Sustainable energy finance – A direction to a green economy?

Submitted by CathHassell on Sun, 06/01/2014 - 03:00

Chris Hocknell & Rita Margarido | eight associates  

What needs to be done?

Commercial sector buildings are responsible for 10% of the UK’s carbon emissions, and it is estimated that £1.6 billion in cost savings could be achieved through investment in commercial energy efficiency. However, the Bank of England states that banks and investment institutions are actually reducing their lending although they have significant financial reserves. Clearly there is an opportunity for directing these funds to productive means; it is called sustainable energy finance.

How can it be done?

Sustainable energy finance can be a tool to capture private investment and redirect it to the Green Economy. Through an‘intelligent funding model’, energy demand and greenhouse gas emissions can be reduced whilst creating a profitable market and a currency of ‘energy savings’. In recent years a growing number of mechanisms, tools and initiatives from public and private institutions have become mainstream, primarily in the EU,and have proven that energy efficiency solutions can be delivered with high levels of reliability and attractive returns on investment. However, for this strategy to achieve deep carbon emissions reductions and to be an attractive option for private investors there needs to be a strong regulatory presence whilst maintaining investment potential. The Energy Efficiency Directive (EED) is a major policy instrument that aims to redirect private investment to fund energy efficiency upgrades to a building. Its key aspects are:

  • a requirement for a long-term strategy for investment in retrofitting of residential and commercial buildings, with 3% of total floor areas of heated and cooled Governmental buildings being renovated each year;
  • mandatory energy audits and reporting, where all large companies will be required to perform energy audits by third parties, with mandatory reporting every four years. In the UK the Energy Savings Opportunity Scheme is implementing this requirement.

Energy performance disclosure among big companies was previously a voluntary approach, often undertaken under CSR policies;now this becomesa mandatory and verifiable requirement. On the assumption that relatively mild carbon reduction policies such as Enhanced Capital Allowances, Climate Change Levy, and the Carbon Reduction Commitment are made more robust and a lot more ambitious, the increasing additional costs to energy hungry businesses should in theory drive them towards implementing energy efficiency measures. Hopefully, this would also foster a realisation that energy inefficient buildings are business liabilities.

Energy Financing in the UK to date

The UK does have some existing examples of energy financing, although regrettably the ‘flagship’ mechanism is not working as well as anticipated. The Green Deal is arguably the UK’s most prominent energy efficiency financing scheme and is financed by the Green Investment Bank. However, it is evidently not delivering adequate results, primarily - in the authors’ opinion – because the financing mechanism is a significant disincentive. For example, the Green Deal Finance Company is currently providing finance at an APR of approx. 8%; their own analysis demonstrates that if a home owner borrows £5,000 for improvements, at 7.9% APR for 20 years, they pay a total of £4,789 in interest and charges alone .Unsurprisingly take-up has been very limited.

The interest and credit payment can be reduced to £2,231 if repayment is made in 10 years, although the APR increases to 8.2%. The resulting total annual payment of £723 would require huge energy savings to be achieved as a result of the improvement measures.

The Green Deal’s economics could be improved by reducing interest rates or increasing energy prices. A higher energy price that accurately reflects the true cost of energy would be desirable more widely and would reduce the payback period; however, it would have regressive impacts for the fuel poor. A more appropriate short-term solution would be to reduce the cost of the loan. The APR should certainly be below 5%, preferably around 4%.

Up and coming

There are more recent mechanisms that are currently entering the UK market which may offer more effective solutions, such as the emerging Energy Performance Contracts (EPCs), which could act as a catalystfor the Green Economy by dynamically promoting synergies among companies, Government and the private sector. An EPC is a service provided by a private company, which provides a client with a set of energy efficiency, renewable energy and distributed generation measures that can be implemented, and itis commonly accompanied with guarantees that the savings achieved by renovation measures will be sufficient to finance the full capital cost of the project.

The key point is that split incentives are mostly avoided as the EPC provider’s income is directly linked to the energy performance of the building after renovation. If the projected savings are not achieved the EPC provider does not generate as much income. This differs from the Green Deal where the provider of finance lends the capital for the renovation and then walks away.

It is also important to remember that the client is typically not technically informed and may not have adequate experience in energy management so may not be able to fully achieve the anticipated savings. Crucially, the EPC provider engages with the client after the renovation measure; they regularly monitor energy consumption and report back to the client on the savings. This also allows the more nebulous component of energy efficiency; occupant behaviour, to be monitored. Where a client’s behaviour is reducing potential energy savings, the EPC provider will surely respond by compelling them to improve their behaviour, either by training and education or by contractual obligation.

There is also a need for qualified experts to act on the client’s side to verify EPCs targets and project implementation strategies as defined by the Energy Services providers as well as to operate the implemented measures to ensure compliance with contractual agreements. Moreover to foster transparency and ensure quality, a more regulated approach from the Government would most likely be required. The largest UK Government Initiative that aims to stimulate private investment in this market is the Green Investment Bank, which operates by sharing project risk with private investors. If the bank can assist in resolving the Green Deal’s problems and shows itself to be profitable and financially viable in the coming years it could be one of the main drivers for delivering a self sustaining energy efficiency market.

EPCs should,in theory,be able to lower GHG emissions and energy efficiency compliance costs. They should also lower the associated risks by having an EPC provider take an active role in generatingenergy savings. However, the high upfront investment costs and long payback periods that result from energy efficiency will necessitate EPC providers to pursue some form of financing. This obviously entails significant risks for the company who takes out the loan and consequently EPCs are currently only used by public organisations and a few private companies. For this to change the EPC mechanism needs to demonstrate that it is not as risky as it is perhaps perceived to be, and it needs to become more prevalent, transparent and,most probably,legally mandated.

Moving forward

In summary, energy finance mechanisms, particularly EPCs, need to become fully operational and trustworthy. This is likely to be achievedby the delivery ofthree fundamental elements:

Low cost financing. Given the nature of commercial buildings the economics would likely be better than for domestic properties; the cost of energy saving improvement measures could be driven down by economies of scale and the high energy consumption typical in commercial buildings. However, financing costs should still be as low as practically possible to avoid slow take-up and limited ambition. Financing should reflect the social benefit of pursuing energy efficiency, and should be around the 5% mark. An often under considered factor is carbon lock-in. If renovation measures that only achieve small to medium savings are pursued, the marginal cost of subsequently pursuing deep emission reductions is very high. For example, in terms of life cycle costs, renovation from single glazing to triple glazing is more economic than renovation from single to double, and then additional renovation to triple. Financing should therefore be structured to encourage deep emission reductions.

Regulatory presence and stability. Probably the simplest but the least often achieved. The inherent risk aversion of private companies means that regulatory uncertainty will simply not be accepted. Too often the Government intervenes to tweak and adapt policy that looks like it will be too successful such as the Feed in Tariff, ECO and the Green Deal. The government must be present to provide the necessary structure and regulatory framework, but it must also provide long-term policy direction and credible assurances that it will not make interventions that fundamentally restructure a policy and its economics.

Ambition. This is intrinsically linked to regulatory presence and stability. Originally ambitious carbon targets are repeatedly watered down because of the anticipated criticism and initial hyperbole. However, this cannot determine policy indefinitely;substantial restructuring of policy mechanisms and markets will be accepted only if there is certainty. The government should commit to substantive policy and stick to it.

We will be watching eagerly.