Four reasons why financial institutions should be active in energy efficiency

This is the first in a series of blogs based on and picking up key elements in the EEFIG Underwriting Toolkit which was published in June. The Toolkit aims to equip financing institutions to better value and assess the risks of energy efficiency projects. 

There are four reasons why financial institutions should consider deploying capital into energy efficiency:

• energy efficiency represents a large potential market. The IEA estimates that in 2015 global investment in energy efficiency was USD 221 billion with approximately USD 32 billion being financed through explicit energy efficiency mechanisms such as Energy Performance Contracts or green bonds.  To achieve our climate goals this level of investment needs to grow to circa USD 1 trillion per annum by 2050 and the provision of finance can help overcome some of the barriers to energy efficiency investment.
• reducing risks in two ways. Firstly, increasing energy efficiency improves the cash flow of clients, thus reducing their risk. Secondly there is the risk of financing assets that become stranded as energy efficiency regulations are tightened. For example, in England & Wales it will become unlawful to lease a commercial building with an Energy Performance Certificate rating below E on 1st April 2018.  This puts owners of low performing buildings, and their lenders, at risk.
• improving energy efficiency has a direct impact on reducing emissions of carbon dioxide and other environmental impacts such as local air pollution and therefore should be a key part of Corporate Social Responsibility (CSR) programmes. Energy efficiency is regarded as one of the key pathways to reducing greenhouse gas emissions.
• bank regulators are increasingly looking at climate related risks. Actions include asking banks to disclose the climate-related risks of their loan portfolios.  In France disclosing climate-related risks is already required by law.  This will allow financial institutions to be better informed about loan performance and thus the cost of risk and carry out better risk appraisal.  Possible future actions may include reducing capital reserve requirements for “green” financing.

Each of these four factors are considered in more detail below.

A large potential market

The IEA estimate that that in 2015 total global investment into demand-side energy efficiency was USD 221 billion, USD 118 billion in buildings, USD 39 billion in industry and USD 64 billion in transport.  Investment into energy efficiency was less than 14% of total energy sector investment but increased by 6% in 2015 whereas investment into energy supply fell. The US, EU and China represent nearly 70% of the total investment into efficiency.  Total investment into efficiency can be split into “core” investments, where the motivation is specifically to achieve energy savings, and “integrated” investments which are the regular transactions in which energy efficiency is not the motivation but which improve efficiency because the new product is more efficient than the one it replaces.

To date about 85%, of all energy efficiency investment has been financed with existing sources of finance or self-financing rather than specific energy efficiency products or programmes.  The global market for Energy Performance Contracts, which are most often associated with external financing, was USD 24 billion in 2015 and of this USD 2.7 billion was in Europe.  In addition, about USD 8.2 billion of green bonds were used to finance energy efficiency.

In order to achieve climate targets the level of investment in energy efficiency, and the level of energy efficiency financing, will need to increase substantially.  The IEA and IRENA estimate that to achieve their “66% 2°C” scenario cumulative, global investment in energy efficiency between 2016 and 2050 will need to reach USD 39 trillion of which USD 30 trillion would be in the G20 economies, implying a global level of c.USD 1 trillion a year compared to the current level of USD 221 billion – a five-fold increase.

The business opportunity for financial institutions falls into two categories:

• creating new business lines for specific energy efficiency projects e.g. specific energy efficiency loans, mortgages or funds.
• ensuring normal lending and investing which is being used to finance projects where energy efficiency is not the primary objective, e.g. building refurbishments or production facility upgrades, is leveraged to ensure funded projects achieve the optimum cost-effective levels of energy efficiency which are usually higher than “business as usual” levels.

Energy efficiency projects often have rapid paybacks.  In EEFIG’s DEEP (Derisking Energy Efficiency Platform) database, which includes over 7,500 projects, the average reported paybacks are 5 years for buildings and 2 years for industrial projects. Despite this economic attractiveness many potential projects do not proceed because of other priorities of the other project host, lack of internal capacity to develop projects, or shortage of investment capital.  Furthermore, normal investments in building refurbishments and industrial facilities or new buildings and facilities often do not utilise all of the cost-effective potential for energy efficiency.  The provision of third party finance through business models that reduce the overall cost to the host is an important way of overcoming some of the barriers to improving energy efficiency and represents a major business opportunity for financial institutions.

Reducing risk

Energy efficiency investments can reduce risks for financial institutions in two ways:

• assisting individual clients, whether they be businesses or individuals, to reduce their energy costs improves their cash flow and profitability, as well as increasing their resilience to energy price rises. Reduced expenditure on energy translates directly to improved cash flow which improves the affordability of loans or mortgages, thus lowering risks to the lender.
• Tightening regulations around energy efficiency, particularly buildings such as Minimum Energy Efficiency Standards, mean that it will become impossible to rent or sell energy inefficient buildings. This is a stranded asset risk for the owner and lender.

Increasing levels of energy efficiency, essentially reducing the amount of energy used for any activity, is a central part of European policy to address concerns about energy security and climate change.  European policy is driving tighter energy efficiency regulations for buildings, equipment and appliances as well as vehicles.  The main EU policies are the Energy Efficiency Directive (EED) and the Energy Performance of Buildings Directive (EPBD) and in November 2016 the European Commission, in its Winter Package, “Clean Energy for all Europeans”, proposed further tightening of energy efficiency regulations.

Some member states have implemented Minimum Energy Efficiency Standards (MEES) (also known as Minimum Energy Performance Standards (MEPS)) which mean that after a certain date buildings with an energy efficiency below a set level cannot be sold or rented. These regulations mean that significant proportions of existing real estate portfolios could lose their income and asset value if they are not upgraded to a higher level of energy efficiency.  For owners of large property portfolios, or banks lending to property owners, this represents a significant risk which needs to be addressed.

The environmental impacts of energy efficiency

For many years advocates of energy efficiency have argued that it is the lowest cost source of energy services and a low-cost route to achieving significant reductions in greenhouse gas emissions. This has now been recognised both by policy makers and by many financial institutions.  The projects in EEFIG’s DEEP (Derisking Energy Efficiency Platform) database suggest that the median avoided cost of energy is 2.5 Eurocents/kWh for buildings and 1.2 Eurocents/kWh for industry, which is lower than generation costs.  Energy efficiency has been described as “the linchpin that can keep the door open to a 2°C future”.  The IEA estimates that in achieving a 2°C scenario energy efficiency must account for 38% of the total cumulative emission reduction through 2050, while renewable energy only needs to account for 32%.  For financial institutions looking to make a positive impact on resolving environmental problems as part of Corporate Social Responsibility programmes supporting energy efficiency should be a high priority.  As well as reducing emissions of carbon dioxide that drive global climate change, reducing energy consumption can also have a positive effect on local air pollution.

Energy efficiency and financial regulators

Financial regulators are taking an increased interest in systemic risks including climate change.  There is also a growing interest from regulators and governments in encouraging the growth of “green finance”.  The European Systemic Risk Board in its Scientific Advisory Committee report of February 2016, “Too little, too sudden”, warned of the risks of “contagion” and stranded assets if moves to a low carbon economy happened too late or too abruptly.  The report’s policy recommendations including increased reporting and disclosure of climate related risks and incorporating climate related prudential risks into stress testing.

In December 2016, the Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures (TCFD) published its recommendations which included disclosure of organisations’ forward looking climate related risks.

In July 2015, France strengthened mandatory climate disclosure requirements for listed companies and introduced the first mandatory requirements for institutional investors as part of Article 173 of the Law for the Energy Transition and Green Growth.  These provisions require listed companies to disclose in the annual report “the financial risks related to the effects of climate change and the measures adopted by the company to reduce them, by implementing a low-carbon strategy in every component of its activities.”  Institutional investors will also be required to “mention in their annual report, and make available to their beneficiaries, information on how their investment decision-making process takes social, environmental and governance criteria into consideration, and the means implemented to contribute to the energy and ecological transition.”  The law also requires the government to implement stress testing reflecting the risks associated with climate change.

This trend towards greater disclosure and open assessment of climate-related risks is likely to continue across Europe.

These four reasons suggest that energy efficiency should be on the board room agenda of financial institutions.  Whatever the markets they operate in there are growth opportunities as well as opportunities to reduce risks.