Why financial institutions should be worried about energy efficiency performance risk
The 22nd June sees the launch of the EEFIG Underwriting Toolkit – a major new publication aimed at assisting financial institutions build capacity in financing energy efficiency, particularly in regard to understanding and appraising the value and risk of energy efficiency projects. As its primary author, assisted by a great Consortium and input from many EEFIG members and others, it will be good to get the Toolkit into the market place after a year of work on it. Although primarily aimed at financial institutions looking to deploy capital into energy efficiency it should also be of use to project developers who can use it to develop projects more in line with the needs of financiers, and CFOs reviewing possible corporate energy efficiency investments who often face the same issues as external providers of capital.
With growing interest from financial institutions in financing energy efficiency projects, and increased recognition that investment and financing of energy efficiency has to grow by a factor of five by 2050 for us to have any chance of meeting our climate goals, it is time to address the elephant in the room on energy efficiency – performance risk. Recent articles in the UK press have highlighted the inadequacies of energy modelling, the performance gap between what a project is supposed to save and what it actually saves. Similarly in the US there has been disquiet about a number of PACE funded projects not performing.
The energy efficiency industry needs to come clean about performance risk and banks and investors contemplating scaling up capital deployment into efficiency need to understand the issue. This does not mean don’t invest in efficiency, or that it is high risk, it just means we need to really understand and where possible mitigate the risks.
So far most financial institutions have studiously ignored performance risk for the apparently rational reason that they are not taking it, or at least they think they are not taking it. Most energy efficiency financing at the moment is straight forward consumer or commercial lending, just and just like any other loan the borrower is on the hook for the payments come what may. The next largest area of efficiency financing is funding investments made under an Energy Performance Contract (EPC) where an Energy Service Company (ESCO) provides a guarantee that the predicted level of savings will be achieved and if they are not, pays the difference. So assuming the ESCO is experienced and credit worthy all is well for the bank, the project fails to deliver, the ESCO pays the client and the client pays back the bank.
However, things are really not that simple and even when financial institutions are not explicitly and contractually taking the performance risk they should be concerned about it for six good reasons:
depending on jurisdiction consumer credit law it may make a lender responsible for equipment performance over its lifetime.
under-performance can lead to customer dis-satisfaction which leads to disputes which put repayment at risk. They also consume time and energy on both sides and create a negative customer experience which these days can be quickly communicated and can cause reputational damage.
some financial institutions count the improved cash flow resulting from the projected energy savings in their credit risk assessment. Even though they do not contractually take credit risk this means that they are implicitly taking performance risk, if the savings are not delivered the customer’s credit risk is higher than the assessed number.
failures of project performance at scale in residential financed projects may lead to reputational loss, even a mis-selling scandal. In the US and UK there has been negative press about the performance of energy efficiency retrofits. Imagine if a bank financed millions of retrofits on the promise of savings being greater than repayments and they were not delivered, the reputational risks and the cost to rectify would be huge.
a better understanding of performance risk will allow development of new products which take some performance risk for higher returns. This has started to happen in wind power for instance where lenders who previously would take no performance risk are now taking some for higher returns. Done right energy efficiency can be highly profitable and secure so there is an opportunity for a funder who really understands the risks.
re-financing markets, specifically the green bond market, will require assurance that underlying projects are performing and having a genuine environmental impact. The green bond market is imposing more stringent standards on what qualifies as green. In order to attract the most investors at the best rates it is important to be able to prove that the underlying projects are actually performing as they were supposed to.
These six reasons mean that financial institutions active in, or contemplating entering the energy efficiency market really do need to understand and manage performance risk.
The Investor Confidence Project (ICP) is an international project to reduce performance risks and due diligence cost through the standardisation of energy efficiency project development. Under the ICP’s Investor Ready Energy Efficiency™ system, accredited project developers, who have to be highly qualified and experienced, develop projects following the ICP’s Protocols which are then independently reviewed by an ICP Quality Assurance professional. Projects that receive the Investor Ready Energy Efficiency™ certification have followed international, transparent best practice and therefore will have lower performance risk and financial institutions can spend less on due diligence – lenders and investors, as well as CFOs, can have more confidence in them. They also have on-going Operations & Maintenance and Measurement & Verification plans both of which help to maintain savings through the life of the project. Standardisation through the ICP will also enable aggregation which is necessary in order to utilise the debt capital markets.
ICP has Protocols available to use in the buildings sector, both tertiary buildings and apartment blocks in the US and Europe. Protocols for industrial efficiency projects, street lighting and district energy are under development in Europe with the support of the European Commission’s Horizon 2020 programme. Project Developers can get training and become accredited – helping to give customers more confidence in their projects.
Financial institutions looking to deploy capital into energy efficiency should engage with the Investor Confidence Project and require its adoption from their project developers and project hosts.
More details on the ICP: europe.eeperformance.org
The ICPEU and I3CP projects have received funding from the European Union’s Horizon 2020 research and innovation programme under grant agreement No 649836 and 754056. The sole responsibility for the content of this document lies with the authors. It does not necessarily reflect the opinion of the European Union. Neither the EASME nor the European Commission are responsible for any use that may be made of the information contained therein.