Financial Institutions and Energy Efficiency
This section sets out the reasons why financial institutions are, or should be, active in energy efficiency financing. These include; a large and growing market opportunity, risk reduction, Corporate Social Responsibility, and growing interest from financial regulators.
Leading financial institutions are active in energy efficiency for four main reasons:
- it represents a significant new business opportunity.
- it can reduce client risk through improving cash flow and reducing the risk of stranded assets through tightening energy efficiency regulations.
- it delivers environmental objectives which are a key component of Corporate Social Responsibility programmes.
- banking regulators are increasingly looking at climate risks and energy efficiency is a major factor in mitigating those risks.
These four reasons should encourage other financial institutions to enter the market.
- Assess the market potential for energy efficiency in key client sectors addressed.
- Assess current and future legislative and regulatory environment for energy efficiency.
- Identify any support mechanisms – either government grants or financial instruments such as guarantee mechanisms.
- Assign senior management responsibility to drive product development.
- Product design needs to be proactive, systematic and address the drivers of demand as well as the provision of capital.
- Encourage and assist clients to identify cost-effective energy efficiency improvements which go beyond business-as-usual when considering normal investments such as building refurbishments or new building construction.
- Ensure energy efficiency loans and investments are tagged to enable future tracking and measurement of risk and environmental impacts.
- Ensure energy efficiency products use best practice technical processes including the use of internationally recognised standards.
- Assess potential for improving energy efficiency within own property portfolio and use to develop products and build capacity.
Although there are pools of private sector capital financing energy efficiency projects and programmes, outside of those programmes promoted by multi-lateral development and policy banks (all of which have had a long interest in energy efficiency), these can be considered pioneering or early adopters. Interest and engagement of private finance in energy efficiency was limited until the last decade as the majority of energy financing has been focused on renewable energy and other energy generating assets. Despite growing interest in energy efficiency, aided and supported by the activities of institutions such as the Energy Efficiency Financial Institution Group (EEFIG) and the G20 Energy Efficiency Finance Task Force, the levels of investment to date fall short of both what is possible and what is needed to meet Europe’s energy and climate targets. Financial institutions, both lenders and investors, can take positive action to accelerate the flow of capital into this important area which can be both profitable and address key areas of corporate and systemic risk.
Four reasons to be interested in energy efficiency
There are four reasons why financial institutions should consider deploying capital into energy efficiency:
- energy efficiency represents a large potential market. The IEA estimates that in 2015 global investment in energy efficiency was USD 221 billion with approximately USD 32 billion being financed through explicit energy efficiency mechanisms such as Energy Performance Contracts or green bonds. To achieve our climate goals this level of investment needs to grow to circa USD 1 trillion per annum by 2050 and the provision of finance can help overcome some of the barriers to energy efficiency investment.
- reducing risks in two ways. Firstly, increasing energy efficiency improves the cash flow of clients, thus reducing their risk. Secondly there is the risk of financing assets that become stranded as energy efficiency regulations are tightened. For example, in England & Wales it will become unlawful to lease a commercial building with an Energy Performance Certificate rating below E on 1st April 2018. This puts owners of low performing buildings, and their lenders, at risk.
- improving energy efficiency has a direct impact on reducing emissions of carbon dioxide and other environmental impacts such as local air pollution and therefore should be a key part of Corporate Social Responsibility (CSR) programmes. Energy efficiency is regarded as one of the key pathways to reducing greenhouse gas emissions.
- bank regulators are increasingly looking at climate related risks. Actions include asking banks to disclose the climate-related risks of their loan portfolios. In France disclosing climate-related risks is already required by law. This will allow financial institutions to be better informed about loan performance and thus the cost of risk and carry out better risk appraisal. Possible future actions may include reducing capital reserve requirements for “green” financing.
Each of these four factors are considered in more detail below.
A large potential market
The IEA estimate that that in 2015 total global investment into demand-side energy efficiency was USD 221 billion, USD 118 billion in buildings, USD 39 billion in industry and USD 64 billion in transport. Investment into energy efficiency was less than 14% of total energy sector investment but increased by 6% in 2015 whereas investment into energy supply fell. The US, EU and China represent nearly 70% of the total investment into efficiency. Total investment into efficiency can be split into “core” investments, where the motivation is specifically to achieve energy savings, and “integrated” investments which are the regular transactions in which energy efficiency is not the motivation but which improve efficiency because the new product is more efficient than the one it replaces.
To date about 85%, of all energy efficiency investment has been financed with existing sources of finance or self-financing rather than specific energy efficiency products or programmes. The global market for Energy Performance Contracts, which are most often associated with external financing, was USD 24 billion in 2015 and of this USD 2.7 billion was in Europe. In addition, about USD 8.2 billion of green bonds were used to finance energy efficiency.
In order to achieve climate targets the level of investment in energy efficiency, and the level of energy efficiency financing, will need to increase substantially. The IEA and IRENA estimate that to achieve their “66% 2oC” scenario cumulative, global investment in energy efficiency between 2016 and 2050 will need to reach USD 39 trillion of which USD 30 trillion would be in the G20 economies, implying a global level of c.USD 1 trillion a year compared to the current level of USD 221 billion – a five-fold increase.
The business opportunity for financial institutions falls into two categories:
- creating new business lines for specific energy efficiency projects e.g. specific energy efficiency loans, mortgages or funds.
- ensuring normal lending and investing which is being used to finance projects where energy efficiency is not the primary objective, e.g. building refurbishments or production facility upgrades, is leveraged to ensure funded projects achieve the optimum cost-effective levels of energy efficiency which are usually higher than “business as usual” levels.
Specific mechanisms for addressing these opportunities are discussed in the Financing Energy Efficiency section of this Toolkit.
Energy efficiency projects often have rapid paybacks. In EEIFG’s DEEP (Derisking Energy Efficiency Platform) database, which includes over 7,500 projects, the average reported paybacks are 5 years for buildings and 2 years for industrial projects. The average for buildings can be misleading as there are two very different types of projects being considered, relatively simple single technology projects with rapid payback periods, and more complex, multi-technology, whole-building retrofits which achieve deep energy savings. The latter typically have long, but still attractive in the context of infrastructure investments, payback periods. Despite this economic attractiveness many potential projects do not proceed because of other priorities of the other project host, lack of internal capacity to develop projects, or shortage of investment capital. Furthermore, normal investments in building refurbishments and industrial facilities or new buildings and facilities often do not utilise all of the cost-effective potential for energy efficiency. The provision of third party finance through business models that reduce the overall cost to the host is an important way of overcoming some of the barriers to improving energy efficiency and represents a major business opportunity for financial institutions.
Energy efficiency investments can reduce risks for financial institutions in two ways:
- assisting individual clients, whether they be businesses or individuals, to reduce their energy costs improves their cash flow and profitability, as well as increasing their resilience to energy price rises. Reduced expenditure on energy translates directly to improved cash flow which improves the affordability of loans or mortgages, thus lowering risks to the lender.
- Tightening regulations around energy efficiency, particularly buildings such as Minimum Energy Efficiency Standards, mean that it will become impossible to rent or sell energy inefficient buildings. This is a stranded asset risk for the owner and lender.
Increasing levels of energy efficiency, essentially reducing the amount of energy used for any activity, is a central part of European policy to address concerns about energy security and climate change. European policy is driving tighter energy efficiency regulations for buildings, equipment and appliances as well as vehicles. The main EU policies are the Energy Efficiency Directive (EED) and the Energy Performance of Buildings Directive (EPBD) and in November 2016 the European Commission, in its Winter Package, “Clean Energy for all Europeans”, proposed further tightening of energy efficiency regulations.
Text Box 1.1. Clean Energy for all Europeans
In its Winter package, “Clean Energy for all Europeans”, published on 30 November 2016, the European Commission put forward three main goals:
- putting energy efficiency first
- achieving global leadership in renewable energy
- providing a fair deal for consumers.
The Winter package proposed that the EU should set a target binding at the EU level of 30% by 2030. Compared to the at least 27% target agreed in 2014, this increase is expected to translate into up to EUR 70 billion of additional gross domestic product and 400,000 more jobs as well as a further reduction in the EU’s fossil fuel import bill.
The Commission proposed to update the Energy Efficiency Directive by:
- Extending beyond 2020 the energy saving obligation requiring energy suppliers to save 1.5% of energy each year from 2021 to 2030
- Improving metering and billing for consumers of heating and cooling.
The Commission also proposed updating the Energy Performance of Buildings Directive by:
- Encouraging the use of ICT and smart building technologies
- Strengthening the links between achieving higher rates of building renovation, funding and energy performance certificates as well as reinforcing provisions on national long-term building renovation strategies with a view to decarbonising the building stock by 2050
The Commission also launched a Smart Finance for Smart Buildings initiative to unlock financing for energy efficiency and renewables at a greater rate.
Some member states have implemented Minimum Energy Efficiency Standards (MEES) (also known as Minimum Energy Performance Standards (MEPS)) which mean that after a certain date buildings with an energy efficiency below a set level cannot be sold or rented. These regulations mean that significant proportions of existing real estate portfolios could lose their income and asset value if they are not upgraded to a higher level of energy efficiency. For owners of large property portfolios, or banks lending to property owners, this represents a significant risk which needs to be addressed.
Text box 1.2 describes the situation in the UK and the Netherlands with regard to MEPS.
Text Box 1.2. Minimum Energy Performance Standards in the Netherlands and the UK
In the Netherlands, MEPS for buildings are in place and regularly tightened. The Dutch government has designed an Energy Performance Coefficient instrument, which consists of minimum norms for new-build buildings. Aiming to reduce CO2 emissions, the instrument reduced the norm (from 0.6 to 0.4) for all new buildings in 2015. In the same year, MEPS were also tightened for renovations in existing buildings. Energy Performance Certificates (EPCs) have become a supporting tool to overcome the challenges of financing energy efficiency measures in the Dutch non-residential buildings. However, in the commercial sector, the EPC as an asset rating is often not regarded as an investment grade instrument by financing institutions. It is also relevant to note that according to the Dutch National Energy Efficiency Action Plan, the EPC of a building could pose a limit to the maximum rent.
In the UK Minimum Energy Efficiency Standards (MEES) come into effect on 1st April 2018. After that date, a non-domestic property cannot be let or sold unless it meets a minimum standard of an Energy Performance Certificate rating of E (on a scale of A to G). If a property fails to meet the minimum standard then an assessment must be undertaken to identify relevant energy efficiency improvements which must then be carried out. Research in 2016 suggested that one in five commercial properties were at risk of devaluing and that the fall in value of the UK commercial property portfolio could be as much as £16.5 billion.
1CO2 Estates (2016) MEES: The implications for rent reviews, lease renewals and valuation
The environmental impacts of energy efficiency
For many years advocates of energy efficiency have argued that it is the lowest cost source of energy services and a low-cost route to achieving significant reductions in greenhouse gas emissions. This has now been recognised both by policy makers and by many financial institutions. The projects in EEFIG’s DEEP (Derisking Energy Efficiency Platform) database suggest that the median avoided cost of energy is 2.5 Eurocents/kWh for buildings and 1.2 Eurocents/kWh for industry, which is lower than generation costs. Energy efficiency has been described as “the linchpin that can keep the door open to a 2oC future”. The IEA estimates that in achieving a 2oC scenario energy efficiency must account for 38% of the total cumulative emission reduction through 2050, while renewable energy only needs to account for 32%. For financial institutions looking to make a positive impact on resolving environmental problems as part of Corporate Social Responsibility programmes supporting energy efficiency should be a high priority. As well as reducing emissions of carbon dioxide that drive global climate change, reducing energy consumption can also have a positive effect on local air pollution.
Energy efficiency and financial regulators
Financial regulators are taking an increased interest in systemic risks including climate change. There is also a growing interest from regulators and governments in encouraging the growth of “green finance”. The European Systemic Risk Board in its Scientific Advisory Committee report of February 2016, “Too little, too sudden”, warned of the risks of “contagion” and stranded assets if moves to a low carbon economy happened too late or too abruptly. The report’s policy recommendations including increased reporting and disclosure of climate related risks and incorporating climate related prudential risks into stress testing.
In December 2016, the Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures (TCFD) published its recommendations which included disclosure of organisations’ forward looking climate related risks.
In July 2015, France strengthened mandatory climate disclosure requirements for listed companies and introduced the first mandatory requirements for institutional investors as part of Article 173 of the Law for the Energy Transition and Green Growth. These provisions require listed companies to disclose in the annual report “the financial risks related to the effects of climate change and the measures adopted by the company to reduce them, by implementing a low-carbon strategy in every component of its activities.” Institutional investors will also be required to “mention in their annual report, and make available to their beneficiaries, information on how their investment decision-making process takes social, environmental and governance criteria into consideration, and the means implemented to contribute to the energy and ecological transition.” The law also requires the government to implement stress testing reflecting the risks associated with climate change.
This trend towards greater disclosure and open assessment of climate-related risks is likely to continue across Europe.
Actions that financial institutions can take
All financial institutions can take an active role in improving energy efficiency. The specific action will depend on the type of institution and the market sectors that they operate in but suggested actions include the following.
Assess the market potential for energy efficiency in key markets addressed by the institution.
Although the potential market for energy efficiency across the global and EU economies is large, financial institutions need to consider the potential market in those sectors and jurisdictions that they operate in. Different sectors have different potentials as well as differing market needs. Even within the property sector there are large differences between different segments such as owner occupied commercial buildings, commercial real estate for rent and housing with its different tenancy and ownership structures. The links between energy efficiency markets and related existing markets, e.g. the market for home improvement, also need to be considered.
Assess current legislative and regulatory environment for energy efficiency.
Even within the EU Policy framework specific legislation and regulations affecting energy efficiency differ across different sectors and jurisdictions and financial institutions need to understand the specific policy environments for those sectors and geographies they operate in.
Assess availability of support mechanisms – either government grants or financial instruments such as guarantee mechanisms.
Each market has differing support mechanisms such as grants, low interest loans and guarantee mechanisms. These can have a significant effect on consumer behaviour and need to be understood when developing new financial products aimed at energy efficiency.
Assign senior team to drive product development.
Driving through the development of new products requires senior management attention. This is particularly true in areas like energy efficiency which can cut across different departments of a financial institution.
Ensure that product and programme design is proactive and systematic rather than just the provision of capital.
Evidence from the market strongly suggests that simply providing capital does not necessarily lead to successful deployment of that capital. It is necessary to consider the factors that drive demand for financed energy efficiency and put in place mechanisms to help drive demand such as technical assistance and marketing.
Ensure energy efficiency loans/investments are tagged to enable future measurement of risk and environmental impact.
Energy efficiency loans and investments are believed to be low risk but there is little hard data to support this. To enable measurement of risk, as well as measurement of environmental benefits which will become increasingly important, it is important to tag energy efficiency loans and investments so that future analysis can be carried out.
Ensure everyday lending or investment operations identify opportunities for energy efficiency. Many normal, everyday investments, for instance in building refurbishments or new buildings, result in some energy efficiency because of better technologies or tighter regulations, however, they often miss cost-effective opportunities to further improve energy efficiency beyond business-as-usual. Lenders and investors can take an active role in encouraging and assisting borrowers to identify these opportunities which can both help hosts to reduce risks, through improved cash flow, and to help lenders increase capital deployment.
Ensure energy efficiency products are based on best practice technical assistance including use of internationally recognised standards such as the Investor Confidence Project.
Energy efficiency projects of all sizes require suitable technical expertise to develop and implement them. Financial institutions should ensure that they have access to best-in-class technical assistance and that projects are developed using internationally recognised, best practice standards such as those of the Investor Confidence Project (see Text Box 3.1 and Resources section). This will help to minimize project performance risks as well as due diligence costs.
Assess potential for improving energy efficiency within own property portfolio and using it to develop products and build capacity.
Many financial institutions own significant property portfolios covering a wide range of buildings ranging through local branches, large complex office buildings and data centres. These portfolios represent both a significant opportunity to reduce energy costs and hence improve profitability, but also an opportunity to build capacity and experience in energy efficiency. They can become test beds for developing new products and programmes.