U.S. Department of Energy - Energy Efficiency and Renewable Energy

Federal Energy Management Program

Ten Ways to Lower Perceived Risk and Finance Rates

Federal agencies have used various methods to lower perceived project risk and finance rates. In some cases, and increasingly as credit tightens, several of these guidelines are prerequisites to obtain private financing. Individual finance companies have their own experience and perception of the importance of specific contract clauses. The following generalizations should be discussed during the negotiation of each project.

1. Time is money

Anywhere you can reduce processing time and facilitate quick closure of your deal, you will save money. First, a short turn-around reduces the administrative cost for your utility and the subcontractors' project development teams. Delays also affect the interest rate. In the past, a finance company could usually hold a rate for a week or two without charge, but given current market volatility, you will need to consult with your finance company. Finally, and most importantly, the sooner the project is implemented, the sooner it begins saving energy and money for your facility, so every day of delay is an opportunity lost for cost savings. Chronic late payments can also result in compensating increased interest rates, so it is important to the entire program to make sure that payments are made on time.

Shopping for the best rates

At least one utility active in this market has conducted its own competitive process to establish a list of pre-qualified finance firms for Federal energy projects. Each time a new project is designed and ready to finance, a standard form is used to share project data with the pre-qualified firms, who can give a quick response to the utility looking for the best value for construction and term financing. A recent $3 million project elicited quotes that varied by about 100 basis points, with final term financing at 7%. Savings compared to the highest interest rate quoted were approximately $580,000 over a 10-year term.

2. Communicate with finance companies

While it may be inappropriate to discuss the financing of a specific project with anyone other than the utility company as the contractor, most finance companies are happy to discuss the rates, adders, and costs associated with financing projects. This provides an opportunity to explore ways to reduce risk and obtain the lowest possible rate for a specific project. Many agencies leave all communication up to the utility or contractor, but there is no prohibition against asking the utility to have its selected finance company attend project negotiation meetings to answer questions and provide financing clarity. Most UESC payments flow directly to the finance company, and those finance costs often represent more than half the total project costs for the government. Consequently, it makes good business sense to get acquainted with the details of financing and ensure that you've done all you can to get the best possible rate for your project. Ask your finance company to identify financial costs separately and to clarify the specific rate impact of individual contract terms and conditions that are significant. You can then evaluate the importance of those clauses individually. Similarly, ask for a breakout of the net present value of the finance company's fee, both at closing and during the payment period, to enable you to compare it with similar projects.

Why Bother?

What are a few basis points worth over the term of your loan? The amount depends on the capital investment financed and the length of the term, but it can be significant. For example, with a 10-year term, an increase of just 30 basis points from 7.0% to 7.3% has the following impacts:

Investment Value Increased Cost*
over the term for 30 basis points

*These dollars could be better spent on facilities improvements.

3. Compare rates

Once the basic parameters of your project (size, type of equipment, expected annual savings) are known, it is possible to get rate comparisons by calling the firms active in this market. A relatively small number of reputable finance organizations specialize in energy projects at Federal facilities. Formal competition for financing (particularly for smaller projects) may result in administrative costs that exceed the value of the competition. Consider a comparison of rates rather than formal competition. Ask your utility for a comparison of rates for recent project financing of similar dollar amounts. The Federal Energy Management Program (FEMP) can provide guidance based on other projects and can help you to identify sources for comparison.

4. Use standard terms and conditions

Contract clauses and formats that are unfamiliar to the finance company can increase risk because they are different from what has been tried and proven. They may also lead to significant increases in transaction costs and longer timetables for execution. To keep costs low, try to use the standard terms and conditions and contractual forms already established for UESCs in the area-wide energy services annex and model agreements with your utility and finance company.

5. Negotiate buydown and prepayment formulas in advance

Standard language for buydown, prepayment, and termination (for convenience or otherwise) with pre-negotiated terms and conditions can, in some cases, hold finance costs down. If these terms are not clearly set forth in the contract, it will significantly increase risk and could cause the government serious problems with future contract administration.

6. Structure appropriate measurement and verification

Cost-effective measurement and verification of energy efficiency improvement and savings, coupled with a performance guarantee, is strongly recommended and can be achieved through alternatives to a contractual cost-savings guarantee. Finance companies reportedly establish the interest rate primarily on the basis of the experience and expertise of the utility and its subcontractors, relying on their credibility to evaluate the risk of specific technologies. While the margin for specific technologies set by the utility can be reduced by negotiating reasonable measurement and verification criteria, interest rates should not be affected by the complexity of the energy conservation measures.

7. Include explicit language minimizing risk to the finance company

A payment structure that minimizes risk to the finance company is the central element of reducing perceived risk and obtaining a lower interest rate. To keep rates low, include clear terms for how and when payments will be made, demonstrated ability to comply with those terms, and standard clauses to protect the finance company from offsets and future claims related to performance (assignment of claims).

8. Avoid unnecessary hedge costs: do not buy an interest rate "lock"

To keep government costs (and the long-term interest rate) low, it is not necessary to require a guaranteed or fixed interest rate long before the date of award. Instead, a formula based on an index rate (e.g., T-bill or swap rate) and adders should be negotiated and set forth in the contract, stating how the final rate will be established on or near the day the delivery order contract is signed. Letting the finance company set the interest rate as close to the actual contract date as possible reduces the risk of rising rates and eliminates the hedge cost.

9. Bundle energy conservation measures

Bundling many energy conservation measures (ECMs) together can result in lower rates and more conservation for each dollar invested. Bundling also offers the facility other benefits by reducing contract and administrative burdens and optimizing energy savings. More ECMs and greater facility improvement can be included when those with longer-term payback periods are bundled with and offset by those with quick payoff terms. Just as some finance companies are bundling projects to attract lower interest rates from a portfolio risk management perspective, facility managers can also spread out the perceived performance risk by combining many ECMs.

10. Show that the project is important for the facility and that the facility is expected to have a strong mission during the contract period

Most finance companies look on a Federal government contract as a secure investment. But if there is any uncertainty about the future operation of the facility where the project is implemented, this can increase the perceived risk of premature contract termination and finance costs, or put the deal in jeopardy during negotiations. Ensure that the finance company understands that this project is an important asset for the facility and that the facility is expected to have an ongoing mission that will outlive the project's contract period. Provide documentation, if necessary.

Additional Savings

Savings may be possible by ensuring that the payment stream to the finance company will not be affected by performance guarantees.

Example: In a Department of Defense project, contract language helped ensure that the payment stream to the finance company would not be interrupted though the utility included an energy savings performance guarantee in the contract. This reportedly helped obtain a discount of nearly 100 basis points (1%) in financing. The project was signed in 1999 for $15 million at 7.0% interest. The estimated benefit to the government of a 100 basis point reduction in interest, given the 10-year term and total investment, was near $2 million.