Financing Alternatives For Energy Savings Performance Contracting

Bank Loans

Occasionally local governments and educational in­stitutions find that working with their local financier and/or bond counsel has particular advantages in light of other financial obligations supported by the financier. While rates are certainly an important factor in finance considerations, it is not the sole charac­teristic of value. Local institutions should be solicited to understand what role and services with which they may wish to participate.

Build America Bonds (BABS)

All ARRA rules, procedures and reporting require­ments must be followed to benefit from funding. The United States Treasury announced the implemen­tation of the Build America Bond program under the American Recovery and Reinvestment Act (ARRA) of 2009 to provide much-needed funding for state and local governments at lower borrowing costs. This will enable them to pursue necessary capital projects, such as work on public buildings, courthouses, schools, roads, transportation infrastructure, government hos­pitals, public safety facilities and equipment, water and sewer projects, environmental projects, energy-efficiency projects, governmental housing projects, and public utilities.

Traditionally, tax-exempt bonds provide a critical source of capital for state and local governments, but the recession has sharply reduced their ability to finance new projects. Supplementing this existing market, the BABs program is designed to provide a federal subsidy for a larger portion of the borrowing costs of state and local governments than traditional tax-exempt bonds in order to stimulate the economy and encourage investments in capital projects in 2009 and 2010.

How Build America Bonds Work

BABs are a new financing tool for state and local governments. The bonds, which allow a new direct federal payment subsidy, are taxable bonds issued by state and local governments that will give them access to the conventional corporate debt markets. At the direction of the state and local governments, the Trea­sury Department will make a direct payment to the state or local governmental issuer in an amount equal to 35 percent of the interest payment on the BAB. As a result of this federal subsidy payment, state and local governments will have lower net borrowing costs and be able to reach more sources of borrowing than with more traditional tax-exempt or tax credit bonds. For example, if a state or local government were to issue Build America Bonds at a 10 percent taxable interest rate, the Treasury Department would make a payment directly to the government of 3.5 percent of that interest, and the government’s net borrowing cost would thus be only 6.5 percent on a bond that actually pays 10 percent interest.

This feature will make BABs attractive to a broader group of investors, and therefore create a larger market than typically invest in more traditional state and local tax-exempt bonds, where interest rates, due to the federal tax exemption, have historically been about 20 percent lower than taxable interest rates. They should be attractive to investors without regard to their tax status or income tax bracket (e.g., pension funds and other tax-exempt investors, investors in low tax brackets, and foreign investors).

Guidance to States on Build America Bonds

The IRS is releasing Notice 2009-26 to provide state and local governments with prompt guidance on implementation of the new direct federal subsidy payment procedures for Build America Bonds so that issuers can begin issuing these bonds with confidence about how these federal payments will be made. This guidance covers the direct federal subsidy payment procedures regarding:

  • How (on new IRS Form 8038-CP available now) ..and when (by 45 days before an interest payment date) to request these payments;
  • When the IRS will begin making these payments ..(July 1, 2009);
  • How to make necessary elections to issue these ..bonds (in writing in an issuer’s books and records);
  • How to satisfy the information reporting require­..ment for these bonds (modified IRS Form 8038-G);and
  • Future implementation plans (electronic plat­..form in 2010).
  • Finally, the Notice solicits public comments on all of the plans for this program. Please review the appendix for additional information.

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Cash – Capital Funds

Capital funding or cash set aside for the purchase of capital or fixed assets can of course be used to com­plete energy efficiency and renewable energy projects.

Public and private entities with sufficient internal funds may want to consider self-financing their Energy Saving Performance Contracting (ESPC) project. A building owner or agency can fund such a project by drawing on its endowment, capital budget, or operating budget or by tapping funds for deferred maintenance or reserve accounts for investment in ESPC projects. Depending on the end user’s financial position, self-financing may represent the least expen­sive means of financing an ESPC because it avoids the need to pay interest and transaction costs on incre­mental borrowing. Internal financing also minimizes the additional paperwork and transaction consider­ations from using an outside financing source.

Attractive returns are possible in an ESPC when an institution, agency or end-user invests its own re­sources to pay for the up-front project costs in what is essentially a project equity investment to be paid back through energy savings. In many cases, building owners have chosen to take equity ownership (buy down) a portion of the project, while paying for the rest of the up-front cost through a leasing or other debt mechanism.

Energy Efficiency Bonds

All ARRA rules, procedures and reporting require­ments must be followed to benefit from funding. There are two relatively new types of bonds that are used to finance energy efficiency projects in K-12 schools.

Qualified Zone Academy Bonds (QZABs)

QZABs are a U.S. debt instrument created by Section 226 of the Taxpayer Relief Act of 1997. QZABs allow certain qualified schools to borrow at nominal interest rates (as low as zero percent) for costs incurred in con­nection with the establishment of special programs in partnership with the private sector. The annual allocation each year has been $400,000,000. The allocation is divided up by all fifty states and US possessions. QZABs are a temporary program, subject to reauthorization. Qualified Zone Academy Bonds were funded by $1.4 billion bond authorizations for each of 2008 and 2009 among the states, based on poverty levels through the American Recovery and Reinvestment Act.

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Authorizations must be used within two years follow­ing the year for which they were given, meaning that authorizations given in 2007 must be used by 2009.

Public schools (K-12) located in empowerment zones or enterprise communities and public schools with 35% or more of their student body on the free and/or reduced lunch program are eligible to participate. In order for a school district to participate, a Zone Academy must be created. The Zone Academy must create programs to enhance the curriculum, increase graduation rates, improve employment opportuni­ties, and better prepare students for the workplace or higher education.

Funds can be used for renovation and rehabilitation projects, as well as equipment purchases. QZABs can not be used for new building construction. The school district must obtain matching funds from a private-sector partner equal to at least 10% of the cost of the proposed project. All state and local laws applicable to bonds also apply to QZABs, including Section 148 of the IRS Code.

A qualified lender as defined by the law must purchase bonds. Qualified lenders can be insurance companies, some banks or other corporations actively engaged in lending (each qualifying entity is determined by the Internal Revenue Code governing each). The lender receives a tax credit in lieu of interest payments from the school. The IRS determines the amount of this tax credit.

"Pay to play" contributions are strictly prohibited. Set up fees, discounts on equipment purchased with QZAB funds, or contributions associated with the district’s construction projects are not eligible.

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Qualified School Construction Bonds (QSCBs)

QSCBs are authorized by the federal government through the American Recovery and Reinvestment Act (ARRA) of 2009.The bonds provide federal tax credits for bond holders in lieu of interest in order to significantly reduce an issuer’s cost of borrowing for public school construction projects.

QSCBs are one of the newest tax-credit bond pro­grams for school construction and rehabilitation. Unlike QZABs, QSCBs may be used for NEW building and land acquisition. As with QZABs, the bondholder receives an annual tax credit – at a rate set by the Treasury Department – in lieu of tax-exempt interest while the bond is outstanding. $11 billion an­nually has been authorized for years 2009 and 2010 for the program. Of this amount 40% must be used for the nation’s top 100 largest education agencies. The remaining 60% will be distributed by basing it on the respective amount of local education grants each state receives under the Elementary and Second­ary Education Act.

For Qualified School Construction Bonds, the guid­ance divides the $11 billion national bond volume authorization for 2009 among the states and 100 largest local school districts based on Federal school funding.

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General Obligation Bonds (GO)

"GO" bonds are a form of long-term borrowing in which the state issues municipal securities and pledges its full faith and credit to their repayment. Bonds are repaid over many years through semi-annual debt service payments.

General obligation bonds are issued with the belief that a public entity (with bonding authority) will be able to repay its debt obligation through taxa­tion or revenue from projects. No assets are used as collateral. Rates are established by the investor marketplace. Elections are required to establish the full faith of the patrons. Transaction and legal fees should be consid­ered as part of the cost considerations of this financial vehicle.

Green Tags

Renewable Energy Certificates (RECs)

RECs are also known as Green Tags, Renewable Energy Credits, or Tradable Renewable Certificates (TRCs), are tradable environmental commodities in the United States that represent proof that 1 mega­watt-hour (MWh) of electricity was generated from an eligible renewable energy resource.

These certificates can be sold and traded or bartered, and the owner of the REC can claim to have purchased renewable energy. While traditional carbon emissions trading programs promote low-carbon technologies by increasing the cost of emitting carbon, RECs can incentivize carbon-neutral renewable energy by pro­viding a production subsidy to electricity generated from renewable sources. It is important to understand that the energy associated with a REC is sold sepa­rately and is used by another party. The consumer of a REC receives only a certificate.

In states that have a REC program, a green energy provider (such as a wind farm) is credited with one REC for every 1,000 kWh or 1 MWh of electricity it produces (for reference, an average residential cus­tomer consumes about 800 kWh in a month). A cer­tifying agency gives each REC a unique identification number to make sure it doesn’t get double-counted. The green energy is then fed into the electrical grid (by mandate), and the accompanying REC can then be sold on the open market.

On the occasions that an Energy Savings Performance Contract includes renewable energy technologies, Green Tags can be used as an incentive or capital buy down of the original principal required for these projects.

Municipal Lease

State and local governments are under great pressure to provide increasing levels of service to constituen­cies, but available funds seldom keep up with this demand. One valuable tool these entities possess is the ability to issue obligations on a tax-exempt basis. The lease contains a non-appropriation clause that states that the only condition under which the entity may be released from its payment obligation, the lease, is when the legislature or funding authority fails to appropriate funds. Since the lessee is a municipality or an organization supporting the government, it is exempt from paying federal income taxes. Thus, the IRS doesn’t charge the lessor income taxes on this type of lease.

A tax-exempt municipal lease is offered only to state and local governments and their political subdivisions. They are structured as lease/purchases or conditional sales, both of which result in ownership by the govern­ment at lease end. Tax-exempt leases are typically far easier to execute than municipal bonds, as no bond referendum is required. Leases can be short or long, from one year to 10 years and beyond. The size of a municipal lease is virtually limitless, as is the range of equipment that can be leased.

The tax-exempt lease benefits a state or local govern­ment ESPC project in a variety of ways, including:

  • Lower Interest Rates – The interest rates on tax-..exempt lease/purchase transactions are lower than those offered on comparable taxable transactions, and thus save you money. In addition, municipal leases do not encumber tax or other revenue’s un­like bonds.
  • No Bond Election Required – In nearly all cases, expensive, time-consuming bond election is required. Since the lease contains a non-appro­priation of funds clause, it does not count against the government’s debt limit nor is it subject to normal debt incurrence procedures.
  • Flexibility – Leases can be long or short, paid ..monthly, quarterly or annually, and can be tai­lored to match the ways in which project funds are expended and benefits from equipment are obtained.

On Bill Financing (OBF)

This financing tool can be partially funded through ARRA and if so then all ARRA rules, procedures and reporting requirements must be followed to benefit from funding. OBF is a utility based method of providing seamless 0% financing through the monthly power bill for energy efficiency improvements.

OBF provides businesses with the opportunity to address energy costs as a "controllable" expense, thus helping the bottom line.

Where OBF programs exist or are being developed, some consideration should be given to the utiliza­tion of this methodology for the capital loan and subsequent repayment of Energy Saving Performance Contracting. This could prove particularly effective for commercial building programs that may have separate ownership and therefore interest in the fa­cility versus the utility consumption and subsequent utility bill payment.

Power Purchase Agreements (PPA)

A Power Purchase Agreement (PPA) is a legal con­tract between an electricity generator and a power purchaser. The power purchaser purchases energy, and sometimes also capacity and/or ancillary services, from the electricity generator. Such agreements play a key role in the financing of independently owned (i.e. not owned by a utility) electricity generating assets.

The seller under the PPA is typically an independent power producer, or "IPP." Energy sales by regulated utilities are typically highly regulated, so that no PPA is required or appropriate. The PPA is often regarded as the central document in the development of independent electricity generat­ing assets (power plants), and is a key to obtaining project financing for the project. Under the PPA model, the PPA provider would secure funding for the project, maintain and monitor the energy production, and sell the electricity to the host at a contractual price for the term of the contract. The term of a PPA generally lasts between 5 and 25 years. In some renewable energy contracts, the host has the option to purchase the generating equipment from the PPA provider at the end of the term, may renew the contract with different terms, or can request that the equipment be removed.

One of the key benefits of the PPA is that by clearly defining the output of the generating assets (such as a solar electric system) and the credit of its associated revenue streams, a PPA can be used by the PPA pro­vider to raise non-recourse financing from a bank or other financing counter-party. Commercial PPA providers can enable businesses, schools, governments, and utilities to benefit from predictable, renewable energy.

In the United States, the solar power purchase agree­ment (SPPA) depends heavily on the existence of the solar investment tax credit, which was extended for eight years under the Emergency Economic Stabi­lization Act of 2008. The SPPA relies on financing partners with a tax appetite who can benefit from the federal tax credit. Typically, the investor and the solar services provider create a special purpose entity that owns the solar equipment. The solar services provider finances, designs, installs, monitors, and maintains the project. As a result, solar installations are easier for customers to afford because they do not have to pay upfront costs for equipment and installation. Instead, customers pay only for the electricity the system generates. With the passage of the American Recovery and Reinvestment Act (ARRA) of 2009 the solar investment tax credit can be combined with tax exempt financing, significantly reducing the capital re­quired to develop a solar project. Moreover, in certain circumstances the federal government will provide a cash grant in lieu of an investment tax credit where a financing partner with a tax appetite is not available.

Solar PPAs are now being successfully utilized in the California Solar Initiative’s Multifamily Affordable Solar Housing (MASH) program. This aspect of the successful CSI program was just recently opened for applications.

Property Assessed Clean Energy (PACE) Bonds

This financing tool can be partially funded through ARRA and if so then all ARRA rules, procedures and reporting requirements must be followed to benefit from funding.

One of the major drivers for commercial markets is finding a mechanism that helps overcome financial barriers. PACE bonds are striving to address various problems, including limited capital budgets, con­sumer incentives, lengthy payback periods, lending issues, and split incentives. Pike Research believes PACE bonding is attractive to the private sector as it is property tax lien-oriented financing that will ad­dress many of the issues with private sector lending and building efficiency retrofits. To begin, we employ the definition of a property assessed clean energy bond:

"A PACE bond is a bond where the pro­ceeds are lent to commercial and residential property owners to finance energy retrofits (efficiency measures and small renewable energy systems) and who then repay their loans over 20 years via an annual assessment on their property tax bill. PACE bonds can be issued by municipal financing districts or finance companies and the proceeds can be typically used to retrofit both commercial and residential properties."

Some claim the PACE bond market has the poten­tial to exceed $500 billion. Pike Research describes how this number was reached, where the immediate potential lies, and in which states legislation has been passed.

PACE Financing Standardized Steps

(A) State legislation allowing for municipal taxing districts Fourteen states have passed legislation enabling PACE in the 12 months starting May 2008, including: California, Colorado, Illinois, Louisiana, Maryland, Nevada, New Mexico, Ohio, Oklahoma, Oregon, Texas, Vermont, Virginia, and Wisconsin. Florida and Hawaii had existing statutory enabling legislation to launch PACE programs. Legislation is pending in Arizona and New York. Many states have passed the legislation because taxpayers agree with PACE be­ing 100% voluntary, and only property owners who apply for PACE funds are involved in the financing measures.

(B) Municipality creates PACE district Local government secures the PACE district with real property within the municipality. Additionally, there is automatic benefit for the municipality, as jobs are created for the energy-efficient measures being imple­mented at commercial buildings in the area.

(C) "PACE" district issues a PACE master bond The proceeds of this master bond are now utilized for the funding of energy-efficient measures and small-scale renewable energy projects.

(D) Commercial real estate owners apply for

PACE funds

Property owners are attracted because of lower energy bills, and the fact that PACE provides lower initial capital expenditures than other private sector lend­ing and therefore improved ROI. Lenders, on the other hand, see a low risk factor because the PACE funding is senior to mortgage debt, and therefore back property taxes are paid off first. Also, if the lender is already an existing mortgage lender, then the property value will continue to increase with energy-efficient measures installed, especially as federal and state legislation provide benefits and tax cuts for more efficient buildings.

(E) PACE funding treated as senior "property tax lien" and repaid to real estate owner over 20 years as annual property tax surcharge.

The amount of seniority to the existing mortgage cre­ated by a PACE lien usually represents less than 1% of the property value. This is because upon foreclosure, only delinquent tax lien are paid, not the entire PACE loan. The information about Property Assessed Clean Energy Bonds (PACE) is provided by Pike Re­search LLC.

Revolving Loan Funds

This financing tool can be partially funded through ARRA and if so then all ARRA rules, procedures and reporting requirements must be followed to benefit from funding. Energy Saving Performance Contracts for public facilities can take advantage of revolving loan fund mechanisms by leveraging its funds—offering incre­mental financing that will either accelerate project development and implementation or expand the scope of ESPC projects—and is matched 3 or 4 or 5 to 1 by funds from other sources. This leveraging allows the state or local government to multiply the value it derives from its American Recovery and Rein­vestment Act (ARRA) funding. One way to consider accelerating project development involves offering a limited pool of funds for a limited time on a first-come, first-served basis. Expanding the scope of proj­ects involves providing incremental project financing so that one or more long-payback technologies, such as boiler replacements or photovoltaic systems, can be added to a project.

Shared Savings

Shared Savings was once used by the Energy Sav­ings Performance Contracting Industry to execute an ESPC project free of initial capitalization. Once savings began to be realized by the technology and system upgrades, a portion of the savings was retained by the owner with the balance going to the Energy Services Company (or an outside financier) to repay the investment. The title to the item usually remained with the vendor until its price is fully recovered from the savings. This concept has become fundamentally defunct as the financial marketplace grew in industry confidence to realize savings. Financiers and facil­ity owners alike generally prefer one of the other methods of funding that support the Energy Savings Performance Contracting Industry.

Tax Increment Financing/Bonds

Tax increment financing can fund infrastructure im­provements through a partnership between local government and a company. Expected growth in property tax revenues from a designated area can be used to finance the bonds that pay for improvements in the TIF district. Some states also allow local sales tax and earnings tax revenues to fund the increment as well as property taxes.

Tax increment financing bonds are issued both as (1) pure revenue bonds, secured solely by incremental tax revenues or (2) as a type of double borrowed general obligation bond. With the general obligation bond approach the bonds are credit enhanced by the full faith and credit of the issuer or plan sponsor. In the absence of this credit enhancement, the bond market would be likely to exact an interest rate premium or discount the revenue stream and reduce the amount of borrowing, or a combination of both. If the sponsor pledges its full faith and credit, the sponsor (and not the marketplace) will bear the risk that the projected incremental revenue will not materialize—meaning, if the incremental tax revenues are not sufficient to pay debt service on the bonds, the entity that pledges its faith and credit must pay.

The primary credit risk of tax increment financing for the tax increment district is that tax rates and the pace of private development in a project area lie outside the control of the redevelopment agency issuing the debt. Actual tax rates that generate the tax are set by the underlying taxing entities—cities, counties, or school districts, among others—that set their tax rates without consideration of the needs of the redevelop­ment agency.

Under tax increment financing, developers or compa­nies continue to pay real estate taxes on the value of the property prior to the creation of the TIF district. As the improvements increase the value of their property, however, the new tax money is directed into a fund to pay debt service on bonds or for the improvements.

The TIF system relies on the appreciation in value of the land and buildings in a TIF district. If a develop­ment is profitable, then the costs will be paid for in the growth of property tax revenues. If the property fails to increase in value, the improvement costs fall back on the general taxpayer (assuming the bonds are issued as general obligation bonds and not pure revenue bonds). Forty-nine states use TIF bonds.

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White Tags

In environmental policy, White certificates are docu­ments certifying that a certain reduction of energy consumption has been attained. In most applications, the white certificates are tradable and combined with an obligation to achieve a certain target of energy sav­ings. Under such a system, producers, suppliers or distributors of electricity, gas and oil are required to undertake energy efficiency measures for the final user that are consistent with a pre-defined percentage of their annual energy deliverance. If energy producers do not meet the mandated target for energy consump­tion they are required to pay a penalty. The white certificates are given to the producers whenever an amount of energy is saved whereupon the producer can use the certificate for their own target compliance or can be sold to (other) parties who cannot meet their targets. Quite analogous to the closely related concept of emissions trading, the tradability in theory guarantees that the overall energy saving is achieved at least-cost, while the certificates guarantee that the overall energy saving target is achieved.

A white certificate, also referred to as an Energy Savings Certificate (ESC), Energy Efficiency Credit (EEC), or White Tag, is an instrument issued by an authorized body guaranteeing that a specified amount of energy savings has been achieved. Each certificate is a unique and traceable commodity carrying a prop­erty right over a certain amount of additional energy savings and guaranteeing that the benefit of these sav­ings has not been accounted for elsewhere. To the extent that White Tags continue to have marketable value, they can serve as an incentive or buy-down to the original capital requirements for an Energy Saving Performance Contract.

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