An Overlooked Way to Raise Trillions for Green Investments

Henry Paulson argues that we need, as a global society, to raise tens of trillions of dollars to support clean energy investments, and notes that most of this money will have to come from private capital. This blog identifies how updating antiquated rules for lending on existing capital can also accelerate adoption of efficiency measures that reduce carbon pollution, complementing the good idea of establishing and expanding green banks.

In some ways, energy efficiency financing can be similar to renewable energy financing.  Consider, for example, a makeover of an apartment house or shopping mall to save $10,000 per year.  These efficiency improvements, in some ways, look a lot like a solar panel that produces $10,000 of energy annually.

But there is a simpler way to finance efficiency. Efficiency is not a stand-alone investment. It is part of a larger entity, for example a building that is already being financed through conventional means. Furthermore, the conventional loan is always much larger than the efficiency project.

So our illustrative $10,000 energy savings would be part of a building whose net operating income is, say, $30,000 a year. Such a building might be appraised for about $600,000 (about 20 times net operating income) and the owner or buyer could be expected to be able to borrow about $400,000 of that.

Thus for a typical efficiency project with a simple payback of 3 years, we are talking about financing $30,000. One can easily envision an easier way to do this: modify an existing loan product rather than create a new one. We simply change lending rules such that all projects, whether amenity upgrades or energy improvements,  that result in $10,000 of net operating income growth would be treated identically.

Note that in this case, the energy efficiency project would support an incremental loan of about $130,000—far more than its cost. This outcome occurs because an increase of net operating income of $10,000 a year that is associated with higher projected rental income is already treated this way. This difference is great: it encourages owners to be more ambitious than just looking at three year simple paybacks, and it provides a cash incentive for efficiency.

This process should work for houses, too, and in even more important and powerful ways. The Millennial generation is having troubles affording home ownership. One reason for that is that, even more than their older peers, they prefer transit-rich walkable neighborhoods, which currently are more expensive than sprawl developments. They are far less likely to “drive till you qualify.”  These preferred neighborhoods could save them (on average) some $6,000 every year, on net, given that they will tend to own fewer cars over the life of the mortgage and also drive them less,  leaving $500 a month of cash on the table for mortgage payments.

A similar process can be applied to energy efficiency: a HERS rating predicts a home’s expected utility bills, counting both energy efficiency and solar power generation at the home. Low HERS ratings (meaning low energy use) are predictive of low probability of mortgage default.

The problem is that most lenders do not recognize this additional purchasing power, so they consider the preferred housing unaffordable. This despite solid statistical evidence that energy efficiency and location efficiency improve affordability, increase property values, and thereby reduce defaults. Changing loan qualification criteria allows private capital to flow to the investments and properties that will deliver energy savings along with higher values.   

The beauty of these suggestions is that these are not government interference in a free market, but rather an attempt to make the current markets more free and more functional. Fannie Mae, Freddie Mac, and FHA use loan standards designed in the 1970s.  Accounting for values of energy use and transit-rich neighborhoods is modernization.  The current system that ignores efficiency results in artificial values, and predictably poorer loan performance and less consumer choice. And the changes we recommend do not require any government money.

Mr. Paulsen’s advocacy for green banks still makes good sense, again noting that their loans ought to apply equally to efficiency as to renewable energy: we need all we can get of both to meet climate goals. One attraction of efficiency is that it not only works well within the project lending paradigm of green banks, but also can be readily financed through intelligently-designed conventional lending products such as mortgages.

So while Mr. Paulson is right that reform of private financing is a key to combatting climate disruption, he’s only half right.  Raising new capital will accelerate market penetration of renewables and efficiency measures.  But that can and must also be promoted through simple modernization of lending criteria for existing financing. 

He’s also only half right that “countries will need to adopt policies that reduce the price of low-carbon investments to make them more attractive for private investors”.  Efficiency is already the least cost option.  And subsidies are not the only government thumb on the scales for carbon-based energy that we need to eliminate.  We also must get the federal government out of the fossil fuel business – and all in on clean energy and efficiency – not just to promote green alternatives itself but equally to ensure the private sector has an unequivocal investment signal about where our energy future lies.