The PPESCO Process
The owner of a public-purpose building can undertake an energy improvement project with the technical and project management assistance of a PPESCO. Because PPESCOs strive for average minimum energy savings of 30% per building, comprehensive energy improvements will result in deep energy savings. The value of these savings can be used to repay the debt and to cover ongoing project service payments to the PPESCO across the life of the project.
Even with deep energy savings, positive cash flow is possible, so that a portion of the public-purpose building owner’s saved energy costs can be re-allocated to fund its public-purpose mission.
The development of "what if" scenarios can provide a clear understanding of the relationships among the key variables that drive project economics and finance:
- Term. The building owner (borrower) hopes to benefit from the longest possible term (15 years or more is ideal) that is not beyond the average equipment life, so that the financing will be sufficient to cover project construction and related PPESCO project management expenses. Shorter terms lead to a narrower project scope. Thus, the scope must be adjusted to the financing term to determine the effects of a smaller project on energy savings—and their effects on cash flow.
- Interest rate. Below-market interest rates are important in targeting public-sector projects. Higher loan rates, similar to shorter loan terms, constrain the amount of borrowing by building owners for energy improvement projects based on the debt service supported by energy savings.
- Energy savings. The estimated energy savings—defined by the audit and subsequent calculations and modeling—support the economics of the PPESCO project. Estimated savings must be sufficient to cover debt service, annual payments for ongoing energy management services and create positive cash flow for the client. If sufficient energy savings are not available, the building owner will not have adequate funds to cover all expenses. Conversely, if actual energy savings are greater than projected, more cash might accrue to the building owner, thus enabling either faster payoff of the debt or more cash flow that the client can dedicate to mission activity.
Increasing and decreasing these three key variables provide insight into the financing and financial risks of a given project.
Project economics for the client
The table below provides a way to gauge the initial economic viability of a given building project, using annual utility costs. This is essentially a quick, easy, and low-cost pre-qualification of a project’s suitability. Using this tool before a walk-through and a deeper audit helps the project move quickly through the initial selection phase. This tool is available in the Resource section as a downloadable file. The user can modify the variables (incentive levels, energy savings levels, client cash flow target, financing terms) to determine project economics. This helps the PPESCO and the building owner understand factors in improving or degrading a project’s economic strength and therefore its risk.
|Client Project Economics||Variables||Total Project|
|Total Project Cost (before incentives)||2.00||Multiple of Annual Utility Bill||$100,000||$200,000||$500,000||$800,000||$1,000,000|
|Incentives||10%||% of Total Project Costs||$10,000||$20,000||$50,000||$80,000||$100,000|
|Project Cost Net of Incentives||$90,000||$180,000||$450,000||$720,000||$900,000|
|Annual Utility Bill||$50,000||$100,000||$250,000||$400,000||$500,000|
|Target Annual Energy Savings||30%||of Annual Utility Bill||$15,000||$30,000||$75,000||$120,000||$150,000|
|Client Savings Target||8%||of Annual Utility Bill||$4,000||$8,000||$20,000||$32,000||$40,000|
|Available for Annual Debt Service and Fees||$11,000||$22,000||$55,000||$88,000||$110,000|
|Annual Debt Service||$7,989||$15,977||$39,943||$63,909||$79,886|
|Annual Fees for PPESCO Services||3%||% of Total Project Cost||$3,000||$6,000||$15,000||$24,000||$30,000|
|Annual surplus / Shortfall||$11||$23||$57||$91||$114|
|Surplus + Client Savings Target (annual positive cash flow for client)||$4,011||$8,023||$20,057||$32,091||$40,114|
|Financing Term (Years)||15|
Projects as low as $100,000 can be economically viable for the client and PPESCO. However, mixing smaller projects with larger ones within a given portfolio serves to diversify that portfolio which in turn mitigates risk and spreads transaction costs. . The critical variables whose effects are more pronounced in smaller projects are current utility costs, the magnitude of potential energy savings, utility or other incentives, term length and rate, positive cash flow target, and the PPESCO-related component of total project cost. All are interactive factors in determining suitability. Although projects in the $100,000 range will often be economically viable, the minimum project size is tied to the individual specifics of a given project opportunity. Therefore there is no hard and fast rule that dictates the minimum project size.
Financing the project
Project financing sources provide project capital to the client directly or as a loan to the PPESCO, which in turn lends to the client.
In the event that a building owner has existing debt, the building owner must present the PPESCO project to its current creditors. The owner's capacity to access new credit might be constrained by the existing debt and related debt covenants. The capacity for new credit might also be constrained by that owner's credit history, the available equity in the building against which the loan might be borrowed, and the lender’s capacity to provide cash flow secured by energy savings. These constraints might be in addition to asset-based credit—lending tied to an asset that, in the event of non-payment, can be seized. The lender might require additional security or enhancement.
Access to credit is a common barrier and is one of the reasons that PPESCOs need to be able to provide credit enhancements.
As PPESCOs begin to grow, however, they will also begin to acquire cash balances. The largest private-sector ESCOs have had some success in securing traditional bank financing, because they have long and proven track records and strong cash balances. This success is due in part to the fact that ESCOs commonly install energy improvement measures that are easily meterable (lighting, HVAC, and equipment) and favor measures which create significant and near term savings, typically to the exclusion of ones that do not. Unlike PEPESCOs, established ESCOs commonly have considerable assets and deep operating histories. As a result, they can present to banks a proven track record as well as back their savings guarantees with strong balance sheets that provide surety of their ability to cover any potential need to cover underperformance of energy savings.
It is the financial strength of the ESCO itself, not the project energy savings per se, that enables access to commercial financing. PPESCOs will not have the same type of fiscal strength that ESCOs have. Accordingly, as previously noted, credit enhancement from a capital partner is needed. . In the case of PPESCOs the use of third party credit enhancements serve as a proxy for an ESCO’s strong balance sheet and hence fortifies the ability to offer energy savings guarantees, an important aspect to of an Energy Performance Contract.
The nature of the PPESCO market—public-purpose buildings—represents a lower risk than most commercial buildings. This is true of much of the ESCO-served market as well. The underlying stability of the building provides an advantage. These buildings are institutionally durable and will continue to be in use for many years, serving the public’s interests.
The PPESCO business model is predicated on financing that is long term, below market rate, and relies on the partnership with patient, mission-focused capital sources. This financing approach is an economically powerful way to provide comprehensive energy services while concurrently offering high-impact ways for capital sources to carry out their missions.
Financing sources will provide project capital either directly to the client or by lending it to the PPESCO, which in turn lends to the client. In instances in which the PPESCO lends to the client, the PPESCO should work with a financial partner that can provide the required loan-processing functions.
Obtaining financing directly from a willing and competent source is preferable to having the PPESCO take on the role of lender. However, in the event that no other options exist, the PPESCO will need to be the conduit between the capital source and the owner. A new PPESCO is likely to have logistical and management burdens associated with direct lending, unless it coordinates this activity with a well-qualified financial partner.
In either case, the interest rate and the term of the loan are critical components of the project economics (see also Formation and Financing). The size and conditions of the financing are determined by some combination of the client's creditworthiness and the strength of the PPESCO's guarantee. Successful PPESCO project economics are predicated on long terms and favorable interest rates.
A client that plans to refinance its debt at some point during the term of a PPESCO loan (that is, sometime within 15 years) might want to work with credit sources to devise a different amortization schedule with a balloon payment that coincides with the refinancing schedule. This payment would then be addressed when the client refinances the whole building. Combining with other capital is referred to as a capital stack. PPESCOs should be aware of this possibility when discussing project finance with their clients.
Certain target markets of the PPESCO have associated financing sources that align well with potential projects. PPESCOs should be aware of the special opportunities that might be available in the markets in which they operate, when they conduct their research for potential projects. Other target markets such as education and health care similarly have aligned funding sources—particularly CDFIs. For more on CDFIs, see the Resources page.