Review and Address Property-Assessed Clean Energy Financing Issues
As the first step in launching a commercial property-assessed clean energy (PACE) financing program, a local government (grantee) should become familiar with issues related to PACE and factor their impact into program design and implementation.
The current regulatory issues include:
Current Regulatory Issues
On July 6, 2010, the Federal Housing Finance Agency (FHFA) issued a statement that PACE programs with senior lien position “present significant safety and soundness concerns that must be addressed by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.” [Senior lien position refers to a debt having priority over all other debt on a property in the case of foreclosure (i.e., it gets paid off first before other outstanding debt, including mortgages). Most PACE programs use a senior lien position for the PACE debt because the PACE assessments are part of the property taxes, and property taxes are already senior to other property debt. But there are some PACE programs that use a subordinate or junior position instead, which means the mortgage has priority over the PACE debt].
In particular, PACE liens were deemed to “run contrary to the Fannie Mae-Freddie Mac Uniform Security Instrument….” —i.e., the standard mortgage contract.
The FHFA letter was specific to home mortgage lending and did not directly address or challenge commercial PACE programs. Regulatory hurdles for commercial PACE are distinct from those for residential PACE. In addition, commercial PACE programs require that the property owner obtain the consent of the mortgage lender before a PACE assessment can be placed upon the property. Such lender consent protocols address the contractual encumbrance clause issues (see Lender Consent below).
On the same day the FHFA released its statement, the Office of the Comptroller of the Currency (OCC) also issued PACE guidance. The OCC regulates national banks. This statement raised additional concerns by specifically mentioning commercial properties in its statement that “safety and soundness concerns” exist.
“The Office of the Comptroller of the Currency (OCC) is issuing this guidance to alert national banks to concerns and regulatory expectations regarding certain state and local lending programs for energy retrofitting of residential and commercial properties*, frequently termed a Property Assessed Clean Energy (PACE) program. PACE or PACE-like programs use the municipal tax assessment process to ensure repayment. Under most of these programs, such loans acquire priority lien, thereby moving the funds advanced for energy improvements ahead of existing first and subordinate mortgage liens. This lien infringement raises significant safety and soundness concerns that mortgage lenders and investors must consider.” [*Note: emphasis added]
Most of the OCC statement addressed residential mortgage issues, but it gave specific guidance regarding commercial PACE in one section.
“National bank lenders should take steps to mitigate exposures and protect collateral positions. For existing mortgage and home equity loans, actions may include the following in accordance with applicable law:… In the case of commercial properties, securing additional collateral*.” [*Note: emphasis added]
The U.S. Department of Energy (DOE) and industry experts are seeking clarification on what this statement means. One possible interpretation is that commercial lending standards may be increased throughout a community that undertakes a commercial PACE program. (Lending standards are typically criteria used by a lender to determine the credit worthiness of a potential borrower, and whether or not to lend to that person or entity. This can include financial ratio thresholds that a borrower must meet, such as a payment-to-income ratio or a debt-to-income ratio.) Another interpretation is that OCC would simply require banks to more carefully underwrite commercial properties that request permission for a PACE lien.
Generally speaking, there is no reason to assume that commercial PACE programs with lender and owner consent provisions—both the existing lender and property owner must give their written consent and acknowledgement for the PACE financing—create unsafe or unsound lending practices. With consent provisions in place, lenders can protect their investment, and property owners are not subject to unwanted debt. However, it appears that regulators have not drawn a firm line between commercial and residential PACE programs.
Most commercial mortgages have a Due on Encumbrance clause that gives the mortgage-holder the right to call the loan due if additional debt is placed on the property without the lender’s consent. Given this clause and the complexity of commercial mortgages, a commercial PACE program requires applicants to get the written consent of their existing mortgage-holder(s) in order to apply for financing. An example of a lender consent form used by the Sonoma County Energy Independence Program (SCEIP), along with information on PACE to help lenders become more comfortable with the concept, is available on the SCEIP website and in the Lender Information and Acknowledgement Form from SCEIP.
Davis-Bacon and Prevailing Wage
Section 1606 of the American Recovery and Reinvestment Act (ARRA) specifically requires that all laborers and mechanics performing work on any project “funded directly by or assisted in whole or part by” Recovery Act funds be paid prevailing wages as determined by the Secretary of Labor (Source: EECBG Program Notice 10-004A “Guidance on Implementation of the Davis-Bacon Act Prevailing Wage Requirement for Energy Efficiency and Conservation Block Grant Recipients Under the American Recovery and Reinvestment Act of 2009”).
Consequently, commercial PACE financing programs that use ARRA funds as a credit enhancement are subject to Davis-Bacon prevailing wage requirements. Credit enhancement refers to techniques used by debt issuers to raise the credit rating of their offering and thereby lower their interest costs. See Credit Enhancements for details.
Grantees/subgrantees and contractors/subcontractors must (a) ensure that all laborers and mechanics performing work on such projects are paid prevailing wages as determined by the U.S. Department of Labor (see Wage Determinations OnLine.gov) and (b) comply with all of the reporting requirements of the Davis-Bacon Act.
National Environmental Policy Act
ARRA funds used for credit enhancement of a financing program— including a debt service reserve fund, interest rate buy-down, or third-party loan insurance—maintain their federal character; therefore, programs that use funds in this manner are subject to federal requirements including the National Environmental Protection Act (NEPA).
Many, if not all, of the projects that are eligible for financing under a commercial PACE program should qualify for a categorical exclusion (CX) determination (PART 1021 National Environmental Policy Act Implementation Procedures Subpart D Appendix B5 [Actions to Conserve Energy]). A categorical exclusion applies to projects that DOE has determined do not normally have a significant negative environmental impact and, therefore, are not required to prepare an environmental assessment or environmental impact statement. A complete list of DOE’s CXs can be found in Appendices A and B to Subpart D of DOE’s NEPA Regulations.
Grantees can complete the State Energy Program (SEP) and Energy Efficiency and Conservation Block Grant (EECBG) Program NEPA Templates if a proposed project meets the CX requirements. The Template helps grantees submit streamlined information about proposed projects that will allow DOE to review their potential impacts and expeditiously apply CXs. Program planners should seriously consider restricting eligible efficiency improvement measures to those that qualify for a categorical exclusion.
If a program does not limit financing to only those project types that adhere to the template, DOE is required to conduct a NEPA review for individual projects that would typically include an Environmental Assessment and/or an Environmental Impact Statement (Sources: EECBG Program Notice 09-002B “Guidance for Energy Efficiency and Conservation Block Grant Grantees on Financing Programs; ” SEP Notice (10-001) and EECBG Program Notice (10-003) “National Environmental Policy Act Guide for State Energy Program and Energy Efficiency and Conservation Block Grant Projects”).
A NEPA review typically adds significant time (on the order of months) and additional cost to a project.