Ten Ways to Lower Perceived Risk and Finance Rates within Utility Contract
Federal agencies use various methods to lower perceived project risk and finance rates to get the best value from utility energy service contracts (UESCs). Ten such methods are outlined below. Each should be discussed during project negotiations:
- Time is Money
- Communicate with Finance Companies
- Compare Rates
- Use Standard Terms and Conditions
- Negotiate Buydown and Prepayment Formulas
- Structure Appropriate Measurement and Verification
- Include Explicit Language to Minimize Risk
- Avoid Unnecessary Hedge Costs
- Bundle Energy Conservation Measures
- Show Project Importance
1. Time is money
Money can be saved anywhere you reduce processing time and facilitate quick closure of your deal. A short turnaround reduces the administrative cost for the utility and subcontractor teams. Delays also impact the interest rate especially as finance companies lose the ability to hold interest rates during grace periods. The sooner the project is implemented, the sooner it begins saving energy and money for your facility. Every 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 for payments to be 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 fund, 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
Most finance companies are happy to discuss the rates, adders, and costs associated with funded projects. This provides an opportunity 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 invite the selected finance company to project negotiation meetings to answer questions and provide 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. 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 compare it with similar projects.
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. With a 10-year term, an increase of just 30 basis points from 7.0% to 7.3% has the following impacts:
|Project Funding||Additional Interest (0.3%)|
These interest dollars could be better spent on facility 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 active firms in the 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 projects funded at similar dollar amounts. FEMP can provide guidance based on other projects and can help identify sources for comparison.
4. Use Standard Terms and Conditions
Contract clauses and formats unfamiliar to the finance company 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, use standard terms and conditions and contractual forms already established in the areawide 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 significantly increases 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 improvements 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. This is done by 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 to Minimize 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. This portfolio approach offers additional 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 spread out perceived performance risk by combining a portfolio of ECMs.
10. Show Project Importance to the Facility
Most finance companies see a Federal Government contract as a secure investment. Any uncertainty about the future operation of the facility where the project is implemented 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.
Savings may be possible by ensuring that the payment stream to the finance company will not be affected by performance guarantees. As an example, contract language in a Department of Defense project 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.