The Fallacies of Energy Efficiency Loan Securitization

Green finance is struggling, judged by the apparent difficulty in the placements of securitized energy efficiency loans, recently by both NYSERDA (NY) and Pennsylvania.

"The market" is always a funny thing, but generally it does work, and, assuming it is working as it should in this case, clearly the message is that the emperor has no clothes on, or at the very least we are not quite sure of the state of his dress. This is in line with some of the observations I have offered in this blog on the state of green finance in general and the NYSERDA programs in particular.

At the crossroads: Energy Efficiency versus Renewable Energy

Following the logic of my proposed Green Finance principles, in essence "energy efficiency" securities are a wasting asset in the extreme. Number one, there is a false appearance of "market beating performance" based on the theoretical better ability to pay because of cash flow improvements thanks to energy efficiency. This is true in the short-term, but very deceptive in the long-term, and it is in effect an investment trap, that might snap shut during the run times of these loans.

The typical 20-30% efficiency improvements are irrelevant in the market because:

1. The improvement is easily wiped out by one or two energy price hikes. Note that even natural gas is now coming off its lows, and note also that in NYC in particular, transportation and delivery is 60-70% of energy bills, and rising faster than inflation as far as the eye can see. The US EIA reference case to 2040 shows flat to mildly rising cost of electricity, and gently rising costs for natural gas and residual fuel.
2. The energy efficiency improvement is further made irrelevant if far greater improvements are feasible - which is the crux of renewable energy, that we can get 70-90% reduction in fossil fuels in the majority of buildings that are now converting to natural gas under the NYC Clean Heat program. As soon as even a few buildings pursue the alternative, the buildings with some marginal energy savings become irrelevant.
3. Even more so, net-zero construction is gaining ground very rapidly, and while it may seem only "marginal," to lay people, it is not from an economic standpoint, for the sustained growth in net-zero construction for the last 20+ years will become the implied reference for energy performance of building portfolios, and NOT the 15, 20 or 25% 'energy savings' over last year. That's mostly narcissistic, not substantive.
4. A further material weakness in the concept of "energy efficiency" loans, as it is practiced today, is that they risk financing short-term improvements with long-term money.
5. The specific investment trap arises because of the diminishing returns on the path of energy efficiency: there is little or no follow-on opportunity after the first 20-30% improvement, and when a building subsequently needs to switch to renewable energy anyway, the initial "investment" in energy efficiency is largely a write-off.

Where the rubber meets the road: Green Finance Politics

The complete political muddle around renewable energy and energy efficiency has resulted in a situation where the dialog has been spoiled by running the two topics together, when in fact they are mutually exclusive, and totally different investment paths. In general there is too much top down reasoning, and too little recognition of the notion that we are a capitalist society, and that the building owner is in the business of maximizing the value of his property, and the regulator should be providing rules and regulations, carrots and sticks, to direct this process towards the public good.

The current regime of incentives is geared towards the energy industry, or towards the manufacturers of specific equipment, but existing programs don't provide the framework or the incentive for property owners to behave rationally. In practice what happens with programs like the NYSERDA MPP, is that building owners try to figure out how they can qualify for the least amount of expenditure. The issue of diminishing returns in energy efficiency upgrades is in effect covered up by the very model the NYSERDA MPP uses, and it sets up an investment trap for property owners.

Why PACE bonds ran afoul of Fannie and Freddie

Green Finance based on Renewable Energy does add up.

PACE bonds should be the poster child of green finance. When the big showdown happened a few years ago between Fannie and Freddie over PACE bond financing, the issue was entirely about the notion that PACE bonds would get priority in case of bankruptcy, and the fact that there was precious little assurance that the programs would achieve greater asset values. Eventually the PACE camp was somewhat able to make the case, but only weakly, because again the confusion over energy efficiency was never far away. The point of PACE is that renewable energy does increase property values, and comes with a greater upfront capital expenditure than your run of the mill energy efficiency program.

If PACE programs are developed with a laser focus on renewable energy, and drop energy efficiency to the second tier status where it belongs, they will be focusing on permanent improvements to properties, and moving energy from liabilities to assets. PACE will promptly become indispensable, and municipalities will support it more and more because it can help them with GHG reductions and Clean Air Act compliance. If energy efficiency is wrongly prioritized, the impact on GHG will be more muted.

How to make Green Finance viable

The one and only constructive solution in green finance is to require that property owners have long-term energy plans. In a world where net-zero construction is the fastest growing segment of new construction for twenty or more years going, net-zero is becoming the de facto benchmark and 20, 25, or 30% improvement over last year will quickly become irrelevant.

To achieve this I have recently published a proposal, which would streamline the whole process, and would make green finance seriously viable, instead of the current muddle. The DaBx Renewable Energy Retrofit Portfolio Standard is a simple and straightforward guideline which would ensure a solid foundation for green finance with a minimum of fuss.

Conclusion:

Green Finance runs into valuation problems as long as it conflates the energy efficiency of carbon based infrastructure with renewable energy alternatives. Renewable Energy produces compound returns by leveraging synergies with different technologies and efficiency measures. If energy efficiency becomes the priority and is applied to a carbon-based energy system, it produces diminishing returns, and competes with renewable energy: the two are not additive, but mutually exclusive. To harmonize the two, green finance should focus on renewable energy first and treat energy efficiency as a subordinate objective, which it is.