Financing Energy Efficiency: Credit Enhancements and Leveraging Strategies

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1 Financing Energy Efficiency: Credit Enhancements and Leveraging Strategies Matthew H. Brown ConoverBrown LLC

2 ConoverBrown LLC Consulting firm with a specialty in financing for clean energy & environmental strategy. Domestic and International government, nonprofit and private clients. Clean energy finance clients include U.S. Dept of Energy, Iowa, Colorado, Michigan, utility, lender, national and regional associations and advocacy organizations. Working with these clients to set up or assist in establishing new financing programs.

3 Why Financing? It s all about going to scale: 100 million households in the United States. Typical basic-only efficiency installation investment is $7,500, including HVAC, duct sealing, insulation -- but can range higher, up to $10,000. Total market, on this basis is $750,000,000,000- $1,000,000,000,000. Utility, government capital will not be sufficient to meet this goal. Private investor capital is critical. (And this is only the residential side)

4 More on Market Size and Need for Financing 3 million furnace, a/c and water heater replacements each year. (Residential focus) Likely market for HVAC retrofits (replacements) alone is approximately $7 billion per year. Additional products and sub-markets in the residential sector include insulation, windows, doors, etc.

5 A Definition: What are we investing in? Energy efficiency investments consist of: Market Measures Typical Per- Installation Cost Residential Commercial Industrial HVAC systems, insulation, duct sealing, appliances, water heaters, windows, doors Lighting, HVAC, Motors Motors, Customized Improvements $7,500 $10,000 and up $100,000 and up

6 2 Typical Kinds of Residential Loan Products Product Characteristics Unsecured Secured High volume, low value loans. Uniform set of measures. Consumer credit model. Underwriting typically based on credit score, debt-income ratios. Fast-response loan evaluation. Conforming product draft in development. Limited 2ndary market. Higher value (>$12,500-$30,000) loans in residential sector. Tax or other lien typical. Often for whole house renovations or solar. Tax-lien financing model is getting attention. Limited 2ndary market.

7 Lender Context: A quick breakdown of costs Servicing: $7-$15/month. Origination: $300-$600/loan is typical On a $5,000 loan, it s really important to keep those costs as low as possible. And typical mortgage lenders will not be interested in these loans. They aren t set up to do a lot of small unsecured loans.

8 Who are the lender partners? Credit unions: Understand small loans, community-minded. Specialty Lenders: Know energy finance very well Community Development Financial Institutions (CDFI) lenders: low cost, but limited amounts of capital Public lenders (state or municipal bonding authorities such as housing finance agencies): low cost capital availability

9 What will bring these lenders to the table? A market for loans deal flow. (Many lenders hungry for good quality loans). Good quality borrowers with good credit. A secondary market for loans (a place to sell the loans). Credit enhancements.

10 Credit Enhancements Come in Several Forms Loss Reserves or Guarantees Subordinated Debt Loan Insurance Interest rate buydowns sometimes fall into this category Not addressed in detail here. Typically structured as a payment to the lender based on NPV of difference between market and target interest rate.

11 Why Are Credit Enhancements Attractive? Help to make lenders comfortable with a new and unfamiliar product. Help to extend the range of potential borrowers to those who might not otherwise be able to borrow. Increases amount of capital available to lend by attracting investor and lender interest in a product.

12 Issues to Consider with Credit Enhancements Make sure that there s a real benefit to the enhancement -- eg. a lower interest rate, more loans. Consider ways to customize the enhancement (eg. Reduce reserve size based on improving default rates). Find maximum leverage 20x leverage based on 5% loss reserve isn t unreasonable. Pre-agreed underwriting standards are critical. Eg. 680 credit score, 50% debt/income ratio.

13 Issues to Consider with Credit Enhancements Don t give away the farm: a full guarantee may not leave enough skin in the game to encourage appropriate underwriting and collections. Recommend structuring the enhancement on the basis of total loans outstanding (a portfolio) rather than on a per-loan basis. Eg. A loss reserve set at 5% of total outstanding loan balance, with lenders able to recover up to 80% of the balance of any individual loan in default. Reserve levels will vary depending on target market risk. Could be as high as 20% for certain markets served by CDFI lenders.

14 Issues to Consider with Credit Enhancements Default definitions critical 90 days/120 days is typical. Assignability credit enhancement should travel with the loan upon sale of the loan.

15 ARRA Regulations and Context DOE Encourages use of ARRA funds as credit enhancements. Loss Reserves, Sub/Senior Debt and loss insurance are allowed uses of ARRA Funds. Loan Guarantees are not allowable uses of ARRA funds.

16 Reserve vs. Guarantees Loss Reserves are provided contingent upon availability of funds (eg. 5% of outstanding loans). Guarantees are available regardless of fund availability.

17 Michigan Example of Loss Reserve (proposed) 5% loss reserve based on the total portfolio of loans that lender holds. Lender would be able to recover up to 80% of defaulted amount (skin in the game). Unsecured loan although possibly tied to a meter and disconnection threat. For this, lenders willing to offer 5-7% unsecured loans. (about ½ market rate).

18 PA Keystone HELP and CO Example of Loans Loss reserve set at 5% of outstanding value available to lender. Investor in this case is the State Treasurer. Lender guarantees loans to Treasurer. Results in leverage of 20x loss reserve amount.

19 Senior/Sub Debt Structure -- WA State Housing Authority (in process) ARRA funds used to provide a subordinated debt at 0% in amount of $1 million. This sub-debt absorbs first loss (ie. before any losses accrue to senior debt). Reflows create a loss reserve. Private investor funds provide $9 million of senior debt (much more secure and lower rate).

20 Loan Loss Insurance Very limited availability of any loan loss insurance now used to be available in the past. Insurance that is available is quite expensive. Not a recommended option at this point.

21 Default Rates Tend to be Low these results should guide level of enhancement It s not the HDTV purchase Program Default Criteria Used to Assess Credit Quality Rate Keystone 1.5% Credit score of 640 minimum. Average score is 720 HELP Manitoba <1% Current on utility bill for at least 12 months; credit score considered Hydro Midwest 0% Current on utility bill for 12 months Energy United <1% Current on utility bill. In business for at least six months. Illuminating Sempra <1% Account in good standing with non disconnect in previous 12 months; applicant must have been a utility customer for at least 24 months. Default leads to disconnection.

22 To Summarize Without financing we can t make our climate, energy independence or other goals. Financing requires working with financial institutions in new ways. And educating finance institutions in part through use of credit enhancements. Credit enhancements, structured properly, provide significant leverage opportunity.