How PACE Affects the Future Financing of Energy-Saving Projects
[Editor's Note: This is the second installment of a three-part series about Property Assessed Clean Energy financing. Part 1, "How the Fate of PACE Could Influence the Clean Energy Economy," is available on GreenBiz.com.]
Property Assessed Clean Energy, and similar financing programs, have the potential to significantly impact a multitude of stakeholders -- ranging from federal and local governments to lending institutions, bond markets, electric utilities, homeowners and individual contractors.
Although the growing momentum of PACE programs has been stifled by the FHFA, and the future of PACE is more uncertain than ever, the business implications of PACE are worth examining. Whether or not PACE survives the political mess it is currently in, understanding the implications of policy-enabled private financing programs on the ecosystem of stakeholders will inform future financing efforts.
This article examines the high-level implications of PACE on the following key stakeholders:
- Federal Government
- Municipal and City Governments
- Electric Utilities
- Mortgage Lenders
- Banks and Financiers
- Renewable Energy and Energy Efficiency Contractors
- Commercial Business and Home Owners
The administration needs to get some wins on the board with regard to spurring the uptake of clean energy adoption on a wide scale -- and they can't all depend on pouring stimulus dollars into R&D and traditional state incentive programs (though that is helpful). With climate legislation stalled, PACE programs represent a type of nationally applicable win-win policy ideas that are low risk, but have the potential to spur significant private sector activity. With the concerns being voiced by the mortgage industry, the federal government's involvement in Fannie Mae and Freddie Mac mean that federal agencies should be incented to push for tightly regulated, well-structured, PACE programs that both achieve the clean energy goals, but also contain their scope so as to not negatively impact the mortgage giants in government conservatorship.
Municipal and City Governments
Municipal and City governments are where the rubber meets the road with regard to PACE as the mechanism at the heart of the financing scheme is a special assessment tax linked to the property tax system – a local government jurisdiction.
Cities are at the forefront of the United States climate action with over 1000 mayors having agreed to the U.S. Conference of Mayor's Climate Protection Agreement. At the same time, the economic downturn is devastating city budgets, requiring across the board cutbacks in most cities. The fact that PACE programs can leverage bond markets without putting the local government's general funds at risk is a large benefit to the approach. Without investing significant funds, local city governments committed to action can spur rapid private sector adoption of clean energy within their city limits.
Obviously time, effort, and initial capital are needed to set up a PACE program in any city, and given current budget constraints, the people and dollars required may not be available. This creates an opportunity for entrepreneurial third parties to step in with a service offering to set up, market, and administer the programs with no cost to the city government.
Utilities around the country need to be proactive in the policy and regulatory environment to break down age-old paradigms in their industry with regard to energy efficiency or risk the gradual erosion of earnings as third parties encroach on their revenue streams with energy saving opportunities. While there has been a steady push among state regulators to require energy efficiency efforts from utilities, very few utilities have proactively worked on regulatory or business strategies to make money from these shifting expectations that they provide customers with efficiency solutions (whether they be decoupling regulations such as in California, or innovative regulatory approaches such as Duke Energy's Save-a-Watt program). Innovative third-party financing models like PACE will emphasize this issue – rewarding the utilities that are proactive in developing the appropriate business models, and eroding earnings from those who do not.
Aside from the most fundamental issue of making money from energy efficiency, there are a few basic issues utilities need to determine with regard to PACE and their current operations. The most basic of these is if, and how, PACE will impact standard incentive programs. Currently, most incentive programs are based off of initial investment costs and payback periods. What happens when a customer is cash flow positive from day one?
Beyond the basic issues, utilities should be trying to figure out how to get in on the party and use PACE as a jumping off point for more advanced efficiency business models. For example, what if they partnered with cities to establish and fund the launch of PACE programs? They could open up a new financing market from which to earn revenue and help to scale-up programs around the nation.
There are two ways of looking at how PACE may impact mortgage lenders, as put forward by advocates and opponents of PACE respectively.
Proponents claim that when structured properly, PACE results in a positive cash flow for homeowners and businesses due to their energy savings being greater than the tax assessment associated with repaying the loan. What this means for mortgage lenders is that the borrowers' cash flow and credit profile improves – increasing individuals' free income available to pay off both their taxes and mortgages. Additionally, property values increase because of the efficiency and renewable energy improvements made to the structures.
On the other hand, opponents of PACE are concerned that establishing a new first lien on properties will undercut the mortgage lender and impede on their ability to collect money if a property goes into default. They further fear that PACE will provide easy financing opportunities for already underwater homeowners to take on increased debt they have no plan to pay back.
The impact on mortgage lenders (FHFA) is rightfully the crux of the debate over the future of PACE. In a shattered economy caused mostly by reckless lending and poor enforcement standards surrounding all aspects of the mortgage industry, critics are right to be concerned about a new product that could impact this market – particularly if the regulations are lax and the result is that homeowners already underwater take on more debt.
Unregulated versions of PACE being implemented in varying forms from city to city (as has been the case to date) are concerning, as there is little assurance that the careful oversight needed is being incorporated into the programs. This does have the potential to put lenders at risk. However, if cities are required to implement a standard version of PACE which includes the appropriate limitations and regulatory oversight (as proposed by the White House and DOE) the risk to lenders effectively goes away, creating a win for both homeowners and lenders by ensuring only qualifying building owners are eligible, and freeing up cash flow.
A study from pacenow.org claims that in the case of default and foreclosure, only the delinquent tax lien gets paid, with the new homeowner assuming the remaining balance. Using their example, assuming a $20,000, 20-year PACE loan at 6 percent interest, the annual payments on the loan amount to $1,700. If a lender were to foreclose on a home with a year's worth of back taxes, the first lien position of the PACE loan would cost that lender $1,700.
The PACE program guidelines proposed by the DOE puts significant constraints around the homeowner eligibility for PACE loans to ensure, among other things, that only homeowners in good standing (not underwater) be eligible for the program. This type of underwriting requirement would put the foreclosure rate on homes with PACE loans significantly below the national average. Even if a portfolio of homes with PACE loans were to have a default rate of 5 percent that would represent an average cost of $85 per home for a lender.
We have yet to see a calculation that shows the average increase in home value, or credit worthiness of borrowers, created by PACE-funded retrofit projects, but imagine that it would more than offset the $85 per home.
If the entirety of the debate about PACE comes down to what would likely be less than $85 per home, there must be a simple solution that could work for mortgage lenders.
Banks and Financiers
To the broader set of banks and financiers, PACE could either be a massive opportunity or a potential threat.
On the opportunity front – most cities that enact PACE are going to need financial expertise to set up and administer the program, issue bonds, etc. For entrepreneurial financial institutions, this could be an opportunity to lock up a large deal pipeline in one fell swoop. The PACE program will also generate a sizeable pool of bond products to be purchased by financial investors as another way of participating in the market and helping to fund the expansion of PACE programs. This, in turn, would lead to additional bond products being sold, and an increase in the number of programs coming to market.
On the flip side, for those financiers not administering PACE programs, or investing in PACE bonds, they risk being cut out of a potentially large financing market.
Traditional financial products are likely to be able to offer more competitive rates than PACE programs to building owners willing to take on the risk of paying off the loan if they sell the property. These lenders will likely benefit from the increased attention PACE programs bring to the clean energy and retrofit space, and can use that tailwind to market more cost effective products to qualified lenders.
Renewable Energy and Energy Efficiency Contractors
A successfully implemented PACE-like program on a national scale would lead to significantly increased demand for distributed renewable generation and energy efficiency improvements, spurring demand for local and regional contractors to implement the upgrades. The market size of renewable energy and energy efficiency retrofits in both the residential and commercial building markets is huge. In the commercial building space alone, Johnson Controls estimates the market for energy efficiency upgrades to be roughly $180-$190 billion in retrofit activity over the next ten years, representing the potential for over 3.6 million jobs. Growth at this scale would lead not only to a boon for small and medium size contractors, but likely lead to a roll-up of small-scale contractors into regionally and nationally integrated providers.
Commercial Building and Home Owners
PACE has the potential to make renewable energy and energy efficiency an immediately attractive opportunity for home and building owners by providing financing for clean technology in an immediately cash-flow positive manner.
With that said, like any debt product, building owners need to carefully understand what they are getting into, and realize that they are taking on debt. While their cash flow will improve, energy prices are also expected to rise over time. This means that overall monthly expenses may still go up (though they would be significantly less than they would otherwise be without the retrofit).
Also, while properly structured PACE programs should have regulations and oversight in place to ensure that only cost effective upgrades are allowed, homeowners will need to ensure the quality of the contractors they hire, understand any performance contracts and guarantees provided, and make sure that the predicted savings promised actually materialize. If they do not, they could end up in a position where they have taken on debt only to later realize that their monthly utility costs have not been lowered as expected. Properly administered PACE programs should reduce or eliminate this risk, but building owners are ultimately responsible for ensuring they don't make bad investment decisions.
With the right safeguards in place, PACE, and programs like it, have the potential to quickly revolutionize the financial attractiveness and feasibility of clean energy and energy efficiency investments. Like any rapid change in the business environment, there will be clear winners from the program, and in this case only a few losers. PACE is just the beginning of what is to be a rapid evolution of financial and business models aimed at accelerating the adoption of clean and efficiency energy systems. Utilities and financiers that fear PACE are better off figuring out their own business models to deal with these disruptive innovations rather than spinning their wheels opposing them and losing out on business opportunities to more entrepreneurial and adaptable competitors.
Given the still very questionable nature of PACE legislation, the last installment of this series will revisit the current status of PACE, identify lessons from the process, and explore the potential future of the program.
Pete Atkin, a senior associate, and Corey Glick work at GreenOrder, an LRN company. GreenOrder is a strategy and management-consulting firm that helps companies achieve competitive advantage through environmental innovation.
Image CC licensed by Flickr user eneKo laKasta.