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.

Off the grid in four easy lessons #4

Off the grid is a direction not a destination, and the principal instruments to get there are financial analysis and economic modeling, not technology. So never mind the government has no energy policy, just a rag-tag group of programs and incentives that tend to confuse people more than help towards a solution. Never mind that utilities and oil companies do everything they can to seduce real estate owners to remain happy carbon customers till the cows come home with all kinds of energy efficiency solutions. It is up to the property owner to make sense of them, and the principal tool you have is the Capital Asset Pricing Model, aka CAPM and once you start studying it, and looking into the various technology options you may have regardless of what your starting point is, you will be amazed. Research CAPM, study Internet resources, including CAPM Free Questions.

Energy Efficiency and equipment payback - the trap to be avoided

To recap from earlier posts: energy companies (utilities, oil companies, etc.), and vendors of equipment will inevitably try to get the attention of real estate owners with investments in  energy efficiency, which are to the benefits of their shareholders, and NOT of the real estate owners. The nature of energy efficiency is that the first investment always looks very good, and typically offers outsize returns (on the basis of payback), and 99.99999% of owners do not stop to think that they are committing to an investment path that perpetuates their indentured servitude to carbon energy. The vendors capitalize on these insights by selling their "solutions" based on marginal analysis of energy savings, always showing a wonderful payback for their equipment, and waiving around Energy Star labels, tax incentives, or other subsidies. If they are successful, you've invested your money in remaining the customer of your energy company forever. This is voluntary vendor lock-in. Various tax incentives, but also NYSERDA, Energy Star, CPC, PACE, and most mortgage providers will steer you wrong because their programs are useful only if your own CAPM analysis says so. Don't run your financial future based on someone else's say so.

The morning after effect comes in when you want to do the next "investment," which is worse but you'll probably still do it. Some day you'll have to realize that diminishing returns mandate that you'll never ever find another investment as good as the first one. The cynic might say these are not investments at all, but operational savings. Even various form of PPAs offered by energy companies tend to suffer the same analytical defects and will benefit the shareholders of the energy companies more than the home owner. Caveat Emptor!

Off the Grid with CAPM

Getting Off the Grid starts with the one and only thing that every property owner should do first, last and in between: make a 30 year financial model of your property, and use it to model your own strategic energy plan, always comparing the base case as the investment in energy efficiency based on the existing infrastructure, with the alternative case using green energy. Again, energy efficiency will never get you off the grid, green energy will, if you figure out the right way of implementation. The first decision is a make or buy decision about energy: should you buy it on a subscription basis, or generate your own. Watch values of net zero properties for reference.

It is never ever what the salesmen will tell you, nor should you let yourself be confused by tax incentives, NYSERDA programs, PACE and/or other energy efficiency finance. They will all steer you wrong, to the detriment of the long-term value of your asset, your property. Study the energy economics of your property first, before you figure out what incentive programs are to your long-term advantage. You will repeatedly find that financing mandates, e.g. of Energy Star equipment, may benefit the energy industry more than it benefits you. Don't buy it unless it actually helps improve the long-term value of your property. Financial sanity starts with CAPM!

Your CAPM Badge

.

To build up capital reserves for your energy investments join the green power referral marketing revolution: GoGreenGetGreen

OFF the Grid: The basic assumptions about the relevant cash flows

Here is a list of the major cash flows and assumptions you need to document:

1. For starting asset value use Zillow, or a similar service.
2. Identify ALL forms of energy you use - it may be two or three.
3. Make a 12 month model so you start to see seasonality, you will therefore have 360 cash flow periods.
4. Track both consumption and pricing.
5. Notice that in deregulated states it probably makes sense to split the cost of delivery and supply. In many cases, certainly in NYC, delivery is 65% of your utility cost per kWh or per Therm, and rising inexorably ABOVE the rate of inflation. For my gas it is 95%, because I use so little of it.
6. Identify specific inflation rates for all your energy component costs and rates.
7. Track reasonable assumptions for maintenance (i.e. annual costs, but also periodic replacements, such as a boiler or water heater that may last 10 or 15 years).
8. Make a base case (A) based on your existing energy mix, with incremental investments in energy efficiency. You will start to see how these investments will get wiped out by ongoing price hikes, let alone spikes such as have happened from time to time.
9. Make a case B based on renewable energy. Try to identify the rationale for a strategy to eliminate one fuel completely (oil or gas), or as near as you can get to it.

Experiment with such a model until you are comfortable. Until you are, you are not ready to begin shopping for energy solutions.

Off the Grid: Sane assumptions for getting there

As much as possible try to think of projects to coincide with maintenance things you'd have to do anyway. In other words, if in five years you would have to replace your boiler, that may be the timing for switching to geothermal, or solar thermal, or some other combination, and you may only need a very small boiler for backup. Or, if your roof needs to be replaced that may be a time to improve on insulation, and/or solar or wind installations. You do not want to install a set of solar collectors with a 20-30 year life expectancy on a roof that only has 5 years of life left in it.

Avoid tankless water heaters like the plague. Domestic Hot Water storage is a very efficient energy store, you may need it in your design later on.

CAPM: valuation issues

Study the energy independence profile of homes in your area. With net zero homes and buildings growing, energy costs will increasingly become important in valuation. If a few homes in an area are energy independent or close to net zero, that will start to diminish the values of all other properties.

Be prepared to learn a lot. Both good and bad. The renewable energy path is more capital-intensive, but it will increase your property value more. You will find opportunities with compound returns because of synergies. Keep studying what is going on in your market, and never ever listen to a sales rep coming with payback periods, and various incentives. He or she is stealing the value of your home.