Originally posted Wednesday, 29 June 2011

Written by Owners Perspective

While owners’ energy costs are based on a variety of factors, one constant factor is energy consumption. Owners will decrease their energy costs when they decrease consumption. Based on such logic, owners are considering ways to decrease consumption, including energy efficiency initiatives. But how do owners pay or finance these initiatives? Capital is scarce, and lenders are not always eager to finance large capital projects at reasonable rates. Owners must therefore resort to alternative financing mechanisms. As discussed below, common ways to finance energy efficiency initiatives include self-funding, energy savings performance contracts, governmental incentives, utility incentives, and tax incentives. Through a combination of such options, owners may find that alternative financing options are more desirable than traditional lending options.

Self-Funding

If owners have the financial wherewithal, they may choose to self-fund an energy efficiency project. Self-funding owners will avoid financing costs and other risks associated with borrowing or raising capital. In spite of the benefits of self-funding, many owners—like any financially accountable organization—shun the capital constraints of self-funding. As a result, unless owners are holding excess cash, they will typically opt for other sources of financing energy efficiency projects.

Energy Savings Performance Contracts

As a financing option, energy savings performance contracts (“ESPCs”) offer an interesting alternative in which projects are funded through energy savings. In a basic ESPC, the contractor will recommend measures that will produce measureable savings, which are guaranteed by the contractor. ESPCs may involve third-party financing for construction costs, but the owner’s payments typically extend over several years.

ESPC measures may include energy conservation and energy production (e.g., waste-to-energy generation from industrial plant by-products). In addition to energy savings and reduced energy costs, the project may result in future revenue for the owner.

Public owners currently dominate the ESPC market due to their large portfolio of facilities. State and local governmental units, including schools and universities, are well accustomed to ESPCs. They received tremendous financial support for energy efficiency through the American Recovery and Reinvestment Act of 2009 (“ARRA”) and have long been able to issue tax-exempt bonds and obligations to fund these projects.

As an example, in Miami-Dade County, the library system entered a 10-year ESPC for several of its facilities, which received a variety of installments, including lighting upgrades, air conditioning unit upgrades, programmable thermostats, and chiller installation. The project is expected to produce $103,093 in guaranteed annual energy savings. Additionally, the state of Michigan implemented an ESPC project for its state capitol complex that is expected to receive escalating annual energy savings starting at $554,103. The project included ballast replacement and disposal, HVAC control upgrades and repairs, heat recovery, and other installations.

Similarly, federal agencies are a solid source for ESPCs because of several laws and rules that encourage or mandate certain energy efficiency standards and goals. For example, on the FDA White Oak Campus in Silver Spring, Maryland, an ESCO installed a combined heat and power plant under an ESPC that is expected to save the agency $6.5 million in annual reduced O&M costs.

Private owners, such as commercial and industrial owners, account for a much smaller portion of the ESPC market. Some experts attribute such lesser participation to the general downturn in the economy and credit markets. Private owners usually require a shorter ESPC term than public owners, perhaps due to uncertainty in the economy and the possibility of facility relocation or closing. Nevertheless, private owners may find that some of the governmental incentives discussed below will make ESPCs more attractive.

 

Governmental Incentives

When self-funding or traditional financing is unavailable or insufficient, governmental incentives might fill the void. Governmental incentives include grants, loans, and loan guaranties. Three important governmental agencies that provide financial and other assistance for energy efficiency projects include the Small Business Administration (“SBA”), the Department of Agriculture (“USDA”), and the Department of Energy (“DOE”).

The SBA provides guaranties and credit support for loans to small businesses for certain purposes. One such purpose includes energy efficiency projects. For example, the SBA 7(a) Loan Program funds costs, such as construction projects for new or existing facilities and the purchase of equipment, machinery, and fixtures. Another SBA program, referred to as the CDC/504 Loan Program, provides long-term financing for major fixed assets and construction costs for expansion or modernization of facilities.

The USDA’s Rural Development division promotes economic development in rural economies for various energy-related projects, including energy audits, energy efficiency improvements, and feasibility studies for renewable energy systems. For instance, the USDA provides grants to small businesses for energy efficiency projects, such as retrofitting lighting or insulation, or purchasing or replacing equipment with more efficient units, and installation of renewable energy systems. In Modena, Georgia, the Rural Development office provided a grant for a building owner to install solar panels to generate electricity and solar-thermal equipment to provide heating. The owner is refurbishing an older building and will install the energy efficient and renewable energy equipment with the assistance of the Rural Development’s grant.

Finally, the DOE provides financial, technical, and research assistance for energy efficiency projects. Many state and local governments have received funds through the DOE Block Grant Program offered by the DOE’s Energy Efficiency and Renewable Energy division. A substantial portion of ARRA funds (approximately $2.7 billion) were allocated to the Block Grant Program. Most of the program funds have been allocated, but a small portion remains to provide technical assistance to the recipients.

The following graph shows the breakdown of the Block Grant recipients.

Other DOE programs provide financial and technical assistance to state and local governments to support their energy efficiency initiatives. For example, the state of Connecticut used $5 million in DOE program funds to upgrade 12 state facilities with energy efficient technologies, such as low-wattage LED lighting and occupancy sensors. One of the facilities is a university that will save an estimated $14,000 in annual utility costs and will recoup its project costs in fewer than six years. Most DOE programs depend on the availability of funds, so owners must actively coordinate with the DOE to ensure funds availability.

Utility Incentives

Many utilities offer rate discounts, rebates, or other incentives to owners that implement energy efficiency initiatives. Other benefits are available to owners that install renewable energy systems. Depending on applicable state law, these benefits may include net metering and feed-in tariffs. Net metering programs differ, but can involve the reduction of an owner’s electricity invoice by “rolling back” the electric meter for on-site generation. In the jurisdictions that require feed-in tariffs, utilities pay premium rates for certain kinds of renewable energy generation. The available incentives differ among utilities and, perhaps more importantly, among regulatory or governmental jurisdictions.

Tax Incentives

Taxable entities that implement energy efficiency initiatives can qualify for incentives under federal and state tax laws. The incentives include tax deductions for energy efficiency projects and tax credits for renewable energy systems. Tax-exempt and public owners should not overlook tax incentives because, in most instances, they can receive the economic benefit through contract negotiation or other means.

The most common energy efficiency incentive is the Section 179D deduction. This deduction is based on the cost of the energy efficiency project, subject to a maximum of $1.80 per square foot of building space. The project must improve the energy efficiency of interior lighting systems; heating, cooling, ventilation, and hot water systems; or the building envelope. The efficiency improve ments must be certified as meeting certain energy-savings standards. With regard to facilities owned or leased by public owners, tax rules governing Section 179D allow designers or design-builders of the project to receive the deduction. The deduction is currently set to end on December 31, 2013.

In addition to energy efficiency projects, owners may consider installing renewable energy generation systems. Such systems may include solar roof panels, combined heat and power systems, or waste-to-energy generators. The tax code provides depreciation deductions and tax credits for installation of these systems. Currently, Congress has extended bonus (100 percent) depreciation for qualifying property until the end of 2011, or 2012 for certain property. When bonus depreciation ends, owners will still be entitled to depreciation deductions on an accelerated schedule, such as five-year depreciation for solar, geothermal power, fuel cells, combined heat and power, or small wind systems. Certain biomass energy and waste-recovery property qualifies for seven-year accelerated depreciation.

Two important tax credits include the investment tax credit (“ITC”) and production tax credit (“PTC”). The ITC is available for installation of solar equipment, geothermal deposit equipment, fuel cells, combined heat and power system, wind equipment, and equipment that uses ground water as thermal energy. The credit is calculated by multiplying the cost of such property by a set percent, usually 30 percent and in some cases 10 percent.

The PTC is available for power produced from wind, biomass, geothermal, municipal solid waste, hydropower or marine and hydrokinetic renewable energy. It is calculated by multiplying the quantity of energy produced and sold by a set inflation-adjusted amount (2.2 cents for tax year 2010) over a set period (usually 10 years).

One additional tax incentive allows taxpayers to receive a grant in lieu of the ITC or PTC, regardless of the taxpayers’ tax liability. ARRA Section 1603 has become an extremely important mechanism for financing energy projects. The tax grant, the ITC, and the PTC are subject to various restrictions and deadlines, so owners should discuss their initiatives with tax counsel.

Conclusion

As energy prices climb, owners and others will consider options to reduce energy consumption or alternative sources of energy. While all of these options will require owners to raise capital, hopefully the incentives discussed above will make finding such capital less painful and, in some cases, politically achievable.

David R. Cook Jr. is an attorney in Atlanta at the construction and energy law firm of Autry, Horton & Cole, LLP. Contact David at cook@ahclaw.com, or view his firm’s construction and energy blog at www.ahclaw.com/cooperative. For additional information on construction issues and project financing, view AHC’s Resources page and newsletters at