MESAandothercommericalfinancetools

Sustainability Roundtable Inc.

Innovative Energy Efficiency Financing Approaches

James F. Boyle, JD Steven M. Byler, MBA, LEED AP

Roger M. Freeman, JD Harry M. Ostrander, MBA, MUP, LEED AP

Kristian A. Peterson, MSRED, LEED Green Associate

© 2009 Sustainability Roundtable, Inc. 169

CHAPTER 5: INNOVATIVE ENERGY EFFICIENCY

FINANCING APPROACHES

TABLE OF CONTENTS

CHAPTER SUMMARY 171

BACKGROUND 172

FINANCING MODELS 173

1. Managed Energy Services Agreement (MESA) Explained 173 1.1. IMPLEMENTING MESA 174

1.2. THE STRUCTURE OF MESA 175

1.3. UNDERSTANDING A MESA PAYMENT 175

1.4. ROLES AND RESPONSIBILITIES 177

The following briefly outlines the individual roles and responsibilities in a MESA contract: 177

1.4.1 Transcend Equity 177

1.4.2 Transaction LLC 177

1.4.3 Landlord/Owner 177

1.4.4 Tenant 177

2. Property Assessed Clean Energy (PACE) Financing Explained 178

3. On-Bill Financing Explained 179

4. EqRM "Energy Savings Generator" Model Explained 180 4.1. Energy Savings Generator 180

LIST OF FIGURES

FIGURE 1: MESA STRUCTURE DIAGRAM 176


INNOVATIVE ENERGY EFFICIENCY F I N A N C I N G A P P R O A C H E S

Chapter Summary

Energy Performance Contracting (EPC) has continued to attract attention as a potential means for

Directors of Corporate Real Estate (DREs) and Portfolio Managers (PMs)1 to improve energy

efficiency; reduce operating costs; and address growing public demand for more sustainable

facilities. Energy Performance Contracting has been utilized extensively in the government and

institutional sectors for years, but there has been significantly less penetration in the Corporate Real

Estate sector due to structural and financial barriers. While some of the larger Members of the

Sustainable Corporate Real Estate Roundtable (SCRER) are aggressively exploring ways to leverage

EPC to reduce operating costs and improve energy and environmental performance, others are just

getting up to speed on the mechanics of EPC.

The chapter on Energy Performance Contracting in the first Sustainability Roundtable, Inc. (SR Inc.)

report of 2009, SCRER 2009 Management Best Practices I (MBP I), presented an introduction and

discussed the following topics:

I) A review of EPC as a business model, a discussion of the parties involved, and the roles

each party plays.

II) A discussion of a joint effort by the Building Owners and Managers Association (BOMA)

and the Clinton Climate Initiative to provide a model EPC to streamline the process for

project design and execution in the commercial office sector; and

III) A discussion of some of the challenges for EPC in gaining more penetration into the

Corporate Real Estate sector, including financing strategies.

This chapter provides a re-cap of the findings of the Energy Performance Contracting chapter from MBP

I and provides a few examples of innovative, emerging financing models including Managed Energy

Service Agreement (MESA), municipal energy financing, on-bill financing, and Equilibrium

Resource Management Corporation's (EqRM) "Energy Savings Generator". These models are

seeking to overcome the challenges of conducting performance contracting in the Corporate Real

Estate sector.

As discussed in the introduction to the report, SCRER Member executives are both leading corporate real estate executives and institutional investors and advisors. This chapter classifies executives from Corporate Real Estate as Directors of Corporate Real Estate (DRE) who oversee both owned and leased real estate portfolios and uses the term Portfolio Manager (PM) in reference to executives responsible for managing portfolios for institutional investors and advisors.


Background

If Energy Performance Contracting is to proliferate and become a management best practice for

Corporate Real Estate portfolio management, then the existing barriers must be identified and

addressed through innovative strategies and transaction structures. This chapter briefly re-caps the

findings of the Energy Performance Contracting chapter of the MBP I report. The chapter then presents

some potential solutions to the challenges presented by the EPC business model for the Corporate

Real Estate sector.

i. Energy Performance Contracting Summary

Energy Performance Contracting (EPC) refers to a business model for improving the economic,

energy and environmental performance of buildings by installation of Energy Conservation

Measures (ECMs) and related improvements where the operational savings generated are sufficient

to cover their installed cost. Typically, an Energy Service Company (ESCO) will work closely with a

building owner from project conception through implementation.2 The ESCO acts as the general

contractor and will install a set of ECMs that will reduce energy consumption and costs. A typical

Energy Performance Contract could include some or all of the following measures:

• Lighting retrofits to install more energy efficient bulbs & fixtures3

• Replacement of boilers and/or installation of controls

• Installation/upgrade of an energy management system4

• Replacement of insulation and windows

• Installation of flow restriction devices to conserve water

• Installation of a distributed energy system

One key to Energy Performance Contracting is that the ESCO guaranties the performance of the

ECMs to ensure that savings are sufficient to cover the cost of financing the ECMs. The investment

capital to pay for the ECMs can come from the host facility or from financing provided either by the

ESCO or a third party financial institution. In nearly all cases, the projects are designed so that the

resulting cost savings are sufficient to meet the return requirements of the owner and the financing

entity.

While some owners have the internal staff capability to plan and execute an energy performance plan, this report is focused on instances where an energy performance contractor is necessary.

3 Available Lighting & Sensors Research from SR Inc.: Chapter 3 of SCRER 2009 Management Best Practices I covers Lighting & Sensors and provides baseline understanding of what other Members are doing in their portfolios. Chapter 3 of this report provides additional information on lighting retrofits and provides a process to manage a lighting retrofit program. The information in both chapters provides insight into what peers are doing in lighting and can provide Members with a lighting retrofit benchmark.

4 Available Energy Management Strategies Research from SR Inc.: Chapter 1 of SCRER 2009 Management Best Practices I covers Energy Management Strategies and discusses what some Members of the SCRER are doing to reduce their energy costs. Chapter 1 of this report goes into further detail about managing energy strategically across a portfolio.


ii. Energy Performance Contracting Challenges

For many building owners, internal capital is simply not available to pay for energy efficiency

projects. For a Director of Corporate Real Estate (DRE), competing demands for capital may take

precedence, or the projected internal rates of return of energy efficiency projects may not satisfy

corporate capital hurdle rate requirements, except for the highest-value energy conservation

improvements. For a Portfolio Manager (PM), capital may be limited or prioritized toward common

space improvements, tenant services or other uses that enhance marketability. In addition to scarcity

of capital, there are collateral security issues that make financing energy performance challenging.

Other significant challenges include structural issues such as: investment managers' recalcitrance to

enter complex multi-year agreements that could be perceived to affect transferability; misalignment

of owner and tenant incentives and utility metering and billing rules. These challenges were

described in more detail in SCRER 2009 Management Best Practices I which Members can access in

the SR Inc. Digital Library.

Financing Models

There is significant value in potential energy savings within existing buildings that has not been

realized due to the challenges discussed above. In response, a number of companies are offering

solutions that seek to address the challenges in new, innovative ways. These companies are seeking

to enable a form of Energy Performance Contracting in the Corporate Real Estate sector. This

chapter profiles one model of innovation in energy performance contracting finance, in particular —

the MESA - and briefly summarizes other models including: Property Assessed Clean Energy as

well as municipal financing, on-bill financing, and a new financial model from a company named

Equilibrium Resource Management Corporation (EqRM). These are illustrative of the innovation

that is currently underway in energy efficiency financing. Whether one or more of these models will

emerge as a Management Best Practice for financing Energy Performance Contracting remains to be

seen, but the trend lines are pointing toward success. An additional but important point to note is

the continued development and expansion of state and rate payer funded initiatives to facilitate

energy efficiency projects. For example, SCRER Member National Grid is part of a coalition of

Massachusetts-based utilities that has recently filed a three year plan for supporting energy efficiency

with the Massachusetts Department of Public Utilities that will commit $1.8 billion to energy

efficiency and generate net savings of more than $4 billion over the next three years.

1. Managed Energy Services Agreement (MESA) Explained

One response in the private sector to the challenges of Energy Performance Contracting in

commercial real estate is the Managed Energy Services Agreement (MESA) created in 2001 by

Transcend Equity.5 In a typical EPC the landlord is ultimately responsible for financing for the

energy efficiency project and the ESCO performing the work guarantees the energy savings from

For more information please see http://www.transcended.com


http://www.transcended.com

the project for a specified period of time. A MESA contract, however, is a unique method of

implementing energy related building improvement with no owner capital commitment and without

increasing property operating expenses. The following are three defining characteristics of a

Managed Energy Services Agreement:

• MESA increases property yield without increases to operating expense

• MESA does not use cost recoveries because it is not a capital expense

• MESA provides a landlord 100% of the project benefit with very littie risk

The primary objective of a MESA contract is to remain expense neutral for energy efficiency

improvement projects. There is no capital expense to the landlord and no debt or lien placed on the

property. Since there is generally no increase in operating expenses the project is also cost neutral to

the tenant. The MESA remains cost neutral because it simply replaces the energy expense in the

building operating financials.

1.1. I M P L E M E N T I N G M E S A

A MESA contract is a services agreement that replaces electricity and natural gas utilities. This report

highlights a MESA contract developed by Transcend Equity. The service provider, in this case

Transcend Equity, is responsible for making utility payments on behalf of the landlord. The landlord

pays to the service provider a MESA payment which is set to equal a baseline energy use, roughly

equivalent to the historical utility use expense. The service provider takes on the risk of creating

energy savings at the property greater than the historical baseline. The landlord benefits because the

MESA payment simply replaces the utility payment in the operating budget with no net increase.

These energy savings created at the property are the payment to fund the energy efficiency project.

A MESA contract works well for many private sector office portfolio owners, including institutional

investors and Real Estate Investment Trusts. One notable user is the Corporate Office Property

Trust REIT who has used MESA on 24 buildings. Many institutional investors are also using MESA,

one of which has contracted to do a building in Chicago. The minimum requirement to engage in a

MESA contract with Transcend is for a landlord to operate a multi-tenant commercial office

portfolio with minimum aggregate square footage of 250,000. According to Transcend, the steps of

the engagement process are as follows:

1. General inquiry on property suitability

2. Discover Meeting

3. Data analysis

4. Project Development Agreement (PDA)

5. Execute MESA

During the initial contact with Transcend a general inquiry of property characteristics may determine

if MESA is right for the landlord. If a MESA contract is determined to meet the needs of the

landlord, which may include L E E D ® for Existing Buildings: Operation and Maintenance

certification and/or ENERGY STAR® labeled building, both parties move forward to a Discover


Meeting. In the Discover Meeting greater detail is discussed and information is provided to

Transcend to run an analysis to determine the candidacy of particular buildings. Once it is

determined the project should move forward, a Project Development Agreement (PDA) is executed.

The PDA step of the engagement process establishes the Savings Potential used to fund the project.

The Savings Potential is based upon the historical energy use of the building. For example, if the

historical utility cost for the building was $1.0 MM annually and it was determined that 15% saving

was achievable, the utility payment would be equal to $850,000 and the Savings Potential would be

$150,000. The landlord would only be obligated to pay Transcend $1.0 MM annually as a MESA

payment. Transcend would pledge a portion of the Savings Potential ($150,000) to the lender entity

and these savings would be factored to provide upfront capital to fund the energy efficiency project

construction.

1.2. T H E S T R U C T U R E O F M E S A

As mentioned above, a MESA contract is a services agreement that replaces the utility expense. The

landlord commits to pay the MESA invoice to Transcend each month, which is roughly equal to

historical energy expense but may be adjusted for building occupancy, weather, change in space use,

and change in utility pricing. These adjustments are addressed within the MESA contract. Transcend

is obligated in the contract to pay the utility providers all energy expenses and to monitor the

amount of energy a building consumes. Transcend may also propose building modifications by right,

but there is no obligation of the landlord to make the proposed changes. The landlord retains the

right to approve or reject each proposal, as well as to approve or reject all contractors should a

modification be carried out. All building modifications, including equipment, are owned by the

landlord who also receives any benefits from rebates and utility incentives. Once the project is

completed, the existing staff of the landlord maintains operation of the building but support in

monitoring energy use is provided by Transcend.

One key factor of a MESA contract is transferability. The structure of a MESA contract includes the

formation of a Transaction LLC. (See Figure 1 below.) The Transaction LLC is a legal entity that is

auditable under GAAP accounting and transferable, upon the sale of the property, to a new owner.

If the landlord chooses to cancel the MESA contract, thereby dissolving the Transaction LLC, the

reduced operating costs of the property increase the net operating income, resulting in a higher

capitalized asset value. The fact a MESA contract may be transferred through the Transaction LLC

structure overcomes the current market barrier of long-term energy efficiency from the short-term

horizon of property owners.

1.3. U N D E R S T A N D I N G A M E S A P A Y M E N T

The Transaction LLC is essentially a two member legal entity which includes Transcend Equity and

the landlord. Both the MESA contract and the loan agreement for the initial property improvements

are held in the Transaction LLC. The upfront project capital is provided from the lender entity to

the Transaction LLC. In a MESA contract the Transaction LLC provides energy services to the

property. Energy services include payment of utility bills and monitoring site energy use, which is


different than the energy commodity that continues to be provided by a utility service provider. In

fact, most cases the existing utility service provider works with Transcend and remains unchanged to

the property.

The MESA payment is administered through a lockbox. As mentioned above, the Transaction LLC

provides energy services to the property at a cost roughly equal to the historical energy expense. The

landlord makes a payment to a lockbox from which the utility service provider, the lender entity, and

the Transaction LLC are each paid. The utility service provider is paid the utility payment from the

lockbox, which ensures the landlord that the payment will be made with no interruption of utility

services. Likewise, a portion of the MESA payment sent to the lockbox is paid to the lender entity as

a debt service payment for the upfront project capital. Finally, the remaining portion of the MESA

payment is distributed to Transcend Equity as profit through the Transaction LLC entity.

Figure 1: MESA Structure Diagram

Transcend Equity

Loan Agr

MESA Structure

Develop i Own & Operate

Profit 1

Upfrc Proje Capit

eement

Transaction M LLC I

•

>nt ct al

•»•

Profit 1 '

_

I MFSA Cr> 1

Energy / \ Services

i * v Historical

Energy $

I N . util ity Pmt

^Debt Service >,.

• Pmt > v

Lender Entity

ntract

Property

i >

Energy

Utility Service Provider

Source: Transcend Equity


1.4. R O L E S A N D R E S P O N S I B I L I T I E S

The following briefly outlines the individual roles and responsibilities in a MESA contract:

1.4.1 T R A N S C I A D EQUITY

The primary function of Transcend Equity is to develop, own, and operate the Transaction LLC. As

the service provider of energy efficiency improvements, Transcend invests in the improvements

using the expected energy savings created according to a MESA contract

1.4.2 TRANSACTION LLC

Members of the Transaction LLC are Transcend Equity and the landlord. The Transaction LLC

provides energy services (including electricity and natural gas) to the property according to a MESA

contract. In addition, the Transaction LLC distributes any profit generated to Transcend Equity.

Profit to Transcend Equity is the difference of the MESA Payment less debt service payment and

utility payment. The Transaction LLC is also the legal entity that signs the loan agreement with the

lender entity.

1.4.3 L A N D I . O R D / O W N R R

The primary benefit of the MESA contract to the landlord is to modernize or "green" a portfolio

with no upfront capital cost and without increasing the operating expense. A MESA contract is

expense neutral, without changes to tenant pass-through or the use of cost recovery language in the

lease. Furthermore, because a MESA contract replaces the operating expense for utilities there is no

net affect to operating expenses.

As a result, existing properties may benefit from near-term cash flow increases in several ways. If a

MESA contract is terminated, or at the end of its contract life, the property will have lower

operating expenses and a subsequent higher net operating income as a result. A MESA contract also

lowers the investment basis because no capital expenditure is expensed for the improvements. The

long-term result is an increase in investment yield at sale of the property.

Another long-term benefit especially relevant to SCRER Members is the benefit of operating a green

building. A number of the L E E D EBOM points attributed to energy efficiency may be achieved by

using a MESA contract to make the necessary improvements. These same improvements also may

help a landlord achieve an ENERGY STAR label for the property. As such, the MESA contract may

very well accelerate portfolio-wide green certification and lead to improved energy management.

1.4.4 T U N A N T

The tenant benefits from occupying space in a building with a MESA contract and the related

energy efficiency improvements. Improving the energy profile of a building often involves

upgrading mechanical systems and integrating other building systems. These improvements increase

occupant comfort and enhance landlord responsiveness through better utilization of diagnostic and

management tools. A more efficient building may also curtail future expense growth by reducing

exposure to rising utility rates. Additionally, a modernized building is likely to limit near-term rent


increases by avoiding costly repair and maintenance charges and rising utility usage from inefficient

systems. At lease renewal, the result of a lower operating expense is a reduction in tenant pass-

through costs and additional rent paid to the landlord.

2. Property Assessed Clean Energy (PACE) Financing Explained

Property Assessed Clean Energy Financing (PACE) allows property owners to borrow money to

finance energy efficiency retrofits and small renewable energy projects and repay over time through

line item on property tax bill. The municipality borrows money either through a municipal bond or

from financers. The loan is secured by a tax lien on the property that takes precedence over any

mortgage claims to the property. Repayment obligation is attached to the property, not the

individual, and the remaining obligation transfers to a new owner if the property is sold before the

end of the repayment period. Existing pilot programs offer 100% financing of the project cost with

loan terms between 5-20 years and interest rates from 7% to 8.5%. In many cases PACE is created

by municipalities and/or state legislatures that either pass ordinances enabling citizens (or

businesses) to add a line item to their property tax bill for the loan or create a special tax district,

assessment district, or Mello Roos.

The creation of PACE bonds solves key problems of energy efficiency financing. Tying payment to

the property solves long-standing credit and collateral issues for the lender. The lender is

underwriting property tax payment history versus property owner credit and historic loss on

property taxes is low with 97% of property taxes current. Attaching repayment to the property

solves the collateral issue faced by lenders because energy efficiency improvements are considered

fixtures and lenders historically had no recourse in event of nonpayment.

The tax-lien financing model also overcomes several well-known barriers to energy efficiency

projects for the property owner. Longer financing terms reduce payments and allow for more costly,

longer payback energy efficiency projects to be pursued. Since the repayment obligation transfers at

sale of the property, the owner only pays for the benefits of energy efficiency while they are

receiving them. The uncertainty about full cost recovery of the improvement at sale is removed. The

age-old owner/tenant split incentive problem can also be overcome because owners are allowed to

pass-through property taxes (in this case retrofit costs) to net lease tenants who also may benefit

from savings.

The PACE model is not without its challenges, many of these with financing. Often a deed of trust

(mortgage) will place a limit on more senior loans, such as a PACE program provides. Of greater

concern, in some states lenders may be able to accelerate assessment payments at the time of sale

which would take away the benefit of separating long-term energy efficiency from the short-term

horizon of property owners. Likewise, a potential buyer may be wary of taking on the extra loan

obligation as well a potential lender may have the very same concern.

For additional information please see http://pacenow.org


http://pacenow.org

Once PACE bonds are standardized and widely available, capital for energy efficiency improvements

will be both scalable and cost effective to the property owner. There is strong interest in buying

PACE bonds by the investment banks because these loans are senior to mortgages and are perceived

to be of relative low-risk. Initial assessment places the potential market capitalization of PACE to be

in excess of $500 billion. Interest in PACE is growing with 15 states in the past 12 months passing

legislation enabling PACE programs. Currently, only 4 PACE programs are in operation as of June

2009: Boulder County, Colorado; Palm Desert, CA; Berkeley, CA; and Sonoma County, CA.

Most of the PACE pilot programs focus on energy efficiency improvements in residendal property,

with the exception of Boulder County, CO and Sonoma County, CA which include provisions for

commercial real estate financing. The first large-scale commercial PACE project in California was

recendy completed at the Santa Rosa Plaza. The shopping mall, a premier downtown shopping

destination in Northern California, is owned by Simon Property Group. The project was a highly

reflective and emissive roofing system (or "cool r o o f ) made possible entirely through PACE funds

provided by Sonoma County. Simon stated one reason for doing the project was to demonstrate the

viability of PACE financing.

3. On-Bill Financing Explained

In on-bill financing, the utility finances energy efficiency improvements and the property owner pays

off the cost through a separate charge on the monthly utility bill. Often, the monthly loan payment

is equal to (or less than) the cost savings so the property owner does not see a large increase in the

utility payment. Existing programs offer a 2-5 year plan period with many offering interest rates of

0% and others 2-5%. Non-payment penalties are often the same as the current utility bill, including

fees and disconnection from service. With tariff-based on-bill financing the repayment obligation

transfers to the new owner/user of the energy efficient improvements. In this case, tenants may be

able to participate in tariff-based financing and still receive the economic benefit while in occupancy

of the space.

There are several economic benefits to the property owner to use on-bill financing. Similar to MESA

and PACE, the program allows for 100% financing of upfront costs. Company project payback

periods may be extended, allowing for more costly energy efficiency improvements to be considered.

Some utilities underwrite utility bill payment history to qualify applicants, solving borrower credit

issues for the lender.

Although beneficial in overcoming many energy efficiency obstacles, on-bill financing falls short in

several categories. If the utility contracts with a third-party lender, there may be disputes over who

gets paid first if the property owner pays a partial bill. Similarly, a utility that is paid for energy but

not the loan may have a challenge in the ability to disconnect service. Finally, the shorter

amortization period of the loan (2-5 years) makes it difficult to design deep retrofits that cost equal

to or less than the average monthly utility payment without increase.


4. E q R M "Energy Savings Generator" Model Explained

A more recent entrant to energy efficiency financing is Equilibrium Resource Management

Corporation (EqRM). EqRM is a new enterprise formed to offer energy savings to Corporate Real

Estate users under a business model structured to address many of the challenges hindering

adoption of the Energy Performance Contracting. EqRM's approach to Energy Performance

Contract finance is similar to the MESA model in providing the capital necessary to fund energy

efficiency improvements off balance sheet. Unlike a MESA, EqRM's model does not involve EqRM

taking responsibility for all the energy utilities of a facility.

4 .1 . E n e r g y Sav ings G e n e r a t o r

Rather, EqRM is proposing to buy, own and manage a so-called "Energy Savings Generator"

located at a host facility. The EqRM model is more akin to a Power Purchase Agreement, where the

host facility buys "energy savings" in electricity or gas on an avoided unit cost basis. According to

Bill Campbell, Principal of EqRM, the company will install cost effective energy conservation

measures at a host site; operate and maintain the equipment to ensure persistence of savings through

continuous commissioning; and sell those energy savings to the building owner. Building owners will

only pay for actual energy saved. Building owners benefit by enjoying reduced operating costs, and

they receive a share of the energy savings in the form of percentage royalty in compensation for use

of the "site."

EqRM is essentially proposing a model to sell "energy savings' to building owners, while keeping the

transaction off the balance sheet. The transactions are structured to be fully transferable and should

present no impediment to effective asset management. One innovative feature is EqRM's stated

intention to offer the energy savings to utilities as well as part of their energy supply procurement

process. While EqRM will not publicly disclose all the aspects of their proprietary The concept of

selling energy savings, what Amory Lovins from the Rocky Mountain Institute referred to as

"Negawatts," is moving from theory to practice as the Commonwealth of Massachusetts has passed

legislation requiring utilities to procure "cost-effective" energy efficiency savings as part of their

energy procurement process.

Conclusion

Energy Performance Contracting (EPC) is continuing to present challenges for the Corporate Real

Estate Sector, but private companies are developing innovative strategies that overcome some of the

challenges with EPC. Transcend Equity's MESA contract is an innovation that has proven effective

with at least one large REIT. Property Assessed clean energy and on-bill financing use traditional

pathways of money transfer - taxes and utility bills - to provide innovative financing. EqRM had

developed yet a different model which allows the property owner to just pay for whatever savings

are actually achieved. SCRER Members are encouraged to investigate these options and other

innovative financing methods as they come onto the market.


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