Step 4a: Choose Your Program Structure—Credit Enhancements
Credit Enhancements Can Include:
- Loan loss reserve funds
- Interest rate buy-downs
- Loan loss insurance
- Debt service reserve funds
- Subordinated capital structures
Many financing programs include credit enhancements that can help reduce the financial partner's perceived risk exposure and therefore increase the pool of eligible energy efficiency project opportunities. They can motivate financial partners to broaden consumer access to energy efficiency-related loans, extend the length of time in which a loan is due, and lower interest rates. The terms of credit enhancements can also be used to negotiate favorable loan products (see below) and relax loan eligibility requirements.
Loan loss reserve funds are common types of credit enhancements. Under a loan loss reserve, public funds are set aside (or reserved) as loans are issued (e.g., typically 5% of the total portfolio of loans). In this way, a 5% loan loss reserve on a $60 million loan portfolio provides up to $3 million to cover the financial partner's losses, should they occur. The loss reserve may be specific to a portion of the loss on individual loans. Compensation for losses is often limited to 90% of any individual loan, ensuring a natural incentive for lenders to apply appropriate underwriting criteria to all loans.
See an example of a typical risk-sharing formula under a loan loss reserve agreement.
Results: Use of Loan Loss Reserves to Achieve Energy Efficiency Goals
Credit enhancements such as loan loss reserves have proven to be effective in many communities and have helped programs achieve their energy efficiency goals. For example, projects financed by Energize Phoenix's loan loss reserve program contributed to the state efficiency programs efforts to reduce energy consumption by 30% on 750,000 square feet of commercial space, create 2,000 jobs, and eliminate 50,000 metric tons of carbon (equivalent to taking 9,500 cars off the road).
The figure below illustrates the typical structure of a loan loss reserve arrangement.
Under a loan loss reserve program, public funds are placed into an escrow deposit account―either with a separate institution or under their own administration. As loans are made, escrowed funds are transferred to a loan loss reserve fund in the amounts specified by the loan loss reserve agreement. Projects are then completed and loans are repaid over time according to the loan agreement between the financial partner and the borrower.
Advantages of Loan Loss Reserve Funds
- Much of the administrative work is done by financial institutions with pre-existing capacity and experience making loans.
- Programs can create market transformation and eventually function without government capital.
- It is in the mutual interest of program administrators and financial institutions to raise the leverage ratio as the program is proven.
Credit enhancement provides several advantages, the most important of which is the ability to substantially leverage public funding, sometimes by as much as 20:1. Such programs require dedicated public management of private partners, as well as partners who are highly motivated to drive the success of the program. Credit enhancement programs are also data-intensive and require continuous monitoring to ensure that demand is being generated and met with skilled energy professionals, underwriters, and loan servicers. A successful program, however, can transform the private market, unleashing the power of the financial market to increase energy efficiency upgrades in communities across the country.
Learn more about credit enhancements from the Michigan Saves Program.
For more information related to loan loss reserves, see Chapter 5 of DOE's Clean Energy Finance Guide for Residential and Commercial Building—Basic Concepts for Clean Energy Unsecured Lending and Loan Loss Reserve Funds.