According to the US Department of Energy, commercial buildings account for 35 percent of US (and 40 percent of global) electricity consumption. Existing commercial buildings on average spend 30 percent of their operating budgets on operating costs and account for close to 20 percent of all global carbon emissions.
Today, the majority of all commercial building owners and managers recognize that energy efficiency retrofits have the potential to yield substantial savings on operating costs, while reducing a building’s environmental footprint. However, considerable time and effort continues to be spent by industry specialists in the identification of the numerous barriers (rather than solutions) to accomplish retrofits on a large scale. Such barriers include, without limitation, lack of available capital, unproven returns on investment (or payback), split incentives between landlords and tenants, lack of technical expertise and continued trepidation from senior lenders.
None of these arguments are insurmountable, and substantial market forces are positioning sustainable/energy retrofits of commercial buildings to be the next big thing. While not intended to be an exclusive list, the drivers of this industry movement include the following:
1. New financial tools created by lenders, academics and entrepreneurs to facilitate underwriting the economic benefits of such retrofits will become mainstream, proving the value of retrofits and thus unleashing untapped capital to finance the requisite reconstruction projects. The University of California at Berkeley, the World Bank, Wells Fargo Bank, former President Clinton and New York Mayor Michael Bloomberg’s C40 planning group, Richard Branson’s Carbon War Room, green financier Ygrene, Lockheed Martin, IBM and Barclays Capital are just a few of the multi-national players leading the charge for viable solutions to the existing funding gap.
2. Existing financing structures will become more acceptable, each serving certain segments of the marketplace: (i) traditional debt (loans and bonds), (ii) shared savings with Energy Performance Contracts (EPC), (iii) Tax-Exempt Lease-Purchase Agreements, (iv) Capital Leases, (v) New Market Tax Credits, (vi) Lease or Bond Pools, (vii) On-Bill Financing, (viii) Tax Lien Financing/Property Assessed Clean Energy (PACE) bonds, (ix) Power Purchase Agreements and (x) Energy Efficient Mortgages.
3. Performance contracting will continue to be used as turn-key solutions for sustainable energy retrofit projects and assist in securing existing third-party financing. Under a typical performance contract, an energy service company (ESCO) assumes some portion of the risk over a retrofit project’s useful life by offering a guaranty of energy and operational cost savings and in certain instances bringing a lender to finance the work. Such a guaranty affords third-party lenders a financeable stream of positive cash flow (regardless of the actual performance of the retrofit) and reduces the overall risk of a borrower default.
4. Green leases and green tenant demands are on the rise, causing landlords to support these market demands through increased energy efficiency. The green lease structure, when drafted and negotiated properly, combined with the ability to measure energy consumption on an outlet-by-outlet basis, motivates tenants to reduce consumption of energy, to produce less waste, to reduce water usage, and to utilize environmentally friendly office furnishings and equipment. On the flip side, the landlords are incentivized to provide the capital outlay, on a pass-through basis, necessary for the requisite energy retrofits. Tenants ultimately incur the cost of the retrofits, but they also see the direct benefits in the lower operating expenditures.
5. According to the Rocky Mountain Institute and Johnson Controls, the ESCO industry was sized in 2011 at $4.1 billion and is currently growing at a rate of 26 percent per year. By 2020, Pike Research projects that the market for retrofits in commercial buildings will reach $152 billion worldwide.
6. In order to meet legislative greenhouse gas (carbon reduction) mandates at the federal, state and local levels, large-scale retrofit projects, in which combined technologies are utilized to optimize buildings as a whole system, will have to be utilized on a national basis. The Deep Energy Efficiency Pays (DEEP) program is one example of a proposed utility-based incentive that is applied on top of other existing rebates to push for whole building retrofits through reduced payback timelines for owners and investors.
7. Advancements in building automation technologies and the convergence of information technology and building data are forcing the commercial marketplace towards DEEP retrofits on a global basis. This collection of information and analysis of data in central databases affords building owners and operators the ability to not only track and identify where a building’s energy inefficiencies lie but also allows for the creation of specialized solutions when effectuating each applicable retrofit. Post-retrofit, these technologies monitor, adjust and synchronize a comprehensive infrastructure that reduces energy consumption on a real-time basis and interfaces with smart meters and smart grids.
8. In the United States, various federal agencies responding to President Obama’s commitment (i) to green the executive branch (requiring LEED Gold certification on all federal building projects) and (ii) in his Better Building Initiative (seeking, through tax incentives, to reduce energy consumption in commercial buildings by 20 percent, which equates to savings of over $40 billion per year), are creating and rolling out programs to incentivize building owners to engage in sustainable/energy retrofits.
9. One of the fastest-growing LEED rating systems over the past two years has been LEED for Existing Buildings Operating and Maintenance (LEED-EB: O&M). This quantifiable measurement and certification standard, and others, will continue to assist the marketplace in monetizing the value applied to sustainable/energy retrofits.
10. Performance disclosures, highlighted by new legislation in California that mandates the disclosure of building performance to all new tenants and buyers, will drive building owners to increase overall efficiency metrics of existing commercial buildings through retrofits.
In our view, while progress towards the goal of catalyzing large-scale energy retrofits in commercial buildings has been frustratingly slow for a variety of reasons, we believe that change is in the wind. New technologies facilitate assessment of energy usage at both macro and micro levels. A new take on traditional legal relationships will allow for the identification and alignment of interests between owners, tenants and their lenders to incentivize the commitment of capital to achieve energy efficiency. Moreover, tenants themselves will continue to take into account energy efficiency when deciding where to lease. While we are of the opinion that no one financing structure will predominate, we do believe that new underwriting technologies, taking into account energy consumption data captured and shared, will permit the rationalization of investment of capital to fund energy-efficient improvements. Combined with continuing government subsidies, these factors will together provide a powerful tailwind to push energy-efficient retrofits to the next level.
Michael C. Polentz is Co-Chair of the Real Estate & Land Use Practice Group at Manatt, Phelps & Phillips, LLP, located in the Palo Alto office. Clayton B. Gantz is a partner in the Real Estate & Land Use Practice Group at Manatt, Phelps & Phillips, LLP, located in the San Francisco office. They can be reached at email@example.com and firstname.lastname@example.org, respectively. This column is part of a series of articles by law firm Manatt, Phelps & Phillips, LLP’s Energy, Environment & Natural Resources practice. Earlier columns have discussed Demand-Response and Energy Efficiency Programs, California’s Cap and Trade Program, Demise of Redevelopment in California, What’s Next for the Renewable Power Industry and Renewable Energy Projects On Tribal Lands.