Capturing BIG Energy Savings with Small Upfront Costs
By Grant Faber, SEMREO Intern and UM Student
Saving energy and generating renewable energy can be very expensive. Everybody knows these projects pay off over the long run, but high upfront costs act as a barrier. It usually costs more to buy energy-efficient equipment than more conventional choices (for example, LED lights are more expensive than traditional incandescents). Likewise, generating renewable energy, such as solar PV, on-site costs a lot to buy and install. Public agencies and nonprofits often find themselves at an additional disadvantage when pursuing energy efficiency or renewable energy projects because they cannot take advantage of tax credits and depreciation write-offs that can greatly enhance the project’s financial returns. 3rd party ownership of projects is an amazing tool for financing renewable energy projects for such entities. For municipalities, these deals involve a 3rd party – one who can either own or sell off the tax benefits from renewable energy projects – purchasing and owning a project on municipal property.
For example, if a tax-equity investor pays to install solar PV equipment on a municipal building, that same tax year they can deduct 30% of the capital expense from their federal taxes because of the solar Investment Tax Credit (ITC). In addition, they can reduce their taxable income by claiming 20% accelerated depreciation in that first year and another 32% in the next year. In short, by the end of the second year after installation, the investor has already recovered much of the capital they invested in the system. These financial benefits are not available to a tax-exempt entity, like a municipality, if it owns the same solar PV system as they have no tax bill to reduce.
In some cases, ownership will “flip” back to the municipality after the 3rd party has earned a predetermined return (an ownership flip), whereas in other cases the 3rd party will own the project for its lifetime and sell any energy produced (or pass on energy savings from efficiency upgrades) to the municipality for an agreed-upon price (power purchase agreement). For energy efficiency projects in particular, energy service contractors (ESCOs) can install an energy efficiency upgrade in exchange for a substantial portion of the energy savings that result from the upgrade. One of the main benefits associated with 3rd party ownership, besides low-to-no upfront costs, is that the host’s savings can exceed fees paid to the 3rd party, making projects cash flow positive from the beginning. Such arrangements can be very attractive for hosts who desire renewable energy but cannot afford to lay out large upfront payments often associated with renewable energy and energy efficiency projects.
With ownership flips, the investor/developer provides the upfront investment for the renewable energy project in exchange for the tax benefits – from depreciation of the renewable energy system and initial Federal tax credits – and a small amount of the project’s cash flow after the flip date. Before the flip date, the investor will effectively gain all of the energy savings from the project as well (the host will pay to the investor what they would have been paying to their utility otherwise). Once the project is paid off from the tax benefits and initial payments and the investor receives a predetermined return, ownership of the project will flip to the host/sponsor, which in this case would be a municipality. Ownership flips can be very powerful tools for reducing costs of renewable energy projects as they monetize tax benefits that municipalities would not otherwise collect.
This description is simplified, however, as it does not take into account the insurance, operations, and maintenance costs that the host assumes after gaining ownership of the project, nor does it take into account the small portion of savings reaped by the host before the flip date. It also does not take into account the buyout price that the host may have to pay to the investor in the year where ownership flips. This is simply a general overview of the structure of energy savings and commercial ownership in ownership flips.
Power Purchase Agreements (PPAs)
With PPAs, municipal hosts agree to purchase energy at predetermined prices from a renewable energy project installed on their property and owned by a commercial 3rd party. The PPA contracts will specify the rates at which the owner will sell the municipality energy from the project; these rates can be constant or increasing slightly over time. These rates are also expected to be lower than the electricity rates charged by the utility, leading to hefty savings as utility-provided electricity becomes much more expensive but the municipality’s bill remains steady and predictable.
The owner of the system is responsible for insurance, operations, and maintenance expenses throughout the life of the project, meaning that the developer/investor will pay these costs with a PPA. At the end of the contract, the host can choose to extend the agreement, buy the system outright, or have the owner remove the system. Often, the total value of PPA structures can be lower than that of ownership flips. This is due to the fact that the municipality is still paying the owner of the system for the electricity, as opposed to owning the system after the flip date in an ownership flip model, where there would be no cost for the electricity (besides insurance, operations, and maintenance). However, PPAs are often simpler to execute, may entail lower legal and accounting fees, and allow the municipality to avoid paying for and coordinating insurance, operations, and maintenance, making them more attractive in some situations.
As an illustration, imagine a Michigan municipality has a solar developer install a 1 MW solar PV system on their property (over a brownfield, for example) in exchange for selling the municipality electricity for 25 years at a locked-in, contracted rate of $.15/kWh (assume this is slightly higher than the current price of electricity). With an average of about 4 hours of peak sunlight per day and an 80% performance standard, this system will produce about 1,168,000 kWh/year, for which the municipality will pay about $175,000 every year for the next 25 years (not considering discounting, for simplicity). If the municipality continues to simply purchase electricity from the utility, then they will end up paying far more each year as electricity prices rise. If the utility-supplied electricity prices increase at about 6% per year (as they have with DTE for the past 10 years), then the municipality would be paying $.52/kWh by the 25th year, or about $600,000, for the same amount of energy. The municipality sees larger and larger savings as time goes on with the PPA, and they also gain other benefits of using renewable energy, including meeting environmental policy objectives, having a green image, reliability, resiliency, and leading by example.
Energy Savings Contractors (ESCOs)
ESCOs are often used for energy efficiency upgrades in municipal buildings. ESCO companies will perform these upgrades for no cost upfront in exchange for a hefty portion of the energy bill savings that arise over time. These are considered 3rd party ownership as the ESCO will own the energy upgrade (even if it is inside, or built into, the government building) until it is paid off.
The main strengths of this kind of 3rd party ownership are outsourcing energy projects to technical experts who have experience with energy efficiency, having the ESCOs take responsibility for the risk and financing of the projects, and having no capital outlay. The main pitfalls of such models include severely reduced cash flows from having to pass savings onto ESCOs, legal and administrative fees for contracts, complex contracts with hidden pitfalls, no guarantee of savings, and poorly designed or unreasonable measurement and verification (of reduced energy usage) costs.
3rd party ownership is a very powerful financing mechanism, particularly for entities that cannot collect tax benefits from renewable energy project deals. However, these structures generally require legal expertise and financial due diligence, which can be costly and require experienced staff.
SEMREO is developing a program that will advise municipalities on ESCO deals and can generally advise municipalities on renewable energy projects. If your municipality is interested, please email Executive Director Rick Bunch at firstname.lastname@example.org.