Financial Efficiency Improves Energy Efficiency

Still, says Carter, energy managers should not focus on a specific type of financing, since there is no one best option for a given borrower, the best structure is one that is created to fulfill the customer's needs and desires at the lowest overall cost," he contends. "The outstanding lender will not try to force a 'structure' on a customer, but will listen closely and be flexible enough to produce that best structure."

Instead, leading energy managers focus on the project that's being financed and the ESCOs and energy-services agreements involved, if any. The reason? If the project is successful, the financing is a piece of cake.

"The energy manager should also understand that the cost of financing is directly related to the nature and strength of the energy-services agreement," adds Heller. "For example, fixed, 'hell-or-high-water' monthly payments for a given term will often yield a lower rate than a contract that has the risk payments tied to project performance."

Yes to ESCOs?
While ESCOs are not a guarantee of better finance terms, they often help, says Carter. "ESCOs are particularly helpful if a customer is seeking to complete a comprehensive energy project involving multiple disciplines, such as lighting, HVAC, and cogeneration; they are specialists at project management and coordinating multiple types of equipment installations."

Another consideration is the related experience that ESCOs bring to the table. "A concern whose core business is manufacturing, patient care, or education may not have the breadth of energy efficiency experience an ESCO brings," notes Peake. This is especially true of the most complex projects and finance arrangements, notes Heller. Performance-based, off-balance-sheet financing structures are extremely difficult without the involvement of an ESCO.

"It is very likely that the ESCO can fund larger projects and install the equipment or infrastructure more efficiently than the building owner, because it's the ESCO's core business," says Heller. "An ESCO can also add value to a transaction by providing turnkey solutions and assuming performance risk. A building owner can off-load to the ESCO the risk associated with the design, construction, performance, and financing of the project."

On the other hand, caution financial experts, an energy-service company actually can be detrimental to project financing if the company's credit is questionable, if they cannot adequately measure and verify energy savings, or if they unreasonably increase equipment or service costs. Facility managers often overlook this last consideration, but it is important to bear in mind. "The disadvantage is that an ESCO will mark-up project costs to make a market-based margin, making the project more expensive than if the customer does the project itself," says Peake. "One way to view the ESCO's margin is as an insurance premium. It gives the customer more comfort, particularly when a performance contract is in place, that the economics of the project will meet the pro forma projections."

Whether or not an organization works with an ESCO, there are some very basic qualities that open the door to financing. Project size and owner reputation top the list.

There are good reasons for the prejudices. Larger project size--and, thus, dollar value--tends to mean more attractive financing, and because transaction costs are more or less fixed, large projects are less affected by the built-in costs of borrowing. As for owner reputation, creditworthiness is critical to the lender, giving some measure of assurance that the borrower will be around long enough and solvent enough to pay off the energy project debt.

Customized Capital
Energy managers seeking out financing can rest assured, however, that if their organization is reputable and the project reasonably large, they will more than likely be offered a loan. The next question is how best to structure the financial package. In both the private and public sectors, it seems, variety is the watchword.

"Corporate financing structures vary widely," says Peake. "Corporate borrowers usually focus on cash flow and prefer that potential energy projects be cash flow neutral, or positive. In other words, energy savings pay debt service during debt repayment, after which all savings go to the corporation."

The key is to minimize the balance-sheet impact of the financing while maximizing its cash flow. For that reason, Heller contends, "The best financing arrangement for an entity trying to achieve these objectives is performance-based project financing. This structure allows a corporation an off-balance sheet solution paid from project performance and savings." By keeping the debt obligation for their energy project "off the balance sheet," it does not affect the company's financial ratios. While this may be an attractive option, it requires some fancy footwork by lawyers and accountants.

For government entities considering their financing options, say financiers, it is important to explore their tax-exempt status and leasing options. "Tax-exempt leases or bonds are clearly the best alternative for a municipality," says Heller, "providing that the new debt will not negatively impact its credit rating, and that it has the ability to access the tax-exempt market."

Municipal leases are quite commonplace and meet the needs of state and local governments, says Peake. "The lease contains a non appropriation clause, which states that the only condition under which the entity may be released from its payment obligation is when the legislature or funding authority fails to appropriate funds."

Like others, Peake expects tax exempt finance to become even more common. "Aging infrastructure drives tax-exempt volume," he explains. "Third-party financing is used when energy projects are not added to large capital projects that are usually funded through public bond issues. Private tax-exempt lease financing has lower transaction costs than bond financing and can be structured off the balance sheet as well."

More Energy Financing
In part due to the exploitation of more favorable financing approaches, there has been a marked increase in the number of projects in both government and private industry that have turned to outside financing. And for a number of reasons, both energy managers and experienced lenders expect the growth to continue.

"This is based on the trend for more projects in general and the possible tightening of capital budgets as a result of the economy," says Carter. "We see increases in the number of projects for every customer group from the federal government to the small, one-unit business owner."

A number of trends can be credited with making third-party financing as popular as it is today:

• Utility deregulation. "Deregulation is certainly affecting energy project financing," Carter believes. "More and more customers are analyzing their utility bills to determine how to reduce costs through projects and different rate structures. Additionally, the stability of the ESCO market and overall economic cycles seem to affect the number of projects being funded."
• Operational cost control. "Industries competing in the global marketplace are under pressure to control their costs, including their energy costs," says Peake. "Healthcare providers coping with managed care competition and diminishing federal reimbursements also focus on cutting costs. And higher education institutions, bumping up against tuition 'sticker shock' are looking for ways to improve efficiency."

Heller concurs, noting dramatic recent growth in financing for commercial and industrial energy upgrades. "These markets offer a tremendous opportunity for third party financing as companies evaluate how to operate more efficiently and competitively. As companies become more aware of earnings, they will continue to look for opportunities to leverage their internal capital."

Because many industrial energy users have concluded their rate negotiations, they are now focusing on demand-side reductions, note experts. Energy projects rarely meet internal "hurdle rates"--minimum criteria for new investments--so managers are looking at ways to fund improvements through their operating budgets.

• Energy awareness. "We anticipate that there will be far greater third-party financing of energy projects in the future simply due to the exposure that energy is currently getting," says Heller. "Whether it is through media or direct marketing, end-users are becoming more aware of the opportunities and advantages that energy projects can offer a company."
• Government initiative. "The federal marketplace will experience significant growth in third-party financed projects due to White House mandates, and contracting offices throughout the federal government gaining experience in the use of energy-savings performance contracts and area-wide contracts," says Heller. In particular, adds Peake, "Executive Order 12902 is driving federal energy project volume and will continue to do so through 2005; third-party financing is the norm in this market."
• Interest rates! Interest rates! Whether on the lending or borrowing side of the equation, no one is losing sight of the most remarkable trend affecting energy financing: historically low interest rates.

In this way, energy financing is like any other type of financing. Still, as evidenced by the unique relationship between project success and financial success, the energy-efficiency market is certainly like no other.