LACK OF COMMERCIALLY VIABLE ENERGY EFFICIENCY FINANCING
When considering the value of energy efficiency as the most cost-effective way to reduce pollution and improve climate control, the opportunities are even greater. Unfortunately, there are several major barriers to the widespread implementation of clean and proven energy efficiency technologies that apply to virtually all stakeholders and countries around the world.
One of the most significant of these barriers is a lack of commercially viable financing, which is not caused by a lack of available funds per se, but rather by an inability to access existing funding capacity at local banks and financing institutions (LFIs) on commercially attractive terms. This lack of access is caused by a “disconnect” between the traditional lending practices of LFIs and the financing needs of energy efficiency projects.
LFIs typically apply their traditional “asset-based” corporate lending approach for energy efficiency projects that is limited to their lending a maximum of 70%-80% of the value of assets financed (or collateral provided). Unfortunately there is often little or no collateral value in the energy efficiency equipment once installed in a facility; rather, the value is the cash flow generated from the equipment after installation. To date, most LFIs (due to lack of knowledge) have not recognized nor appear to believe that meaningful cash flow can be generated from energy efficiency projects, or that such cash flow can be relied upon to repay the related loans. Consequently, LFIs generally assign no value to the cash flow generated, thus requiring end-use energy consuming facility owners (“Hosts”) to encumber their credit capacity to finance energy efficiency.
Many end-use energy efficiency projects can reduce the existing operating costs of Hosts enough to pay for 100% of the required debt service. These “paid from savings” projects, called Energy efficiency and renewable Savings-based Projects (“ESPs”), create substantially new credit capacity for the Hosts, which is essential for LFIs to consider in their evaluation of financing ESPs. LFIs do not seem to recognize this increased credit capacity, which is caused, in large part, by the fact that they:
- do not appreciate the broader business opportunities and economic benefits of ESPs;
- are not familiar with the unique complexities of ESPs;
- do not have the internal capacity to properly evaluate risks and benefits of ESPs; and
- are unwilling to invest in building internal capacity to properly evaluate ESPs due to the relatively small dollar size of the investment.
Underlying the difficulties in financing energy efficiency is the low priority private sector Hosts place on investing capital or utilizing their credit capacity to finance energy efficiency versus their core business activities. The problem emanates from the relatively small investment and returns of energy efficiency projects coupled with a perception that they reflect energy and “utilities” infrastructure investments that only need to be made when if and when they break. Even energy efficiency projects with very high 25 to 50 percent IRR’s are unable to compete with one-year internal hurdle rate of returns “projected” for core business investments of many large industrial Hosts.
Unfortunately, there are relatively high risk factors associated with “projected” returns on core business investments that are not properly compared to the relatively low risk of investing in energy efficiency. For example, when a Host secures a loan to increase its production capacity, the loan repayment must be reflected in new budgeted product costs. The ability of a Host to repay a loan for an increased production investment like this one depends on the market’s acceptance of the product and its price – third party customers must be willing to purchase the products at the expected higher volumes and/or accept higher product prices in order for the Host’s expected repayment funds to materialize. The higher costs affect the Host’s competitive market position and result in a negative impact on its business that could affect the Host’s ability to repay the loan.
In contrast, when a loan is secured to fund a cost-effective energy efficiency project, the loan repayment stream comes out of the avoided utility costs already being incurred by the Host. No new budget costs need to be recouped since the project pays for itself out of operating savings. Control of the available funds is an internal matter that can be monitored with relatively low risk. Further, when a loan is secured to improve energy efficiency, the net effect is reduced operating costs, which lower product costs and make the Host more competitive. The Host, in this case, improves its creditworthiness.
LFIs have two basic business functions: one is to “rent” (lend) money and the other is to provide traditional banking and financial services to its customers. Funding ESPs for a Host also provides a secure means of renting money, while providing a valuable service to the Host and its suppliers, and supporting efforts to improve our environment.
The major risks in providing an energy efficiency loan are:
- initially, the quality of the engineer’s auditing abilities and calculations; then
- implementation according to design; and finally
- sustained savings and agreed measurement thereof
Acquiring or training personnel to evaluate an engineer’s audit is relatively simple. If an Energy Services Company (ESCO) is involved in the ESP, the LFI’s risks are significantly reduced because of the ESCO’s assumption of the performance risks. An ESCO is a performance-based company that: i) develops, finances and implements ESPs on a “turn-key” basis, and ii) risks payments for its services on actual savings performance of equipment installed. The ESCO typically guarantees that energy savings from its ESPs will cover their capital and financing cost, which includes the loan repayment to LFIs. As discussed above, loans to a Host for core business activities like a production enhancement carry a far greater risk than energy efficiency due to the marketing risks and possible engineering risks.
Once LFI personnel understand the comparative business propositions and can effectively evaluate the benefits and risks of the energy efficiency measures proposed, they will find that financing energy efficiency carries a much lower risk than financing business expansions and other capital investments.
If LFIs are to fulfill their role in serving the world’s energy, economic and environmental needs through greater energy efficiency, they must understand the potential market and have the ability to effectively serve it. Once LFIs understand the multiple benefits of financing energy efficiency, they can not only improve their respective businesses, but also take the lead in explaining the project economics to their customers who ultimately are the Hosts for ESPs.
THE NEED FOR GUIDANCE AND EXPERTISE ON ENERGY EFFICIENCY FINANCING
In July 2004, the UN Foundation’s Energy Future Coalition sponsored a stakeholder workshop in which a broad group of experts in energy efficiency and finance met to discuss barriers to increased use of funds for energy efficiency projects. The experts agreed that local financial institutions (LFIs) lacked the guidance and expertise to feel comfortable lending money on a cash flow basis to energy efficiency projects. A consensus was reached that an International Energy Efficiency Financing Protocol (IEEFP), as proposed by Mr. Thomas K. Dreessen, could help to bridge the gap between funding sources and their financing of energy efficiency projects. The meeting further concluded there is already a number of documents, materials and other tools that could be assembled in an IEEFP Repository with relative ease.
Later that year, the Efficiency Valuation Organization (EVO) agreed to sponsor the IEEFP and began efforts to obtain funding. It formed a global working group (GWG) comprised of interested stakeholders with expertise in various aspects of energy efficiency financing to oversee development of the IEEFP. As the world’s only organization solely dedicated to a mission of providing tools to quantify energy efficiency business transactions, EVO developed and published the International Energy Efficiency Financing Protocol (IEEFP) in 2009.
IEEFP was created as a global “blue print” for educating and training LFIs around the world on the special intricacies, benefits and risks of financing end-use energy efficiency projects. The objectives of IEEFP are to create a better understanding amongst LFIs of:
- how energy efficiency projects generate reliable savings in operating costs of end-use energy consuming facility owners (Hosts), and
- how such savings equate to new cash flow and increased credit capacity for Hosts to repay energy efficiency project loans and investments.
In 2017, EVO has engaged the process of updating and modernizing the IEEFP to reflect the growing needs of the financial community. It is intended that this IEEFP will be expanded to further address among other things, the perspectives of prospective lenders, how to recruit them to this field, and how to develop energy efficiency finance as a profitable new line of business. This would include dealing with how to market financial services in the energy efficiency sector and structure programmatic relationships that can generate a flow of business with equipment vendors, ESCOs, utilities, local governments and other stakeholders.
Should you be interested in being part of this important protocol upgrade project, please contact EVO’s Executive Director, Denis Tanguay.