It’s that time of year – time to look back at 2013. One energy efficiency deal stands out: In August, the New York State Energy Research and Development Agency quietly sold a pool of efficiency loans to investors. Selling loans is unremarkable on its own, but the way NYSERDA made this deal work was genuinely innovative and offers important lessons to other states, cities, and utilities for 2014 and beyond.
Background on the loan program before getting to the innovation...
NYSERDA’s efficiency loan program is typical – they make loans to utility customers to cut energy waste by repairing or improving their property, such as by adding insulation, repairing weather sealing, or replacing an air conditioner with a high efficiency model. Their loans are generally unsecured (like a credit card), but the model would also work well with loans secured by a lien (like a conventional “home equity” loan). NYSERDA also offers an on-bill loan, which means the monthly loan payments are charged on the customer’s utility bill. Loans can be made to residential and commercial customers. (Click for more on NYSERDA's loan programs).
NYSERDA makes efficiency loans using a revolving loan fund -- money goes to the customer (or to the customer’s contractor) from a large fund, and borrowers’ monthly loan payments then replenish the fund over the many years. The total volume of loans that can be made from a fund of any size is limited by the pace of repayments.
Selling the loans is a powerful tool -- NYSERDA immediately recovers the entire loan balance, and it can turn to make new loans right away. This enables much greater loan volume from the same fund.
Selling loans has been a longstanding goal for many efficiency programs. The challenge has been finding investors interested in buying and holding loans of this kind at a price that works. Investors have not exhibited an appetite for home improvement loans or small commercial loans with credit risks, low loan balances, and uncertainty.
Now, for the innovation...
New York, like all states, maintains a large fund to finance water projects (it's confusingly called the State Revolving Fund or SRF). It is capitalized by regular federal and state contributions. New York’s SRF has net assets over $5.0 billion. North Carolina’s SRF, for instance, has net assets of about $1.0 billion. These large funds have been used for years to make direct loans, at low interest rates, to municipalities or other entities to finance water improvement projects. For example, a city could borrow from the state SRF to fund a waste-water treatment plant then repay over time at lower cost than issuing bonds. (For more on how the SRF works, click here).
NYSERDA's innovation was to turn to the NY SRF to serve as a backstop for the efficiency loan sale. The State of New York essentially promised investors purchasing the efficiency loans that if NYSERDA were unable to fulfill any of its promises regarding the efficiency loans, the SRF funds would cover the commitment. It’s like a parent co-signing a loan.
This guarantee allows NYSERDA to the sell loans to more investors at a better price. As a result, NYSERDA can make more efficiency loans at a lower price to customers for efficiency improvements. (For more detail on how the deal was put together and the other agencies that made the deal work, see this good paper by CE+BFI)
Two Critical Controls.
Using a state's clean water fund to undergird an efficiency loan program can make sense -- making buildings more energy efficient means less toxic pollution ends-up in water and less water will be used by power plants, because they avoid burning dirty fuel to make electricity that would otherwise be wasted. But, the SRF resources are precious and must be allocated wisely and carefully protected. Two controls are essential --
1. Tie to clean water. New York’s clean water plan identifies the goal of improving energy efficiency in buildings, and the U.S. Environmental Protection Agency validated that NYSERDA’s loan program is directly tied to accomplishing the purposes of the SRF. For other states to follow the model, their clean water plans should target increasing energy efficiency in buildings.
2. Conservative loan terms. NYSERDA has reserves and protections so that the SRF would only be called upon in dire circumstances -- stringent credit screens on the loans, quality assurance programs, loan loss reserves, a regime to assure energy efficiency results, and overcapitalization (with projected cash flows from the loans exceeding the amount obligated to investors). Any state considering the approach outlined here should give significant attention and weight to these kinds of protections.
The Major Lesson for Efficiency Financing
NYSERDA’s deal demonstrates a path to reach investors to fund efficiency loans. It’s doable today, offers many benefits, and it does not hinge on financial institutions introducing new loan products.
Much effort has been devoted to recruiting lenders to offer and make efficiency loans to finance customer projects to improve or repair property. For example, see the recent decision from the California Public Utilities Commission directing utilities to pilot loan loss reserves and other tools. These efforts have value and there are good reasons to try to induce lenders to the market.
But in places with a well-run efficiency loan program operated by the city, state, utility, or program administrator, NYSERDA's model offers a path to replenish a limited loan fund and offers benefits that private lenders might not be able to deliver.
One advantage is that a utility or agency like NYSERDA is in a better position to market efficiency projects to customers, with financing as an option – the loan is not the primary product, but an enabler, and it's from a trusted source. A utility or program administrator is also likely to have rich customer information for marketing, credit screens, and project assessment. They also can help the customer to navigate and apply applicable incentive programs. FInally, for banks and lenders to offer efficiency financing loans will require time to introduce new products and (probably) additional loan fees.
For these reasons, NYSERDA's deal stands out as likely to illuminate the path ahead fior 2014 and beyond.
[* One final note: There are important differences between selling whole loans and selling bonds backed by loans, which is what NYSERDA did. But, with regard to the questions and issues raised here the distinction is not material. For NYSERDA and similar programs considering whether to sell loans or bonds backed by the loans, the differences are mostly mechanical, legal, and go to pricing. See here for a more full explanation of securitization.]