and is the most common solution.
Conduit Financing: Private universities, not-for profit hospitals and higher education institutions typically utilize conduit financings to access lower rates in the tax-exempt market to reduce interest expense and overall program cost.
The transaction is underwritten based upon the financial fundamentals of the lessee or borrower, ESCO expertise and balance sheet, collateral, project savings, size, term, and pricing.
Federal and local governments continue to provide grants and incentives to encourage clients and investors to retrofit older facilities while creating clean energy jobs and reducing carbon emissions. ESCOs play a vital role in designing, engineering, and installing ECMs to reduce energy consumption and lower utility bills. Frequently, the ESCOs guarantee the savings for a portion or all of the project’s useful life for an annual M&V fee. The project savings typically exceed or match the financing payments to create positive cash flows or a break-even scenario for the client. The savings flow directly to the lessee/borrower bottom line upon repayment of the loan or capital lease.
A number of financing tools exist to fund energy conservation projects. The most widely used in the MUSH market are the non-appropriation tax-exempt lease and conduit financings. It provides the client with a lower financing rate and the investor an attractive after-tax yield. The investor is typically secured by the installed equipment or unencumbered real property.
Overall, the building energy efficiency market creates utility savings for the client and the opportunity to have new equipment installed in older facilities still in use. The project financing offers the investor attractive asset diversification, high credit quality, longer financing terms and attractive yields. The $4 – $6 billion MUSH market is vibrant and growing and continues to create clean energy jobs to reduce carbon emissions in the US. It has something for all the market participants.
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