U.S. Department of Energy - Energy Efficiency and Renewable Energy
Federal Energy Management Program
Financing for Utility Energy Service Contracts
Financing is a significant portion of utility energy service contract (UESC) costs. Experience shows several things the Federal Government can do to get the best value by reducing UESC financial transaction costs and interest.
Interest rates are based on the sum of an index rate on the date the transaction is signed and a "premium" or "adders" usually measured in basis points where 100 basis points is equal to 1%. The premium reflects the costs of obtaining the financing under prevailing market conditions, financial risk, transaction costs, and profit for the finance company.
The cost of financing varies depending upon a number of factors. Optimizing one or more of these factors can reduce interest rates in favor of Federal agencies. Factors include:
- Term of financing
- Amount of financing
- Utility bond rating/financial status of contractors
- Perceived performance risk
- Contractual provisions
- Pertinence to agency mission
- Type and complexity of project
- Perceived risk to the finance company.
Utility companies recover transaction costs and overhead as a separate finance charge, or more rarely in the premium. The final result is a premium that typically adds 100 to 250 basis points (1.0% to 2.5%) to the base index rate.
Financial transaction costs (and the margin to cover them) have decreased as more Federal agencies use the same basic contractual forms and clauses, and as finance companies become more familiar with the constraints and uniqueness of funding Federal energy projects.
All other things being equal, using standard, acceptable contract terms and conditions reduces the perception of risk, shortens approval time, and reduces transaction costs.
Fluctuations in the financial markets affect premiums and index rates. For example, the current trend includes falling index rates offset by higher premiums due to a more conservative and restricted corporate credit market. This may continue as long as current concerns about the economy persist.
Until recently, the base index for utility energy service contract finance rates was the U.S. Treasury bill (T-bill) rate for a time period approximating that of the loan. In 2001, the finance community indicated that the international "swap rate" was preferred because it best reflects the cost of money on the markets where these projects must compete for financing.
The financial market for UESC projects is very different from consumer loan markets (e.g., home mortgages). This is a very limited, structured market. If the finance company is required to use a T-bill rate and it is lower than the prevailing swap rate (which better reflects the market where the project will get financed), the difference will probably be erased by a larger spread.
To track T-bill and swap rates ("interest rate swaps") for different maturity periods, see the Federal Reserve website. You cannot influence the value of an index rate. However, whatever the agreed-upon index rate, the practices discussed in this section could help reduce the premium or adders that go on top of it as well as other financial transaction costs.