Financing an RHC Project
Financing is the act of providing funds for the development of a project. How you will finance or pay for a project is one of several issues you can expect to face when evaluating renewable heating and cooling project opportunities. Project development involves risk. Project financing structures help to address barriers by assigning project risk to those stakeholders who are most able to handle the risk. How you deal with project risk can make the difference in whether a project is financeable or not.
Common project development barriers and risks include:
- Capital availability or access
- Capital cost
- Credit risk
- Performance risk
- Operational risk
- Resource availability or fuel price risk
- Technology risk
Successful financing requires detailed knowledge of federal tax credits, state-level incentives, renewable attribute markets, renewable technology installation and operation costs, and many other site-specific considerations. Your choice in financing structure may vary depending on who you are—i.e., a federal agency, state or local government, investor-owned or municipal utility, commercial business, or homeowner.
When evaluating different financing structures, it is important to keep in mind the following questions:
- How long do you want to use the equipment?
- What is your tax situation?
- What is your cash flow situation?
- What do you intend to do with the equipment when you are done using it?
- Are you creditworthy?
The basic premise of project finance is that an owner, lender, or investor will evaluate a project opportunity based on its risk and future cash flow potential. Different financing structures address common project development barriers, such as upfront cost, while distributing project risk to those stakeholders who are most able to handle the risk.
There are several common financing models used to develop renewable energy projects. Some of these models are common to RHC projects, while others are emerging. These financing models include:
- Cash (equity) financing
- Debt financing
- Operating leases
- Capital leases
- Energy performance contracts (guaranteed savings model)
- Energy performance contracts (shared savings model)
- Energy purchase contracts
Cash (equity) financing is the simplest and most straightforward approach to project development. Under this model, an individual or organization uses its own cash resources to invest in a project or seeks an equity investor to share in the project’s investment and ownership. Consequently, the project owner(s) assumes all the related risks, but also receives all the benefits coming from the project.
This financing option requires that the project owners assume both the performance risk and maintenance costs over the life of the project. The owner of the project can take advantage of available tax credits, as well as the allowable depreciation expense. A challenge of this model is that the capital required for the project’s development must compete with other capital investment opportunities.
Debt financing involves taking on debt to pay for the development of a project. The debt is often in the form of a loan or bond, which the borrower pays back or “services” over the life of the loan. Debt financing is available to individuals and commercial entities for developing projects. This financing approach is often desirable when a borrower does not have enough cash to cover the upfront cost of the project investment. Commercial borrowers can often deduct the loan interest and the allowable depreciation expense.
A potential drawback of this approach is that the cost of capital is not always as favorable when compared with cash or equity investments. Another possible disadvantage is that the commercial borrower must reflect the debt on their balance sheet. Debt financing can in many cases take longer to secure than other options, as the creditworthiness of the borrower and the risks of the project can take time to evaluate.
Operating leases are used in situations where the lessee (project host) does not wish to use their own equity in a project investment. Instead, a commercial lender owns the equipment, and the project host (the lessee) pays the lender (the lessor) lease payments for use of the equipment. Consequently, the lessee does not take on the risk or receive any of the benefits of project ownership.
Although the present value of all operating lease payments under this approach is less than the actual price of the asset, the overall cost over the lease can be more expensive to the lessee than standard debt financing. The lease term also must be less than 75 percent of the actual useful economic life of the project asset. Under an operating lease, the lessee can have the option to either buy the project at fair market value or return the equipment. The lessee is also responsible for maintenance costs associated with the project’s operation during the lease term. Benefits of an operating lease include no upfront capital investment cost to the lessee as well as the ability to generate or free up cash flow for the owner. This model also allows the lessee to recognize lease payments as a commercial operating expense.
Capital leases are another financing structure where the lessee (project host) assumes some of the risks of project ownership and in turn enjoys some of the benefits. The project host (lessee) chooses the project asset and pays the commercial lender (the lessor) a series of lease payments for use of the asset. As a result, a capital lease offers the project host (the lessee) substantively many of the risks and benefits of project ownership.
Capital leases must cover more than 75 percent of the actual useful life of the project, resulting in the net present value of all lease payments being nearly equal to the actual price of the asset. Project assets under a capital lease are recognized as both an asset and liability (for the lease payments) on the project host’s balance sheet. At the end of the lease term, the lessee has several options available, including a choice of purchasing the equipment outright, returning the equipment to the lessor, or extending the term of the lease and continuing to make payments. Capital leases often include a buyout option where the lessee can purchase the project at the end of the lease term at predetermined bargain purchase price (e.g., $1) or at a price less than fair market value.
Energy performance contracts (guaranteed savings model) are commercial financing arrangements where the customer contracts with an energy service company (ESCO) to design, develop, and operate a project. Guaranteed savings contracts are based on the amount of energy saved. As such, the value of the energy saved must be sufficient to service the debt obligation over the financing term. Because the ESCO assumes the design and performance risk, it generally does not also carry the credit risk of the customer. Instead, a lender finances the project directly with the customer based on an evaluation of the customer’s creditworthiness. The customer in turn must repay the loan directly to the lender.
If the savings generated by the project prove to be insufficient to cover the loan payments, the ESCO is responsible, by contract, for making up the difference. If the savings are greater than the debt service, the customer usually pays a fixed percentage of the savings to the ESCO. Most guaranteed savings contracts also include a provision that the savings guarantee is only good so long as energy prices do not drop below a certain level, which helps ensure that neither party benefits from energy price changes. A possible drawback for some organizations is that a guaranteed savings arrangement requires that the customer reflect the financing or debt on their balance sheet.
Energy performance contracts (shared savings model) are another type of commercial financing arrangement where the customer contracts with an ESCO to develop a project. The shared savings performance guarantee is based on the cost of energy saved as opposed to the amount of energy saved. Unlike the guaranteed savings model, the customer assumes some of the performance risk of the project in exchange for not assuming the financing or credit risk.
Under this scenario, the ESCO collateralizes the loan with anticipated savings payments from the customer, based on its share of energy cost savings. This model is particularly useful for customers that do not have adequate access to financing or for customers who do not wish to reflect the financing debt on their balance sheet. To address potential changes in energy prices, it is common for the ESCO and customer to agree contractually on the value of the service upfront, setting a single energy price. Shared savings agreements tend to favor projects that provide the shortest payback period.
Energy purchase contracts allow customers to purchase energy from a third-party developer of a project. The customer pays for each unit of energy used. The energy purchase agreement typically relieves the customer of the responsibility for structuring and managing project development, construction, operations and maintenance, and decommissioning. This model is particularly advantageous for customers who have no tax liability and cannot take advantage of available tax incentives.
Under this type of agreement, the third-party project developer is the owner of the project and passes through any available tax incentives to the project investors in exchange for upfront capital to build the project. The customer will lease a space on their property and provide access to the project during its operation so that the third-party developer can ensure the project’s performance. Generally, energy purchase contracts will include provisions for different situations including a customer buyout option, decommissioning, and failure to deliver the contracted energy.
- Read EPA publications with more information about energy purchase contracts and ESCOs.
- Read the Guide to Federal Financing for Energy Efficiency and Clean Energy Deployment (pdf)).
- Visit the RHC Webinars page to watch an EPA webinar about project financing.
- Visit EPA’s Financial Incentives for RHC page to learn more about tax credits and other incentives for installing renewable heating and cooling systems.