In the fight to fund energy upgrade projects, the rules of engagement are changing.

As facility executives know, getting an energy upgrade project approved by an organization is no small task. One of the biggest obstacles facility executives face is demonstrating a project’s worthiness even though it doesn’t generate revenue.

At best, financial lenders say an energy upgrade falls in the middle of an organization’s priorities. Manufacturing, product or service improvements that generate revenue for an organization often beat out energy upgrades. One way to get around that perennial predicament is to demonstrate a project will cost no money up front and will produce savings in the long run.

Financing upgrade projects allow facilities to do just that.

For government and institutional buildings, financing allows facility executives to upgrade equipment without having to ask taxpayers or donors to approve the spending. For the private sector, financing allows an organization to become more energy efficient while preserving its credit rating and good standing among investors.

"Financing eliminates the need for the company to make the initial capital outlay," says Matthew Ide of First International Bank, which loans money directly to facilities and through a national utility cooperative to fund energy upgrades.

There are myriad financial options available to facility executives. The financial structure can run the gamut from a traditional loan financed over a few years to a structure that allows facilities to sell the infrastructure of their energy-using systems to an energy service company (ESCO) and buy the commodity that the system produces. What binds all of the structures is their ability to deliver certain financial advantages, including tax benefits and reduced debt, and to ease the process of gaining approval for the project.

Operating Leases
Financial structures, such as operating leases, make it possible to treat the upgrade project as a business operating expense as opposed to a capital expense. That arrangement allows the organization to borrow the money to pay for the upgrade, eliminate the need for capital investment, and repay the money through the savings generated by the project over a specified term. Some operating leases even allow the facility to purchase the equipment at the end of the lease term.

Terms of the lease can vary depending on the type of energy upgrade. A simple lighting upgrade might be funded over 5 years while a project that combines a couple of building systems, including an on-site generation component, can run as long as 20 years. The key to the agreement is that the equipment is at least partially paid for through the energy savings generated by the project. Some projects save enough money to fund the entire cost of financing.

"Most end-users would like a lease to be cost-neutral," says Jerry Chapman, vice president of energy finance at CitiCapital. "That means the monthly payments equal the savings."

In some cases, he says, organizations will increase the length of the loan term to generate positive cash flow from the upgrade project. That means the monthly payments are actually less than the amount of savings generated through the upgrade.

In addition to an operating lease, lenders offer capital leases, conventional loans and variations of each. Each type of financial structure has its own advantages and can be structured depending on the needs of an organization, the type of facility involved and the willingness of the lending institution to finance the agreements.

While commercial and industrial corporations tend to favor operating leases because the payments are tax deductible and require them to incur no debt, public entities and institutions, such as schools, prefer tax-exempt leases, which offer considerably lower interest rates.

Lenders point out that most of the financed energy upgrades occur within the public sector. Some estimates show that this sector accounts for 65 to 80 percent of all financing projects.

Industrial and owner-occupied space is the next largest category, with leased commercial real estate in last place. One of the difficulties in penetrating the lease-spaced sector involves the ownership structure prevalent in the market. Many commercial buildings are owned by limited liability partnerships, giving the financial institutions little to claim as collateral.

Many of the same general rules apply to energy upgrade projects as to any sort of financing. For one, the more risky the project — meaning the less certain it is to produce a given level of energy savings — the less chance it has of getting financed. Also, increased risk in the organization’s ability to repay the loan leads to higher interest rates.

Jerry Carter, director of sales and marketing for Dana Commercial Credit, says facility executives can take steps to improve their prospects of securing financing by making sure financial data is current, audited and complete when sent out.

Lenders
Any number of lenders can help facility executives finance projects. Some lenders deal exclusively with financing energy upgrade projects, while others have divisions dedicated to the energy sector. In most cases, the energy finance company works through an ESCO that will arrange the financing and look for a willing lender.

Lenders say facility executives are renewing their interest in energy financing as they continue to hear of deregulation’s less-than-stellar performance in California and as energy prices continue to rise. No longer are facility executives waiting for deregulation to make energy-saving moves.

"People are looking for any way they can to reduce energy costs," says Bob Dixon, director of performance solutions for Siemens Building Technologies. "Energy conservation, where it may have taken a backseat to deregulation, is now on the forefront of everybody’s mind."

Exactly how the sluggish domestic economy will affect both the willingness of facility executives to undertake and finance energy upgrades is unclear. Some lenders expect the market for energy upgrades to slow significantly while others see any economic downturn having less of an impact.

Chapman of Citicorp says that while it’s true the energy finance business is better in good times than in bad, some facilities benefit by financing a project during slow economic times.

During slow economic times, companies are usually interested in preserving cash, which serves as a "rainy day" fund of sorts. Financing an upgrade allows those companies to pay for upgrades without spending cash needed for other projects.

On the other hand, interest rates on lease and loan terms could rise. Despite any action taken by the Federal Reserve Board, financial institutions could raise rates on projects they view as risky or set high rates on organizations whose poor credit ratings suffer even more during an economic slowdown.

Facility executives considering financing an energy upgrade will very likely work with ESCOs to help structure the deal. In some cases, the ESCO will be such an integral part of the deal that the facility executive has little contact with the lender.

In the past couple years, that role of the ESCO has grown in importance. To drive business and improve the energy performance of facilities, ESCOs have been increasingly willing to tackle upgrades that encompass a number of building systems, including roofs, windows and plumbing systems.

Ide of First International Bank says his company has financed projects in which the plumbing systems, heating systems and central plants of a single facility have all been upgraded.

Dixon at Siemens has even seen the resurfacing of parking lots included in energy upgrade financing arrangements.

The success of those sorts of projects depends upon the energy savings one of the systems can produce to essentially pay for the other upgrades.

"Anything a facility can save on operating costs — in our case it would involve energy upgrades — can help drive revenues for an organizations," says Louis Buck, vice president and chief financial officer of Con Edison Solutions, an energy service company.

One other trend, says Herbert Muther, senior vice president for business development at ABB Energy Capital, is for facility executives to sell their energy-using systems to an ESCO and then pay a monthly fee for the chilled water, conditioned air, light or electricity produced by that system. In that arrangement, the facility typically receives a one-time payment for the asset totaling about 75 percent of its appraised value. It then pays the fee in exchange for the commodity, maintenance and future upgrades to the system.

"The biggest advantage to financing is that facility executives do not have to spend their capital dollars on improving infrastructure," Muther says. "They can enter into a performance-based agreement that doesn’t increase their debt obligation on their balance sheet."

Terms of Financing
Facility executives researching financing options to pay for energy upgrades undoubtedly will be bombarded with unfamiliar terms and expressions.

Here’s a partial list that defines some of the financial options available to facility executives:

Performance Contract: A way to fund energy upgrades in which the energy service company performing the upgrade guarantees that the savings from by the upgrade will pay for the project.

Shared-Savings Plan: An arrangement in which the savings from installing new infrastructure pays both the lender and energy service company for the equipment. It also generates cash flow for the facility. No up-front payment is required.

Operating Lease: An arrangement in which the energy service company or some other contractor or vendor maintains ownership of the equipment. Payments made by the facility are considered operating expenses. At the end of the lease term, the facility generally has the option to purchase the equipment.

Capital Lease: An arrangement in which the energy service company or other contractor or vendor installs and maintains the equipment. Unlike an operating lease, however, monthly payments the facility makes appear as a debt on the organization’s balance sheet.