Contents
• KEY POINTS
• RECOMMENDATIONS
• • The size of the energy efficiency
    investment and finance markets
    and the barriers to growth
  • Types of energy efficiency
    projects
  • Energy efficiency technologies
  • Types of energy efficiency
    financing
  • Considerations when choosing
    finance source and structure

Financing Energy Efficiency

This section sets out different ways in which energy efficiency can be financed and the types of structures and contracts that can be used. It is aimed primarily origination teams and project developers.

KEY POINTS

Energy efficiency can be financed through the following mechanisms:

• savings and equity
• loans/mortgages specifically for energy efficiency upgrades in buildings such as homes, new energy efficient buildings, industry and commerce
• leasing for energy efficiency products
• ensuring normal lending/investment for everyday building refurbishments or upgrades incorporate the optimum level of cost-effective energy efficiency measures and achieve levels of performance beyond business as usual
• specialised energy efficiency funds offering equity or debt for projects
• property funds specifically for energy efficient / green buildings
• financing through specialised energy service contracts such as Energy Performance Contracts.
• secondary financing through forfaiting funds, bonds, yieldcos and securitisation.

Most existing energy efficiency financing is through equity, savings or normal commercial/residential lending.

Financing of energy efficiency specifically faces a number of barriers compared to financing energy supply projects. These barriers include amongst others:

• benefits are in the form of savings rather than revenues
• savings can be hard to measure without Measurement and Verification protocols
• projects are generally small when compared to supply side projects
• projects can be embedded into wider projects with other purposes e.g. building modernisation
• the split incentive in commercial or residential property whereby the tenant benefits from energy savings whereas the landlord makes the investment.

Financing of energy efficiency projects, particularly in buildings, needs to consider interactions with existing finance, interactions with existing leases and balance sheet issues.

RECOMMENDATIONS

• Review existing methods of financing energy efficiency that are most applicable to your market segments.

• Review existing lending/investment procedures to identify and develop mechanisms to assist borrowers identify and assess additional cost-effective energy efficiency investments that go beyond business as usual.

• Make energy efficiency assessments a required part of Physical Needs Assessment and due diligence procedures for financing or re-financing commercial property.
• Banks should identify and tag loans that have an element of energy efficiency to allow future risk analysis.

• Depending on sectors of interest:
• Identify leading providers of energy efficiency solutions such as Energy Performance Contracts.
• Engage with groups and projects working to standardise energy efficiency mortgages
• Engage with groups and projects working to standardise energy efficiency criteria for green bonds.

The size of the energy efficiency investment and finance markets and the barriers to growth

The first section of this Toolkit, Financial Institutions and Energy Efficiency, reviewed the size of the energy efficiency investment and financing markets. To recap:

• Total global investment into energy efficiency in 2015: USD 221 billion.
• Global market for energy performance contracts in 2015: USD 24 billion with c.USD 2.7 billion in the EU.
• Green bonds used to finance energy efficiency in 2015: USD 8.2 billion.

To achieve energy security and climate goals investment levels will need to grow by a factor of five.

There are a number of barriers to achieving these elevated levels of investment and finance which are specific to energy efficiency. These barriers include amongst others:

• the benefits are in the form of savings rather than revenues, making it harder to secure cash flows compared to energy supply projects
• savings can be hard to measure due to the difficulties of metering and the influence of variables such as weather and changes of patterns of use
• projects are small compared to supply side projects and the typical investment size required by the debt capital markets
• there is little standardisation in the development and documentation of projects
• project development and due diligence costs can be high relative to investment size
• projects are often part of larger projects with other purposes e.g. building modernisation
• energy efficiency assets are usually embedded into buildings and processes which presents difficulties for asset finance models
• the split incentive in commercial property whereby the tenant benefits from energy savings whereas the landlord makes the investment.

Types of energy efficiency projects

Energy efficiency projects can either be:

• retrofits - stand-alone projects where the primary purpose is improving energy efficiency such as changing lighting to LEDs.
• embedded – part of wider renovation projects such as building refurbishments or an upgrade of a production line that is being undertaken for other purposes such as increasing rent or change of product. An example would be replacing heating plant or adding insulation as part of a building refurbishment.
• new build – new buildings and production lines tend to be more efficient than old ones due to improved technology and tighter regulations. Building just to regulation or norms should be considered “business as usual” because in most situations there are cost-effective opportunities to improve energy performance beyond those levels which are neglected.

Energy efficiency technologies

Energy efficiency technologies are diverse but well proven. They can include technologies in space heating and cooling, building fabric, mechanical and electrical environmental systems, controls technologies, lighting, electric motors and drives, on-site energy generation and distribution systems (including steam and hot water systems), industrial process heating and heat recovery. With a very few exceptions, which should always be made explicitly and with full understanding of the risks, energy efficiency projects utilise proven, well-understood, commercially available technologies and do not involve technology development risks. A glossary of common energy efficiency technologies likely to be encountered by lenders and investors is included in the Resources section.

Types of energy efficiency financing

The financing of energy efficiency can be achieved in several forms, the choice of which should be dependent on the type and size of the investment, the risk preferences of lenders/investors, and market acceptability. Possible types of energy efficiency financing include:

• savings or equity
• loans/mortgages specifically for energy efficiency upgrades in residential and commercial buildings, industry and commerce
• loans/mortgages specifically for the purchase of energy efficient buildings
• leasing for energy efficiency products
• ensuring normal lending/investment for everyday building refurbishments or upgrades incorporate the optimum level of cost-effective energy efficiency measures and achieve levels of performance beyond business as usual
• specialised energy efficiency funds offering equity or debt for projects
• property funds specifically for energy efficient / green buildings
• financing of specialised energy service contracts including:
  • Energy Performance Contracts
  • Chauffage contracts
  • Efficiency Services Agreements
  • Managed Energy Service Agreements
  • Metered Energy Efficiency Transaction Structure contracts
  • Lighting as a Service contracts
• Secondary financing can be achieved through:
  • forfaiting funds purchasing receivables from energy service contracts
  • bonds
  • yieldcos

With the exception of self-financing through savings or equity, these are described below and examples given here and in the Resources section of this Toolkit.

Consumer and commercial lending

Most energy efficiency financing is simply through normal lending, either to the residential or commercial sectors. In most cases this activity is not specifically identified as energy efficiency lending as the detailed purpose of the loan is not usually known in sufficient detail, whether energy efficiency is the main purpose or it is embedded into a larger project. In the residential sector for example the loan may only be identified as being for “home improvements”. Banks should identify and tag loans that have an element of energy efficiency to allow future risk analysis as well as measurement of environmental results. 

Energy efficiency loans should improve customer cash flow and a few banks have begun to take the improved cash flow into effect when considering credit risk. Although this is a positive development as energy saving clearly does improve cash flow, lenders taking into account this improved cash flow need to be aware that they are implicitly taking some performance risk - if the savings are not delivered the consumer risk is higher than anticipated. This is one of several reasons why banks should be concerned about performance risk. This is discussed further in the Value and Risk Assessment section.

Most consumer and commercial loans are recovered from the borrower in the normal way but there are specialised means of loan recovery in the global energy efficiency financing market which have considerable potential for growth in Europe, namely On-Bill Recovery and Property Assessed Clean Energy. They are described in Text Boxes 2.1 and 2.2.

Green Mortgages

A green or energy efficiency mortgage is one that is used to finance purchase of an energy efficient building or refurbish a building to a higher standard of efficiency. Lower energy bills resulting from high levels of energy efficiency improve the building owner’s cash flow and improve the building's value and therefore should reduce risk of default and potentially allow lenders to offer higher levels of borrowing and Loan to Value and/or lower interest rates.

Energy efficiency mortgages have been available in the USA since the 1990s through a programme supported by the Federal Housing Administration which provides mortgage insurance for qualifying loans. Borrowers must obtain a home energy assessment and financed measures must pass a cost-effectiveness test. When the home being purchased meets minimum energy efficiency standards the borrowers qualifying debt to income ratio can be stretched two percentage points above standard limits.

At present there is no clear definition of a green mortgage as different lenders are offering consumers different options. To address this issue and help grow the market for green mortgages the European Mortgage Federation and European Covered Bonds Council (EMF-ECBC) have started a project known as the Energy Efficient Mortgages Action Plan (EEMAP), described in Text Box 2.3. In the UK the LENDERS project is seeking to demonstrate that more accurate assessments of energy bills can allow lenders to provide larger mortgages responsibly – see Text Box 2.4. In Romania a consortium of banks, developers and the Romanian Green Building Council, is working to develop a market for green mortgages – see Text Box 2.5.

Lease-Purchase/Equipment Finance

Figure 1: Lease-Purchase/Equipment Finance

Leasing is a well established method of financing energy efficiency projects. While the term is virtually interchangeable with equipment finance, the contracts typically cover all materials, labour and soft costs associated with an energy efficiency project. However a critical distinguishing feature of equipment leasing is that the equipment is the collateral for the financing. The possibility that an equipment finance lender would repossess the equipment for non-payment puts the lender in a strong position but in practice it may be difficult to remove energy efficiency equipment that is embedded into a building or process. 

Ensuring normal lending and investing encourages energy efficiency

Every working day loans, mortgages, leases and investments are made into new buildings, building refurbishments and modernisation as well as upgrade and replacement of industrial processes and production plants. In nearly all cases, energy efficiency is not the primary purpose of the investment being financed but the future levels of energy efficiency are effectively being decided and “locked in”, in some cases because of the long life of major assets for many decades. Although new buildings, refurbishments or new production plants generally achieve higher levels of efficiency than the units that they replace due to a) improved technologies and b) tighter regulations and codes of practice, many cost-effective opportunities to improve energy efficiency are missed. This occurs due to a number of reasons including; lack of knowledge on the part of project hosts, time pressure, the conservative nature of engineering design, and treating regulations as a target that have to be achieved rather than a minimum level of performance. Banks and financial institutions can play an active role in ensuring financed projects of all types achieve optimum levels of efficiency over and above business as usual by adjusting the lending/investing process to include queries about energy efficiency and the provision of assistance to identify viable projects. By doing this they can both reduce risks, by financing measures that improve customers’ cash flows, and potentially increase lending. The EBRD has long been a pioneer in exploiting the opportunities provided by everyday lending, see Text Box 2.6.

During the due diligence process for acquisition or refinancing of a building an investor or lender will typically review the building’s financials, rent roll and history and require a Physical Needs Assessment (PNA) or comparable review. If significant deficiencies exist the lender may even require that certain capital replacements be made as a condition of refinancing. It can be a relatively simple matter to make energy efficiency assessments and ratings such as Energy Performance Certificates part of that PNA, and even to make performance standards part of a lender’s requirements. Some banks including ING and ABN Amro have implemented these kinds of programmes and going further by providing tools to assist owners to identify energy efficiency measures.

Specialised energy efficiency funds

The multi-lateral banks, with their long interest in energy efficiency, have established specialised energy efficiency funds in their areas of operations over many years, examples include the World Bank’s Renewable Resources and Energy Efficiency (R2E2) Fund in the Western Balkans or the Romania Energy Efficiency Fund (FREE) funded by the World Bank and the Global Environment Facility (GEF). Over the last five to ten years a number of specialised energy efficiency funds have been established using private sector and private-public funding.

These funds offer a range of equity and debt financing products to energy efficiency projects, often projects implemented using Energy Performance Contracts. 

Examples include the European Energy Efficiency Fund (described in Text Box 2.8), the London Energy Efficiency Fund (LEEF) and the SUSI Energy Efficiency Fund.

Financing of specialised energy service contracts

The two most common forms of energy service contract are Energy Performance Contracts (EPCs) and Chauffage contracts. Both have been in use in Europe for many years and sometimes the terms are used inter-changeably even though they are contractually different. They are reviewed below. The relative complexity and cost of developing and establishing these contracts means that they are restricted to relatively large capital value projects. Other types of energy services contracts are starting to emerge and these are also described here.

Energy Performance Contract (EPC)

An Energy Performance Contract (EPC) is a contractual arrangement between the beneficiary and the provider of an energy efficiency improvement measure in which the provider, an Energy Service Company (ESCO), provides a guarantee of performance for the installed measures . The ESCO does not generally provide the required capital but usually works with established lenders to facilitate provision of finance, although the customer can also decide to directly finance the project with its own equity. ESCOs usually operate as the Main Contractor with turnkey responsibility for the energy assessment, project development, technical design, bidding, construction, commissioning, and provision of a savings guarantee. The ESCO’s guarantee is meant to ensure that the savings are sufficient to pay debt service. If there is a shortfall, the host, but not the lender, has recourse to the ESCO. The savings guarantee is the critical element that makes a contract an EPC and binds the various pieces together. Lenders require ESCOs with good track records and strong balance sheets that can ensure construction is completed on time and on budget and can support the performance guarantee.

Figure 3: Energy Performance Contract

In addition to the responsibilities above, the ESCO usually maintains an ongoing service contract, tied to the new equipment installed as part of the retrofit. Because of the performance guarantee some form of performance measurement and verification (M&V) is required for the life of the contract and the methodology should be specified in the contract in the form of an M&V Plan. The M&V responsibility should be executed in a way that avoids conflict of interest, i.e. the ESCO effectively measuring its own success and independent third party M&V specialists, expert in the application of recognised standard techniques such as those of the International Performance Measurement & Verification Protocol (IPMVP), can be engaged to ensure independence.

In the USA and Europe the majority of EPC contracts are with the public sector. The complexity of EPCs has led to the emergence of EPC facilitators in some market, as well as procurement frameworks to assist public sector agencies to develop and implement contracts, and link projects to financing. An example is the UK’s Carbon and Energy Fund (CEF) which focuses on projects in the National Health Service. CEF is described in Text Box 2.11.

Chauffage Contracts (Energy Supply Contracting)

In Europe, Chauffage Contracts are traditionally more common than the EPC described above. Under Chauffage, the contractor takes over the provision of an agreed set of energy services, most often heat (hence "chauffage“) but also potentially light, compressed air etc. The host pays to the contractor some historical average of its energy cost. The contractor then takes responsibility for all elements of energy services, including purchasing fuel for the building and upgrading systems. The developer may choose to discount the historical bill charged to the building owner to ensure savings and incentivise the signing of the contract. The building owner has other motivations, however, typically receiving new equipment and a set of energy services that it might otherwise have to purchase. Chauffage contracts are typically long, 15 to 30 years or more, and are best for buildings where an owner is comfortable outsourcing all elements of the energy infrastructure, energy purchasing and Operations & Maintenance.

Efficiency Services Agreement

In an Efficiency Services Agreement (ESA), a developer retrofits the host property, and the host property pays the developer the savings, typically with a negotiated discount to the facility’s historical costs. Savings are measured against historical energy usage and operating expense, allowing for adjustment based upon current energy prices, weather and other factors. Where calibrated models and precise measurement are not possible, the savings may be stipulated. In contrast to a Managed Energy Services Agreement (MESA), the ESA provider does not take responsibility for utility payments, which remain in the hands of the host property. The ESA is illustrated in Figure 4.

Figure 4: Efficiency Services Agreement

The ESA developer may act as designer and installer of the project, engaging contractors directly, or outsource the function to an ESCO.

Managed Energy Services Agreement

In a Managed Energy Services Agreement (MESA), the developer assumes responsibility for payment of utility bills on behalf of the host asset. Rather than a bill based on savings, the host asset pays the developer an amount equal to the historical energy usage adjusted for current energy rates, weather, and occupancy of the building. This approach typically requires a fully calibrated model reflecting 365 days of energy usage and capable of replicating historical usage with a high degree of accuracy. The formulae for calculating MESA bills based upon future rates, weather and occupancy are provided in the MESA contract. The MESA structure is shown in Figure 5.

Figure 5: Managed Energy Services Agreement

The MESA developer does not typically assume responsibility for procuring energy, which otherwise could represent a conflict of interest; since the asset pays the developer based on historical usage multiplied by current rates, the developer would have a natural disincentive to source lower-cost energy. Typically the MESA makes payment of the energy bill a contractual obligation and an administrative function of the MESA developer, but it does not generally require that energy bills appear in the name of the developer. These bills typically remain in the name of the host asset.

The developer may or may not engage a full-service ESCO to implement the project. MESA presents a higher degree of performance risk for the developer, who may wish to manage that risk directly rather than outsourcing project design and construction. 

Metered Energy Efficiency Transaction Structure

The fundamental shift in the Measured Energy Efficiency Transaction Structure (MEETS) structure is that energy efficiency is metered. Metering is achieved by combining smart meter consumption data and building modelling to produce a dynamic baseline, against which savings are measured. Units of energy saved are then paid for on a per unit basis. The MEETS structure is illustrated in Figure 6.

Figure 6: Managed Energy Services Agreement

The model has only recently emerged in the United States in a pilot transaction which funded additional energy efficiency measures in a new build net zero building, the Bullitt Center in Seattle. The utility can fill the role of developer, or the equity provider, or this can be undertaken by an experienced project developer working in partnership with capital providers.

A number of advantages are claimed for the MEETS structure including:

• the deal structure resembles a Power Purchase Agreement, a well understood instrument that can be financed
• it provides an incentive for the utility to sell efficiency
• the energy tenant agreement looks like standard real estate leases and therefore is easy to understand for real estate professionals
• energy efficiency could become a tradable resource.

Despite these apparent advantages the MEETS structure has not yet been replicated although there is growing interest in the concept in the US and Europe. 

Lighting as a Service (LaaS)

With the introduction of LED and internet enabled lighting offering rapid paybacks on lighting conversions Lighting as a Service (LaaS) models are growing. In LaaS the provider installs lighting upgrades at no cost to the client and finances the project, usually through leasing or asset finance. They also take on maintenance of the system and lamp replacements and the customer pays a regular service fee. Taken to its logical extreme the customer pays for a set level of lighting – “pay per lux” and has no interest in how that lighting level is produced. The falling cost of LED lighting will continue to improve payback periods for LED conversions however they are financed and presumably help drive LaaS models. Navigant Research estimate that the global LaaS market will grow from USD 35.2m in 2016 to USD 1.6bn in 2025.

Other structures

Two other structures that may play a role in energy efficiency projects are more associated with energy supply projects, Power Purchase Agreements and Sale and Lease Back. They are relevant here though as many energy efficiency projects may include elements of energy supply, particularly from distributed sources such as Combined Heat and Power or local renewables such as solar. This is likely to become increasingly common with the growth of distributed energy, demand response, energy efficiency and energy storage.

Power Purchase Agreements (PPAs)

PPAs are a vital component of renewables finance and have been used for co-generation projects for many years. A PPA is a long-term contract for the purchase of electricity or some other utility such as steam or chilled water by an off-taker. The PPA allows a lender to underwrite the financing of the renewable or co-generation project. Just as the credit quality of the tenant is fundamental to the mortgage for commercial property, the credit quality of the off-taker has a significant impact on finance for renewable and cogeneration projects. A PPA may cover a single site or a portfolio of sites. The PPA may cover a single site or multiple sites as part of a portfolio. Although PPAs are concerned with the purchase of generated power they can have a role to play in integrated energy efficiency and supply projects. 

Sale-leaseback

The sale-leaseback structure has become an important piece of transaction architecture for solar installations in some jurisdictions. It grew out of the need for investment vehicles that would allow investors to own the tax attributes of a solar investment in order to receive tax benefits and motivate investment of equity that could benefit from beneficial tax rates. However, the structure also allowed solar contractors to originate projects efficiently by providing surety of financing for the solar projects they install. It also allows for aggregation of power by capital providers and the efficient sale of power to an off-taker. 

Figure 7: Sale-leaseback

Rather than signing a PPA with a host, the host signs a lease for the equipment and installation. The contractor then sells the solar installation and the contract for receivables from the host to the capital provider, who promptly leases the equipment back to the contractor. Lease payments flow from host to contractor and thence to capital provider. 

Secondary financing

In order to grow the energy efficiency financing market it is essential to have an active market in secondary financing in order to recycle capital. The secondary market is only now starting to emerge due to the relatively small scale of the energy efficiency finance market and the lack of standardisation and aggregation of projects. The various secondary financing methods, forfaiting funds, bonds and yieldcos are discussed here.

Forfaiting funds

Energy service contracts such as Energy Performance Contracts produce long-term stable cash flows which can be an attractive asset for long-term investors. Forfaiting funds can refinance EPC contracts, thus allowing the primary investors and banks to recycle their capital into new projects. 

Bonds

Bonds, particularly green bonds, have a large potential role in financing energy efficiency as energy efficiency projects have a clear environmental benefit. Most specific energy efficiency projects are too small for the issuance of a bond on a single-project or single-owner basis, a stand-alone energy efficiency project of EUR 10 million is unusual and still too small for a debt capital market bond. Even if several such projects were identified, the development and execution of those projects and the uncertainty associated with the pace of draws on capital over time would make the use of bonds unwieldy. Green bonds have, however, been used successfully to finance energy efficient buildings, a notable example being Berlin Hyp.

Green bonds are likely to be important for the re-financing of green mortgages and the EMF-ECBC EEMAP project referred to above under Green Mortgages is important in this respect. Bonds are also likely to play an important role even in retrofit projects once a sufficient volume of projects can be aggregated. A set of standardised projects, originated and financed utilising other forms of capital, such as equipment leases or loans, can be aggregated and refinanced through a bond issuance. As a hopeful sign of a market maturing, pooled retrofits have been refinanced by bonds in some instances in the United States. A secondary bond market would allow primary lenders for energy efficiency to recycle capital and grow their energy efficiency lending portfolios.

Important questions regarding bonds for energy efficiency remain including; what characteristics make a bond for energy efficiency projects distinct from other bonds, how to define and measure energy efficiency of the underlying projects, and how to ensure the underlying projects are performing as planned? There are a number of initiatives to develop standards for green bonds including those of the Climate Bonds Initiative which are addressing these questions. For new build projects bond financing could only really be considered energy efficiency if the buildings or industrial facilities financed have an energy performance better than regulations, i.e. better than business-as-usual. Standardised development and implementation protocols at the project level, such as those developed by the Investor Confidence Project, are an important foundation for the growth of future energy efficiency green bond issues.

Yieldco

The emergence of the Yieldco for renewable energy portfolios, while it has had mixed success, represents the maturation of renewable finance and could have future application in energy efficiency. A Yieldco is a company that bundles together a series of renewable transactions such as the sale lease-back shown above. This aggregation blends risk and allows for steady, relatively predictable returns. It also allows parent companies to raise cheaper capital for established projects and to recycle the capital thus unlocked for new project development. Renewable energy Yieldcos have been quoted on public stock markets such as the London Stock Exchange. As with bonds energy efficiency financings have to date been too small to consider Yieldcos but the emergence of aggregators could make them viable.

Figure 8:YieldCo structure

Considerations when choosing finance source and structure

There are a number of factors to consider when choosing an external financing mechanism for energy efficiency measures which are considered here.

Contract Interaction with Permanent Financing

Covenants prevalent in commercial mortgages present formidable obstacles to the investment of third party capital in energy efficiency. Property is divided into “fixture” physical assets attached to a building that are not generally moved or movable, and “fittings,” those items that are generally moved or movable. Fixtures are part of the real property covered by the mortgage, and fittings (or chattel, such as furniture) is not. At the point a mortgage is signed, the lender has a primary secured interest in all of the real property, which includes all of the energy systems in a building that are not part of a tenant’s improvements. Mortgage covenants prohibit the facility owner from giving another lender a security interest in the real property without permission. It is this feature embedded in mortgages that makes additional third-party finance difficult and refinance an appealing way for building owners to pursue comprehensive energy efficiency improvements for a building, since covenants applying to the new permanent financing will apply to the new installations.

Mortgage covenants affect not only the viability of traditional loans and leases for energy efficiency but any agreement that gives a lender or investor a security interest in real property without mortgage lender consent. The energy service contracts discussed above generally seek to avoid running afoul of the permanent financing by structuring other types of security. In a MESA, for example, non-payment of the MESA bill will result in non-payment of the utility bill and jeopardise the operations of the building. A MEETS allows the same recourse. It is the lack of security in real property, however, that has limited uptake of some of these novel investment structures, since real property investors and lenders struggle to justify security for debt in something other than real property itself.

Balance Sheet Impacts

An additional consideration that may be important, both for lenders or investors as well as the host properties involved in an energy efficiency project, is where an energy efficiency project resides from a balance sheet perspective. Some of the energy service contracts were developed in such a way as to qualify as an above-the-line operating expense rather than a below-the-line debt. However, these contracts vary considerably, and calling a contract a “services contract” does not make it one. Some services contracts are unambiguously contracts for debt. The International Financial Reporting Standards (IFRS), developed to harmonise accounting standards in the European Union, provide relatively clear guidance for lenders and investors. Specifically, IFRIC 4 gives guidelines for determining whether an arrangement contains a lease. If it does contain a lease, it must appear on the balance sheet as a fixed asset, and payments must be shown against a liability declining over the term of the contract.

For some firms, the balance sheet treatment of the underlying contract is a critical consideration. They may seek to avoid increasing the balance sheet for any number of reasons including taxation and mandatory distributions to ownership. If a vendor of the energy efficiency project has developed a contract that does not effectively place the transaction on the balance sheet of the host facility, it must necessarily reside on the books of the vendor or the entity it has established to execute the project. This balance sheet treatment has accounting implications for investors and lenders to that project. Accounting review is a critical step in the development and assessment of a large-scale energy efficiency investment.

For public sector bodies in the EU there is an additional accounting issue concerned with Energy Performance Contracts. According to the 2015 Eurostat guidance note on the accounting treatment of EPC, investment has to be accounted on the balance sheet of public authorities. This has been a major impediment to the spread of EPCs in the public sector but efforts are under way to change this. At the beginning of 2017, along with competent national statistical bodies, a review of the current rules and their interpretation was instigated. Options being considered to resolve the issue include:

• the possibility of splitting assets e.g. splitting out the land element of a building’s value.
• using a specific contract model (the buy and leaseback model), under which the capital expenditure would be recorded on the government account but would then be leased back to the contractor, thus removing its impact on government debt.

Provided these options receive support from the national statistical bodies (as part of the Excessive Deficit Procedure Statistics Working Group) the relevant Commission guidance would be amended in 2017. This would facilitate the growth of the energy performance contracting market across Europe.

Contract Interaction with Existing Leases

In some kinds of assets, particularly in multi-tenant commercial buildings, the energy savings from an efficiency project may not flow to a single beneficiary. While it is a consideration that is more important for the host asset than the lender or investor, it is nonetheless important for underwriting to understand how savings flow through the underlying asset.

Operating costs in leases are on a spectrum extending from a net lease where tenants pay for all capital and operating costs to a gross lease where landlords pay for all capital and operating costs. Energy savings from a retrofit in a building with a fully netted lease will flow to the tenants. If the lease makes tenants responsible for capital upgrades (i.e. triple net), the landlord can make the retrofit and charge the tenants pro rata but may have little incentive to undertake the planning and development effort required given that it receives no savings. If the lease makes the landlord responsible for capital expenditures and tenants for operating, there is even less incentive to do so since the tenant will receive the savings having paid nothing for them. This is the problem of split incentives.

Figure 9: Types of building lease

In a fully gross lease (also called full service gross) a landlord pays for all operating costs, typically excluding increases in property taxes, meaning that all energy savings from an energy efficiency project would flow to the landlord. In such leases, there is no diminution of landlord incentive to pursue a retrofit.

Most leases, however, exist somewhere in between these two poles. A common formulation makes landlords responsible for all capital costs and for the operating expenses of the building that exist prior to the signing of the lease, also called the “base year operating costs.” The landlord can charge tenants only for increases in those operating expenses above the base year. Typically, if the lease allows the landlord to bill tenants for capital costs, it may do so only for improvements that save operating costs and even then only according to the useful life of the equipment. Since operating expenses always rise, any savings to the landlord on the operating side are quickly subsumed by increases in all other operating costs. For deep retrofits where capital equipment installed may have a useful life of 15 to 30 years, the landlord’s capital recovery is extremely slow. The landlord may gain as leases turn over and base years for new tenants are lower, but as a general rule roughly half of the energy savings or less accrue to the landlord of a multi-tenant commercial building.

To the extent a contract depends upon payments deriving from savings or upon improvements in the underlying credit resulting from savings, these leasing considerations may have fundamental importance for underwriting. They are the reason that many energy service contracts are tailored in a way to make the services and the provision of capital equipment part of a contract for operations, and therefore chargeable to tenants. How and whether they accomplish this goal is both a legal question and a marketing one, given that tenant perception of the fairness of operating costs may affect lease renewal.