Breaking Through the Financing Hurdles for Buildings in Cities

Mark Fulton, Managing Director, Deutsche Bank Group – DB Climate Change Advisors

Transcript

Gordon Feller

Well, we figured having a couple trillion dollars worth of corporate assets on the podium would be a way to get your attention in the morning. But we also know that the nexus that is where energy systems and transportation systems meet in the city are only two parts of a nexus; that now we’re going to talk about the third part, which is a lot bigger than the transportation industry and that’s all the buildings in the world. That’s where energy efficiency makes itself abundantly significant for our discussion.

Some of you have heard Daniel Yergin’s new book which is out, “The Quest,” and the last chapter, Yergin makes a point – he understands the energy industry I think pretty well – which is that there’s one resource, there’s one energy resource, which probably has the potential to have the most profound impact on what we’re discussing today. It’s probably also the hardest one to wrap our heads around, and it’s energy efficiency.

We decided that rather than talk about buildings as systems, which frankly is very appealing to Cisco, or buildings as data repositories, or buildings as places where we maybe live, work, play and learn, we wanted to talk about the building and the retrofit and the energy efficiency challenge from the standpoint of the bank, the financier who really is the one that’s the critical missing ingredient. Because we have the technology, we know we have the will, but we may not yet have the financing solutions that are required to move us to an energy efficient future.

So with that, I’d like to introduce Mark Fulton to you, who’s traveled here from New York at Deutsche Bank and Mark, please join us and give us a picture of the energy efficient future from a banker’s standpoint.

Mark Fulton

Thank you very much. Well, it’s very nice to be here with you, and we are very proud to be a global sponsor of this meeting.

I work at Deutsche Bank climate change advisors, actually in the asset management division of the bank, but we work closely with all the other divisions. We felt very strongly that there’s a tremendous opportunity for investors in alternative energy, renewables, water, agriculture – so many of the sectors that are going to be impacted by climate change. It’s my role to write research which is available publicly on our web site and to advise our internal investment teams as to what they might be doing and also to look for opportunities. We very much look for the leading edge ideas about what’s not being done at the moment; how it might be done better.

Of course that brings us to energy efficiency, it brings us to buildings and it brings us to cities; there’s my logical reason for being here, because the buildings are mostly in the cities that we’re interested in. So this is why again, we think such gatherings are very important.

Energy efficiency was always the low hanging fruit, but it seems no one’s actually tall enough to actually reach it and the reason is actually probably financing. Because when we’re going to see this yet again in buildings, as I think so many of you know, that I think it’s simply a question of how do you finance an upfront payment from a long-run payment stream that can be risky and uncertain? Who’s going to do that and what are the different incentives for everyone to do it?

And when people just rolled up their sleeves years ago, they suddenly found how difficult that was, to everyone’s – you know, being upset about that. But now we are moving much closer to seeing the finance industry beginning to respond, because we think this is a financing issue. We don’t need regulators to come in and totally solve this by any means at all; that’s the good news. Because one of the other things that we feel very strongly about is that where we can find investment opportunities that are not dependent upon incentives, then this is very powerful. It’s going to be much more that the private sector, the investors, can really get on with it and get it done.

Essentially, what are we focusing on? Why is it important? Well, it’s important because what you can see is that – probably see it better than I can – the built environment is about 51% of energy demand in the United States, and that the operations section of the built environment is 39%, and within that, 17% is commercial. So we’re dealing with a very important – from a sustainability aspect, we’re dealing with a very important section of carbon emissions and efficiency.

Now the other thing to note is that buildings in America have been built quite a long time ago, 72% before 1989. And of course this data only goes up to 2003 but given the difficulties in building markets over the last decade we haven’t seen too much more capacity built. So we’re dealing with a fairly old and therefore reasonably inefficient sort of building stock.

How do we look at that building? Because when you invest the key is to segment the market and decide what is interesting and why it’s interesting. Obviously we’re dealing here with public buildings. We’re dealing with private buildings. Within that, the MUSH market as it’s called, the municipal, universities, schools and hospitals market, sometimes called the institutional market, is a very important market for building retrofits and for looking at efficiency. Within the commercial side, we’ve got office, industrial, we’ve got retail, sometimes lumped up into corporate. And then we’ve got this residential multi-family and finally, residential single family. We can then segment that into the size, the age, the energy cost, credit quality, geography, debt capacity and so on, which we’ll come to.

So you can really sort of segment this market and decide what needs what. Here again we pick up the first theme that we get involved in many different aspects of climate financing; the overwhelming thing is that generally, one size does not fit all. You really have to get down into the market, into the segment that you want to be interested in, and you have to adapt what you’ve got to do to that segment. So you can see that’s important.

What’s a retrofit? We call real estate the gating factor. Essentially we’ve got a bunch of capital, we’ve got people like us that would like to go out and make decent returns from investing in retrofit buildings. What about the technology? We’ve got technology that can be applied, and we’ll look at that. It’s local and regional experts exist; there are ecosystems around that we can tap into. Then in the real estate market we know that people would like to do real estate. And I’d go down to that final bullet point at the bottom: It can be driven by mandates; regulators can drive this. It can be because you’ve got old equipment and you’ve got to replace it, that’s a nice one. And then you can have a potential for returns of brand building within the building. These are the basic core drivers of why we think building owners would want to get involved in this, logically.

So what technologies? Again, the beauty of this: it’s not rocket science. I mean, you’ve got controls, you’ve got HVAC, you’ve got lighting, you’ve got the envelope, the building envelope as it’s called, the windows and so on. None of this is – you know, when you hear McKenzie’s talk about this, they’ll always say, “Wow, we love the energy efficiency sector. In particular we love the buildings, because the technology is ready to go.” We don’t need charging stations of the twenty-fifth century developed. We can get on with this stuff. It’s pretty low hanging fruit. And some of the window technology is interesting, but generally it’s fairly low hanging fruit. We know what we’re doing with that.

Can you make money out of it? This is the Empire State Building. We think it’s got an internal rate of return, which is what we in finance measure, these things by, a return of nearly 31%. These are really big IRRs. This is private equity style return. Just the retrofit of the Empire State showed you, wow, these returns are very good.

And this begs the question: if they’re so good, why isn’t everyone doing it? Because, okay, let’s get to it. They’ve had several options, building owners, in the past. They can do it off their own equity and off their own balance sheets. But that tends to be – not everyone’s, like the Empire State Building, got the money. There’s quite a lot of constraint there. They could take on debt at the company level, but again there’s often constraints about those companies increasing their leverage. Then they could take it on at the asset level. The problem there is you run, as we’ll talk about later, into mortgage covenants and the ability to leverage debt, and you’re going to see we return to this debt thing. Many, many times this is what we’re really trying to overcome: the leverage issue. And then you could maybe use rebate programs from utilities or subsidized capital sources from governments, but they’re never really going to be around forever, so you don’t want to base your business on that we don’t think. Or you could use these energy service companies, these ESCOs which I’ll come to. So those are sort of the basic options.

Now what is it that we’re trying to – what is the barrier? What are the problems? Well the first one is this classic split incentive. You’ve got the tenant and the landlord and if they’re not the same, there’s a split incentive. Why should I do this? What do I get out of it? That’s always been the classic. But I’ve got to tell you, the more that we’ve got involved in this it’s important, but I think the next two are important, the killer of the day. Because essentially, in so many markets, you can’t leverage the building and you can’t leverage the asset. You actually can’t get the debt or you don’t want to get the debt. And that’s why, you know we were talking last night to some people even in the public sector, which has the ability, in theory, to increase its leverage, no one really wants to, at the moment, increase their leverage very much. Debt is not a good word. So therefore, on that basis, there’s all sorts of buildings out there, public and private, they’re saying, “If only we could find a way of doing this that really didn’t increase our debt, got over our split incentives, and got over the first cost hurdle. I don’t want to put the money up. I don’t want to put it up.” Well, there is a way of doing all this.

Now the first way around it that’s been used up to now which is well known is the so-called ESCO service model, the energy services company. They generally need debt structures. These apply to buildings and often in the MUSH market. In the public markets they’ve been applied to buildings that could leverage their debt. They come in; they’re often the people that make the goods, that make the technologies that are going to go into the retrofit. So they come in, they can provide a performance guarantee that you’re going to get what you think you were going to get. They’re going to guarantee it for you and they’re going to put all the equipment in and they’re going to get paid for that. And they can get paid very handsomely for that which is no problem, but some building owners think that payment can be handsome. They’re not sure if the performance guarantees are as strong as they say they are and they’ve got to be able to leverage the building. So we’ve seen ESCO rollout, mostly public, but it seems to be that it won’t be applied to many, many buildings.

When, as we investors are saying, “Okay, we’ve got to get over this split incentive. We’ve got to get over the debt problems. We’ve got to get over the first cost.” Where are we going to go and look at this? Well, the first thing we’re going to have to do is to say that a residential multifamily and residential is just a little bit too complex for the structures we’re about to talk about. They may be doable, but we’re not going to go and put our pilot money into stuff that can be much more complex. So we’re going to concentrate on the public and private markets outside of the residential.

Then we’re going to filter it. We’re going to say, “Yeah, okay, we’ve got that public/private market.” We’re looking for buildings that don’t actually – have debt constraints on them because we think – or else they may go to the ESCOs. Then we’re going to say – obviously we’re looking for buildings with high energy costs because we’re going to get the greatest savings. We’d like large buildings because that gives us scale. We want them probably older because again there’s more energy savings. And we’d like them to good credit quality. And here I’ll come in and say the first really important point: the perfect building is the owner-occupied corporate headquarters, isn’t it? You know, I said to Cisco, “We’d like to do your building,” and they’d say, “Sure you would.” Because they’re not going to default on this; they’re just not going to default on us. They’re extremely low risk. So that sort of credit quality. So that’s our filter to look at this sort of market.

And that market’s pretty big. One estimate, you know, the private, owns real estate, $100B market. But in reality it could be trillions. You know, there’s lots and lots of different figures rolling around. I’m only talking about America, just talking about America and American cities in effect, and buildings. So the market is very, very large. That we do know.

Could the government solve it for us? Throw the money at it, budget constraints. Good luck getting this Congress to spend anything. So on the basis that that’s probably not going to happen, will local governments do? Yeah, they might spend a bit here and there, but they’re all, everyone’s constrained. So again, nice to get the money when you can, don’t base your business model on it for the very long-term.

We can have laws that give us – help what we call the financing mechanisms. Now I haven’t got time to go into the Property Assessed Clean Energy (PACE) program because I’m not here to talk about it. That’s again had another commercial launch recently. Good luck, we’d like to see how it goes, but there are uncertain impacts on the mortgage covenants from that so no one’s quite sure how that might work in the enabling legislation. When we get actually down to the residential level, unbilled tariffs and liens, but you need enabling legislations. Interesting, but we wouldn’t base our model on that.

What we think the government can do is provide what we call an enabling environment. The President just launched his Better Buildings Initiative. We’ve got the Department of Energy, really very useful, and in our longer presentation which will be on the food for thought, you’ll see there’s a whole page on the DOE’s performance database. Because one of the key things is, if you don’t know how the building is performing then you could really get your energy savings estimates wrong, and that’s going to be terrible for the investor and everyone else. And also, if you can get standardized ways of looking at it, that could be very useful and DOE’s really doing a lot of work on that and we think that’s very encouraging.

Again, that leads to this question about disclosure and benchmarking. What you could say is what we really need to do is to expose all the inefficient buildings. And once they were exposed in public, those owners might feel a little bit nervous and then people would start moving through buildings based on that information. At the moment the building, we’d be first to say the real estate industry is a little nervous about this and there’s some pushback. Will the regulators do it or could you go a voluntary way? And later I think in this agenda, the Chairman of our real estate business called RREEF will be giving a presentation as the head of Greenprint which are looking at voluntary ways of disclosure. But getting the data on the building is very important. And again there are these more state and local specific ideas like the New York City Energy Efficiency Corporation which we’re a supporter of in Deutsche Bank where again these are useful ways of getting access to buildings and getting data and getting partners for us to do this with.

So I’m going back to, for us, debt versus non-debt. We really like to look for people that can’t do the debt because we think we’ve got an answer for them. And therefore again, now we’re coming to our answer. We talked about the other three. Now we’re going to talk about – this is where it starts to get a little bit technical but stay with me, if you can – off balance sheet service agreements or managed energy service agreements (MESAs). We tend to use this MESA idea, that’s the terminology we tend to use. We think it will meet the needs of the owners and the investors and it’s a very interesting structure which I’m about to run you through now.

So before we do that, Jake Baker, who is sitting in the front, will be staying around – because I’ve got to head back at lunch – will be staying around the whole time and he’s the guy. I’m just the front man, you know. Jake did the work. It’s always the same way, isn’t it? But essentially Jake’s done the great work on this. He’s networked everybody. Go and see him if you’ve really got an interest in this.

He said to me, “Think about it as mineral rights.” Essentially, basically these buildings are like green field sites and they’ve got this great thing you can tap into, but they need someone to come in and look at how to do it and they need to work out who gets paid for doing that. I don’t want to actually make the Australian mineral right thing confuse you here because it’s a little bit more complex there, but anyway, that’s the general view.

So how does it really work? Well, it’s an energy service contract, in effect. Think of it like this: you’re going to contract out an energy service to somebody. So essentially it’s going to be like an energy efficiency PPA, we call it, purchasing power agreement. And what it allows the owner to do is the owner doesn’t have to put any upfront capital but they could in negotiation with the developer get some access fee or royalty payments for allowing these people, the developer, to come into the building. The tenant, it’s really neutral to them unless they can, as we say in the last bullet point or second last bullet point, arrange – could they get a bit of the savings, too? That’s really between the owner and the tenant but essentially for them they just get a better building and better place to live and work, and that’s what they would get out of it.

Now most importantly it’s off balance sheet. There is no debt. There is nothing associated with this structure onto the building at all. And that has been ruled by the four big accounting firms now have said yes, these structures are off balance sheet. That’s very important. The landlord could see the ability to pay a higher dividend, particularly if what you’re really doing is using this structure instead of actuallyñyou’ve got an old boiler. You were going to spend the money on the old boiler. Now you’re not going to spend anything, you’re just putting it out to a service agreement. So that can be very useful in that situation.

We don’t think – it doesn’t encumber a sale of a building. An owner can choose to terminate the contract through a buy-out if they want to change the structures or so on. The landlord gets what are called these operating improvements that can be capped up at sale. That means essentially it can affect the value at sale in a positive way. And of course as we said the tenant gets better performance, it could get some payment, and it could be that there are compliance laws that the owner has to do. So it can cover all of that.

So how does it work for investors like us? Well, we think it can give high cash yields over an eight to ten year period. We’re not going to exactly put that down, exactly what we think the numbers are, but we think they’re going to work. We think most importantly that we’ll address the key risks, which I’ll go into more, such as bankruptcy, counterparty risk, energy risk. And essentially what the investor is really being paid for is for being able to back the performance that it’s going to work and that they’re going to get their money from the energy savings. We think there are many ways to make sure that the whole structure doesn’t get defaulted on, and that’s really critical, and so it looks very interesting again.

This is the simplified version. The horrid version which I would be here all day talking about is in the chart pack, but essentially what it says is, “Look at this lock box.” What it basically says is, “I’ve got a property. I’ve got a utility. I’m going to estimate historical energy.” The key thing is I’m going to estimate the realized savings, realized savings over history and of course the key is for the investor to be sure that’s going to be big enough to pay the returns. And that goes into this retrofit transaction box which is what everyone accesses in terms of returns.

So in a sense, this MESA contract sits as the energy services contract between that retrofit group and the property owner. And that looks very easy; unfortunately in reality, it’s way more complex. But it’s a good start to show how it’s structured.

So what do we then do? What risk are we taking out? Well in terms of bankruptcy, I talked about it a bit earlier, and we can say that we’re taking out – if we choose the right building that will help us. We can essentially, the counterparty risk we can – the retrofit company can do very nasty things to the building, essentially, if it doesn’t pay. You don’t really want to do that so you want to pick buildings that aren’t going to default on you, but you’ve got the ability to get on top of it. You’ve got to take the performance risk but you can actually insure that out and you can either take the energy risk or pass it through.

So you know you’re really financing what we’d call receivables. That’s what you’re financing, in terms. It’s a stream of money. It’s not really asset secured. You’re really financing a contract around making sure they pay you. We think the default options are there, and we think that that is enough to make that not too heavy a risk. Therefore, we think the role for people like us – why do you need people like us? Because we think the project developers need large institutions to enter a new market that can raise capital and co-invest alongside them. So that’s why we think we’re needed; because it’s a new market and it’s not well established and the banks won’t lend against it. We’re talking about private equity. This is really an off balance sheet, equity structure that replaces the debt.

These were some of the questions; I just about got there, two minutes late, questions for the audience. I won’t take these now, and I’m actually going to disappear because I know I only had twenty minutes. What we said is we put some questions. Jake is here. I’m here. Any of you want to come and either help us answer those questions or ask other questions we’d be very happy to talk with you.

And this, by the way, this is being heavily discussed in the industry, so it’s not – this structure, there was a big conference on it earlier in the week and we think this is the one that could really emerge to unlock the retrofit market in the United States and indeed in other countries, and if that’s true, this is a really big breakthrough from the finance community, if we can pull this off. Because finally, we’ve grown tall enough to eat that low hanging fruit.

Thank you.

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