What's Wrong With the Energy Retrofit Model and What To Do About It

Energy retrofitting will be a big business for the next few decades, for the simple reason that there are more old buildings than new. Granted, some buildings will be scrapped if they can't make it in the new net-zero and near-zero age, but many buildings are eminently capable of material overhauls that can eliminate 70-80% of GHG-emissions.

Premature Energy Efficiency:
The Best Prophylactic against Deep Energy Retrofits

The unfortunate fact is that the structure of various incentive programs as well as typical financing approaches have prevented deep retrofits and favored shallow programs that achieve just 20-30% GHG-reductions. A typical example was a deal sheet I recently saw from NYCEEC, effectively the New York City Green Bank: easily 80% of their projects were in the 20-30% GHG-reduction category, and just a few projects here and there were in the 70-80% GHG-reduction bracket. On their website, they focus almost entirely on marginal improvements in "energy efficiency," complete with their "Energiensee(tm)" calculator of energy savings potentential - therefore, the focus is on O&M, not on capital improvements. Yet, purely mathematically, in a state that has an objective of 50% GHG-reductions by 2030 and 80% GHG-reduction by 2050, clearly anything less than 50% GHG-reductions guarantees failure of the state's objectives, and the idea of providing incentives, including subsidized finance to do such deals is absurd on the face of it.

If you understand the economics of energy retrofits in buildings, it is clear that what is going on here is the clash between O&M (Operating and Maintenance), which tends to be on annual budgets, and Capital Budgeting. The structure of the real estate industry is that energy tends to be looked at through the lens of O&M, but there are now so many alternatives that represent structural change of building energy infrastructure, that these decisions need to be looked at as capital cases, and the investors/owners need to be involved. Long term building values are at stake. Capital improvement should be the driver for energy retrofits, and if you can't do them, you should probably get rid of the building, it's going to be scrapped.

Capital destruction results from an incremental O&M approach

Many, many, "upgrades" should not be done at all once you look at them through the lens of long term capital appreciation. That list includes:

• Tankless Water heaters. They are mostly a mistake, for DHW (Domestic Hot Water) storage is immensely valuable for e.g. Solar thermal, or Heat Pumps, but sometimes even for Solar PV. There are some valid uses of these, as backup in renewable retrofits.
• OTG (Oil-To-Gas) conversions, sure, you may save on your energy spending, but again, looked at from a capital budgeting standpoint, on a 30-50 year lifecycle timeline, these kinds of marginal improvements are usually pure capital destruction in the face of better alternatives such as hybrid solar thermal or heat pump solutions.
• Condensing boilers are a liability if there is solar thermal or heat pumps in your future, because if the boilers become the backup the heat recovery systems rot out in record time due to condensation under intermittent use. In other words, incremental decision making creates massive sunk costs that undermine building values in the long run.
• Solar PV. Especially at Northern latitudes solar PV retrofits are pure capital destruction in many if not most buildings when evaluated from a capital budgeting standpoint under a 30-50 year lifecycle assessment. Solar PV should be relegated to whatever space remains at the end of a retrofit process. It is too inefficient.

The Height of Folly: Tesla/SolarCity

Recently, I have been writing about Tesla and their SolarCity merger, which is the height of capital destruction. SolarCity never figured out the economic value they could provide for their retail customers, and their business model was driven by the demand of tax-equity finance and the Wall Street appetite for ABS-notes. It was clear that recent financings, starting at least from the John Hancock transaction earlier this year, meant that SolarCity was under water under those terms compared to the discounted cash flow model they sold to investors as being the "retained value" of the company, so they slipped from arguable "value creation" into "value destruction:" the installations were a loss leader for a fallacious "retained value" that is increasingly not working out, because it's only feasible by assuming lower discount rates on an equity basis than what they are actually paying on their recent deals, so that both the front end and the back end of their transactions is now under water.

This development was bad news for SolarCity shareholders, but the whole business model was bad for retail customers, for SolarCity sales people have an incentive to sell you the most solar panels they can fit on your roof, and NOT to add the most value to your property. And because their whole sales model is wrong, they are destroyers of asset values for their retail residential clients. This is the reason why they are not a Solar energy company, but a Solar panel financier (and not particularly good at it). SolarCity's unique contribution has been that they figured out a way to sell sub-prime financing to prime customers, for their sales proposal to clients rested on a foundation of stretching the payments long enough to be nominally "cash-flow positive" based on the projected energy savings, and the sales mottos were "free solar panels" and "sell'em on the payments!"

The easy test was the study from Arizona State University, and the conclusion was that:

Solar panels owned by a home seller add 4 to 6 percent to the value of a home sale, often less than the cost of the panels, according to an analysis of local home sales and reports from real-estate agents. Houses with leased solar panels actually sold for less than those with no solar. (see story on AZCentral)

However, Solar panels installed with a lease or PPA might deduct 3-8% of the value of the property at the time of sale, for it places the seller between a rock and a hard place, namely, they either have to pay off the lease, or they have to get the buyer to assume it, at which point the buyer can negotiate a discount on the property.

And again, there are deeper issues here as well, and the value of the SPV install might not be optimal if other parts of retrofitting are ignored. Typical experiences in existing homes suggest that you should most often only require 50% of the SPV capacity that sellers like SolarCity will offer, if you implement the optimal mix of passive measures, ranging from insulation, radiant heat barriers on windows, and power quality solutions. The decisions are easier if your home is all electric, but usually the payback can be 20-50% shorter if you pursue the optimal balance of passive (insulation, etc.) and active (generation).

I recapped a lot of these issues in two articles on Seeking Alpha, about the Tesla mess, here:

•  The Solar Roof is Coming Off at Tesla
• 'Teslaverse:' of the Epitome of Failure of Energy Policy

Energy Efficiency Versus Energy Retrofitting:
History Lessons

For good historical reasons, originally it all started with energy efficiency, squeezing more energy from systems, but gradually, structurally different solutions came into being, which enabled different financial decisions, for once you enter into retrofitting, there are lots of interdependencies within a given building, and you have to make a clear decision about what your upgrade path is going to  be since many of the technology choices are mutually exclusive with other possible solutions. Here's how it has worked:

1. Phase one was pure O&M, lowering your bills year over year, which works initially, but in the end, you cannot save yourself rich, and this approach runs out of steam because of diminishing returns. The answer should have been capital budgeting, but instead financial slight of hand was used to "justify" further retrofits.
2. Stretching the financing became the way to make bigger and bigger retrofit projects happen, and as a result, financiers were effectively stripping value out of buildings, and building owners did not know any better. The financiers win and property owners lose. Just watch for buildings in the Northeast with Solar PV: they were sold a bill of goods, as per the analysis above.
3. We are now entering the capital budgeting phase, for the number of retrofit options have grown so much that a growing number of owners find out the hard way that incremental decision making produces capital destruction, and that a decision made one year ends up being undone a few years later. Typically failing to plan means planning to fail and in depth energy audits and thirty-year capital budgets must become the new normal.

The transition to the capital budgeting model will increasingly be precipitated by the emergence of more and more net-zero or near-zero buildings that go up right next door to older buildings so that economic competition will force the older buildings to either upgrade or be scrapped. 

The Key to Deep Retrofitting:
Holistic Approach and Value Creation 

Meanwhile, with my company, we are hard at work with the marketing of harmonic power filters that get rid of harmonic noise in power circuits, and while the payback is great, especially here in NY, where it's usually months, not years in most commercial applications, the real message is that in a deep energy retrofit, this technology alone can reduce the overall project payback by 20-50%. In other words, incremental "efficiency" retrofits should not be squandered by implementing them in isolation, but be viewed as part of the overall energy model, and enable building owners to undertake the retrofits that create true long-term property value. The magic is to add a sub one year payback to a project with a seven year payback, and create a project with a four year payback that's easy to finance.

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.