The Self-destruction of PACE finance

The PACE idea is powerful: Property Assessed Clean Energy. It was recognized that the switch to clean energy for existing buildings was going to be capital-intensive, and PACE financing was designed to enable projects with longer paybacks, by providing longer term financing. Lenders were given the assurance of low risk because collection was done through property taxes. For the property owner, there was the advantage that the building could be sold with the existing PACE finance being assumed by the new owners - it did not need to be refinanced. But then the energy efficiency lobby kicked in by co-opting the moniker "clean energy." I am not sure of the exact historical circumstances, but the fossil fuel business has a vested interest in selling energy efficiency as a functional equivalent to "clean energy," and calling themselves "green." It is not, but PACE organizations bought into this fallacious argument.

GSE Trouble

Fannie and Freddie did not like PACE one bit, because it would get seniority over existing mortgages. In the end, a compromise was reached, limiting PACE financing to 10% of the assessed value. The PACE team could only barely show some positive impact of Energy Efficiency on home value, but they produced a study that seemed to confirm the relationship. Apparently unbeknownst to them (believe it or not), energy efficiency and clean energy are not the same thing. Energy Efficiency is pointless as a primary objective, from financial, economic and environmental points of view, not to mention it is pointless with respect to building property values, for it produces diminishing returns. Only renewable energy will reduce GHG-emissions, and only renewable energy is an investment, because it moves energy from liabilities to assets.

The choice is between fossil fuels or renewable energy, and whatever system you choose, you want to make it as efficient as is economically feasible. The choice is not, not ever, between energy efficiency and renewable energy. If the PACE folks had focused on Clean Energy as the name implies they would have convinced Fannie and Freddie hands down to not only allow PACE (with restrictions), but to promote renewable energy retrofits with PACE finance as constructive to asset values. The only thing holding it back was the absence of an effective underwriting policy. With our (see www.dabxdemandsidesolutions.com) Green Underwriting 2.0 initiative, we have proposed an alternative that focuses on projects with in excess of 50% GHG-reduction, which would help building values, increase resilience, and could only be done with various types of renewable energy solutions, because they offer compound returns, particularly if more than one type can be implemented.

Energy Efficiency: the lightbulb moment

Energy Efficiency is the prevailing religion, but it is financially disastrous and environmentally regressive. It buys short-term gains with long-term financing, and creates a temporary lift which masks the fact that the underlying problem gets worse. If our problem is emitting green house gases (GHGs), then the solution cannot be to make it cheaper to burn more GHGs, and thereby expand the market, and encourage people to keep on emitting them for longer periods of time. Doing so, the problem becomes more entrenched. The solution must be to switch to renewable energy as fast as possible. And the way you do that in a capitalist system is focusing on the low hanging fruit, meaning the most profitable projects, not with soviet-style 20 year plans that never work. Energy efficiency is pointless, and causes capital destruction because of diminishing returns.

A simple lightbulb can demonstrate the point:

• We used to use a 60 Watt bulb that cost $1
• We then switched to a 14 Watt CFL that cost $2 (actually a four pack at Home Depot today has them as low as $1.25). This savings was 46 Watts or 77%. At $0.35 per kWh, we saved $0.0161 per hour, and paid for it in 62 hours.
• Now we are considering a switch to LEDs, which in the same range go for $15 at the moment. The incremental savings is 6 Watt, or 43% against the CFL, but only an incremental 10% against the original incandescent. At the same electrical rate we save $0.021 per hour, and pay for it in 3095 hours (8.5 years at 2 hrs a day).

In short, the first "energy-saving step" books impressive results for a small incremental marginal expenditure, and it makes obvious sense. The next step is financially absurd, because of the math of diminishing returns. Our further incremental investment buys us only a 10% savings off the original base consumption of 60 Watts. In dollars, it cost us $1 to save 46 Watts in step one, or $0.02 per watt saved. But in step two the price is $2.17 per watt saved. This is typical in energy efficiency spending, the first step or steps look good, but there is no economically viable follow-on. Many, if not most, government programs incentivize the first few steps of energy efficiency (my preferred example in NY is the NYSERDA MPP program), and leave the property owner stranded in a cul-de-sac, with no alternative but some day writing off most of what they did.

PACE finance for EE: Painting lipstick on a pig

Renewable energy (Solar, Wind, Geothermal, Hydro, etc.) moves energy from liability to asset, and moreover if we can combine multiple technologies, or appropriate energy efficiencies, we can produce compound returns. Energy efficiency reduces, but does not eliminate a liability, but it can be made irrelevant easily, among others by the following:

• Growth in net-zero and near zero properties in the market, making the typical 15-25% efficiency "savings" all but irrelevant.
• A few energy price hikes, or even if energy prices were to stay stable, the delivery cost of the grid may continue to increase (in NYC ca 65% of the bill).
• Growing numbers of similar properties go the renewable route, and achieve 50-90% GHG-reductions, making the 15-25% reductions look paltry.
• Any form of carbon taxation in the future. (Note e.g. that adaptation of the Baucus energy tax reform if it includes the demand side, like well it should, would indirectly have the same effect)

Energy efficiency is a limit function, and environmentally it is dubious, it produces a short-term gain, but a long-term increase in CO2 emissions. The problem becomes more entrenched, instead of coming closer to a solution. Financially, Energy Efficiency is a secondary issue, and operational savings, not a capital decision. The real choice is fossil fuels or renewable energy. And all the elements that make PACE financing attractive to investors are wasted, if they are used to dress-up energy efficiency loans. It's like putting lipstick on a pig.

PACE and EE: mismatched maturities

From a pure financial standpoint, the four points listed above, of how and why an "energy efficiency" investment can go sour very easily, all are variations on the theme that the financial value of the "investment" could evaporate easily, meaning that the effective ability to pay may be threatened over time. And thus it's the mismatch of short-term investments with long-term maturities which is the most pressing issue here.

PACE, as it was clearly intended and as its name implies, was meant to finance permanent capital improvements with long-term money, so that energy retrofits with longish paybacks could get done. Mostly the asset backed approach for the equipment does not tend to out too far. If PACE financing is wasted on energy efficiency projects, it will self-destruct sooner rather than later. PACE should be limited to projects with a principal focus on renewable energy, that clearly move energy from liability to asset, and therefore improve the underlying value of the property. That will ensure the viability of the project, if it is otherwise designed right. Typical projects should achieve 50% or better GHG-reductions. If this is not done, PACE finance has every potential of becoming the next sub-prime scandal, right along with solar PPAs.

Conclusion

PACE finance is a brilliant solution that is being misapplied by purposing it for short-term energy efficiency projects rather than long-term renewable energy projects.

Energy Efficiency, Killing Us Softly

St. Patrick's day reminded me that it is high time we learn to tell the real green from the fake stuff, beginning with energy efficiency, which has been unjustly conflated with sustainability, when in fact it does the opposite: it increases carbon emissions over time, except at a slower rate. It's high time the FTC should start taking on green washing, beginning with such seriously misleading names as the ConEdison Greenteam. The fact is that, when energy efficiency is pursued without further qualification, and it is applied to systems that are 95% driven by fossil fuels, we are shooting ourselves in the foot with a bazooka. Making a bad system better will solve nothing, except making fossil fuels viable longer, instead of finding a real solution. The fact is, efficiency applies equally to fossil fuel-based systems or renewable energy systems, but only renewable energy systems can reduce GHG-emissions. So we are reminded once again, that it does not pay to major in a minor, or, in the words of the incomparable computer scientist Donald Knuth:

Premature optimization is the root of all evil.

Here is the quote from Donald Knuth, discussed in an article, the Fallacy of Premature Optimization. The energy equivalent to this proposition is that:

Premature Energy Efficiency is the best prophylactic against deep energy retrofits. Or, to but it more simply, if you pursue energy efficiency first, without regard to the long term energy plan for a facility, you will incur sunk costs, if nothing else because of diminishing returns.

Let me count the ways

In no particular order, but with some attempt at logical grouping, here come all the reasons, with some links to other posts on this site or other sites where appropriate. A completely logical and progressive ordering is not feasible due to the interdependence of many of the items listed here.

1. The obvious issue is that energy efficiency makes economic sense (to the extent that it is optimal) whether fossil fuel or renewable energy is used. Therefore, it is a secondary objective in an optimal design, not a primary one. The payback for efficiency comes from reduced energy bills in the future in the case of fossil fuels, or reduced capital expenditures in the present in the case of renewable energy (less installed capacity needed). Another way to state this is that energy efficiency does not generate energy: it is not an alternative method to generate energy.
2. Historically, the conflation of energy efficiency with "green" energy or sustainability, goes back to the energy crises of the 1970's. It was then thought, probably correctly, that the marginal dollar spent on reducing demand was more effective than investing it in increasing supply. The concept was enshrined by the thinking of Amory Lovins, who made the confusion complete by treating energy efficiency as the "fifth fuel." This type of thinking resulted in policy making that treats energy efficiency and renewable energy as interchangeable and complementary, or even additive, which most often is not the case, because different decisions would be made about energy efficiency in a fossil fuel infrastructure than in a renewable energy system. In truth, energy efficiency is not even an investment, it's a mere operational savings, and financially it should be treated accordingly. Renewable energy is truly an investment, a make versus buy decision, a permanent price hedge, and it improves building resilience, and adds value to the asset.
3. Then there is the famous Jevons paradox, which in effect states that increased efficiency increases demand, and therefore does no such thing as conserving energy. Jevons was speaking about coal, and by and large his predictions came true, and are equally relevant today about oil and gas.
4. It gets better (or worse, depending on your point of view). Steve Hallett, in The Efficiency Trap, takes his perspective from biological/systems thinking, and notes not only that greater efficiency lowers the cost of the energy input and stimulates demand, but there are often knock-on effects. For example not only did we fly more as flying became more efficient, but we also built more airports, etc. The end result is that energy efficiency "improvements" make the problem worse, not better, and we have plenty of historical examples to show this. At the other end, exploration costs are going up all the time, so that the massive carbon deposits we theoretically still have are becoming less and less economical to exploit (even aside from the GHG-emissions question). In short, energy efficiency keeps carbon energy more economical for a longer period of time, and therefore increases GHG-emissions over time, which is the opposite of what we want. Hallett's conclusion is simply that the road to hell is paved with efficiency. In his words: "Efficiency promises to conserve, but actually consumes. Efficiency is a trap."
5. The Jevons paradox and the efficiency trap are bad enough on a macro level, but on an individual project basis we see that if we do our economics right you cannot save yourself rich: energy efficiency yields diminishing returns whereas renewable energy generated on-site can bring compound returns. The truth quickly becomes evident if proper capital budgeting is done for the energy infrastructure of a building (home). Thus, within a given building retrofit, energy efficiency (of the fossil fuel-based infrastructure) competes against renewable energy. As long as payback of the equipment from marginal savings is used for decisions, energy efficiency will initially always seem to outperform renewable energy, but when 30-year cash flow analysis is used, renewable options often prove more attractive. Compound returns can be achieved from engineering synergies by integrating several technologies.
6. On the margin it is already clear that net-zero building is the healthiest construction sector, and has been so for several decades, regardless of economic cycles, and in downturns these buildings have kept their value better than other buildings. Since in the larger economic sense the rate of change at the margin drives valuation, it should be clear that fossil fuel buildings are going to continue to lose value at an accelerating rate.
7. Therefore, any older buildings worth preserving should switch to renewable energy and attempt to become net-zero or near-zero, and buildings that cannot make the switch to renewable energy will be the slums of the future, and ultimately headed for demolition. Along those lines the current fashion (think NYC Clean Heat) of switching fuels mostly from coal and heavy fuel to natural gas, amounts to capital destruction. The same applies for energy efficiency initiatives such as New York's Local Law 84/87/88: these measures constitute majoring in a minor, and therefore guarantee failure in the form of strongly suboptimal outcomes, including, at the extremes, the preservation of some buildings that should be demolished, and the failure to convert other buildings to renewable energy when they have the potential.
8. A systems approach is needed, and almost all policies and incentives have been targeted at the technology (widgets) level, not the system level. The smallest system, the economic atom of real estate is a single property (house, building), and above that are neighborhoods, towns, cities, regions, states, countries, and eventually the whole world. In some cases regional planning can be very effective, but we should engage everyone from the smallest economic unit of a single property on up. Incentivizing specific technologies leads to market distortions and bad engineering. Solar PPA's are a case in point. At 17% efficiency, Solar PV should be the last choice, as solar thermal is 98% efficient (or arguably more, because process heat is easy to store for intra-day usage, which gives you higher returns than selling your kWh's back to the grid or using expensive chemical batteries).
   Incentives for individual widgets reinforce a bad financial habit of evaluating options based on the payback of the equipment from energy savings, which flies in the face of optimal design on the level of the property as a whole. The Baucus energy tax proposal focuses on overall GHG-reductions, but so far addresses only the supply side of the grid. Clearly, the demand side should be included due to the huge potential for generating energy on-site with renewable energy.
9. Green finance, so-called, has been a mixed bag of various flavors of asset backed lending, justified by the fact that it is theoretically "low risk" because it offers what are deemed to be largely self-liquidating propositions, based on energy savings. This is a complete fallacy, and energy efficiency loans and solar PPAs may be the subprime loan scandal of future years. In many cases it is the ease of finance, ease of installation (solar PV!), and Wall Street greed, fueled by misplaced incentives, which are fleecing property owners of their equity, locking them into a suboptimal solution. They waste their roof space, and borrowing capacity when with the same space, using solar thermal (98% efficient), they could have easily provided complete HVAC, reduced GHG-emissions by over 50% while homes and buildings become much more valuable in the process.
10. Securitization of energy efficiency loan portfolios has already encountered some headwinds, and these issues will only become more evident as analysts learn to understand the absence of a sound economic foundation. The typical 15-25% "energy savings," is easily wiped out by both energy price hikes (the winter of 2014 gave us a taste of that!), and by comparable buildings going the renewable route and eliminating 50-90% of their energy bills, and GHG-emissions. (See #6 above).
11. The combination of technology-level incentives (such as tax incentives based on Energy Star ratings), and decision making based on marginal payback of equipment, and partial solutions, lead to either the wrong decisions from a whole building level, in some cases such that they lock buildings out of other, superior solutions, or else they risk "cherry picking" a whole building solution - which benefits the financiers who want to write "easy loans," but rob the building owners of the potential to add value.
12. Policies which limp on the dueling concepts of Energy Efficiency and Renewable Energy recall the roulette player who puts equal amounts of black and red. Treating Energy Efficiency as an alternative to Renewable Energy, or as a proxy for GHG-reductions ensures policy failure.

New York State Energy Plan

The review period for the 2014 Draft New York State Energy Plan is still open, and I have supplied my comments along the lines indicated here. On the whole, the plan has the laudable objective of 50% GHG-reductions by 2030 and 80% by 2050, but otherwise continues the errors that have ensured past policy failure by including energy efficiency and fuel switching in the options. Both of these options are environmentally counterproductive, and ensure minor GHG-reductions in the short term at best, and of course, if we want to achieve the objective of 50% GHG-reduction by 2030 and 80% by 2050, we should focus only on projects that can achieve over 50% GHG reduction. Therefore, neither fuel switching nor energy efficiency should be in the plan.

Letting the market take care of energy efficiency

There is huge potential for renewable energy retrofits that can produce 50% or better GHG-reductions right away, and more later, and in ways that make economic sense today, if property owners make use of the right decision-making models. The EPA provides the Energy Star Portfolio Manager to assess projects on a whole building basis, and the resulting models should be evaluated based on a 30-year CAPM cash flow analysis. This will quickly show that many renewable options that seemed expensive are actually economical based on the long tail of zero energy bills, while the 15-25% "energy savings"  from energy efficiency upgrades will quickly be found wanting, unless some of them can be integrated to directly increase the payoff from renewable energy options.

In short, competitive pressures will become more effective if policies and incentives support renewable energy first, and leave it to fossil fuel companies and their customers to work out arrangements for energy efficiency wherever it is economically justifiable.

Conclusion

We are now experiencing a paradigm shift from the fossil-fuel era to the renewable era, and there is huge potential for quantum improvements, even on a building retrofit basis. The major impediment to GHG-reductions is not technology but proper financial analysis along with incentives and programs that reinforce the wrong decisions. In short, as in any other paradigm change, it is our thinking that gets in the way, but that can be corrected. Once you get it, it's obvious. The 2014 New York State Energy Plan should focus on Renewable Energy, and leave Energy Efficiency to the market.

Renewable Energy, the Star of the Show

Renewable Energy has been the step-child of energy policy, which has been dominated by Energy Efficiency (EE). This emphasis on EE is really a relic of the energy crises of the last century, when it was thought the cost of energy and energy independence were the issue, and not so much the environmental dimension. Times have changed. Reducing Green House Gas emissions (GHG-emissions) now has taken center stage. Renewable Energy (RE) is the only path that will get us the reduction in GHG-emissions which are now generally seen as a priority. The simple truth is that Energy Efficiency is not a generating technology, it only improves the performance of whatever system you have, be it based on fossil fuels, or based on renewable energy, therefore, it is equally applicable to both. The only real choice is between Fossil Fuels (FF) and Renewable Energy (RE), and RE is what we want, not more FF, or for our addiction to FF to last longer.

In the public dialog, and in public policy, EE is mostly treated as an end in itself, which results in policies that achieve the opposite of what we want to achieve, assuming that a reduction of GHG-emissions is really our goal. The reason for this is simple. Our existing systems are overwhelmingly based on Fossil Fuels, and if you improve them with EE, you are throwing good money after bad by making FF economically more attractive. If we make fossil fuels cheaper to use, people will use more of them and will use them for a longer time, which is strongly regressive for climate risk. If the government is subsidizing EE without further qualification, they are subsidizing the fossil fuel industry, which is the opposite of what they want to do.

The only rational policy towards GHG-reductions is one that minimizes GHG-emissions through Renewable Energy, and leaves it to the Fossil Fuel industry and their customers to make their systems as efficient as possible. It is not rational to subsidize Fossil Fuels indirectly by subsidizing Energy Efficiency without qualification.

Renewable Energy Failure in NYC

Despite many signature projects that demonstrate what's possible, New York City overall has fallen into the trap of prioritizing EE, hand in hand with state programs like NYSERDA, as well as various federal programs. Even worse, the NYC Clean Heat program diverted a large portion of the housing stock to natural gas for heat, in a laudable attempt to reduce particulates emissions and GHG-emissions, but by doing so missed the opportunity to begin the serious conversion to RE, which would have produced quantum advances in reducing GHG-emissions. As we now know, the switch from coal to gas, and from heavy fuels to gas, yield no reductions in GHG-emissions, except a displacement. So nominally NYC wins a little in the short run, but in the long run it is meaningless.

Typical EE projects yield 15-25% reductions in energy costs, mostly "savings" on fossil fuel bills, and these seem easily justifiable, however in many cases we are missing the opportunity for radical conversions to RE, which could easily produce over 50% reductions in GHG-emissions, and be financially successful for building owners, far more so than the EE projects that are now the norm. If proper capital budgeting were utilized throughout, it would become quickly apparent that in many cases integrated RE solutions for buildings have superior long-term economics, and PACE financing is a readily available vehicle to address the heavy up-front capital investment required for these projects. Simply put, every RE component we can retrofit in a building comes with a lifetime of no energy bills equivalent to the amount of energy it provides.

In the winter of 2014 New Yorkers paid the price for the massive shift to natural gas. Electricity in January 2012 was 7 cents/kWh (ConEd), in 2013 it was 13 cents and in 2014 it was 22 cents. Winter normally had low electric rates, now it has some of the highest rates of the year. New York City has become massively, recklessly and unnecessarily dependent on a single fuel: natural gas. Building resilience has been made infinitely worse as a result, while at the same time we're spending money on improving building resilience. The single biggest thing we could do for building resilience is to stop converting buildings to natural gas, and encourage them to switch to renewable energy instead.

It's all economics and finance

The problem is not technology, there are more options every single day, The big things that are holding us back are practicing proper economic and financial analysis, to understand how rewarding RE retrofits really are. Thirty years worth of free energy will beat out 15-25% energy savings in most projects, especially if there are integration opportunities that produce legitimate engineering synergies which compound the returns from individual technologies. That geothermal heat pump combined with a wind turbine, or solar PV, becomes an energy harvesting system, and hot water storage tanks are cheaper and more environmentally friendly than batteries.

The primary importance of economics and finance is driven home forcefully by the fact that the 2014 Draft New York State Energy Plan cites the inroads of solar PV on Long Island as a success.  This is a success that is driven by Asset Backed Lending/Leasing based on marginal energy savings, and achieves shallow results, compared to what could be done if financial analysis were done right, and projects were engineered for the long-term. If property owners were to use proper capital budgeting techniques and did 30 year models, there is no way that 17% efficient solar PV should win over 98% efficient solar thermal installations. People are saving 10% on their electric bill, when with the same roof space they could do central HVAC and Domestic Hot Water for their entire property. This approach is more work, so it does not get done, but we as a society lose. Property owners who sign for these solar panels in most cases miss an opportunity for a major value enhancement to their properties.

C40Cities needs to prioritize renewable energy

I have submitted an Open Letter to C40Cities in hopes that this group will start addressing these issues, and not have the rest of the world repeat the mistakes that were made in New York. Appearances always deceive, and this case is no different: in the short run some reductions in GHG-reductions were realized, but because it all came from EE and from fuel switching, it merely extends the reign of fossil fuel and is therefore regressive with respect to climate risk in the long run.

Will New York become a leader in renewable energy?

Recently, I submitted an open letter to Governor Andrew Cuomo pertaining to the Green Bank. The Green Bank initiative could be coming at the right time for Mayor de Blasio, who has an interesting challenge. To his eternal credit, Mayor Bloomberg got climate change and energy policy the attention it deserved, but some key programs have been counterproductive, even if that is not widely recognized as yet. I have documented these issues with an open letter to Mayor de Blasio. Further clues are in my letter to C40Cities. Clearly, there is a big opportunity for the de Blasio administration to change course with some of the programs that have us going backwards instead of forwards. The opportunity for New York City to become a leader in this area is certainly there. Our infrastructure lends itself to rapid progress, but it will require the necessary regulatory changes to enable such developments, for besides bad financial analysis, regulatory hurdles are the principal brake on a breakthrough to clean energy.

Conclusion: Lasting Reductions in GHG-emissions from Renewable Energy

It is time to break the stranglehold of the fossil fuel era by pursuing renewable energy breakthroughs that are well within reach, but often ignored, because EE seemed "cheaper" and "easier." Heretofore, we did not realize that the short-term reductions in GHG-emissions from Energy Efficiency would ensure long-term losses. Therefore, the time has now come to focus on creating the breakthroughs in renewable energy with projects that achieve in excess of 50% reductions in GHG-emissions, and New York City can certainly become a leader in the context of the C40Cities, much to the benefit of its citizens.