The California Pilot Program Will Serve as a Model for Other States
It is not difficult to make the case for reducing a building’s energy consumption – reducing energy consumption lowers energy and maintenance costs, creates better, more efficient buildings and reduces greenhouse gas (GHG) emissions. Furthermore, with energy costs increasing to meet the ever growing demand – and the evolving national, state and local energy regulatory frameworks, which may include caps on GHG emissions, energy consumption disclosure requirements1 and mandatory building retrofits2 – building owners that act now to implement energy efficiency projects will remain ahead of the curve. In addition, building owners will reap increased savings from the efficient management of a building’s energy use and be well-positioned in the marketplace to compete for tenants and building purchasers. In fact, a recent study conducted by CB Richard Ellis reported that owners of sustainably-managed buildings expect a 4 percent higher return on investment and a 5 percent or more increase in building value than do owners of traditionally-managed buildings. The study also noted that approximately “79% of owners surveyed believe sustainable properties perform well in attracting and retaining tenants, yielding a 5% increase in building occupancy and 1% increase in rental income.”3
Many building owners are eager to lower their energy costs through implementation of energy efficiency retrofits, but often do not have the upfront funds needed to finance such often extensive and expensive building retrofits. Energy performance contracting (EPC) has emerged as a means to achieve these energy savings with the financial security, in most cases, of a guarantee that the energy savings from the project will equal or exceed the costs of financing the project over a certain term. With EPC projects resulting in energy savings of 15 to 35 percent (or more), building owners are keen on realizing such savings, but still must find a way to finance the upfront costs of the retrofits. A pilot program in California is offering a solution to this problem by providing building owners with access to the financing needed for energy efficiency projects by using local government bonds and property assessed clean energy (PACE) assessments to develop and promote private financing of these projects (the “Program”). This alert will provide an overview of EPC and the Program and how these mechanisms are breaking down the barriers commonly faced by building owners who wish to implement energy efficiency projects.
Energy Performance Contracting
EPC provides building owners with a unique opportunity to retrofit an existing building in order to achieve substantial energy savings with the security of a guarantee that the energy savings from the project will be sufficient to cover the long-term cost of the financing. EPC is not a one-size-fits-all solution, but rather, a comprehensive process that is best suited for buildings that need or could greatly benefit from major re-commissioning and retrofitting of energy systems.
For building owners, the first step is to find and select an energy services company (ESCO).
ESCOs provide the full range of services needed to carry out an EPC project, including:
- an initial energy audit
- design and specifications engineering
- construction management
- training of staff
- ongoing maintenance
- savings monitoring/verification
ESCOs will typically help an owner secure available public and utility incentives, and may help arrange project financing. Often, a building owner will issue a request for proposals (RFP) in order to select the ESCO, which will require the ESCO to detail its qualifications, experience with similar projects, corporate financial information, approach to savings verification, and, if applicable, financing options.
As part of the RFP process (and therefore without any financial or contractual obligation by the owner), the ESCO will identify and evaluate the energy savings opportunities that are available for the building and present its recommended improvements and how the cost of such improvements can be paid for through the energy savings achieved. Retrofits and building improvements may include: new lighting technologies, HVAC upgrades, building automation systems, building envelope improvements, and water and sewer system improvements. For example, the three EPC projects described below demonstrate a wide range of technologies and building improvements.
Empire State Building (New York, NY)
- Window retrofit (on-site remanufacturing to add suspended coat film)
- Tenant energy management metering system
- Radiator insulation
- Building automation system enhancement
- Chiller plant retrofit
Richard J. Daley Center (Chicago, IL)
- Lighting upgrades
- Water fixture replacement
- Energy management system optimization
- New boiler controls
- Chiller upgrades
Boston Housing Authority, Retrofit of 4,300 Apartments in 13 Public Housing Developments (Boston, MA)
- Replacement of centralized boiler plant with approximately 23 smaller, satellite boiler plants
- Individual apartment temperature controls
- Renewable energy generation and co-generation
(Holland & Knight represented the owners on these EPC projects.)
Two other key components of an EPC are the guarantee and monitoring/verification.
The guarantee is the contractual commitment by the ESCO to the client that the project will result in a specified reduction in energy, water use and possibly maintenance over a set period of time. In most instances, the guaranteed savings, when translated into dollars based on contractually stipulated utility rates, will be sufficient to offset the annual debt service on the project financing. If in a given year, the guaranteed savings are not achieved due to an ESCO-attributed failure, the ESCO will pay the difference between the guaranteed savings and the actual savings to the building owner. In order to avoid disputes between the building owner and the ESCO, the guarantee provisions in the EPC must include a clearly defined process for calculating the energy savings, with the savings based on energy units.
The EPC must detail the measurement/verification process the ESCO will employ to track and confirm the savings, as well as the reports the owner will receive to ensure the savings are “on track” and to confirm the ESCO’s calculations. Any “causes for adjustment” of the formulas used to calculate savings must be clearly defined, as well as the division of maintenance responsibilities between the building owner and ESCO.4
California PACE Commercial Pilot Program Provides Innovative, Replicable Model for Commercial Retrofit Financing
An innovative pilot program in California uses local government bonds and PACE assessments5 to facilitate owner-arranged private financing for large commercial building energy retrofits. Owners of commercial buildings throughout California, as well as in other states with existing or pending PACE legislation, will be particularly interested in the Program as a model for financing commercial building energy retrofits that addresses common critical barriers such as inability to access capital and lack of security or repayment guarantee for retrofit lenders. The Program allows an owner to finance all costs of its participation through energy efficiency savings, with bond investor security derived from a lien on the property and additional building owner security derived from the EPC performance guarantee if an EPC is in place.
A cornerstone of the Program is its reliance on sophisticated players, including commercial property owners, mortgage holders and investors, to negotiate financing terms. To obtain Program financing for building energy retrofits, commercial building owners must first identify investors willing to underwrite the project and negotiate deal terms directly with these investors. The owner must also obtain from any existing mortgage-holders consent to a PACE lien on the property (see below for additional information regarding PACE). It is possible – and in many cases, preferable – for an existing mortgagee to invest in the project and underwrite and purchase the bond.6 Finally, the building owner must identify a contractor to undertake the retrofit work. An EPC with an ESCO is an ideal structure for the arrangement between the building owner and the retrofit contractor.
After deal terms are negotiated, the building owner submits an application package to the local government agency administering the Program, and the application is vetted to verify the project’s eligibility and to confirm that property taxes and assessments for the property are current. If a project qualifies for the Program, the building owner, investor(s) and local government enter into a loan agreement reflecting the negotiated deal terms, and the local government sells to the owner-selected investors in a “private placement” sale bonds structured according to the loan agreement. Proceeds from the bond sale are used to fund the project, providing the building owner with up-front capital necessary to pay the contractor to complete energy-saving retrofits.
To secure the investor’s loan, the local government places a contractual PACE assessment on the commercial building’s tax bill, which assessment is paid at the same time as regular property taxes. The PACE assessment constitutes a lien against the property until it is fully paid, and continues to exist even if building ownership changes. Importantly, the PACE lien has “super-priority,” which means that it has priority over mortgages and other non-priority liens against the property. However existing lienholders’ interests remain protected because PACE assessments typically cannot be accelerated due to non-payment.
The PACE structure is attractive to investors because it provides the security of a dedicated loan repayment source. For each tax period during which the PACE lien is in place, the PACE assessment amount reflects the total financing due during that tax period. Money collected by the local government through PACE assessments is paid to the investors who purchased the private placement bond that funded the project. In addition, PACE assessments provide investors with security as the financial savings that accrue to the commercial property owner as a result of the building energy retrofits are designed to support or exceed the amount of the PACE assessment, thereby ensuring that a building owner has adequate cash flow to pay the assessment. Another layer of security is provided if the building owner utilizes an EPC that includes an ESCO guarantee of the projected energy savings as discussed above. The current Program guidelines recommend that owners obtain security for the savings used to pay the assessments, making an EPC an attractive model for participation. Other instruments such as energy savings insurance can also be used to provide security for the guaranteed energy savings.
Implementation of the Program has started with the City of Los Angeles’ Energy Upgrade Los Angeles Commercial Building Performance Initiative (the “LA Program”). The LA Program is slated to be the first large-scale commercial retrofit program in the United States, and is intended to accelerate the adoption of energy efficient and renewable energy products, services and practices. In total, the LA Program is expected to result in comprehensive retrofit and retro-commissioning of at least 33 building projects totaling over 13 million square feet of commercial space. LA Program participants will work with contractors of their choice, and may (but are not required to) enter into an EPC. Through a partnership with the Clinton Climate Initiative (CCI), the LA Program will be replicated in San Francisco and Placer County. In addition, the LA Program will prepare “guidance packages” that can be used by other local governments interested in establishing an owner-arranged commercial PACE financing program.
The Program is supported by diverse stakeholders and substantial public funding. Entities collaborating in the Program include the Local Government Coalition, the Community Redevelopment Agency of Los Angeles (CRA/LA), the CCI, the California Energy Commission (CEC), and the Los Angeles Department of Water and Power (LADWP). The Program is funded through American Recovery and Reinvestment Act (ARRA) Energy Efficiency and Conservation Block Grant (EECBG) and State Energy Program (SEP) funds. ARRA funding will be used to fund no-cost Phase I and Phase II energy savings opportunity assessments, industry outreach and technical assistance to participating building owners. Of particular interest is the anticipated establishment of $2.5 million debt service reserves for the LA Program, which are expected to leverage up to $50 million of private capital (assuming 5 percent in potential total outstanding delinquencies).
In the current economic and regulatory climate, energy performance contracting allows building owners to implement energy efficiency projects in a way that minimizes financial risk and provides significant short- and long-term financial and environmental benefits. Commercial building owners in California will find that EPC and the PACE program together present an especially attractive opportunity for financing energy efficiency retrofits.