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Energy Efficiency Finance in Plain English: An Intro to Leases

July 22, 2014 By Michael Park

Michael Park

According to our most recent survey of C&I energy efficiency professionals, the most cited barrier to energy efficiency project approval is the lack of budget. Whether upgrading a chiller, installing solar, or bundling projects under a whole-building retrofit, energy efficiency projects require large upfront investments, which many building owners have not budgeted. As a result, many projects don’t move forward due to lack of available capital, despite often-impressive ROIs and short payback periods.

So, if most projects don’t get approved because of budget, why don’t investment proposals include options to use external funding? Using credit to finance equipment purchases is standard practice for building owners, so why is it not commonplace with energy efficiency equipment investment proposals?

According to our survey, the majority of project developers we surveyed told us that they didn’t have a strong enough understanding of energy efficiency financing options to include them in their project proposals.

In this series, I’m going to walk through the most common and the more sophisticated types of financing options to give you a greater understanding of the different options out there. This series will by no means make you a financing professional – that’s what the bankers do, but it’ll help you get comfortable with what’s out there so you can begin to have the financing conversation with the building owner, enabling him or her do the project when budget is not available.

Let’s start with the most common vehicle: the equipment lease.

Operating Lease

For building owners interested in obtaining use of the equipment similar to how they might lease a copier for their business, using operating leases may be the best option. Operating leases are off-balance sheet structures that involve making lease payments as a standard operating expense with no ownership of the asset by the end user (lessee) during the lease term. At the end of the lease term, a lessee may purchase the asset at the then fair market value, return the equipment, or renew the lease for a new lease term. This helps the building owner preserve their corporate line of credit as well as any cash they may have set aside for other business needs.

Capital Lease

For the building owner who prefers to enjoy the benefits of ownership of the assets without actually owning the energy efficiency project assets, a capital lease may be the best financing vehicle. It is still a lease where the building owner is a lessee, but the lessee has access to any tax and depreciation benefits that the equipment may have. In terms of the building owner’s balance sheet, the equipment would need to be recorded as a capital asset and the lease payments would be recorded as a liability. At the close of the lease contract term, the energy efficient equipment transfers ownership to the building owner for a nominal purchase price, usually $1.

Finance Agreement

A finance agreement, or a regular debt or loan agreement, is most similar to a capital lease in length of loan term, and in lending to the credit of the building owner rather than lending to the value of the asset. However, a major distinction is that the building owner owns the equipment outright, and is not a lessee. All tax and depreciation benefits reside with the building owner.

How It Works

The key to utilizing these financing options, and other types for that matter, is to structure the project such that the lease or debt payments on a monthly basis are less than estimated energy savings. This allows the customer to see the benefits of energy savings while making the lease or debt payments over time without the need to dip into their line of credit or other capital reserves just to fund this project. Noesis Energy works with energy efficiency project developers to make sure that this structure is in place so that at the end of the day, the building owner is not paying any more money out of pocket than if they do not implement the project. This concept of energy savings covering the cost of the financing is of strategic importance to both the developer and the building owner; the building owner can preserve its cash and credit for business operations while the developer can get the project done. Additionally, since the building owner is not using his own cash or credit to finance the deal, more energy efficiency projects across other properties can be implemented, through financing again or through self-funding. Had the building owner self-funded the first deal, there would be less of an opportunity for them or the project developer to explore implementing energy efficiency projects at the building owner’s other sites.

The projects that quality for finance agreements and capital or operating leases typically run in the $100,000 to $10 million (majority in the $100,000 – $250,000) range, but can be as low as $10,000.

Capital Lease Example

The most commonly utilized lease in energy efficiency financing is the capital lease, also known as “lease-to-purchase.” Typically, the capital lease has $0 or minimal down payment, monthly payments structured over a term of 3-5 years, and a $1 buyout provision at the end of the term.

Below is an example of an energy management system (EMS) controls upgrade. ABC Company needs to update its current EMS controls to a new more efficient system. The project cost is $100,000 with expected annual savings of $50,000. This translates to a simple payback on the investment of 2 years.

Despite the large energy and dollars savings potential, ABC Company sees the $100,000 investment as funds not available to launch its new product offering that should will additional revenue for the company.

ACME Developer brings a capital lease financing option to the table under the following terms: 3-year lease, $0 down payment, $100,000 amount financed, and monthly payments of $3,214.

Monthly savings equates to $4,167. The monthly savings more than covers the monthly financing payment, making this project cash flow positive by $953 per month from day 1.

In the end, ABC Company reserved its cash to invest in its core business, but also reaped the benefits of the controls upgrade – a win/win!

Advantages

With these three types of financing situations, there are several advantages for the building owner. Lease payments are typically set to match estimated energy cost savings providing net positive cash flow with little or no up-front cost. There is also the potential for the building owner to capture tax benefits (capital lease) or receive lower rates due to the lender capturing tax benefits (operating lease). The building owner may also be given the option of deducting monthly lease payments as an operating expense.

Another advantage in choosing from a capital lease or operating lease is that it provides the building owner with the ability to customize the terms depending on particular needs and ability to capture tax benefits.

Lastly, the building owner has preserved is working capital line, cash reserves, or other available business credit for business needs rather then spending on the retrofit.

Things to Consider

As with any project, there are options to consider when you are choosing financing. With these financing options, each may create balance sheet or debt concerns, particularly with a capital lease or finance agreement.

In summary, lease and finance agreements are simple options to finance energy efficiency equipment, and they are vehicles that CFOs know and use.

Michael Park is a transactional finance professional with deep experience in project finance, tax credit financing, commercial real estate lending, corporate banking, and innovative energy finance. Previously with the Department of Energy, he is now the Vice President of Project Finance at Noesis Energy.



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