Uses for Recovery Act Funds to Support Large Commercial Energy Efficiency Finance
States can leverage their funding by using one or more forms of credit enhancement that will decrease risk for lenders and encourage them to lend in markets or for projects in which they have not previously participated. American Recovery and Reinvestment Act (ARRA) funds can be used in multiple ways to provide credit enhancement to support financing of commercial sector energy efficiency projects. Leading approaches include loan loss reserve funds, debt service reserve funds, and subordinated co-financing structures, as described below.
Loan Loss Reserve Funds
Loan loss reserve funds (LRFs) are funds set aside to cover potential defaults within a loan portfolio. An LRF provides partial risk coverage with the goal of motivating lenders to pioneer new products, broaden access to finance, modify underwriting criteria, increase the size of unsecured loans, extend loan tenors, and lower interest rates. Loan loss reserve funds are well-suited finance programs targeting the single-family residential market. The LRF takes a “portfolio approach” to the credit structure of the loan program. LRFs are useful where the target market consists of a large number of small projects and financial institutions will be making a large number of small loans. The small commercial sector, which requires loans typically up to $50,000 per loan, can also fit this definition.
LRFs can also be useful as credit enhancements for large commercial sector projects; but because these projects tend to be much larger, there will typically be far fewer transactions in a given portfolio. Each individual transaction will represent a larger portion of the total portfolio. So, the ratio of LRF funds to total energy efficiency loan portfolio size needs to be larger to offer risk protection against loan losses. Hence, the leverage ratio of grant dollars to financing supported will be lower. Where the target market has a smaller number of larger loans, as is the case in the large commercial sector, other forms of credit enhancement may be more appropriate than loan loss reserve funds.
Debt Service Reserve Fund
With a debt service reserve fund (DSRF), funds are set aside to cover the borrower’s failure to pay its regular principal and interest debt service payments. Unlike LRFs in which funds are drawn down when a default and loss occurs, DSRF funds can be drawn when late payments occur. That allows the loan to stay current while the lender works out arrangements with the borrower. When the borrower becomes current on debt service, then the funds can be returned to the DSRF. This structure is appropriate for larger transactions. The funds are typically in the range of 10% of total bond principal, but sometimes are sized to represent 3 to 6 months debt service.
Debt service reserve funds are often associated with a bond issuance. DSRFs can be used to back property-assessed clean energy bonds, Qualified Energy Conservation Bonds (QECBs), tax-exempt bonds, and other long-term bond financings. The borrower benefits from the use of grant funds as a DSRF in terms of lower cost financing and access to financing. The DSRF also enhances the credit structure of the financing, thus increasing access. One disadvantage is that typically a DSRF is capitalized in the bond financing, which adds to the amount the borrower must repay and makes the financing more expensive.
Subordinated co-financing structures entail two separate loans (senior and subordinated) to cover a project’s financing needs. “Subordination” refers to the order of or priority for repayment. The senior lender typically gets paid first and then the subordinated lender. With subordinated co-financing, the ARRA funds are loaned to pay for a portion of the energy efficiency project, but the repayment of the ARRA-funded loan is made subordinate to the senior loan. Subordinated debt is typically structured so that it is repaid from project revenues after all project operating costs and senior debt service has been paid. Thus, the subordinated lender assumes greater risk, but still has a claim on project revenues before others who have contributed equity to the project. Subordinated debt provides capital to a project financing structure and is typically in the range of 10% to 25% of a project’s sources of funds. Use of subordinated debt can substitute for and reduce the amount of senior debt. That will improve the loan-to-value ratio and the debt service coverage ratio for the senior lender, thereby reducing risk and strengthening the project’s financial structure from the senior lender’s perspective.
As stated above, the subordinated lender takes on much greater risk than the senior lender—including absorbing all losses up to the total subordinated loan amount. This structure, however, allows the senior lender to put in more capital and charge a lower interest rate than the subordinated lender because the subordinated lender is absorbing most of the risk. Grantees can also provide this subordinated co-financing at a below-market rate to reduce total costs of capital for the project and the energy user.
Subordinated co-financing can also substitute for and reduce the project sponsor’s equity requirements. Thus, it has good application for energy service company (ESCO) project finance programs. For many ESCOs, a key limiting factor to project financing is lack of available equity for project investment. Subordinated co-financing can fill that gap, reduce the ESCO’s project equity requirement, and allow the project developer to preserve controlling ownership interests in its project or company.
U.S. Department of Energy regulations permit state and local governments to use ARRA funds as subordinated co-financing. For example, the State of Washington is using ARRA State Energy Program funds in this manner. Alabama is also considering this structure for its large commercial sector program. Other state clean energy funds offer subordinated debt financing to support renewable energy investments. For instance, the Vermont Clean Energy Development Fund and the Delaware Sustainable Energy Utility use subordinated debt financing alongside other options.