Retrofit project financing can often be the Achilles heel of energy efficiency. In our experience, there are three critical elements you need to consider –
- Financial Availability - An assessment of the availability of financing early in any energy efficiency program,
- Financial Metrics - An analysis of the efficacy of the energy efficient retrofit project in the appropriate financial metrics (i.e. not just payback), and
- Financing Alternatives - A solid understanding of the increasing array of available financing alternatives.
1. Financing Availability
Always near the top on the list of impediments to energy efficient retrofits is the lack of capital. In many studies, lack of capital has led to the failure to move forward on energy-efficient retrofits in almost 50% of the cases studied. This is bad enough in itself, but it is absurd for this to come up after the commitment of internal and external resources to pursue these opportunities. In our experience, there are a number of issues that should be reviewed right up front, in addition to the actual choices in sources of funding.
Internal Revolver Discipline
As may be evident from the title, this describes an internal financial discipline drawing on the analogy of the conventional bank revolving loan mechanism. In this case we are referring to a pooling, or “bucket” of funds that starts with an allocation of internal funding. A portion of this bucket is used to undertake energy efficient retrofits, the resulting savings are verified and at least some portion are put back into the bucket to finance other energy efficient retrofits. It has been our experience that this discipline fosters programs of investments in energy efficiency rather than just individual projects. We would be delighted to assist you in setting up your internal revolver bucket.
These incentives/rebates are essential inducements put out by the providers as a subsidy to swing the cost/benefit analysis to a “yes”. We continue to run across companies that have either:
- not made energy efficient retrofit investment decisions because they appear to have not heard about applicable incentives and because, absent any incentives, they do not make hurdle,
- made these investment decisions ignoring incentives because they did not have time to capture them, given the constraints that often come with incentive programs.
Similar to incentive programs, energy efficient retrofits are often assessed far away from the corporation’s tax department. And this is another missed opportunity. While not as broadly available as the utility incentive programs, there can be a substantial subsidy embedded in tax breaks (tax credits, accelerated tax deductions such as 179D in the US, 43.2 in Canada, etc.)
Not only are we aware of the array of Federal, provincial and state tax programs that encourage energy efficient retrofits, but we actively engage in the development of new rules, such as our current engagement in the efforts to secure additional tax benefits at the Canadian Federal level. Again, all of these opportunities need to be factored into any analysis up front.
2. Financial Metrics
Payback – and why this is the wrong metric
The analysis of an investment in energy efficiency at its most simple involves quantifying the amount of incremental capital required and the value of the assumed energy savings to be achieved. The payback analysis simply establishes the time period for recovering the capital investment – it does not take into account the time value of money or the actual life of the equipment. More importantly it precludes comparison with other corporate investment choices that need to be made on an ongoing basis, such as production process improvements, probably using more sophisticated metrics. The one thing that can be said in favour of the payback metric is that it is easy to understand. The much more important thing that has to be said against the use of the payback metric is that in terms of energy efficiency investments, it typically leads to the decision not to proceed (it does not appear to grasp the concept that energy savings can more than pay for the underlying equipment.)
ROI is misleading too
While return on investment ("ROI") may look like an improvement as a financial metric, in that it takes into account the life of the equipment, it still does not deal with the time value of money (nor for the purist, the benefits of compound interest.) Absent a steady cash flow stream, it will produce misleading results and, again, it does not allow for effective comparative investment decisions.
IRR is the smart Decision-Maker metric
Internal rate of return ("IRR") is the metric that allows for the evaluation of overall profitability of the investment decision and is the only metric that allows for direct comparison with other internal investment decisions. IRR is the measurement tool most widely used by financial professionals. But it is not the best metric where there are multiple investment choices, all of which achieve the necessary IRR, in that IRR cannot reflect the relative size of investments and the related energy savings.
NPV analysis Yields the Final Decision
After running IRR computations to assess retrofit project compliance with your company’s hurdle rate, the last set of financial metrics to be run is net present value ("NPV"). This is actually the best method for evaluating or prioritizing a number of projects – with one caveat. It does require commitment to an appropriate discount rate. While this should reflect the known cost of capital to your company, this is often a “plug” number, the choice of which can lead to inappropriate conclusions. Assuming an effective discount rate choice, running the NPV computations on those retrofit projects that achieve sufficient IRR should deliver the road map to optimizing your savings.
Do not use these metrics to simply identify and fund only the lowest-hanging fruit. You will only be throttling the full range of savings, short and long term, that a holistic retrofit program can deliver. If you simply always select the no-cost, low-cost projects, you will never have the funds nor the will to take on the longer-term payback investments. In our experience, there should always be at least an appreciation for the “blended” approach.
Our Business Case Output
All of our reports and analyses reflect our preoccupation with ensuring that you have the appropriate set of financial metrics embedded in our business cases to optimize your internal discussions regarding energy efficient retrofits.
3. Financing Alternatives
There is no question – it has been relatively tough to find cost-effective financing for energy efficient retrofits in the marketplace for some years. In our view, this reflects a congruence of events:
- An apparent lack of demand from the market,
- A level of angst among lenders regarding their level of confidence in the reported savings of energy efficient retrofits, and
- A relative tsunami of funds being made available for renewables.
Fortunately, it would appear that those needing funding for these retrofits and those willing to provide it, outside of conventional debt financing based on overall borrower creditworthiness etc, are coming close to meeting in the middle. Much of the good news is coming from two prime sources:
- Different levels of government stepping up and
- The dens of Corporate Finance with their increasing array of structured financing alternatives.
Probably the best known examples of government active involvement would include the PACE programs and variations on what have been called PAPER programs in Canada. Simply put, these programs reflect local municipal governments crafting new bylaws that facilitate entities wishing to undertake energy efficient retrofits to raise the necessary funding through adding it to the related property tax bill. Suffice it to say that these programs can completely eliminate the problem of raising funds, in the right circumstances. It should be noted that these related circumstances are now constantly evolving – and we keep track of the changes in this landscape for you.
Obviously one of the more traditional mechanisms through which governments deliver fiscal policy is the tax statute. This typically involves various levels of federal, state and provincial governments while municipal, state and provincial governments often have sales tax-type incentives.
The other place governments are stepping up is in providing various forms of loan guarantees. The April, 2014 US Department of Energy $4 Billion commercialization of renewable and energy efficiency technologies loan guarantee program is a recent example.
Structured Financing Alternatives
This array of funding sources can best be described as simply decoupling the user of the energy from the owner of the energy-producing asset. There are investors now in the marketplace that have any number of reasons for wanting to own energy efficient retrofit assets. This interest can be a function of the sheer scale of perceived financial results derived from ownership or the need to be seen to have investments in the energy efficient sector. Or it can essentially reflect vendor financing.
Without needing to get into all the details for purposes of this commentary, these types of financing are best recognized by their reliance on simple acronym nomenclature – ESPA, MESA, ESA. We are familiar with all of these structures and can assist you in assessing your ability to tap into this funding.