ESPC Financing Options
As you explore explore what financing options might be available, you'll want to talk with your finance and budget departments to learn what is possible and what is not.
The options fall into two categories: funding and financing. Funding involves a source of money that does not need to be repaid, such as a capital budget allocation. Financing does need to be repaid, but the payments can be covered by the cost savings from the improvements. ESCOs can offer information on how financing is generally managed for ESPC projects, and your finance people will likely have preferences for how to finance the work.
It’s important to note that your entity will need to be ready to pay for the IGA if the project does not go beyond the IGA phase e.g., you decide not to proceed for some reason. In most cases, the cost of the IGA is folded into the overall project cost and financed or funded accordingly.
Choosing a payment option is not an either/or question. It may make sense to use funding sources to pay for a portion of the project and to finance the rest. Funding sources can be especially useful for measures that might not be well-suited to financing, such as those with longer paybacks. Even a relatively small capital budget appropriation will help, and once your finance people get some experience with ESPC, they may be more comfortable with a larger project the next time.
Bonds
General Obligation Bonds
Pros: General obligation (GO) bonds are debt instruments which are typically considered safer investments than other types of bonds because they are supported by the full faith and credit of the issuer. As such, they tend to pay lower interest rates than revenue or hybrid bonds. This means that, if need be, the issuer could raise taxes in order to pay the bond. Bonds tend to be issued for longer terms (up to 30 years or more), which allows more energy efficiency measures with longer simple paybacks to be installed.
Cons: Because they are supported by the tax base of the issuer, generally a voter referendum is required to issue this type of bond. Bonds, in general, must overfund the project costs to cover direct issuance costs (e.g., legal council, financial advisor, rating agency, and bond trustee fees, insurance, escrow account and auditor fees, printing and distribution costs, etc.), and underwriter's discount, when necessary.
Revenue Bonds
These are bonds with repayment tied to a specific revenue or cost savings stream. For example, cost savings from an ESPC project can be pledged to pay off a bond. Because the bond issuer’s repayment obligation is limited to a specific revenue stream, revenue bonds are often viewed as higher-risk than a general obligation (GO) bond that can be repaid from general tax revenues, resulting in a higher interest rate cost. Revenue bonds may or may not require voter approval. See this US DOE web page on Bonding Tools.
Pros: Unlike GO bonds, revenue bonds are secured only by specific income or projects (income producing projects). Revenue bonds can be issued with multiple maturity dates ("serial bonds") which can allow for a variety of assets being financed.
Cons: Because they are not backed by the taxing power of issuer, they are considered to have a slightly higher risk factor and, as such, usually carry a slightly higher yield than an equivalent GO bond. Because revenue bonds are issued to pay for income producing projects, it is typically more difficult to finance energy efficiency projects with this type of bond as compared to a renewable energy project that sells output and generates income.
Tax Credit Bond - Qualified Energy Conservation Bonds (QECBs)
State, local, and tribal governments can sell QECBs up to a certain dollar value that is based on their population. QECBs are direct-subsidy bonds, meaning that the issuer receives a direct rebate from the U.S. Treasury, essentially reducing the cost of borrowing. QECBs can be a valuable source of low-cost loan capital. For more information on QECBs, visit this QECB page on the National Association of State Energy Officials (NASEO) website or this US DOE QECB and CREBS Primer.
Pros: Allows the bond issuer to receive a direct interest rate subsidy or federal tax credits in lieu of the traditional bond interest, resulting in very low interest rates.
Cons: The original funds were allocated to states, cities, and counties. Local governments that have an unused allocation may reallocate to other local government units by an official resolution or ordinance. If the host does not have sufficient allocation, requesting a reallocation could prove laborious, time consuming, and politically challenging.
Tax Credit Bond - Clean Renewable Energy Bonds (CREBs)
CREBs may be issued by state, local, and tribal governments to finance renewable energy projects. The bondholders receive federal tax credits, enabling the issuer to pay the bondholders a below-market interest rate. The issuer remains responsible for repaying the principal reduced interest on the bond. To learn more about CREBs, visit the DSIRE CREBS page or this US DOE QECB and CREBS Primer.
Pros: Allows the bond issuer to receive a direct interest rate subsidy or federal tax credits in lieu of the traditional bond interest, resulting in very low interest rates.
Cons: Must be used to finance renewable energy projects, including: wind, closed-loop biomass, open-loop biomass (including agricultural livestock waste), geothermal, solar, municipal solid waste (including landfill gas and trash combustion facilities), small irrigation power and hydropower. State and local governments may apply to the Internal Revenue Service (IRS) for a CREBs allocation.
Loans
Bank or ESPC Specialty Financier
A loan from an existing creditor may be the easiest and fastest way to access the needed funds. Because the lender may already have additional funds on deposit (i.e., a bank), the interest rates on these types of loans can be favorable. Often traditional lenders require large down payments on new loans and they may insist on strict restrictive covenants and/or additional collateral. Most lenders prefer shorter terms, which may cause cashflow shortfalls when the energy savings must cover the entire costs of the energy improvements. Specialty ESPC lenders may allow longer terms. It may not be the lowest-cost option, but the convenience of working with a lender who is comfortable with performance contracting makes this a frequent choice.
Pros: A loan from an existing creditor may be the easiest and fastest way to access the needed funds. Because the lender may already have additional funds on deposit (i.e., a bank), the interest rates on these types of loans can be favorable.
Cons: Often traditional lenders require large down payments on new loans. In addition, they may insist on strict restrictive covenants and/or additional collateral. Most lenders prefer shorter terms, which may cause cashflow shortfalls when the energy savings must cover the entire costs of the energy improvements. Specialty ESPC lenders may allow longer terms.
Leases
Equipment Lease - Type A (Capital)
Capital leases are common in performance contracting. The lessee (the entity using the equipment) assumes many of the risks and benefits of ownership, including the ability to expense both the depreciation and the interest portion of the lease payments. The equipment and future lease payments are shown as both an asset and a liability on the lessee’s balance sheet, and the lease payments are classified as capital expenses. Capital leases often have a “bargain purchase option” that allows the user to buy the equipment at the end of the lease at a price below market value.
Pros: Leases usually allow for more financial structuring than other traditional financial instruments. For example, the lease payments can be structured to be a portion of the energy savings and increase/decrease as the project is installed and performing.
Cons: Capital (or Type A) leases are considered "debt" for financial reporting purposes. Most lenders prefer to limit commercial lease terms to 7 years, 10 years if lessee is considered "investment grade".
Equipment Lease - Type B (Operating)
In these leases, the entity providing the equipment retains full ownership, so it does not appear as an asset or a liability on the user’s balance sheet. This can appeal to users that are near their borrowing capacity. There are specific IRS rules regarding when a lease can be treated as an operating lease versus a capital lease.
Payments on an operating lease are usually less than for capital leases and loans, since the lessor owns the asset and the user is not paying to build equity. It is assumed that the residual value of the asset can be recovered at the end of the lease. Because of this, operating leases are typically limited to equipment with substantial residual value.
Pros: For the time being, leases that meet FASB 13 tests can be considered "off balance sheet" transactions. This changes in 2018 when new leasing rules come into effect.
Cons: Effective 2018, keeping lease payments "off balance sheet" will no longer be available unless the lease term is less than 12 months.
Tax-Exempt Lease Purchase Agreement (TELP)
Also known as municipal leases, these are perhaps the most popular option for financing performance contracting. TELPs presume that the state or local government will own the asset after the lease expires. Further, the effective interest rate is reduced because interest payments received from the government are exempt from federal income tax. In most states, TELPs are not considered debt and rarely require public approval. If funds are not appropriated to pay the lease in future budgets, the equipment is returned and the lease is terminated. For this reason, these leases are usually limited to equipment that is essential to the operation of the entity. To learn more, see this US DOE web page on Leasing Arrangements.
Pros: Issued at tax-exempt interest rates. For smaller projects (e.g., less than $5 million), the net interest cost is usually less than issuing a bond. Easy approval process. Fast access to lease funds. Can set up a Master Lease (like a lease line of credit) to cover a variety of other non-energy projects. Usually no additional direct issuance costs are needed (unlike a bond). The inclusion of "non-appropriation language" may keep this from being considered "legal debt" and have an easier approval process (state specific).
Cons: Interest rate may be slightly more expensive than a bond for larger projects (over $5 million).
Tax-Exempt Conditional Sales Agreement or Tax-Exempt Equipment Sales Agreement
Pros: Tax-Exempt Conditional Sales (or Equipment Sales) Agreement is an alternative to a Tax-Exempt Lease Purchase Agreement. The primary difference is the substitution of the word "finance agreement" for "lease" and the elimination of "non-appropriation language" from the document. It is used in certain states where there is a legislative prohibition on leasing equipment by tax-exempt entities.
Cons: Because the "non-appropriation language" is not included in this agreement, this type of financing is typically considered "legal debt" and is subject to all the approval requirements necessary for new debt.
Other
Energy Services Agreement (ESA) / Managed Energy Services Agreement (MESA)
Pros: Third party installs energy efficiency equipment and only earns fees when savings are realized. They control utility budgets and can insure that funds are available to repay financing obligations. Keeps investment off your state/city/county's balance sheet.
Cons: Third-party financing is always more expensive than if the city/state would borrow directly (taxable vs. tax-exempt rates). Limited number of companies offer this kind of energy services agreement. Longer-term contracts would be needed to maximize energy conservation measures. This structure is generally for projects $5 million or higher. Often difficult to track real savings as the facility’s energy usage evolves and measurement and verification should be done by an independent third party (additional cost).
Power Purchase Agreement (PPA)
Pros: Third party installs renewable energy equipment. Customer agrees to host the renewable energy equipment on their property and purchase the resulting electricity. Allows third party to monetize tax credits. No upfront cost, no operations and maintenance costs, locked-in energy price.
Cons: Only works for renewable energy. No guarantee that resulting cost of electricity will be lower than grid-purchased electricity.