Energy Efficiency Financing: Risks and Mitigation Strategies

In general, energy efficiency projects utilize proven, well-understood, and commercially available technologies. With very few exceptions, they do not involve technology development risks. In theory, this reduces the risks of financing an energy efficiency project (EEP).

Given the near absence of technology risks, the financing of an EEP has two primary risks – credit risk and performance risk.

Credit Risk

Credit risk relates to a borrower not repaying a loan, lease, or third-party investor on an EEP. It can be caused by cash flow problems, going out of business, or just not being willing to repay the lender due to higher priorities. This is a typical financing risk for any type of loan and a core competency of financial institutions.

Therefore, in the context of EEPs, it is assumed that financial institutions can assess the credit risk of the building owner where the project will take place.

Performance Risk

On the other hand, performance risk relates to project-related issues that could reduce savings below the financial institution's debt service levels. It is the primary risk of financing energy efficiency projects.

This risk typically occurs where some portion or all of the financier's repayment is contingent on the achievement of savings, specifically if actual savings are not sufficient to repay the investment plus the targeted return to the investor/lender. The performance risks associated with savings being generated from a project are not typically known to financial institutions.

The most significant performance risks of implementing an EEP lie in the following areas:

• Achievable savings and capital expenditures (CAPEX) estimates
• A comprehensive investment grade audit (IGA) and a well-prepared project design
• Procurement and installation of quality equipment
• Well-designed and implemented measurement and verification (M&V) plan

Once credit officers understand these risks and evaluate an EEP's benefits effectively, they will find that financing energy efficiency carries a much lower risk than financing business expansions and other speculative types of capital investments.

In their lending procedures, financial institutions consider risks as they structure loans and assign interest rates. When the repayment of a loan relies on a customer's realization of an EEP's savings, consideration must be given to the risk of not delivering the estimated savings.

Performance risks typically can be classified into the three major phases of an EEP: 1) development, 2) implementation, and 3) operation.

Development Phase

In the development phase, estimated savings may not be realistic, or the budgeted CAPEX is not in line with all the technical aspects of the project.

Financial institutions can mitigate these risks by ensuring that an IGA is adequately prepared. When in doubt, they could have the IGA independently reviewed by technically competent energy engineers.

They can also utilize a multi-level and independent savings estimates review process during the IGA and reconcile estimated savings to the performance requirements of each of the contractors/vendors. Recognized and experienced professionals must perform this work.

Implementation Phase

Other risks are also present during the project's implementation phase. For example, the specified equipment is not installed according to design and savings specifications. The project cannot be completed for the budget CAPEX. The project does not comply with local regulatory requirements, or the equipment does not work correctly.

Many mitigation strategies can be utilized at this stage. Imposing rigorous commissioning procedures on contractors that include energy efficiency performance specifications is an obvious one. Using a job cost control system and have project managers review progress frequently is another one. The financial institution could also ensure that each major contractor/vendor has an adequate financial capacity to cover its technical risk and that all permits and licenses are secured before beginning work.

Operation Phase

And finally, there are additional risks during the operation phase. It could be that savings cannot be measure and verified or that estimated savings are not achieved. There could be changes in the facility where EEP are implemented, impacting their performance. And, of course, required operation and maintenance may not be adequately performed.

These operational risks can be mitigated by ensuring that an IPMVP adherent M&V plan is developed during the IGA phase by an M&V professional and implemented. The M&V plan defines how the EEP's performance is to be evaluated. For example, in the case of an energy performance contract, it specifies the level of savings payments due to the facility owner.

These are just some aspects of energy efficiency financing risks and mitigation strategies. Interested parties should read the International Energy Efficiency Financing Protocol (IEEFP) recently updated by EVO to learn more about mitigating these risks.