The Top 10 Energy Efficiency and Solar Financing Mistakes and How to Avoid Them
Lance Weislak is an investment banker at Wulff, Hansen & Co. He can be reached at firstname.lastname@example.org.
When implementing solar and energy efficiency (“green”) programs, local governments frequently spend the majority of their time debating and discussing the physical attributes of a program: how many megawatts of solar will be installed, which heating, ventilation and air conditioning (HVAC) units will be replaced, and so forth. The actual financing of the project is considered an afterthought and is often decided upon only at the very last minute — and may be dictated by the vendor. This is a mistake because the project’s financing can dramatically affect the program’s success. In extreme circumstances, a poorly thought-out financing package can not only negate the beneficial aspects of the program itself, but it can also be detrimental to the government’s overall fiscal health. In my experience, the 10 most common energy-project financing mistakes comprise the following list.
1. Using Inflated Utility Escalation Rates. Savings calculations are projections that are highly dependent on estimated utility rate increases. Any project can be made to look good by using aggressive escalation assumptions. Use realistic and conservative escalation rates. If rates increase by less than the assumption, savings could be substantially diminished. You should run project economics under a variety of rate escalation scenarios: high, middle and low. Negative savings at net present value (explained below) in some rate scenarios mean the project has a potential financial downside.
2. Not Calculating Savings at Net Present Value. A dollar today is worth more than a dollar tomorrow. Savings numbers need to be converted into their net present value (NPV) to be useful. This is done by discounting savings by the “cost of capital.” Your cost of capital can be approximated by your long-term bond rate. Once you have that number (PV of savings) you need to subtract the cost of the project to obtain your net present value (NPV of savings). A negative number means that the project will cost more today than it will generate in savings.
3. Not Considering Solar Alternatives: Power Purchase Agreement Versus Ownership. Solar financing should be considered separately because solar can either be owned outright or “rented” under a Power Purchase Agreement (PPA). A PPA allows you to lock in steady and potentially inexpensive electricity rates for 20 to 25 years and is (indirectly) subsidized by a 30 percent Federal Investment Tax Credit and accelerated depreciation; there may also be substantial state incentives. Operations, maintenance and system upkeep are the responsibility of the system owner, not your city. With a PPA, you pay only for the electricity the system produces so all system risk is shifted to the owner. On the other hand, solar systems are fairly easy to maintain and don’t have much risk associated with them. Owning yours holds the potential for (nearly) free electricity once the system is paid off. Consider both carefully as they have very different pros and cons.
4. Projecting Savings and Financing Terms Exceed Expected Useful Life. All equipment wears out and has an expected useful life. Light-emitting diode (LED) lights eventually stop working. Motors burn out. Solar-panel efficiency degrades slowly and predictably over time. Many savings projections run for 30, 35 or even 40 years without allowing for repair and replacement costs. This can be very misleading, as in this timeframe most equipment will have long since stopped working. Savings should be calculated only for the expected useful life of the equipment or should include the costs of repair and replacement. Otherwise, savings projections will be significantly overstated. Similarly, the term of the financing should not exceed the average useful life of the project.
5. Not Understanding the Savings Warranty/Guarantee. The guarantee is a large part of the value an energy service or solar company brings to the table, so ask questions until you understand it. Some companies even promise to write a check if savings don’t materialize. Don’t confuse your guarantee with the performance bond that insures construction, because they are entirely separate. Make sure you understand exactly what is being warranted (actual dollars or electricity savings or production?) and by whom. Is the guarantee the responsibility of the company or the equipment manufacturer? For how long? What happens if the company is sold or goes bankrupt — what rights do you have? In what ways can the company make good on its warranty/guarantee? The devil is in the details.
In my experience, few clients take the trouble to fully understand the substance of a guarantee or warranty, let alone what the warranty actually warranted. The details are important. Most energy efficiency companies warrant kilowatt hours saved, not actual dollar savings. In addition, companies usually retain the right to address a shortfall not with cash but with remedial measures such as installing even more energy-saving equipment. Companies also have various ways to measure savings — usually they simply compare pre- and post-project energy consumption or production measures, which is useful but less than completely accurate unless all other conditions are identical, including the outdoor temperatures where heating or air conditioning are involved. You can ask for more extensive monitoring and verification (M&V) of savings, but it is expensive and time consuming. For simple energy retrofits like replacement of incandescent lights with LEDs, you may not need much (if any) M&V; savings calculations aren’t complex, and the project isn’t risky. A more complex project, like converting landfill gas to energy, may require extensive monitoring and verification backed by a comprehensive warranty along with a third-party guarantee in case things go wrong. Furthermore, a warranty or guarantee is only as good as the company providing it. Does it have the operational and financial strength to stand behind its promises? You should examine a company’s track record, claims history and audited financial statements before you sign on the dotted line.
6. Not Factoring in Operation and Maintenance Costs. To generate the savings projected, systems and equipment must be maintained. Production or revenue projections assume that this is being done but don’t always mention the cost. Even solar systems require maintenance — inverters needs to be replaced every 10 to 15 years, panels need to be washed regularly and so forth. Maintenance can be performed by external companies or by existing staff, but someone must pay the costs. These costs need to be included in the project economics.
7. Incurring a General Fund Obligation Unnecessarily. Popular financing mechanisms such as loans, tax exempt lease purchases and Certificates of Participation are General Fund obligations. Fiscally, this can negatively impact daily operations if project performance is less than planned and savings are less than the original projections. Sometimes, however, this can be easily avoided. For instance, financing an installation done for an enterprise such as the water or wastewater system can utilize a revenue pledge. The debt payment is then made directly from system revenues. Similarly, city improvements such as LED streetlights can be structured as assessment bonds. With an identified stream for repayment, you avoid taking cash from the General Fund. Such financing projects are also typically more attractive to investors, which can result in a lower overall financing rate.
8. Not Conducting a Competitive Process. Many governments wouldn’t even consider purchasing goods or services without first conducting some type of competitive process, yet sometimes these same governments eagerly accept the first energy-financing package presented to them. You almost always get a better financing package by employing a competitive process. I’ve seen dramatic differences in interest rates offered to similar clients for a similar project by the same bank. The only difference was that one borrower obtained unbiased third-party financial advice and used a competitive process while the other one did not. Even small differences in interest rates can have a major impact over time. For example, a 20 basis point difference in a $10 million financing over 15 years equates to $300,000 in additional interest cost.
9. Making a Financing Decision Based Solely on the Interest Rate. The interest rate isn’t the bottom line when it comes to financing. You need to closely examine the terms and conditions. For example, some proposals may include all transaction fees while others do not. Similarly, one bank may accept a “validity” opinion from your own counsel while another may specify an expensive external counsel. Prepayment terms can often have a dramatic impact on overall value: One proposal may allow for prepayment at any time; one may prohibit repayment; and another may allow for repayment with a substantial penalty or premium. Prepayment options are especially significant if you need financial flexibility in the future. Similarly, sometimes a lender will require the borrower to pledge an asset in order to obtain financing. Pledging an asset may be necessary; however, a mistake here can have dramatic negative consequences down the road and reduce your future financial flexibility. The impact of financing terms and conditions can be enormous, so look before you automatically leap at the lowest nominal interest rate, and be sure you’re comparing apples to apples.
10. Ignoring Low-Cost and Subsidized Financing. Numerous federal and state programs offer very attractive financing for green projects. At the federal level, both Qualified Energy Conservations Bonds (QECBs) and Clean Renewable Energy Bonds (CREBs) offer long-term financing (more than 20 years) at rates typically less than 2 percent and sometimes less than 1 percent. The actual rate depends on your credit. At the state level, there are several program, including funds from Prop. 39 and the California Energy Commission, offering both zero percent and 1 percent loans for smaller projects. Cost-free grants may also be available. Don’t count on your vendor to identify these for you — explore these sources first and then fill in any gaps with traditional methods.
Fortunately, these mistakes can be easily avoided. Ask about the financing early in project development. Evaluate and consider multiple alternatives. If you need to bring in outside expertise, don’t hesitate to do so. Invite a member of your Finance or Treasury Department to be a part of the project team. And be sure to shop around for the best overall financing package. Finally, don’t be afraid to ask “stupid” or “obvious” questions about the financing. Financing is an important component of making your project a success.