Choose Capital Sourcing Approaches for Property-Assessed Clean Energy Financing Programs
The third step in launching a commercial property-assessed clean energy (PACE) financing program involves choosing how the financing will be funded.
The ability to fund PACE programs can be the biggest hurdle for many local agencies. Some local governments with reserves or investment portfolios may choose to use them as a source of capital, thus using their PACE program as one of their investment portfolio strategies. Otherwise, despite the current lack of availability of large-scale private capital, there are a number of financing models that can provide an investment with low risk and a low-enough interest rate that will result in long-term savings (i.e., total costs less than total savings) for program participants.
Generally, local governments can choose from three approaches for commercial PACE programs:
In the warehoused approach, a large line of credit (in the millions of dollars) is secured to fund energy efficiency and renewable energy projects. (Similarly, local or state governments can choose to fund projects from their reserves or investment portfolios.) When a commercial property owner submits an application and the PACE program approves it, a reservation is placed for the project amount against the total line of credit, thus reducing the total remaining line of credit available. The project is then allowed to proceed to implementation right away. When the project requests payment for work completed, it is paid from the reservation previously made.
When the PACE program has issued enough total project funding from the line of credit to reach a certain threshold (determined by the program planners and their financial partners), the line of credit is then replenished—for example, by issuing a bond against the group of funded projects and using the proceeds to pay down the credit line (the threshold being a certain dollar amount that makes the transaction costs of issuing a bond a reasonable charge against the proceeds). The warehoused approach is the fastest way to fund projects because the funding from the line of credit is essentially available on demand without additional delay. See Figure 1below for a diagram of the process flow.
The San Francisco GreenFinanceSF program is an example of this warehoused approach in action using a large line of credit, specifically for its residential PACE financing program. The Sonoma County Energy Independence Program (SCEIP) is another example, but differs in that it uses the county’s investment portfolio for warehousing. SCEIP has financed both residential and commercial projects using this approach.
The pooled bond approach involves a waiting period during which applications for PACE financing are accepted and aggregated. The applications can be approved during the aggregation period, but the participants are not given permission to proceed to implementation. When a sufficient pool of requested project funding has been assembled, the local government sells a bond to cover and fund all of the included projects. This approach introduces two waiting periods: one while projects are aggregated (~30 to 90 days, or however long it takes to reach a sufficient dollar threshold), and the other while the bond completes the issuance process (~30 to 90 days). It is only after the bond is issued that the covered projects are given notice to proceed with implementation because it is only then that funding can be guaranteed. See Figure 2 below for a diagram of the process flow.
This pooled bond approach is similar to the one used by Boulder County, Colorado, which recently launched a commercial PACE program. See the Boulder County website.
If a property owner has a lender that is interested in providing project financing directly and is willing to accept the PACE securitization and payback framework, then owner-arranged financing is an option. This avoids both waiting periods associated with the pooled bond approach and allows for immediate financing of projects at interest rates set by the underlying credit of the particular project. Owner-arranged financing is easier for program planners to design and program administrators to run because they do not have the responsibility to secure or replenish funding for the projects that are financed by the program. This approach puts the onus on property owners to find and secure their own financing from lenders.
There are two potential drawbacks to owner-arranged financing. The first is that putting responsibility on property owners to find their own financing can limit program participation to larger properties or more sophisticated owners who have the knowledge and the network to secure funding on their own.
The second is that if a local government’s PACE program uses both owner-arranged and pooled bond approaches, then the owner-arranged financing option has the potential to siphon off the best (i.e., most credit worthy) properties and projects from the rest because lenders will be more interested in providing financing for them and at more favorable rates. If this occurs, then the remaining projects (that are less attractive individually to lenders under owner arranged) will have to use the pooled bond option, which will likely have a higher interest rate because the projects’ combined credit worthiness is lower.
This owner-arranged financing model is similar to the one being pursued by the City of Los Angeles for a commercial PACE program in partnership with the Clinton Climate Initiative.
Weighing the Options
Regardless of the type of financing a commercial PACE program uses, the type, condition, and image (i.e., how big and/or well-known a property or its owners are) of the properties included in the pool can have a significant impact on the interest rate available (offered by the funders) for the capital to finance the clean energy projects. A group of projects made up of mostly signature office buildings and premier hotels will almost always achieve more favorable interest rates than small, less well-known commercial projects, unless program planners apply significant credit enhancement (see Choose Credit Enhancement and Apply Recovery Act Funds).
Local governments should carefully structure a private capital commercial financing program with a watchful eye toward project credit quality, particularly at the start of a program, to attract funding with low interest rates. In one program under development in California, capital providers quoted an interest rate range of 7% to 15% for a pool of projects, depending on the type of projects included.
The warehoused approach has a number of potential advantages over the other two approaches due to its on-demand availability; but in the current tight commercial lending environment, it is difficult to secure a large commercial line of credit without a substantial credit enhancement from the sponsoring program (and may not be possible even with credit enhancement). Therefore, either the pooled bond or owner-arranged approach is a more viable option in the short term for local or state agencies.
That said, the pooled bond approach is also dependent on the bond market having an understanding and appetite for this kind of debt. Initially, there may not be much market enthusiasm for it, or the bond may be at interest rates that are not very attractive, particularly if the pool includes a number of undesirable projects. Boulder, Colorado, however, had success in issuing a PACE bond based on a pooled approach in late 2010.
The lingering question as to whether or not the Office of the Comptroller of the Currency (OCC) will support commercial PACE (see Current Regulatory Issues) has caused some local governments to be concerned about the impact that could have on the warehoused approach (for those instances where the plan is to eventually do a take out of the financed projects) and the pooled bond approach. The concern is whether the OCC uncertainty will either render take out or bond issuance impossible, or will cause the interest rates to be exceptionally high.
The caveats noted above have led a number of communities to structure their new commercial PACE programs to use the owner-arranged model to launch their programs more quickly and with more certainty. This enables them to start getting projects done and to start gathering statistics on repayment and default rates. Those statistics are expected to be helpful in building the case for banks and investors that commercial PACE is low risk and, therefore, banks and investors should support pooled bond and warehoused approaches for commercial PACE and offer attractive rates.
Each grantee should consider the above caveats in light of the grantee’s unique situation and decide which capital sourcing approaches work best in the local context at program launch.