Assembling the jigsaw of energy efficiency financing.

Keynote address at DENEFF EFFIN event 25th March 2015.

On 25th March I made the keynote address at DENEFF’s (the German energy efficiency trade association) event launching the report on energy efficiency financing resulting from their EFFIN project. Here are the notes of my presentation – the slides can be found here.

Introduction and status report

Good Afternoon everybody.

I am very pleased and honoured to be invited to speak to you all at this critical time for energy efficiency and energy efficiency financing in Germany and in fact across Europe and the rest of the world.

Today I want to give a wide ranging view of where we are on developing the energy efficiency financing market – globally -and my own views on what we need to do to grow that market to the levels that we know are needed to achieve our medium term energy goals around energy security and the environment.

As I will be speaking about the Investor Confidence Project Europe, which is supported by a €1.9m grant from the Horizon 2020 programme I am obliged to show this disclaimer slide – I will take it that you have all read it.

I want to start with a status report on energy efficiency financing:

– Those of us who have been working on energy efficiency for a long time have known that the potential for energy efficiency is huge. It is a massive untapped energy resource. Those of us on the inside have known that for decades but it is true to say that the scale of the potential has now been generally recognized. That is a step forward.
– The co-benefits of energy efficiency – and by that I mean all the other benefits that come with energy efficiency other than just energy and cost savings – are now increasingly recognized. There was some great work by the IEA on multiple or co-benefits last year which I highly recommend. We still have a way to go on recognizing and valuing co-benefits but things are improving in that respect.
– We have growing interest in investing in energy efficiency from institutional investors. This is good news.
– However, despite these positive developments the growth of the energy efficiency financing market has been slow. Not just in Europe, but in North America, Asia and everywhere else that I go I encounter the same sense of frustration that things are not happening as fast as they need to.

As one of the bankers in the USA trying to do stuff in this market said: “the trouble with this energy efficiency business is that the ratio of conferences to deals is too high”.

If we think for a minute about what a healthy European energy efficiency market would look like – if everything was rosy – it would have the following characteristics:

– strong demand from building owners and investors for energy efficiency retrofits
– a highly skilled and accredited workforce
– a mix of financing products at different rates
– standardized tools for tracking and quantifying savings
– and finally a secondary market that the primary investor can sell onto – ultimately the debt capital markets.

Right now we don’t have those characteristics – and in fact I don’t think we have them in any market anywhere in the world.

The jigsaw of energy efficiency financing

Now, this is not one of my holiday photos that slipped into my presentation. Last year I went to Neuschwanstein Castle for the first time ever and I really enjoyed it – although on the day I visited there was so much cloud that we could not see the Castle from the ground.

My mother who is 82 likes doing jigsaws and so when I was at Neuschwanstein I bought her a jigsaw puzzle and this is as far as she has got (up until last Sunday at least).

Looking at the energy efficiency market makes me think of a jigsaw and it has at least six pieces – it is just as well it does not have 1,000 pieces:

– product offerings from the energy efficiency industry
– standardization
– the development gap
– supply side capacity building
– demand side capacity building
– and capacity building in the financial institutions.

I want to say something about each of these but I will start with standardization because that is the area that the Investor Confidence Project is active in.

Now we all know that standardization is essential if you are making cars in a factory or washing machines or in fact any other manufactured product.

Of course people forget that banks are also factories – banks and other financial institutions cannot operate at scale without standardization. Every financial market, whether it be mortgages, car loans or credit cards, needs standardization.

It is not just me saying this. I know that some of you are very familiar with the EEFIG report and indeed some of you contributed to it.

The EEFIG report concluded that standardization was a key factor affecting both the demand and supply of energy efficiency financing.

The Joint Research Centre of the Commission also came to similar conclusions and also highlighted:

– high transaction costs
– the difficulty of predicting savings
– the lack of standardization.

Michael Eckhart, the head of Finance & Sustainability at Citi said it very well when he said:

– “energy efficiency projects do not yet meet the requirements of capital markets”
– “no two projects or contracts are alike”
– “Say you have 1,000 energy efficiency projects, Standard & Poor’s would have to read 1,000 documents to assess the risk. Fees won’t pay for that level of review.”

And finally the IEA concluded that standardization was important and that the Investor Confidence Project could “facilitate a global market for financing by institutional markets that look to rely on standardized products”.

Energy efficiency financing compared to energy financing

To sum up let’s look at the whole area of energy financing – and I mean energy financing not just energy efficiency. This is what I see.

For oil and gas projects, if you happen to own an oil or gas field, the ways of developing and documenting the project are standardized. You have to hire a Competent Person who will be a geologist and who will follow strict guidelines set down by groups like the Society of Petroleum Engineers and if you have an oil and gas company floated on a stock exchange then the use of certain standards is required by the exchange itself. Oil and gas financing is entirely mainstream. There is a large volume of money available for oil and gas projects from a wide range of sources – although of course this may reduce with the divestment movement.

Now let’s look at renewables, solar and wind. Twenty five years ago when I did some early wind farm projects in the UK the same was not true of renewables, we made it up as we went along and there was only one bank in London we could go to – and they pretty much made it up as they went along. Nowadays of course funding renewables is as standardized, and almost as mainstream as oil and gas and you can go to multiple sources for money.

However, when we look at energy efficiency projects, here represented by the Empire State Building retrofit project, we see something completely different. Processes and documentation are NOT standardized, it is NOT mainstream, there is only a small amount of lending/investing going on and there are only a few sources you can go to.

The Investor Confidence Project

So let’s consider the Investor Confidence Project which is a direct response to the lack of standardization. I want to give you a flavor of the Investor Confidence Project, what it is and what has been achieved in the US, and then talk about the Investor Confidence Project Europe project. Our German representative, Dr. Frederic Brodach of Plus Ultra, is here today and he will be able to talk to you about the project in German and give you more details today or in future.

As we have seen there is currently a lack of standardization on the way that energy efficiency projects are developed and documented. Here we see three different projects that use three different routes through what we call the alphabet soup of different standards and practices.

The lack of standardization imposes several negative things:

– greater performance risk
– higher transaction costs
– financial institutions cannot build capacity around ad hoc processes even if they do want to invest in this area
– financial institutions cannot aggregate projects, aggregation is essential because we know that energy efficiency projects are small compared to the needs of the institutional investors. To get to the debt capital markets and access cheap money we need to aggregate projects.

The Investor Confidence Project Energy Performance Protocols organize the process into the different stages of developing and implementing a project and for each stage define the standard or combination of standards and best practices that should be used. It is not about writing new standards but rather about standardizing the process – organizing the alphabet soup to give more uniformity.

The Protocols are developed working with financiers, building owners, project developers, government agencies and utilities. It is an open source project co-created by the contributers.

In the US six Protocols have been launched and are now being applied in real projects and programmes. They cover different sizes and types of projects in commercial and residential buildings.

As well as Protocols the Investor Confidence Project is also developing accreditation for Project Developers, and they now the first eight accredited developers. There is also a programme of accrediting software, that is project development software that automatically follows the Protocols. In the US they have six accredited software providers and I can tell you that we already have two European software providers working on software that will be ICP Europe compliant. Finally there is a Quality Assurance programe and very soon the ICP will announce its first QA providers in the US.

All of these components come together to make a project “Investor Ready Energy EfficiencyTM”. The final output is a badge, a seal of approval. When we talk to investors, including some of Europe’s largest real estate investors and lenders they say that is what they want – a stamp that gives them confidence that a set process has been followed every time.

So let’s look at the Investor Confidence Project Europe. In our project, which is supported by Horizon 2020, we are focused on getting early adoption of European Protocols in five countries: Germany, the UK, Portugal, Austria and Bulgaria. We will go beyond those countries – and already are – but they are our immediate priorities under the grant.

We have an Investor Confidence Project Europe Steering Group which provides direction and oversight and includes some of Europe’s largest energy and efficiency companies, major lenders and investors, important trade associations representing the energy efficiency industry, and government agencies.

We also have a network of nearly 50 allies already. Please sign up on the website – www.eeperformance.org/europe

It does not cost you anything and gets you in the conversation.

Note these two red boxes – this is an example of how the Investor Confidence Project has already helped put projects in touch with an investor. SEA, an Italian ESCO, was looking for an investor in residential projects and we put them in touch with Joule Assets, a US investor now active in Europe.

The Investor Confidence Project Europe is in three phases:

– creating the tools
o protocols
o accreditation
o labels
o open data

– take the tools to market
o private investors
o public programmes
o developers
o property owners
o utilities
o associations

– be a catalyst for change by:
o inspiring action
o connecting projects to capital
o create working examples of functioning markets for energy efficiency finance

Capacity building on the demand side

Now let’s go back and look at the other parts of the jigsaw – starting with capacity building on the demand side. We have to acknowledge that lack of demand for energy efficiency retrofits is a problem that we have to address. Generally people do not wake up in the morning and say they want to buy some energy efficiency.

We also have to acknowledge something that is hard to accept for those of us who have spent our lives in energy efficiency. Energy efficiency is just boring – for most people most of the time it is extremely dull. People are not interested in energy efficiency or if they are it is only for a fleeting moment now and again. Only when we recognize that can we move forward.

One the most promising ways of making energy efficiency less boring is to talk about the layer cake of benefits that come from energy efficiency. It is always good to talk about cake – especially in Germany. Those co-benefits, or non-energy benefits, occur at different levels; in the energy supply system, in the participant or host, and in society at large. Here I am only concerned with the benefits to the host, the project owner.

These benefits include things such as; improved productivity, increased retail sales, increased quality and reduction in hours lost at work, and they are increasingly being recognized and they are just starting to be measured in a few leading edge organizations. The important thing here is that often the value of these benefits will be much larger than the value of the energy savings alone. Also they are often more likely to lead to a management decision to invest in energy efficiency. For example, when a retailer recognizes that LED lighting retrofits lead to an increase in sales (as some have done) and starts to value that benefit, you can be sure that energy efficiency rises up the management agenda. That subject will be on the board agenda, things will happen.

Capacity building on the demand side should include ISO50001 – which is great for putting in place an energy management system, the importance of valuing the co-benefits, the massive benefits that can come from true integrated design, and consideration and evaluation of outsourced energy services that bring with them external expertise and finance.

Mind the development gap

Let’s talk about the development gap. Anyone familiar with the London Underground will know – we have an expression “mind the gap” – which means don’t fall down the gap between the train and the platform. The gap I am talking about is the gap between potential projects and bankable, actionable projects. We know the potential is huge but still there is a lack of high quality bankable projects, particularly at large scale.

To overcome the development gap requires:

– vision about what is possible at the top level
– technical and financial skills – particularly around the issues of portfolio optimsiation and sub-project interactions
– finance – developing projects, especially big projects, costs money, money that is at risk
– standards – we need to develop multi-building projects all using the same standards which is where the Investor Confidence Project comes in.

We need to learn how to develop these kinds of projects, how to finance the development process and how to increase the rate of project development. In energy supply projects there are established ways of developing and financing the development process but we don’t have that for large scale energy efficiency projects. There is real potential here in cities for instance, which can bring scale quickly, but financing the development process is difficult for cities with tightly constrained budgets.

Product offerings

Let’s talk about the product offerings from the energy efficiency industry.

Let me say that Energy Performance Contracts are not the answer that some people seem to think they are. It is a model that evolved to meet the needs of a particular market segment (public sector) and originally to exploit certain sources of finance that are available in the US – Federal money or municipal bonds. The EPC model has never grown to the extent that people thought it should but when you analyze it there are good reasons including:

– debt is on the balance sheet of the host
– debt is constrained by mortgage covenants or finance structure
– the guarantee is not a credit enhancement
– transaction costs are high
– they don’t address the split incentive

In summary they may work in the public sector but they don’t work in the commercial sector. For too long the energy efficiency industry, new entrants and some policy makers have pushed EPCs as if they are the answer to everything – let me tell you that they are NOT.

Innovation is appearing around the world in the form of services agreements such as ESA, MESA and MEETS and we need more innovation like that.

Building capacity on the supply side

On the supply side we need to build capacity in different ways. The energy efficiency industry needs to learn to work with the finance industry right at the start of the project, not just at the end. As I have said we need to learn how to develop projects at scale and be innovative. Most importantly the energy efficiency needs to understand markets better and sell co-benefits. Traditionally the energy efficiency industry has been very bad at understanding the market’s real needs and motivators and has relied on the rationality theory; “it is a two year payback period project and therefore you should do it – it is a no brainer – it is low hanging fruit”. Well, as the real marketing experts know, people are not rational.

Building capacity within financial institutions

Within financial institutions we need standardization and capacity building on:

– the co-benefits – what they are and how to value them
– technologies
– contract types
– standards
– available support for development and project work such as EC or national programmes.

Assembling the jigsaw

So now we have considered each of the pieces in turn we have to put the whole jigsaw together.

By the way, you can use a laser cutter like this one to make very precise jigsaw pieces but if you don’t have all the pieces you can’t finish the jigsaw. Work on all the pieces together. I think many of the programmes around the world have focused on making one or two very precise pieces but not thought about the other pieces of the puzzle, and then they have problems deploying money.

A few words on policy

I was asked to comment on policy in this area. I am always reticent to talk about policy in other countries but I have some general views that apply everywhere. They are as follows:

– reward all the value streams i.e. all the value that is created by energy efficiency projects, not just the energy component
– design the energy market to value and pay for all the benefits
– consider benefits that cut across normal Ministry or departmental boundaries e.g. spending money on energy efficiency can save money in health budgets. In the UK we are experimenting with doctors prescribing insulation or new boilers to people who are in fuel poverty and as a result have lots of heath problems. It actually works, spending health budgets on insulation actually saves money because after the works are done, the people visit the doctor or the hospital less frequently. Institutionally this is difficult to do but policy makers need to make it happen.
– Ensure that supply-demand decisions are balanced e.g. network operator regulations. In the UK the DNOs acknowledge that in some cases investing in demand side measures like energy efficiency and demand response is more cost-effective than investing in supply side infrastructure upgrade projects such as putting in bigger cables. However, the regulations have not caught up with this and the DNOs are still only incentivized to invest in supply side assets. If we can change that it will have a large effect.
– We need to move away from top down programmes towards creating a real market for energy efficiency. For forty years governments have been carrying out a big experiment in energy efficiency based on the notion that it is somehow special and needs exhortation, public subsidies, energy company obligations or top-down bureaucratic programmes. We need to move towards creating a real market for energy efficiency and we are starting to see the tools for that appear such as Measurement & Verification, new contract forms and the Investor Confidence Project.
– Stable policies or clear policy trajectories are always good. In the UK we have had examples of policies being changed at short notice for short term political expediency. That does not work.

The future

So what about the future? This by the way is a German cigarette card from the 1920s or 1930s which shows two ladies who appear to be using Skype on an early form of iPads! Amazing. If anyone can get me an original set of those cards I would be grateful.

So back to my jigsaw. I am positive and I think we can complete assembling this jigsaw.

What would it look like when we finish the jigsaw? We talked earlier what would a healthy energy efficiency market would look like and how we don’t have that now – clearly if we do build the jigsaw we will have those things in place and there we can focus on other problems.

At that point energy efficiency financing will look just like energy supply financing – it would be:

– standardized
– mainstream
– large volume
– and be available from multiple sources.

In short there would be more deals than conferences and that is a future I would like to live in.

Thank you very much. I look forward to talking to you further and working with you in future on the Investor Confidence Project Europe and putting together the other parts of the jigsaw.

Dr. Steven Fawkes
DENEFF event to launch the EFFIN project report, Berlin, 25th March 2015

Disclaimer

The Investor Confidence Project Europe has received funding from the European Union’s Horizon 2020 research and innovation programme under grant agreement No 649836. The sole responsibility for the content of this presentation lies with the authors. It does not necessarily reflect the opinion of the European Union. Neither the EASME nor the European Commission are responsible for any use that may be made of the information contained therein.