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Building Bipartisan Collaboration on Energy Competition?

Bipartisan Energy Bill

All indications are that the bipartisan Energy Savings and Industrial Competitiveness Act (“ESIC”) introduced by Sens. Jeanne Shaheen (D.-N.H.) and Rob Portman (R.-Ohio) will be brought to the Senate floor for debate once Gina McCarthy’s nomination hearing is done and the Senate debate of the 2014 transportation spending bill, and the prognosis for passage is generally positive (there is still some concern that attachments of unrelated amendments could derail the bill).

The bill is meant to spur the use of energy efficiency technologies in residential and commercial buildings as well as in industrial and manufacturing operations. One of the key focal points of the bill is on supporting the update of building codes to integrate energy efficiency improvements and requirements. Whether the concept can move through the House remains unclear, but there are some indications that there is an appetite to collaborate on these small low-cost energy efficiency steps in that chamber as well.

The bill is a set of very low cost, low impact provision that are meant to encourage energy efficiency investment with the goal of reducing energy waste – this certainly seems like a natural place for bipartisan cooperation – much less contentious than leaving behind light bulbs using 19th century technology. Laying the framework for updating building codes is a simple and obvious step towards promoting more efficient energy use in commercial residential and industrial buildings and an excellent idea.

Without undermining the approach or appeal of ESIC I think there is an opportunity to do much more with one small related addition. Defining a set of criteria for the inclusion of energy efficiency and energy use projections into the credit review process for FMHA loans would naturally accelerate the adoption of new approaches for financing energy efficiency. Efficiency upgrades are generally up front expenditures and the value is realized through savings over time. Often these are systems (or improved systems) that are integrated into a building and so not easily borrowed against as a lender can’t recover in the event of default because the specific energy efficiency upgrades can’t be removed and resold (challenges are both physical and legal).

Further adding to this challenge is that lenders (and appraisers) don’t accurately value efficiency upgrades, which means that a complete financing often won’t cover the value of the building plus the efficiency upgrades. The result is that the upgrades have to be financed with the building owner’s cash and recovered over time – this substantially limits the appeal of these kinds of investments. Here’s a simple example: Buyer is going to pay for a building to be constructed at a total cost of $100. Bank will lend buyer $75 for 20 years, buyer will use $25 of its own cash. Instead buyer would like to include $20 in efficiency upgrades that will reduce energy costs by $4/year for a total building cost of $120. Bank, however, sees the same building – same market, same sq. ft., same exterior. Bank will lend buyer $75 and buyer’s equity requirement is now $45. Most efficiency upgrades don’t happen with this math. And the result is the same even where the Bank recognizes only a partial value of the upgrades: bank will now lend buyer $80 on an assumed value of $107 (because the bank does not recognize the increased value of several of the installed efficiency systems based on existing valuation methods).

Buyer’s equity investment in the efficient building will be $40 on a loan to value ratio of 66/33 rather than $30 on 75/25 split as would have been the case had the bank treated the efficiency upgrades at full value in the larger financing package. The additional $10 is often enough to cause buyer to walk away from at least some of the efficiency upgrades. The curious result should be obvious. The buyer has significantly more free cash from the energy savings than is necessary to pay the principle and interest on the incremental amount borrowed for the efficiency upgrades. The building is more valuable because it costs less to use. Despite these facts, the bank is still using tradition valuation methods and the result is that an investment that makes financial (not to mention social) sense doesn’t happen.

I used a business example for clarity, but the same fundamentals are at work in the residential context. Adding a set of energy use and efficiency criteria to lending requirements, and requiring the reduction in net energy use and expense be considered in the valuation of property would immediately cure this inconsistency. However, legislating lending standards, which are generally market driven won’t really work – with the notable exception of FMHA and USDA residential loans. Changing the FMHA requirements may seem like a small and possibly insignificant step, but it isn’t. When PACE (property assessed clean energy) bonds were first introduced, FMHA took a hard stand against the financing tool (more on that here and here).

While there has been some progress on commercial uses of PACE progress remains slow and one of the key challenges has been an unwillingness of underwriters to adopt a process directly in conflict with FMHA standards – some of this may be for industry consistency, but some seems more like an unwillingness to learn a new language. By forcing energy into the FMHA standards the reverse could be true, an expansion of the existing language and discourse on lending standards would act as a significant pull on others (and of critical importance, provide a template for non-FMHA loans) to begin to incorporate these consideration into loan underwriting.

An earlier version of this post appeared in my column Banking Energy over at Energy Trends Insider.”

Elias Hinckley's picture

Thank Elias for the Post!

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