Accounting Standards and Potential Constraints to Scaling up Energy Efficiency Finance in Boston

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1 Accounting Standards and Potential Constraints to Scaling up Energy Efficiency Finance in Boston Summary Issue Brief Prepared for the Boston Green Ribbon Commission This memo was prepared in response to a request from the Boston Green Ribbon Commission to investigate the implications that proposed changes to US accounting standards might have for energy efficiency investment. The Boston Green Ribbon Commission is a group of business, institutional and civic leaders in Boston working to develop shared strategies for fighting climate change in coordination with Mayor Thomas M. Menino s Climate Action Plan. The key findings are that: Accounting rules can allow some financing structures to be accounted for as off-balance sheet 1 i.e. not counted as debt. Off-balance sheet financing can provide entities with greater flexibility to invest in energy efficiency. Historically, energy service companies (ESCOs) have used operating leases as a vehicle for financing energy efficiency off balance sheet. As part of an ongoing process to harmonize the US and international accounting standards, operating leases will likely no longer be able to be used for off-balance sheet financing. The final rules related to leases have not yet been released, but the accounting of leases as on-balance sheet appears highly likely. There is also a lack of clarity as to whether emerging financing strategies, such as PACE, on-bill repayment, and energy service agreements (ESAs) will be treated as on- or off-balance sheet. Stakeholder consultations reveal that PACE and on-bill repayment are likely to be considered onbalance sheet, whereas there may be ways to structures ESAs so that they remain off-balance sheet. In terms of pathways forward, there may not be effective avenues to organize advocacy at the national level on these issues, but there may be opportunities to work with Boston-based accountants in major institutions to review potential models and determine whether they would consider them on- or off-balance sheet. This type of review could build a foundation for actual offbalance sheet project implementation, which would in turn create a precedent of transactions for others to build on. Background The City of Boston s Climate Action Plan established a target to reduce community greenhouse gas emissions 25% by 2020 and 80% by A central focus of the Climate Action Plan is to reduce emissions from commercial and industrial (C&I) buildings, which account for over 50% of Boston s total 1 It is important to note that the term off-balance sheet refers to the fact that the debt is not accounted for on the balance sheet of the host. However, the debt is accounted for on the balance sheet of a developer or financier, rather than that of the host property 2 City of Boston. (2010). Sparking Boston's climate revolution: Recommendations of the Climate Action Leadership Committee and Community Advisory Committee. Boston, MA.

2 greenhouse gas emissions. 3 The primary strategy for reducing greenhouse gas emissions in buildings is to scale-up energy efficiency and conservation measures. This scale-up will require a significant amount of new investment. It is estimated that the investment required to achieve the 25% by 2020 target in Boston is $728.5 million (see Appendix). Assuming that the utilities current energy efficiency incentive program levels remain consistent during the Climate Action Plan time horizon, and that Boston is able to secure its fair share of these funds, utility incentive programs should account for $320 million of this total. The remainder of required energy efficiency investment-- $408.5 million will need to be sourced from the private sector. Energy efficiency opportunities and barriers Energy efficiency measures are acknowledged as among the most cost-effective greenhouse gas abatement strategies available, 4 and their widespread deployment would generate significant benefits for the economy and the climate. Deutsche Bank, for example, recently estimated that scaling up building energy efficiency retrofits could mitigate 10% of U.S emissions (i.e. 600 million tons) and generate 3.3 million new direct and indirect job-years. 5 Energy efficiency markets, however, face a wide range of barriers, which have been detailed in a series of recent publications. 6 One potential barrier to energy efficiency is that proposed changes to accounting standards may limit the manner in which energy retrofits can be financed. Entities that do not have sufficient capital to purchase and install energy efficiency upgrades themselves may seek to borrow money from other sources. An organization that takes out a loan to finance energy efficiency, however, increases the amount of debt that must be accounted for on their corporate balance sheet. Higher amounts of debt can negatively impact an organization s credit score and impact its ability to secure additional financing. Given a limited amount of capacity to take on new debt, entities may opt to not finance attractive energy efficiency investments in order to make investments in core business activities instead. FASB and IASB In order to finance energy efficiency, a variety of structures have been developed that attempt to shift debt related to energy efficiency off of the balance sheet of the host organization. One of the most 3 City of Boston. (2011). A climate of progress: City of Boston Climate Action Plan update Boston, MA. 4 Creyts, J., Derkach, A., Nyquist, S., Ostrowski, K., & Stephenson, J. (2007). Reducing U.S. greenhouse gas emissions: How much at what cost? Chicago, IL: McKinsey & Company. 5 DB Climate Change Advisors, & Rockefeller Foundation. (2012). United States building energy efficinecy retrofits: Market sizing and financing models. New York, NY: Deutsche Bank Group. 6 See e.g., Granade, H. C., Creyts, J., Derkach, A., Farese, P., Nyquist, S., & Ostrowski, K. (2009). Unlocking energy efficiency in the U.S. economy. Stamford, CT: McKinsey & Company; Kapur, N., Hiller, J., Langdon, R., & Abramson, A. (2011). Show me the money: Energy efficiency financing barriers and opportunities. Washington, DC: Environmental Defense Fund; Hiller, J., Mills, V., & Reyna, E. (2011). Breaking down barriers to energy efficiency: Findings from EDF Climate Corps Boston, MA: Environmental Defense Fund; Palmer, K., Walls, M., & Gerarden, T. (2012). Borrowing to save energy: An assessment of energyefficiency financing programs. Washington, DC: Resources for the Future; Hinkle, B., & Kenny, D. (2010). Energy efficiency paying the way: New financing strategies remove first-cost hurdles: CalCEF Innovations; Henton, D., Melville, J., Grose, T., Brown, L., Mesher, M., & Yoder, I. (2010). Untapped potential of commerical buildings energy use and emissions. San Francisco, CA: Next 10.

3 frequently used tools to accomplish this is an operating lease. Under the Generally Accepted Accounting Principles (GAAP), which is the set of accounting rules utilized in the US, operating leases are not accounted for on the host site s balance sheet. Energy service companies have successfully structured energy efficiency performance contracts as operating leases, through which they have channeled significant amounts of capital. The GAAP rules are developed and maintained by the Financial Accounting Standards Board (FASB). FASB is a private, non-profit organization that has responsibility for setting accounting standards for public companies in the U.S. This responsibility has been formally designated by the Securities and Exchange Commission. 7 FASB is currently working with the International Accounting Standards Board (IASB) to harmonize GAAP with IASB s International Financial Reporting Standards (IFRS), pursuant to a memorandum of understanding signed between the two organizations in As part of this process, FASB and IASB have launched a joint project to standardize the way that leases are accounted for. 8 Based on a series of drafts published to date, it is widely anticipated that the new harmonized standards will not draw a distinction between capital leases (which are on-balance sheet under GAAP) and operating leases. Instead, leases will broadly be considered on balance sheet. 9 The intent of having all leases accounted for on the balance sheet is to enhance investors ability to properly value companies. 10 While the harmonization between FASB and IASB will likely increase transparency and accountability, it will also likely have the unintended consequence of constraining investment in energy efficiency by eliminating the ability for operating leases to be considered off balance sheet. At present, the final outcome of the FASB/IASB process remains uncertain. The release of a final decision on the issue of leases has been postponed several times already. The next publicly available exposure draft on leases is scheduled for release in Uncertainties about emerging energy efficiency financing models The fact that the FASB/IASB lease proceedings have not yet been completed has created uncertainties in the marketplace regarding a range of emerging financing mechanisms. During the past several years there has been a significant amount of innovation related to energy efficiency financing with the 7 FASB is overseen by the Financial Accounting Foundation (FAF). FAF selects the members of FASB and funds the organization. FAF members include the American Accounting Association, American Institute of CPAs, CFA Institute, Financial Executives International, Government Finance Officers Association, Institute for Management Accountants, National Association of State Auditors, Comptrollers and Treasurers, and the Securities Industry Association. 8 A summary of the lease joint project, including comments submitted by stakeholders in the proceeding, can be found on the FASB website 9 Lines, S., & Supple, D. (2010). Mind the GAAP: A study on the effects of proposed changes in accounting standards for leases on investment in energy efficiency retrofits in the United States. Washington DC: Institute for Building Efficiency and Johnson Controls. 10 In a recent study, for example, it was determined that 2,900 companies have off-balance sheet debt totaling over $765 billion in corporate liabilities. See Trainer, D. (2010, November 8). Off-balance sheet debt: Bad enough that FASB notices, maybe you should too? Forbes.com. 11 See the timeline on the FASB Current Technical Plan and Project Updates website

4 development of concepts such as PACE financing, on-bill repayment, energy service agreements (ESAs), and managed energy service agreements (MESAs). 12 A recent assessment of these strategies concluded that they each had a large potential to serve as pathways for scaling energy efficiency financing up to $150 billion annually. 13 Although it has been argued that each of these strategies could be structured to be off balance sheet 14, there has been no formal decision that would broadly clarify their status. To prepare this memo, a series of stakeholder interviews were conducted to scan current viewpoints on the FASB/IASB process as it relates to different financial structures. The findings of this scan are summarized in the table below. Financing Mechanism Commercial loans Capital and operating leases On-bill financing / repayment PACE ESAs/MESAs Current Status On-balance sheet It is expected that the distinction between these two lease types will be removed and that leases will be accounted for on-balance sheet. Unclear. However, if FASB rules that an on-balance sheet is defined by whether there is a beneficial use of equipment by the host (which appears likely), then these mechanisms may be considered on-balance sheet. Unclear. According to WSGR, Property assessments are generally treated as an expense, not capitalized on the balance sheet as a long-term liability 15. However, there is no consensus on how PACE would be treated since it differs in significant ways from most other types of property assessments. The PACE community considered seeking an advisory opinion from an accounting firm on this issue but concluded that the cost could not be justified at this point. Informal opinion, however, seems to be that PACE would be considered on-balance sheet under the new rules. Unclear. Interviews with industry stakeholders revealed that these structures have the potential to be considered off-balance sheet even if the proposed FASB/IASB decision is finalized -- if they are carefully structured. The ESA and MESA structures that are in current commercial use, however, are considered proprietary by the companies that have developed them and their precise details cannot be shared without a non-disclosure agreement Pathways Forward? National FASB advocacy. There have been proposals to advocate that FASB define leases in a way that would support energy efficiency. This could be accomplished, for example, by arguing for an energy efficiency carve out in the lease definition that would allow energy efficiency financing to remain off balance sheet. Although the FASB process is not yet complete, there is a sense among market participants that such FASB advocacy would be unlikely to change the current direction of 12 Schiller, S., & Hinkle, B. (2008). New business models for energy efficiency. San Francisco, CA: CalCEF Innovations.; Hinkle, B., & Kenny, D. (2010). Energy efficiency paying the way: New financing strategies remove first-cost hurdles: CalCEF Innovations; 13 Kats, G., Menkin, A., Dommu, J., & DeBold, M. (2012). Energy efficiency financing strategies: Pathways to scaling energy efficiency financing from $20 billion to $150 billion annually. Washington, DC: Capital E. Prepared for the Energy Foundation. 14 Kim, C., O'Connor, R., Bodden, K., Hochman, S., Liang, W., Pauker, S., et al. (2012). Innovations and opportunities in energy efficiency finance. New York, NY: Wilson Sosini Goodrich & Rosati (WSGR). 15 Ibid.

5 negotiations. FASB generally responds to arguments based on accounting principles rather than arguments that reference unintended consequences and strong arguments in favor of preserving current avenues for off-balance sheet energy efficiency financing have not been well articulated to date. Similarly, the energy efficiency interests have not been well represented in an organized fashion in the FASB proceedings to date and it may be difficult for their voices to be heard without critical mass. 16 There are currently 700+ stakeholders that have submitted comments related to the lease project alone during the most recent comment round and many of these have been at least partially coordinated. Members of the utility industry, for example, have submitted numerous and mutually reinforcing comments on the treatment of utility power purchase agreements (PPAs) under the new standards. No comparable, coordinated push on behalf of energy efficiency (or renewable energy) appears to exist. Review of the emerging energy efficiency financing structures by accountants affiliated with GRC organizations in order to determine whether the structures could be considered on- or off-balance sheet. When the final FASB rules are issued, they will not provide specific clarifications about instruments such as PACE or MESAs as a result, there may still be some uncertainty as to the status of these mechanisms. In order to determine whether these models are on- or off-balance sheet, accountants will need to review them and build up a body of precedent. It might be possible to ask one of the Big 4 accounting firms for their assistance to clarify these models, but such an approach would likely be costly and potentially inconclusive. In the near- to mid-term, it might be useful to have a group of GRC in-house accountants collaborate to evaluate the emerging finance structures and determine whether they would be considered on- or off-balance sheet. If GRC accountants can identify which structures they are comfortable accounting for as off-balance sheet, then this could open the door to projects to be financed and track record for off-balance sheet transactions to be established. This could be particularly useful in the near term for ESAs and MESAs since these structures appear promising, but they are relatively new to the market and to the accounting community. Focus on other energy efficiency barriers. The lease definition issue may not have a severe impact on the status quo of private sector energy efficiency financing. First, ESCO financing to date has not relied heavily on operating leases. Although operating leases have been a useful tool for the ESCO industry, off-balance sheet projects have accounted for only about 5% of energy efficiency deals done by ESCOs to date, with the remainder financed through upfront purchases or capital leases. 17 Second, ESCO financing in general has not been utilized to support private sector projects. According to recent statistics, the ESCO industry secures only 7% of its revenues from private sector clients. 18 Third, access to capital has not been cited as a major constraint among large users in Boston. A recent Waypoint survey of large, Boston-based commercial building owners found that only 10% of respondents identified access to capital as a barrier to energy efficiency. 19 Given these statistics, it may be useful to focus resources on higher priority energy efficiency barriers. Several studies from Waypoint, for example, concluded that there would be a 45% reduction in energy efficiency achieved in the future in Class A commercial property as a result of barriers such as split incentives, 16 One exception to this has been interventions on behalf of New York State hospitals, coordinated by the Green Group Energy Collaborative. See Schroth, C. W. (2012). Comment Letter No. 1. New York, NY: Green Group Energy Collaborative (GREENCO). Comments submitted to the Financial Accounting Standards Board. 17 Ibid. Lines & Supple 18 Satchwell, A., Goldman, C., Larsen, P., Gilligan, D., & Singer, T. (2010). A survey of the U.S. ESCO industry: Market growth and development from 2008 to Berkeley, CA: Lawrence Berkeley National Laboratory. 19 Waypoint Building Group. (2012). Market assessment of the largest 55 commercial buildings in Boston and implications for energy efficiency in the Boston commercial market. San Francisco, CA. Prepared for the Green Ribbon Commission.

6 tenant demand, hold periods and organizational barriers. 20 This is not to say that the FASB issue is not important -- it will be very useful to clarify the status of innovative financing models from an accounting perspective in order to enable scale-up. However, the FASB issues may not be the primary, near-term constraint on energy efficiency deployment in Boston. Support the creation of internal energy efficiency financing mechanisms. Identifying dedicated sources of internal funds can be a positive step to financing energy efficiency for many institutions. There has been a rapid increase in the number of revolving loan funds employed by non-profit institutions such as colleges and universities. 21 Similarly, creating dedicated set-aside funds for energy efficiency is emerging as a best practice among private sector companies as well. 22 Internal loan funds are typically structured to be off-balance sheet. Continued research. It is recommended that the GRC and its staff continue to monitor this issue and consult with its network of partners as the FASB issue develops. 20 Waypoint Building Group. (2012). Green Ribbon Commission: Understanding the energy efficiency and renewable energy performance and potential of the large commercial real estate market in Boston - Findings Report. San Francisco, CA. 21 Weisbord, D., Dautremont-Smith, J., & Orlowski, M. (2011). Greening the bottom line: The trend toward green revolving funds on campus. Cambridge, MA: Sustainable Endowments Institute. 22 Hiller, J., Reyna, E., Riso, C., & Jay, J. (2012, August 12-17). The virtuous cycle of organization energy efficiency: A fresh approach to dismantling barriers. Proceedings of the ACEEE Summer Study on Energy Efficiency in Buildings, Pacific Grove, CA; Hiller, J., Mills, V., & Reyna, E. (2011). Breaking down barriers to energy efficiency: Findings from EDF Climate Corps Boston, MA: Environmental Defense Fund.