Financing

Cost and financing issues are key in determining which energy efficiency measures will be included in the final project plan. Even at this early stage, the team should look at the cost and financing issues, begin developing some rough cost estimates, and consider financing options. After completing more detailed analyses later in the process, the initial cost estimates will be refined and the best way to finance the project can be determined.

There are five general financing mechanisms available for investing in energy efficiency:

Internal Funds: Energy efficiency improvements are financed by direct allocations from an organization's own internal capital or operating budget.
Debt Financing: Energy efficiency improvements are financed with capital borrowed directly by an organization from private lenders and includes municipal bonds.
Lease or Lease Purchase Agreements: Energy-efficient equipment is acquired through an operating or financing lease of 5 to 10 years with no up-front costs.
Energy Performance Contracts: Energy efficiency retrofits are financed, installed, and maintained by a third party that guarantees savings and payments based on those savings.
Utility Incentives: Rebates, grants, or other financial assistance are offered by an energy utility for the design and purchase of certain energy-efficient systems and equipment.

These financing mechanisms are not mutually exclusive. An organization may use several of them in various combinations. The most appropriate set of options will depend on the type of organization (public or private), size and complexity of a project, internal capital constraints, in-house expertise, and other factors.

The U.S. Department of Energy's Federal Energy Management Program (FEMP), which works with federal agencies to promote energy-efficient design in government buildings, provides useful information and resources for commercial finance and construction. For more information, especially about financing options, visit FEMP's Financing Mechanisms Web site.

More details on each of these financing options are shown below:

Internal Funds

The most direct way to pay for energy efficiency improvements is to allocate funds from the internal capital or operating budget. Financing internally has two clear advantages over the other options: it retains internally all the savings from increased energy efficiency, and it is usually the simplest option administratively. All or some of the resulting savings may be used to decrease overall operating expenses in future years or retained within a revolving fund and used to support additional efficiency investments. Many public and private organizations regularly finance some or all of their energy efficiency improvements from internal funds.

Debt Financing

Direct borrowing of capital from private lenders can be an attractive alternative to internal funding for energy efficiency investments. For both public and private organizations, this approach avoids tapping internal funding, and financing costs can be repaid by the savings from increased energy efficiency. Additionally, municipal governments often issue bonds or other long-term debt instruments at substantially lower interest rates than private corporate entities. As in the case of internal funding, savings from efficiency improvements, less only the cost of financing, are retained internally. Debt financing is administratively more complex than internal funding, and financing costs will vary according to the credit rating of the borrower. This approach may also be restricted by formal debt ceilings imposed by corporate or municipal policy, accounting standards, and/or federal or state legislation. As a key example of the latter, the Tax Reform Act of 1986 placed a cap on the total amount of revenue bonds that a state and its local public agencies may issue. This cap has resulted in substantial competition for the available bonds and can reduce the availability of tax-favored financing.

In general, debt financing should be considered for large projects that involve multiple buildings and pose relatively little risk in achieving their energy savings targets. When considering debt financing, organizations weigh the cost and complexity of the type of financing against the size and risk of the proposed projects.

Lease or Lease Purchase Agreements

Leasing and lease-purchase agreements provide a means to reduce or avoid the high, up-front capital costs of new, energy-efficient equipment. These agreements may be offered by commercial leasing corporations, management and financing companies, banks, investment brokers, or equipment manufacturers. As with direct borrowing, the lease should be designed so that the energy savings are sufficient to pay for the financing charges. While the time period of a lease can vary significantly, leases in which the lessee assumes ownership of the equipment generally range from 5 to 10 years. Specific lease agreements will vary according to lessor policies, the complexity of the project, and whether or not engineering and design services are included.

Operating leases are usually for a short term and occasionally, for periods of less than one year. At the end of the lease period, the lessee may renegotiate the lease, buy the equipment for its fair market value, or acquire other equipment. The lessor is considered the owner of the leased equipment and can claim tax benefits for its depreciation. Financing leases are agreements in which the lessee essentially pays for the equipment in monthly installments. Although payments are generally higher than for an operating lease, the lessee may purchase the equipment at the end of the lease for a nominal amount (commonly $1.00). The lessee is considered the owner of the equipment and may claim certain tax benefits for its depreciation.

Municipal leases are available only to tax-exempt entities such as school districts or municipalities (Section 265(b)(3) of the Internal Revenue Code). Under this type of lease, the lessor does not have to pay taxes on the interest portion of the lessee's payments, and can offer an interest rate that is lower than the usual rate for financing leases. Because of restrictions against multi-year liabilities, the municipality specifies in the contract that the lease will be renewed each year. This places a higher risk on the lessor, who must be prepared for the possibility that funding for the lease may not be appropriated. Therefore, the lessor may charge an interest rate as much as 2 percent above the tax-exempt bond rate, but still lower than rates for regular financing leases. Even so, municipal leases are generally faster and more flexible financing tools than tax-exempt bonds.

Guaranteed Savings Leases are the same as financing or operating leases, but with an additional guaranteed savings clause. Under this type of lease, the lessee is guaranteed that the annual payments for leasing the energy efficiency improvements will not exceed the energy savings generated by them. The building owner pays the contractor a fixed payment per month. However, if the actual energy savings are less than the fixed payment, the owner pays only the amount saved and receives a credit for the difference.

Energy Performance Contracts

Energy performance contracts are generally financing or operating leases provided by an Energy Service Company (ESCo) or equipment manufacturer. What distinguishes these contracts is that they provide a guarantee on energy savings from installed retrofit measures, and they usually also offer a range of associated design, installation, and maintenance services. The contract period can range from 5 to 10 years, and the customer is required to have a certain minimum level of capital investment (generally $200,000 or more) before a contract will be considered.

The U.S. Department of Energy's Federal Energy Management Program (FEMP), which works with federal agencies to promote energy-efficient building design, has a Web site that provides information on energy savings performance contracts, and working with energy service companies.

Under an energy performance contract, the ESCo provides a service package that typically includes the design and engineering, financing, installation, and maintenance of retrofit measures to improve energy efficiency. The scope of the improvements can range from work that affects a single part of a building's energy-using infrastructure (such as lighting) to a complete package of improvements for multiple buildings and facilities. Generally, the service provider will guarantee savings as a result of improvements in both energy and maintenance efficiencies. Flat-fee payments tend to be structured to maintain a positive cash flow to the customer with whom the agreement is made. With the increasing deregulation of conventional energy utilities, several larger utilities have formed unregulated subsidiaries that offer a full range of energy efficiency services under performance agreements.

An energy performance contract must define the methodology for establishing the baseline costs and cost savings and for the distribution of the savings to the parties. The contract must also specify how the savings will be determined and address contingencies, such as utility rate changes and variations in the use and occupancy of a building. While several excellent guides exist for selecting and negotiating energy performance contracts, large or complicated contracts should be negotiated with the assistance of experienced legal counsel.

Some guidelines for a successful ESCo project:

Look for more than the low bid. Select an energy service company (ESCo) with a good track record that can provide other necessary services such as project design, installation and maintenance. Get references.
Negotiate a contract that reasonably limits ESCo profit-making and establishes a win-win arrangement. Carefully weigh the pros and cons of shared savings versus fees for services and other contractual arrangements.
Require the ESCo to take a "comprehensive approach" to energy conservation—bundling measures with rapid paybacks and measures with longer paybacks—rather than a "cream-skimming approach" (the practice of doing only easy, quick payback measures).
Ensure the agreement does not allow the ESCo to sacrifice quality for energy savings.
Ask your ESCo to incorporate extended product warranties and personnel training into the bid specifications.
Organize an in-house project team to work with the ESCo to choose appropriate energy measures, prepare bid specs, prequalify prospective bidders, and perform other tasks when the contract is signed.
Work with the ESCo to test new technologies in order to determine their performance and applicability.
Design the project and coordinate construction in a way that minimizes disruption of the building's functions. Document both energy and non-energy benefits of your project and publicize its success to the community.

Utility Incentives

Some utilities still offer financial incentives for the installation of energy-efficient systems and equipment, although the number and extent of such programs appears to be decreasing as utility deregulation proceeds. These incentives are available for a variety of energy-efficient products including lighting, HVAC systems, energy management controls, and others. The most common incentives are equipment rebates, design assistance, and low-interest loans.

In general, the primary purpose of utility incentives is to lower peak demand. Overall energy efficiency is an important but secondary consideration. Incentives are much more commonly offered by electric utilities than by natural gas utilities. The extent to which these incentives will be continued or expanded by the utility industry is uncertain. Utility assistance that is typically available includes:

Equipment rebates

Some utilities offer rebates on the initial purchase price of selected energy-efficient equipment. The amount of the rebate varies substantially depending on the type of equipment. For example, a rebate of $0.50 to $1.00 may be offered for the replacement of an incandescent bulb with a more efficient fluorescent lamp, while the installation of an adjustable-speed drive may qualify for a rebate of $10,000 or more.

Design assistance

A smaller number of utilities provide direct grants or financial assistance to architects and engineers for incorporating energy efficiency improvements in their designs. This subsidy can be based on the square footage of a building, and/or the type of energy efficiency measures being considered. Generally, a partial payment is made when the design process is begun, with the balance paid once the design has been completed and installation has commenced.

Low-interest loans

Loans with below-market rates are provided by other utilities for the purchase of energy-efficient equipment and systems. Typically, these low-interest loans will have an upper limit in the $10,000 to $20,000 range, with monthly payments scheduled over a 2-to-5-year period.

The Database of State Incentives for Renewables and Efficiency (DSIRE) provides information about utility incentives on a state-by-state basis.

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