The Fads and Foibles of Green Finance

Green Finance is a growing segment of the finance business, and as usual with anything new, it is full of fads and fallacies, and it sometimes does not live up to its billing. One part of green finance is large-scale projects, but since buildings are a large part of the problem in terms of GHG emissions, the opportunity for major renewable energy projects in buildings is huge. Evidently, the term green always risks being useless, and smacks of greenwashing, which in many cases it is. To begin with, the current practice mostly focuses on energy savings, not on improving property values, which only renewable energy would do. As a result, it is focused on marginal contribution, and equipment finance. More importantly, this methodology is by nature conducive to financial instability for the underlying property:

• Relatively small "savings" from energy efficiency: because most 'energy savings' strategies yield only a small incremental improvement--typically in the 20-30% range, which is easily wiped out by a price hike or two, and the effect on property values is negligible;
• Efficiency improvements are not unique in nature: because the same efficiencies are available to everyone, eventually all buildings will catch up, and be the same again. Boilers are now 95+% efficient and replacing older units that were 50-60% efficient, but going from 95% to 96% some day is not meaningful. Same for LEDs replacing fluorescents and incandescents.
• Financing short-term enhancements with long-term money is a risk factor: these programs frequently finance short-term improvements with long-term money, which does not contribute to long-term financial stability of the properties that avail themselves of such financing.
• No follow-on strategy: because of diminishing returns: all "energy savings," or "energy efficiency" strategies suffer from strongly diminishing returns for subsequent investments, so the energy savings strategy is a financial dead-end. Again, not good news for long-term property values.

Considering that the only objective for the property owner should be to maximize property values, and the only objective of the government should be the reduction of GHG-emissions, the current mishmash of rules and incentives adds to the confusion, and frequently creates constraints that prevent the best projects from happening. The supporting roles in creating this confusion are played by the government, including tax incentives which are typically tied to a technology, such as solar panels or water heaters, and programs by the utility industry, and/or semi public institutions such as New York's NYSERDA which provides incentives for property owners to do what's good for the grid.

Good intentions aside, it must be understood that none of these programs are designed to help a property owner maximize property values, which is the only objective the property owner should have. When you put them altogether, these programs amount the a government sponsored capital destruction, to the extent that they tempt property owners to do things that are not conducive to improving property values, in the name of being green.

Green Finance - the theory

What you can do with it is what makes it green

The green finance theory that supports all of these wonderful developments is that at the macro level the highest marginal return is thought to be on improving the efficiency of the systems we do have, and that's why macro-economists tell policy makers to provide incentives for energy efficiency. This approach puts the world on its head exactly, because the first point is that our energy model is wrong. The new model is based on renewable energy, which will increasingly mean buildings producing their own energy. And so, on the margin the biggest advances in "energy efficiency" in aggregate come not from the absolutely moronic spending on more and more energy efficiency, but from finding the low hanging fruit for converting to renewable energy, which is the only permanent solution, and the only one that enhances property values.

Lastly, the reassuring notion that "energy efficiency improvements" are self financing in nature is fallacious. The theory is that it improves operating cash flows, and thus are lenders assured of the ability to repay. This may seem harmless when it pertains to equipment financing, it is still destructive to property values in the long-term, if it crowds out viable renewable energy projects and prioritizes worthless efficiency improvements that fail to make a radical change. It becomes positively disastrous if the financing stretches for longer terms with a real estate collateral. In that case it makes the mistake of financing short-term measures with long-term money. In general, the mistake here is to prioritize the projects that are easy to finance, at the expense of the projects that would add value.

Green Finance - the practice

The unfortunate corollary to the usual energy efficiency financings is that, again because of diminishing returns, only the first few energy savings projects can be financed this way, after which by definition subsequent efficiency projects become prohibitively expensive, and this kind of abusive finance dries up, leaving a property owner stranded.

What happens in practice is that tax incentives, advantageous financing, and various subsidy and incentive programs that are all equipment driven, or driven by the energy suppliers, e.g. subsidized natural gas conversions(NYC Clean Heat), all serve other interests besides the property owner. As a property owner it behooves you to beware of all these wonderful offers. All of these programs have a potential hidden cost, namely they steal asset appreciation from the property owner.

The popular free energy audits are another ally of this fleecing of property owners. They are fine for a renter, to reduce their utility bills, but for a property owner, they are useful information, but no action should be taken unless a proper long-term plan exists with a view to improving property values. They promote frittering away money on trivialities, and never doing the big steps that are necessary. They trade on people's needs to do something, anything, and cheat them out of their money.

Green Finance, resiliency, and Property Values

Just as much as you cannot save yourself rich, all energy savings programs, taken in isolation, produce capital destruction, unless they stand in the context of making the property energy independent with renewable energy. The thing to do as a property owners, is to have your own 30 year DCF (Discounted Cash Flow) model of energy improvements to your property, based on a good grasp of the engineering, for there may be intense engineering interdependencies, which dictate in what sequence things should be done.

What you will learn if you do this long-term capital program, is that once you take one step in the direction of renewable energy, you have the benefit of potentially compounding returns in subsequent phases of implementation. At the very least you will see that you now start having two options at almost every turn, namely either more efficiency (insulation etc.) or more generating capacity - you are doing a direct trade-off.

It should also be noted that building resiliency is another obvious victim of prioritizing energy savings over renewable energy. For again, with making the fossil-fuel, grid-dependent systems more efficient, we are making ourselves dependent on the grid for longer. We are investing our own in customer retention by our energy vendors. No wonder many energy vendors and utilities are only too happy to provide 'subsidised finance' for such programs. Look at the site of the NYC Clean Heat program, and you'll find all the usual suspects there (CPC, NYSERDA and various energy companies), providing a range of green finance options, or so they think.

Of PACE bonds and property values

PACE bonds should have been the savior in this situation, but instead they got embroiled with Fannie and Freddie a few years ago, and since they had made the general mistake of prioritizing energy efficiency, their arguments did not carry much weight and the program had to accept some limitations and trade-offs, so that it cannot presently fully live up to its potential. One can only hope that PACE programs could adopt standards like the DaBX Renewable Retrofit Portfolio Standard, so as to regain their relevance, and indeed prove very clearly why sound renewable energy investments are much more conducive to rising long-term property values than energy efficiency overhauls ever will be.

Conclusion

We only just came off a property bubble resulting from easy money for second mortgages, ARMs, reckless lending and mortgage fraud, which undermined the market for all property owners. Now we risk robbing property owners of asset appreciation in the name of being green if we prioritize energy efficiency over renewable energy where such an alternative exists.

Green Finance, where it pertains to buildings, and any forms of real estate, is deeply flawed in its current form, because of its pre-occupation with energy efficiency. The only way to select meaningful priorities is with a 30 year capital budget for each property. Green finance should prioritize renewable energy over energy efficiency, because that moves energy from a liability to an asset, and is conducive to raising property values as well as improving air quality.

Property Values in the Age of Renewable Energy

Once the market begins to grasp that renewable energy, any form of clean energy, means free energy and therefore no energy bills, and therefore permanently lower O&M (Operating & Maintenance) costs compared to a fossil fuel infrastructure, property values will forever be affected by that information. Property values will become directly related to energy prices for the one and only reason that now there is an alternative--there is a benchmark. It is only a matter of time until net-zero is that benchmark, because it is so simple and easy.

As economists would tell you, the action always happens on the margins, and in this case what's happening on the margin is that net-zero construction flourished all through the recent real-estate downturn. That is important information for property valuation. Currently, we are at the dawn of a more public awareness of that net-zero homes and buildings, as the financial industry is grappling with the related underwriting issues, and beginning to formulate green financing methods for renewable energy retrofits, which they somehow stubbornly continue to misunderstand as energy efficiency retrofits.

The sceptics will argue that the incremental cost of renewable energy is sometimes greater than the incremental value added, but that is a short-sighted argument. This may have seemed true at times during the recent low energy prices... Just wait until energy prices start rising again! the point being that whoever was able to find renewable solutions will see the value of their property go up in tandem with the energy prices. The mission is simple: find such renewable energy solutions as make sense today, and be prepared to add-on in the future. For existing buildings, net-zero is a direction, and what matters is getting closer to it.

The secondary issue affecting property values will become resiliency: to what extent is your property able to continue functioning if the grid comes down. This implies that net-zero is not the be all and end all, must have objective, after all net-zero is easier to do in new construction than in old construction. Even approximating net-zero can only be achieved with renewable energy options, however - no amount of 'energy efficiency' will get you there. Independence from the grid is more important than achieving net-zero status, even if it is only partial. Just ask the people who were without utility service for weeks and months after hurricane Sandy. They would have given their hen's teeth for hot water, if nothing else. Valuing resiliency is trickier, and will depend in part on how many power outages we had in the last year.

Case one: property values for Net-zero or not-zero (but close)

Green Looks are not enough

If you can start from scratch, with new construction, net-zero is now a broadly feasible thing, and it is in high demand. Given that this was the only area where construction flourished during the downturn, it is clear that the market values the notion of net-zero, and developers would not be building it if it wasn't financially worthwhile. So all the theoretical arguments that the costs exceed the benefits are out the window. Like with everything else, some designs will be better than others, and no doubt there are solutions that are uneconomical in the short-term. Thus it is up to property owners to figure out the winning formula for their properties that will get them partial independence from the grid. The central strategy is renewable energy in whatever form.

We might notice that in the data center industry it has been the rule for a long time now that the most reliable designs are to use the grid only for a backup, not as a primary source of power. This is another fringe phenomenon that holds a lot of information value. With respect to property values, any property that is practically independent from subscription energy sources and therefore the grid, will go up in value with every energy price hike and with every major power outage - all else being equal. These will be the premium properties. The benchmark will be the energy usage for comparable homes. And remember again, you can only get there with forms of renewable energy--energy production, not energy savings (although they help).

CASE TWO: ENERGY EFFICIENCY WAS ALL WE COULD DO

There is almost no case where you can't do at least some renewable energy, and but in the worst case you make your home as efficient as possible, and provide a generator to get you through the storms. Broadly speaking, these will be the mediocre homes, and for a long time they will be the majority, in part because people invested foolishly in energy efficiency even if they could have done renewable energy. Energy efficiency alone is a lousy strategy because of diminishing returns. Usually, 30% "energy savings" is very good from an energy efficiency standpoint, but with renewable energy 70-90% reductions in energy are usually within reach.

The underwriting industry for the most part is focused on energy efficiency as a priority and a requirement for certain financing, mostly referred to as green mortgages, etc. This is a trap for the financial industry as a whole and for building owners as well. There seems to be a general energy efficiency mania going on, which will have us miss the boat in terms of what could be done with renewable energy. Pity the poor property owners who get trapped in all these misguided incentives. Investments in energy efficiency will be wiped out if same/similar buildings implement successful renewable energy strategies.

Financially, the funniest part of the market will be those buildings that went along with the energy efficiency mania, but will come to trade at a discount, because investment-wise the efficiency strategy is a dead-end, and the resale value of these buildings will suffer as a result, if they had evident potential for renewable energy infrastructure, but followed the pied piper of energy efficiency.

case three: property values without potential - scrap it or fix it up?

The next class down is the lowest, and here increasingly tradeoffs between energy retrofits and demolition will take place. If the building is in bad shape, and doesn't have the potential for a serious renewable energy overhaul, the value will come under increasing pressure, again, simply because net-zero will emerge from the fringe and become increasingly main-stream. Entire classes of buildings will see property values decline because of it. Sometimes whole streets.

Location, location, location, and four more times

Assessment of property values will never be the same again, and NYC will never be the same when these lessons sink in. Manhattan will tend to be a permanent energy sink, and a future energy slum, although there are interesting options such as triple glazing with capabilities for shedding and harvesting heat as needed, which are a renewable energy option. The recent 90by50 report from the Urban Green Council put a lot of emphasis on this option, but for Manhattan, this is just about the only viable renewable energy option. All other options are overwhelmed by the scale of buildings. Most will never even get close to net-zero.

The outer boroughs by and large are in far superior position to exploit renewable energy quickly. Of course, the opportunity is rapidly being squandered with the current gas conversion tsunami, with the NYC Clean Heat program as cheerleader for the lemmings going off the cliff. Be that as it may, eventually property owners will get it, and there will be a tremendous shift in the NYC real estate landscape as a result. Besides the insights offered above, about the three broad classifications of buildings along the lines of their energy independence, any property must be evaluated on the basis of its suitability for all types of renewable energy: geothermal, wind, and solar, and in some cases hydro-electric power. Along with it the options for passive solar etc. need to be considered. And how close a property gets to net-zero status will become the benchmark for success.

Conclusion

Valuation of properties will never be the same as the impact of renewable energy is being felt. Besides the old location, location, and location, there will be 3 or 4 more: suitability for solar-, geothermal-, wind- and hydro-power. Net-zero buildings are becoming the gold standard in renewable energy implementation, and property values will reflect how close a building comes.

DaBx Renewable Energy Retrofit Portfolio Standard for Multi-family Buildings

DaBx Renewable Energy Retrofit Portfolio Standard for Multi-family Buildings - 06/12/13

Purpose: This document sets forth proposed criteria for existing multi-family buildings to transition to a renewable energy infrastructure and qualify for financial incentives such as might be proposed by financial institutions for green mortgages and special energy retrofit financing. It provides both consumer protection and assurance of asset appreciation of the property. It therefore assures the property owner of the soundness of their plan, and firm prospects of asset appreciation, and the underwriters of appreciation of their collateral.

Criteria – the building shall:

1. Initially, achieve a 25%-50% reduction in emissions, with 50% or more of the reduction coming from renewable generation.
2. Achieve a reduction of 50%-75% of total building emissions within 10 years, with 50% of the reduction coming from renewable energy generation.
3. Provide a comprehensive energy plan for 30 years on a net present value basis, comparing against the existing infrastructure, with commensurate efficiency enhancements, with the reference case from DOE for energy price inflation.

Notes for renewable energy conversion of multi-family buildings:

1. Financiers and lawmakers should target incentives for reductions in emissions, with a 50% renewable standard, in order to build asset appreciation in real estate. Energy efficiency is an operational savings, and when mistaken for primary design criteria leads to capital destruction. Renewable energy moves energy from liability to asset.
   * Relevant links: Renewable Energy and Asset Appreciation, Energy Efficiency and diminishing returns.
2. It is suggested that this standard be adopted as basis for exemptions from existing rules, such as the NYC Clean Heat Program, but also of the Energy Star requirements, and eventually tax incentives should be adjusted accordingly. Until that time, building owners must work around these counter-productive rules.
   * Relevant links: NYC Clean Heat, Energy Star counter productive.
3. If subsidies are on equipment, they benefit energy companies and manufacturers, not building owners. If subsidies are on buildings for achievements in emission reductions, they stimulate demand for equipment just the same, but will focus on asset appreciation, instead of risking capital destruction.
   * Relevant Links: compound returns from renewable energy,
4. Notice that within the bandwidth of each phase, incentives could be used to stimulate higher achievements in emission reductions.
5. Notice also that by providing up to a 10-year horizon for such a plan, things can be phased in on the back of normal replacement cycles in lieu of forcing uneconomical replacements. Typically this program would extend the economic life of the old boiler. Depending on the type of financing available and economic replacement cycles, the results can optionally be achieved all at once or spread over 10 years. Moreover newer technologies can be adopted, by allowing phased implementation.
   *Relevant links: Leveraging NYSERDA's MPP on behalf of renewable energy.
6. In the long-term Energy Star requirements for subsidized financing or tax incentives, should be abandoned as they can conflict with good design and economics. Longer term all incentives for specific technologies should be phased out in favor of incentives for renewables in buildings, i.e. also at the federal level (IRS). Only the results matter, not the technologies used.
   *Relevant links: Energy Star requirements giving false signals.
7. Note that also public safety is improved by buildings coming partially off the grid. Some buildings may even end up with an energy surplus. Indoor air quality will improve with the removal of combustion sources. Tenants will enjoy a higher quality of life and lower energy costs if buildings can generate energy at a competitive price level, while landlords get another revenue stream. The split incentives between landlords and tenants will be a thing of the past. Using energy in the building or even selling energy to tenants at retail is more attractive than selling it back to the grid at wholesale.

By focusing any improvement incentives on individual properties, with appropriate benchmarks, a far more rapid and wide scale adoption of renewable energy is assured, along with significant appreciation in real estate values.

NB In this document, references are included to posts on this blog to document the issues.

Conclusion

The portfolio standard proposed here, seeks to ensure asset appreciation from implementing renewable energy in multi-family properties. The proper focus for regulators is reducing GHG emissions. Solar energy, wind energy, geothermal energy, or any form of clean energy all have a role to play. Multi-family buildings provide the best opportunity for conversion to renewable energy with an assurance of asset appreciation, particularly the older, simpler buildings. When all types of renewable energy technologies can be brought to bear, the compound returns resulting from synergies among technologies will ensure asset appreciation.

Renewable energy delivers asset appreciation through compound returns from successive investments, and multi-family buildings have the capacity of providing better quality of life for tenants and better financial returns for landlords.

DaBx Renewable Energy Retrofit Portfolio Standard for Multifamily Buildings
by Rogier Fentener van Vlissingen is licensed under a
Creative Commons Attribution-NonCommercial 3.0 Unported License.
Based on a work at http://www.vliscony.com.
Permissions beyond the scope of this license may be available at http://www.dabxdemandsidesolutions.com.

Energy Efficiency Will Sink Green Underwriting

By conflating energy efficiency in buildings with renewable energy, and treating them as if they somehow are additive to sustainability, the underwriting industry is doggedly digging itself another hole by means of green financing initiatives. It may not become a worthy successor to the tsunami of mortgage fraud that nearly sank our financial system, but is certain to become another self-inflicted wound, judging by the growing numbers of green mortgages and other financing solutions. Whenever there is a realistic renewable energy alternative, buildings are potentially sacrificing future asset appreciation because the terms of loans coerce them into pursuing energy efficiency rather than renewable energy. This type of Green underwriting is the ally of bad or non-existent energy policy, primarily because of diminishing returns on energy efficiency. Bad financial planning does the rest.

As demonstrated on this blog, energy efficiency in itself is not an objective, unless one first addresses a make or buy decision to determine if it is economical to generate electricity at the building level. Energy efficiency is an attribute of whatever system you have, and if you started out with a fossil fuel system and you spend your money on making it more efficient, you are also committing yourself to paying energy bills for the foreseeable future, unless there is a solid component of renewable energy in your program.

Green Underwriting Will Founder on the Rock of Energy Efficiency

Would be "green" mortgages, and other forms of would be "green" financing for energy retrofits, and other financial instruments (PACE bonds come to mind), are all hitching their ride to energy efficiency as a primary objective, and as demonstrated on this site, energy efficiency as applied to an existing fossil fuel based infrastructure is an absolutely desperate measure of last resort, which should only be pursued if you cannot implement green power infrastructure economically.

Diminishing returns mean that every next step in efficiency is explosively more expensive than the last, and programs like the NYSERDA MPP are designed to get around that issue, but in effect leave the building owner stranded without any options for subsequent improvements. By contrast, if you implement green power technologies as a retrofit strategy, you will experience, as you do the engineering and the economics, that your project will enjoy compound returns. Initially, the capital requirements are higher, but in the long-term, the returns are very promising. Normally we estimate that such green power-driven buildings could command a 10-20% premium within 10 years.

Green Power: What Green Underwriting Should Be

The prime rationale for PACE bonds was always the capital intensity of energy retrofitting, but as this story makes clear, the PACE community missed the boat in the confrontation with Fanny and Freddy. They came away with only a Pyrrhic victory, and the reason was that they got lost like everyone else in energy efficiency, and the complete obfuscation of the original objective, which was the transition to renewable technology. The nature of the renewable transition is exactly that it is more capital-intensive up front, and this is what PACE bonds were designed to address. If their use were limited to renewable energy conversions, they would promptly be indispensable, and they would indeed reduce risk for underwriters. So perhaps PACE could enforce the standards. Right now PACE bonds are just a lost opportunity, if they go along with the general energy efficiency craze, which is based on bad financial planning. What's more, if PACE bonds did fill this role, they could function alongside regular mortgages, and indeed provide an assurance of asset appreciation.

Green Underwriting: Don't Underwrite Operational Savings with Long-term Money

The biggest problem with would-be "green" mortgage products is that energy efficiency is a disastrous objective and benchmark to use, which may marginally improve the financials of a building, but can never make the sort of massive advances that are possible by leveraging renewable technologies. Energy efficiency typically achieves 20-30% reductions in consumption, renewable energy conversion can achieve 25-50% reductions in the first phase and 75% within 10 years. More importantly, with green power technologies, a building has an energy price hedge, and therefore goes up in value with every energy price hike, while the "energy-efficient" building next door merely sinks in value slower than if it did not invest in. The availability of financing and replacement cycles with dictate the order in which such a transition can be made.

Thankfully, there have already been signs or market hesitation around ill-conceived energy efficiency loans such as NYSERDA's. The whole business of subsidized energy efficiency loans is about "investing" in the difference between the Titanic going down in five minutes or ten, Energy Star labels or not.

Incentives Should Be Targeted Only for Renewables

Any renewable energy infrastructure in a building will add value, for it moves energy from the liability to that asset column. With careful planning, miracles are possible. It is hopefully going

Conclusion

Green underwriting is bound to be a failure as long as it sets energy efficiency as a primary objective, and the major opportunities for real estate asset enhancement are by definition with green power technologies.

NYC Clean Heat is regressive with respect to Clean Air Compliance

The NYC Clean Heat program is in effect strongly regressive, for at a time when it is completely viable for multifamily buildings to switch to green energy, the net effect of the way the present NYC Clean Heat program works is with NYC boiler conversions, and shifting buildings from oil to natural gas en mass. Evidently, natural gas burns cleaner than #6 or #4 oil, but nonetheless a more substantive shift to renewable energy is long since feasible, and moreover is economically more attractive for building owners, tenants and the city. NYC Clean Heat should put more emphasis on the shift to renewables. Most importantly, the shift to renewable energy would have far greater impact on the city's Clean Air profile, than practically forcing these buildings to commit to another 30 years of fossil fuel burning, even if the emissions per se are lower. In short, the net result is that this program in the way it is being practiced is strongly regressive from the point of view of achieving the vaunted improvements in Clean Air Act compliance.

The NYC Clean Heat Cookie Cutter Approach

By and large the program now is focused on prolonging the fossil fuel era as long as possible, because it focuses entirely on the adoption of clean fuels, and happily continuing to burn things, which will be for the most part natural gas and in a few cases either #2 oil or even biodiesel. In short, its impact on actually meeting Clean Air Act standards, will be absolutely minimal, and when one considers that it is possible to switch to far more renewable energy today, it is in effect strongly regressive. To be specific, we assume the reference building has an old-fashioned steam boiler, with hot water from a coil in the boiler. Further, natural gas does not have any particulate emissions, and between greater efficiency of a modern boiler and cleaner burning gas, we can expect perhaps a 50% reduction in CO2 emissions:

1. Building burns #6 oil and the base line CO2 emissions are 100, and particulates 100.
2. Building switches to Natural gas, CO2 goes to 50 and particulates to 0.
3. Over thirty years that means cumulative CO2 emissions of 30x50= 1500.

This path adds up to passing off the difference between the Titanic sinking in 10 minutes instead of 5 as an "investment" opportunity. If this option is anything, it is not an investment, but an operational expenditure. The problem gets compounded even further if businesses take on long-term debt for a short-term fix of this sort.

Clean Air and sustainability from renewables

Now the alternative, as proposed in DaBx PlaNYC2020:

1. Replace Domestic Hot Water (DHW) with a renewable solution, which eliminates 30-50% of fuel consumption (these are proven stats, DHW is year-round, heat only half the year) this reduces emissions by 30-50%, so both CO2 and particulates go to 50-70% of former number, I will use 50% for the example here. The choices are geothermal or solar thermal.
2. The economic life of the boiler is now extended, since the boiler gets a summer vacation from now on.
3. When boiler replacement becomes economically necessary, which we'll estimate is in 10 years, replace with either a solar thermal HVAC solution or individual heat pumps, (driven by solar PV or wind energy) or in the worst case a new natural gas boiler. Combine with better insulation, new windows as needed.
4. Results over 30 years now are: years 1-10: CO2 50, particulates 50, and years 10-30 CO2 0, particulates 0. Total CO2 10x50+20x0= 500, particulates 500, and particulate emissions would be limited to the winters, when smog is less of a problem.

Note: These numbers are obviously only schematic, and there are a lot of nuances there which we ignore for the sake of this example, such as the fact that gas may be cleaner burning, but the transportation losses also figure into the emissions, to say nothing of the fracking debate.

Sustainability is the only way to clean air

Sustainability is not just an idle thought, it is also economically very powerful. Properly analyzed, business sustainability follows directly from making the right decisions in this transition. Building preservation is enhanced by switching to renewables. Most importantly, since the sustainable technologies of sun, wind, water, geothermal all eliminate the need of burning things, except in some very limited backup functions, such installations are all enhancements to the asset value of the building.

Energy efficiency is of fossil fuel is mere life extension

Evidently, if no economical entry point can be found for a building to convert to renewable energy, and achieve sustainability, and a measure of independence from the grid, then efficiency measures for the existing plant are the only option. In the vast majority of buildings there are serious steps that can be taken towards sustainability. Whenever a building has any renewable option--free energy, after all--it should take it.

Nowhere on this site do we argue against energy efficiency, we merely point out it should never be the first objective. The first objective should be do we make or buy our energy, and if instead of energy efficiency, we take reducing emissions and achieving Clean Air standards as an objective, the building is then free to pursue that objective with whatever means is the most economically attractive, and that is how it should be. The 90by50 report from the Urban Green Council pointed out the top line feasibility of massive change, but meanwhile we are missing a huge opportunity for shifting to sustainability, and make significant progress towards Clean Air in 2013, 14, 15.

Conclusion

NYC Clean Heat is shifting buildings from #6 and #4 oil towards Natural Gas at the expense of Clean Air, and long-term sustainability of buildings, which goes against an interest in building preservation.

Financing Energy Retrofits and Capital Destruction

Creative finance solutions for energy retrofits abound, but most underwriters, including alternative financing programs such as PACE bonds, fall for the generally accepted delusion that energy efficiency should get top priority. This is a mistake - majoring in a minor - which increases underwriting risk, instead of decreasing it, for several reasons:

• If you start out with "energy efficiency" of an existing installation, that is not an energy retrofit at all, for you blithely accept that the design that was in place was the best one possible, and you are merely upgrading it, as in with more efficient versions of the same technology. The point of an energy retrofit is to use newer technology, which may necessitate a different design. An efficiency improvement in most cases is not a capital investment, but an operational expenditure.
• Since many of the newer technologies are about generating energy with solar, wind, geothermal, or even hydropower, they all imply a different model, and different designs. Specifically they enhance the capital asset, the building, with independent generating capacity. Financially they are also a permanent price hedge against energy price increases.
• Energy efficiency upgrades are also by nature short-term, they usually only achieve about a 30% improvement, which is easily wiped out by a few price hikes, therefore such upgrades should not be financed with long-term money, let alone be subsidized.

As demonstrated in earlier posts, financing energy efficiency with long-term money in most cases is a mistake, because the typical 30% or so improvement is all too easily wiped out by one or two price hikes, and because of the issue of diminishing returns, there is no follow-on strategy, and therefore it is financially unsound. Financially, energy efficiency is a horrible dead-end and should be avoided like the plague: again, it increases underwriting risk if it is pursued at the expense of an existing renewable option. As a strategy, investing in energy efficiency should be an absolute last resort, if you can't do anything better.

Renewables are an immediate and permanent asset of the building, regardless if you use solar, wind, or geothermal, or hydro-electric, plus any improvements to the building envelope now come back to you directly in terms of reducing the installed capacity you need. Renewables are an immediate energy price hedge. Because of diminishing returns, "investment" in energy efficiency is financially a shaky proposition, while renewables immediately raise building value.

Energy Retrofits Gone Wrong

Energy retrofits that prioritize energy efficiency amount to capital destruction, assuming there was an economically viable renewable option available. Thus underwriters of financing for buildings who focus on energy efficiency first are in most cases likely to be deteriorating their portfolio and needlessly increasing underwriting risk. This is long-term money for a short-term benefit, and that does not make for financial stability of the asset. Even PACE bonds have completely missed this issue, and all programs that I know of focus on energy efficiency first.

With proper financial planning, which is to say a 30 year capital budget for energy upgrades to a building, it will become very visible that renewable options are financially superior, for 30 years of zero energy bills will outweigh 30% energy savings. Or to put that differently, renewables may initially have a longer payback, but, properly evaluated, the renewable solution with a 7 year payback, may be superior over its life to a 4 year payback on an efficiency component, which "saves" 10%. The renewable energy equipment comes with zero energy bills, or in the worst case some 10-15% in back-up from a fossil fuel source.

How to underwrite energy retrofits

renewables improve value

The bottom line is that responsible financiers should demand a 30 year CAPM analysis of energy retrofits to the building, which could include an installation that could be spread over several years, and obviously realistic measures for maintenance and operating costs, noting that O&M are typically lower for renewable energy than for fossil fuel. Further, underwriters should rate projects based on the percentage of energy that is derived from renewables. The higher it is, the greater the financial stability of the building. My consulting firm DaBx Demand Side Solutions, publishes the DaBx Renewable Energy Retrofit Portfolio Standard (DaBx RERPS)

Conclusion: renewables reduce underwriting risk

Financing energy efficiency means financing short-term operational improvements with long-term money; energy retrofits with renewables reduce underwriting risk and improve the asset value of the property.

NYSERDA MPP and Diminishing Returns

The NYSERDA Multi-Family Performance Program, aka the  NYSERDA MPP, is an ostrich approach to the problem of diminishing returns on energy efficiency spending; it deals with an investment problem by sticking its head in the sand. To put it a different way, when it comes to a traffic light, which is red, and then knocks out the light and proceeds through the intersection. Specifically, the problem is the diminishing returns from investing in energy efficiency measures, and the designers of this program adjusted the program so this problem does not get in the way.

Energy efficiency done serially

Diminishing Returns Example:

1. Your initial consumption was 100, let's assume you had 4 options, and you prioritize.
2. Your first "investment" of $5,000 produced a 10% reduction. Your base is now 90. You paid $555 for every percentage point reduction. Payback was less than a year.
3. The next "investment" of $25,000 produced a further 10% reduction but now off a base of 90, so the combined result is a 19% reduction in consumption, and your base is now 81. You paid $2,500 for every percentage point reduction. Payback was about 3 years.
4. The third "investment" of $35,000 also produced a 10% reduction on the remaining 81, or 8.1% off the original number, and your new base is 72.90, and you achieved a total "savings" of 27.1%. You paid $4,321 per percentage point reduction. Payback was 4 years.
5. The next best option is $55,000 also producing a 10% reduction, but now on a base of 72.90, for a return of 7.3% savings off the original, or $7,534 per percentage point reduction, and it is not worth doing, so we leave well enough alone. Don't even ask the payback.

Note, some smart fools could try to change the order, and do #5 first, and then #2 might not look so bad. Is that a solution? Watch how NYSERDA solves this conundrum:

NYSERDA MPP: Obfuscating diminishing returns

The MPP program and anything designed like it--and the model is fairly common-- "solves" this problem by shuffling it under the rug, namely it stipulates an overall target, of say 30% (the program targets 15% or better with higher incentives with subsequent levels of achievement). In other words the various subsidies are used to overcome the issue of diminishing returns to the building, and incentivize the owner to do what's good for the utility, never mind if it's good for asset appreciation of the building.

To go back to the prior example, the NYSERDA MPP model works with an aggregate savings, and an overall savings target, and incentives to make sure that 5th project gets done to get the property to over 30%. The bundled approach obfuscates the problem of diminishing returns. The incentives serve to disguise that the 5th one is not economical.  The thinking behind it is very evidently to incentivize owners to do what's good for utilities (and equipment manufacturers).

Renewables versus energy efficiency

The Energy Efficiency Merry Go-round

With the NYSERDA MPP, you cannot come back for ten years. In the meantime they pray that some other innovation comes along for even more "efficiency." However the conundrum of diminishing returns will be even greater, for after you once upgraded your boiler from the old clunker that was 50-60% efficient, to one that was 95% efficient, what are you going to do? Go to 96% efficiency? No, unless it blows up you're not going to replace it.

In short the problem never gets any better, and what you should have done was to figure out how to get off the merry go-round. If only in one part you were able to switch to renewables economically, you'd be ahead of the game. In an apartment building or a residence the obvious candidate is geothermal hot water, followed by total geothermal HVAC. Solar thermal is next in line.

Make sure you evaluate the renewable options in the context of a 30 year capital budget, and pre plan every next step, so that you pre-engineer for subsequent expansion. Depending on the nature of your financing, You may do a total renewable retrofit in one go, or incrementally over as many as 10 years. Notice that with a renewable retrofit, you usually enjoy compound returns from different project phases.

Investment implication of diminishing returns

Directly relevant observations from this problem are:

1. The NYSERDA MPP should serve only as a cheat-sheet to see if you can qualify for the incentives and the subsidized financing, but you need to do a proper capital budget first, and if the renewable options work in your building, you will wildly exceed NYSERDA's targets. Most consultants in the area come from the standpoint of energy efficiency, and they do not represent the interest of capital formation in your building, but they work for the benefit of the utilities and the equipment providers.
2. Clearly, either investing or underwriting on the basis of energy efficiency or energy savings is a dicey business proposition, as a 30% improvement is easily wiped out in one or two energy price hikes.
3. In general the framework of the NYSERDA MPP is not about investing at all but about operational savings, and inappropriately uses long-term money for short-term fixes, thus potentially worsening the financial stability of buildings. Banks and PACE bonds both are missing the mark here with financial solutions. The difference between the Titanic sinking in 5 or 10 minutes does not an investment make.
4. Conversely, only investment in renewable solutions effectively can significantly boost the capital value of the building permanently, and could legitimately qualify for long-term financing.

The framework of the NYSERDA MPP and energy efficiency in general combined with using payback as a criteria, means that owners are doing the minimum to get the NYSERDA subsidies, which is even against their own long-term interest, if there is a viable renewable energy retrofit available for their buildings. To put it differently, because the tabular presentation of an aggregate result generally is mistaken for a financial model, buildings are in many cases making sub-optimal decisions with it, and the presentation hides the diminishing returns. Nobody in their right mind would invest in a sinking ship, just to delay the speed with which it's sinking.

Conclusion

The NYSERDA MPP is regressive, and mostly inappropriately used to substitute for a capital budget for energy retrofits. By doing so renewable energy options are sacrificed to energy efficiency, and there are no follow-on investments because of diminishing returns.