Policy will play an essential role in overcoming the present barriers that limit large-scale investment in energy efficiency. Based on a dialogue with institutional investors and efficiency experts, this paper finds three key areas of policy—utility regulatory policies, demand producing policies and finance-enabling policies—can together catalyze the development of secondary markets for energy efficiency retrofit loans and thus attract investment from institutional investors.
The first section of this paper describes institutional investors’ current interest in energy efficiency as an investment vehicle, as well as their current methods of mitigating climate risk in their portfolios. The second section proposes that a financing structure in which energy efficiency loans are securitized and sold on a secondary market may represent an attractive option for institutional investors to expand their investments in energy efficiency while also lowering the cost of financing projects for building and industrial facility owners. The third section outlines investors’ policy priorities for stimulating the creation of secondary market financing for energy efficiency.
Energy Efficiency: A Compelling Opportunity for Risk Mitigation and Investment
Energy efficiency can present steady returns and attractive yields for investors. At the same time, efficiency is an essential strategy in the effort to mitigate the economy-wide risks of climate change. Indeed, in scenarios presented by the International Energy Agency, one-third of the emissions reductions needed to avoid the worst impacts of climate change are expected to come from energy efficiency in buildings and industrial facilities. 4 Investors can play a role in ensuring that those emissions reduction targets are met.
Institutional investors have already achieved a number of notable energy efficiency successes. As active shareholders of corporations, they have encouraged companies to improve energy efficiency and thus boost profitability and achieve corporate sustainability commitments. They are also stock- and bondholders of companies that develop energy-efficient technologies or provide energy efficiency services. In addition, institutional investors have begun to embed efficiency metrics into real estate investments and other alternative investment vehicles.
Energy efficiency can make institutional investors’ existing investments more profitable, improve the corporate bottom line, present new profitable investment opportunities, and offer the fastest, easiest and cheapest way to significantly reduce greenhouse gas emissions and advance corporate sustainability goals.
However, perhaps the most appealing energy efficiency investment opportunity—the ability to finance energy efficiency retrofit loans through a secondary market—is not yet available. Secondary markets are routinely used to as a way to bring cheaper funding from the capital markets to various forms of debt. Loans, such as car loans, mortgages, and credit card debt can be aggregated (pooled) and repackaged as securities (bonds) that can be purchased by investors. Such secondary market financing provides low-cost financing for borrowers and creates investment vehicles for institutional investors.
Though energy efficiency projects often pay for themselves over time through energy savings, many projects go unrealized for lack of capital to cover the initial project cost. While some owners of homes, buildings and industrial facilities have cash on hand or a mortgage they can use to secure debt for retrofits, many are not in such a position. Innovative financing mechanisms have been created with loans that are repaid using cost savings. 5 The cost of this financing could be reduced—and the scale of its deployment expanded—through the creation of a secondary market for these loans.
Secondary markets for energy efficiency finance should be a shared priority for those who are seeking to make their facilities more efficient and investors who are looking for investment opportunities with attractive rates of return. Policy can help catalyze the development of these secondary markets by helping to overcome market failures and other barriers to energy efficiency and energy efficiency finance.
Secondary Markets for Energy Efficiency Loans: Opportunities and Challenges
By definition, secondary markets are markets where financial instruments are bought and sold. Even stock exchanges are secondary markets: After an initial public offering (IPO) of shares by a company to investors, investors can resell these shares on secondary markets (i.e., stock exchanges). Institutions that originate loans also use secondary markets as a way of generating capital for more loans at lower cost. For example, mortgage lenders might package and sell shares of their loans to investors on a secondary market in order to raise cash for future mortgage lending.
For nearly two decades, experts have discussed the value of secondary markets for energy efficiency loans. 6 Since individual energy efficiency loans are typically too small for institutional investors to consider for investment, many loans could be bundled together (as is done with credit card debt, home mortgages and car loans) and then securitized and sold to institutional investors. So far, there have been limited sales of energy efficiency securities, such as a single instance of securitization of energy savings performance contracts. 7 To bring the market to scale, two interrelated sets of barriers must be addressed.
The first set relates to the challenge of building sufficiently sized pools of energy efficiency loans. The creation of such pools is currently inhibited by the lack of uniform standards for energy efficiency loans, limited data on loan and project performance and an insufficient pipeline of projects to build rated, investment-grade pools of loans that exceed $100 million, a level many institutional investors observe as an investment threshold. 8
The second set of barriers relates primarily to the challenge of building a sufficient pipeline of projects (i.e., scale). These barriers are well documented and often cited. They include split incentives between landlords and tenants to invest in efficiency, utility disincentives to pursue energy efficiency, limited information for consumers and other challenges.
Policy can help address both of these barriers by overcoming the energy efficiency financing “chicken-or-egg” problem, in which the secondary market that could help to catalyze energy efficiency retrofits is not materializing due to a limited level of energy efficiency retrofit activity. 9 If greater scale was achieved through public policy, and secondary markets were established as a result, there could be a virtuous feedback cycle. That is, as secondary market financing opportunities become established, financing costs for energy retrofits should fall and thus drive more demand for such retrofits. 10
Smart policy can help to close the gap between energy efficiency investment potential and the largest investors in the world. In the United States those policies are numerous and are adopted at several levels of government: local, state and federal. However, the patchwork of policies has not yet had a sufficient impact on removing barriers and bringing the market to scale. In this policy landscape, which energy efficiency policies are most important to institutional investors?
Identifying Investors' Priorities for Energy Efficiency Policies
For the purposes of this report, 29 investors and energy efficiency experts gathered together in New York City in March 2013 to identify energy efficiency policy priorities from the perspective of institutional investors. Project participants were selected to represent a diverse cross sampling of energy efficiency financiers, institutional investors and policy experts.
Participants cited three key areas of policy—utility regulatory policies, demand-producing policies and finance policies—as those most needed to drive the energy efficiency investment opportunity.
First, investors noted the importance of leveling the playing field with utility regulations that would encourage utilities to pursue aggressive energy efficiency goals. To this end, legislators and Public Utility Commissions (PUCs) should eliminate disincentives that discourage utilities from investing in energy efficiency and move toward performance-based ratemaking. In addition, PUCs should support energy efficiency financing through equal treatment of efficiency loans with electricity sales and information sharing between financers and utilities. Such policies could include a backstop for energy efficiency loan programs (a “true-up” mechanism), which could help unlock institutional investment in energy efficiency by lowering the risk of investment.
Next, institutional investors expressed their support for a broad range of policies that drive demand for energy efficiency retrofits, including appliance and equipment efficiency standards, building codes and standards, and building energy disclosure requirements. These policies stimulate interest in energy efficiency projects and programs while also increasing the amount of information available to investors.
Finally, the participants stressed the importance of policies that enable innovative financing tools such as Property Assessed Clean Energy (PACE) and on-bill repayment (OBR). Policies that authorize municipalities and utilities to run these programs help overcome the initial cost barrier that many individuals and institutions face as they consider an energy efficiency retrofit. The policies also address the challenges of limited tenancy and ownership. Such programs are also of interest because they create secured loans that could be part of a securitized loan pool.
This paper finds that these three key areas of policy—utility regulatory policies, demand policies and finance policies—can together catalyze the development of secondary markets for energy efficiency retrofit loans and thus attract investment from institutional investors. As policymakers look to scale up energy efficiency it is the hope of this paper to provide an investment perspective. Policymakers will likely be happy to know that, as one participant in this project noted, “few of the policies discussed here require any public expenditures.”