PACE: A Smart Way To Finance Retrofits For Energy Efficiency And Water Conservation

Tuesday, September 18, 2012 - 15:30

Suppose your company wishes to increase energy efficiency and reduce operating costs by retrofitting its existing properties. What if the retrofit costs could be paid without diverting funds from the company’s capital budget, impairing growth capital, reducing cash reserves or drawing on traditional credit sources? What if these costs could be financed through low-cost, long-term funding arrangements where the annual debt service payments are less than the annual savings actually derived from the retrofits? It may sound too good to be true, but all of this is possible under PACE – the Property Assessed Clean Energy program.

PACE is an innovative, common sense program that enables property owners to receive funding for energy efficiency retrofits and water conservation improvements.[1]  PACE financing is attractive because it enables property owners to avoid the high up-front cash outlays that are a common barrier to upgrades for energy-efficiency and water conservation. Because the payback period may range from five to 20 years, conventional lenders are often reluctant or unable to make long-term loans to finance the upgrades.

Several different models of PACE financing have evolved, ranging from private-sector owner-arranged financing to funding mechanisms utilizing government-issued bonds. In all cases, the key to PACE funding lies in the nature of the collateral – PACE funding is secured by special assessment liens voluntarily imposed on the property by its owner. In most cases, the liens are tantamount to, and have the same priority as, property tax liens.  For this reason, PACE loans are exceptionally safe investments for lenders and other investors. PACE loans also tend to be attractively priced for the borrower on account of their low-risk profile. Debt service payments on PACE loans are collected by local taxing authorities as a separate line item on the property tax bill and are then remitted to the holders of the PACE loans.

PACE financing transfers with any sale of the property so that future owners assume the payments while continuing to receive the benefit of the positive cash flow derived from the energy cost savings. As a general rule, the consent of the holder of any first mortgage lien on the property will be required before applications for PACE financing are approved and assessments imposed on the property. 

PACE programs exist by virtue of special enabling legislation at the state level. The first PACE program originated in California in 2007 and was successfully implemented, primarily with respect to residential property.[2] As of this writing, almost 30 states and the District of Columbia have adopted some form of PACE legislation.[3] But the statutory framework for structuring and administering PACE programs varies widely from state to state. A common thread in all PACE legislation involves authorization of special assessment districts to be created at the local level for the purpose of financing energy-efficiency improvements. The legislation generally provides that local governments may prescribe the types of energy-efficiency improvements that qualify for PACE financing as well as underwriting standards for the financing program.

PACE was initially conceived as a mechanism for financing energy-efficiency retrofits for residential property. But there is a strong and growing business case for investments in commercial and industrial building retrofits. As a result, PACE programs for commercial and industrial properties are the current driving forces for the nationwide growth of PACE.[4]  Studies by several agencies, including the EPA, consistently show that energy consumption by existing commercial and industrial buildings can be reduced by 25 to 40 percent through a variety of retrofits.  Moreover, many types of retrofits can provide attractive returns on investment with relatively modest payback periods.

In the industrial sector alone, there are numerous opportunities for achieving greater energy efficiency. For example, the industrial sector in Texas accounts for 19 percent of total industrial electricity consumption in the United States. In Texas, industries such as refining, petrochemical, cement, steel and manufacturing consume significant amounts of energy and could enjoy substantial economic benefits from energy efficiency retrofits. Energy efficiency is important not only from the standpoint of savings in consumption costs but also with regard to its impact on the demand side of energy availability. 

Maintaining reliable energy sources is critical to continued industrial growth. Due to a variety of market and regulatory constraints, there is little likelihood of significantly increasing electrical production capacity in Texas in the near term. Therefore, reducing demand for energy supplies is a critical component of meeting ever-increasing energy needs. By facilitating energy-efficiency retrofits, PACE financing helps drive down the demand side of resource availability. As Tripp Doggett, CEO of the Electric Reliability Council of Texas (ERCOT), recently noted,

To ensure future electric reliability in the ERCOT region, we need to take immediate steps to address this issue – on both the supply side and the demand side of the resource adequacy equation. For now, energy use – or “load” – will play a significant role in the near-term reliability equation.

PACE has the potential to dramatically accelerate the energy-efficiency retrofit market for commercial buildings. Examples of eligible commercial properties include (but are not limited to) office buildings, shopping malls, hotels, restaurants, condominiums and apartment complexes. Unlike conventional financing arrangements, the repayment period under the PACE program is frequently tied to the expected useful life of the improvements.  In many cases, the repayment period for PACE financing may extend for up to 20 years.  The extended term of PACE financing, coupled with the program’s requirement for annual energy cost savings to exceed the total amount of the annual assessment payments, means that retrofits financed under PACE will generate positive cash flows from the outset. In addition, PACE financing removes the “split-incentive” barrier in buildings with net lease agreements because property taxes generally qualify as a pass-through expense to tenants.[5]  Thus, tenants will reap the benefits of lower utility costs while also paying their allocable share of the assessment costs tied to the upgrades.

The PACE program is a smart way for owners of commercial and industrial properties to finance retrofits for energy efficiency and water conservation for a number of reasons, including the following:

  • One hundred percent of the retrofit cost can be financed without utilizing the owner’s credit sources or investment capital for ongoing business operations.
  • There is no additional mortgage debt on the property.
  • The PACE loan is secured by the assessment lien on the property and does not affect the borrower’s credit.
  • The PACE structure results in positive cash flow immediately since the annual energy cost savings will more than offset the annual assessment costs.
  • For multi-tenant investment properties, assessment costs (and associated savings) can be passed through to tenants under existing leases in most cases.
  • Ownership turnover is irrelevant because PACE financing follows title to the property. Future owners of the property assume the remaining PACE assessment payments while benefiting from the cost savings realized from the energy-efficiency upgrades.
  • By avoiding building obsolescence, retrofits financed under the PACE program help preserve the value of the property.
  • In addition to the contractor’s guarantee of the energy savings that will result from the retrofit work, the property owner can obtain energy savings insurance to cover any shortfall in energy cost savings below projected levels.

Yes, PACE may sound too good to be true, yet the approach is real and the word is spreading. In addition to the numerous benefits of PACE financing for commercial and industrial property owners, retrofits financed through the PACE program will produce significant energy savings in the future.

[1] A retrofit involves replacement or upgrade of old building systems with new energy saving and/or renewable energy technology and processes.

[2] PACE was initially conceived as a mechanism for financing energy efficiency retrofits to residential property. In the summer of 2010, Fannie Mae, Freddie Mac and the Federal Housing Finance Agency (“FHFA”) moved to quash residential PACE programs. Specifically, FHFA (which was created in 2008 to regulate Fannie Mae and Freddie Mac) believes that PACE creates unacceptable risk for its regulated entities and has issued policies that prohibit Fannie and Freddie from underwriting mortgage loans on residential property with PACE loans. FHFA’s actions with respect to residential PACE programs have been widely criticized and challenged in several ongoing judicial proceedings, and federal legislation has been introduced that would override FHFA’s policy position. A discussion of these challenges is beyond the scope of this article, but suffice it to say that FHFA’s opposition to residential PACE programs had a chilling effect on all PACE programs.

[3] TEXAS ISSUES: Texas (where the authors reside and practice law) enacted PACE legislation in 2009, but the statutory framework failed to satisfy certain Texas constitutional requirements for imposition of the PACE assessment lien. As a result, property owners in Texas cannot participate in the PACE program unless and until the legislature amends the existing statute. The authors are actively involved in efforts to advocate for passage of such an amendment during the 2013 legislative session. Information about these efforts, as well as links to various resource materials regarding the PACE program in general, can be found at the website for Keeping PACE in Texas: www.KeepingPACEinTexas.org.

[4] According to the U.S. Energy Information Administration, commercial and industrial buildings account for at least 50 percent of total U.S. energy consumption and 75 percent of all electricity consumption. Reliable sources estimate that the volume of commercial building retrofits may grow to $15-18 billion per year by 2014, up from $3 billion in 2009. Thus, there is a huge potential market for energy efficiency retrofits financed through the PACE program.

[5] The “split incentive” is an issue hindering investment in capital improvements to multi-tenant buildings. For equipment upgrades that provide a return on investment through energy savings, there is a “split incentive” between the landlord and its tenants. The landlord often has little to no ability to recover the capital investment in energy-efficiency retrofits. Although individual tenants would enjoy the benefit of the investment through lower occupancy costs, they are unlikely to contribute to the cost of capital investments that benefit multiple other tenants and whose payback may extend beyond the remaining terms of their leases.

Stephen M. Block is a Partner in the Houston office of Thompson & Knight, where he represents clients in a broad range of real estate and related transactions. James C. Morriss III is Thompson & Knight’s Austin Office Leader and the firm-wide Environmental Law Practice Leader, representing clients in environmental matters. Both are actively involved in the Keeping PACE in Texas efforts.  For more information, please visit www.KeepingPACEinTexas.org.

Please email the authors at stephen.block@tklaw.com. or james.morriss@tklaw.com with questions about this article.