hb&c workshop summary final

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MEMORANDUM

TO: Jennifer Finnigan, Jeanne Clinton FROM: Matthew Brown and Dave Carey DATE: February 23, 2012 RE: HB&C Summary of the CPUC OBR Workshop After a week’s discussion of On Bill Repayment (OBR) and its appropriateness for California, we offer the following commentary that, we hope, will be useful. We apologize for its length, but felt it was important to lay these points out in some detail. We offer two over-‐arching points first and then discuss several critical elements of OBR. 1. Terminology is tremendously important and parties were not always talking

about the same thing when they used words like “OBR.” The key difference was the some parties referred to OBR meaning only a repayment mechanism. Others thought of OBR as including a repayment mechanism that included all traditional utility means to collect payment (for simplicity sake we refer to this as disconnection in the remainder of this memo).

2. The purpose of the CPUC workshop was to explore how OBR might help California achieve two goals: build EE loan volume and increase EE project comprehensiveness.

Discussion Concept and Framework The following logic supports the use of OBR: 1. Given the following goal: Increase the uptake of EE (more numerous projects, more comprehensive projects). 2. A method to increase the uptake of EE is to provide energy users w convenient, low cost EE financing.



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3. A method to provide convenient low-‐cost financing is to make EE attractive to lenders. 4. A method to make EE attractive to lenders is to:

• Improve the credit performance of borrowers • Create large volumes of loans

5. A method to improve credit performance and to build loan volume is to:

• Put the payment on the bill (which gives the homeowner and the lender the imprimatur/trustworthiness of the utility)

• Allow shut off (which gives the lender recourse) • Provide bill neutrality (because borrowers like positive cash flow,

lenders like the monetized savings) • Distribute payments to lender and utility proportionately (because

lenders don't want the utility to get preferential repayment and lenders don't want to be solely responsible for shut-‐off)

• Allow the loan to transfer the debt to the next owner/tenant (because lenders don't want loans to prepay)

Fundamentally, the finance mechanisms need to (1) build volume (2) make financing more affordable and (3) attract capital. The finance mechanisms described below are compared against these goals. OBR Absent Disconnection

1. OBR (absent disconnection) should build volume because it: a. Is an easy sale for contractors, since contractors are already

embedded in the energy efficiency sales process – the energy efficiency “stream of commerce.”

b. Appears easy for consumers to understand their bill and related savings.

c. Places the utility as a trusted party implicitly behind the product (the imprimatur of the utility, mentioned above).

d. Allows for some entities (Green Campus Partners noted this in the commercial sector) to more easily capture and monetize energy savings.

2. OBR (absent disconnection) is not likely to have a significant impact on affordability because it is unlikely to affect either term or rate. That said, OBR does absorb some collection costs that a lender would have to incur and these reduced collection costs may be reflected in rates, although it is unclear that this reduction in collection costs will be enough to materially affect rates. There could be servicing savings but there are significant interfacing costs which will likely consume the savings.



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3. OBR (absent disconnection) may have a positive impact on the ability to

attract capital because it is likely to build volume. Some parties suggested that even if disconnection is not a part of the program, that many customers may believe potential of disconnection still exists, and take the risk of non-‐payment more seriously than another kind of bill. “People pay their utility bills” was a common theme. That said, utilities noted correctly that although people generally pay their utility bills, that they may pay those bills late; PG&E noted a 22% delinquency rate. Investors will price in this delinquency because of the time value of money. And although investors may view a customer operating under the threat of disconnection as, ultimately, more likely to pay the bill, the fact that the payment arrives late will add to the rate. Do we want to add “cons”, e.g., the investor/funder will have to price for remittance delays and the credit/counterparty risk of the utility (PG&E did file for BK)

OBR With Disconnection

1. OBR with disconnection should build volume for the same reasons cited above.

2. OBR has potential to have a significant impact on affordability of efficiency (as a result of either longer terms or lower rates). However the extent of that impact is uncertain.

a. In order to assess a new financial product, the financial industry looks to history of comparable financial products. To the extent that a new financial product can look a great deal like other products, financial institutions will be able to assess its quality with a de minimus premium for it being a new product. An efficiency finance product that essentially reflects the characteristics of other utility service may allow financial institutions to assess this new product on the basis of the performance of the existing utility ratepayer pool.

b. Disconnection is not in and of itself well understood as a security mechanism (or a proxy for collateral). Financial institutions may not be sure how to value it in the beginning, although it is likely that they would give it some credit as per above; that credit will be somewhat discounted because of the uncertainty. As financial institutions look more closely at not just disconnection policies, but also disconnection practices, they may place a lower value on disconnection itself. (i.e. under what circumstances are customers disconnected and how reliable is disconnection as a proxy for security?)

c. In the non-‐residential sector there were some questions raised as to the value of disconnection, for instance it would be likely that the business would already be in a lot of trouble in the event



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disconnection occurred. We also heard that many businesses that would be likely to apply for a loan would see the threat of disconnection as one more reason to be "serious" about the project and not to over-‐commit. In a sense, the threat may help to weed out the poor credits from the beginning.

d. In residential customer base, there appeared to be a fair amount of agreement that disconnection would be a valuable an inexpensive alternative to taking a collateral interest. Note also that the disconnection threat is both inexpensive and fast; it requires no additional paper filings and no additional research. In this sense it is very different, and better than, a typical secured loan that requires title search and appraisal (with associated time of 2-‐3 weeks and cost)

e. Disconnection for failure to pay a third party (regardless of collection mechanism) appears to be contrary to CA statute for the residential sector.

3. OBR with disconnection has good potential to attract outside capital for all

the same reasons cited above that could lead to lower rates and longer terms than are currently available for financing product.

OBR with the Payment Obligation Tied to the Meter

1. Tying to payment obligation to the meter may have greatest value in increasing volume for the rental/leased space market.

a. For further marketability it may be important to require that projects tied to the meter and in the rental market also be projected as cash flow neutral or cash flow positive projects.

2. The impact of tying a payment to the meter on affordability is unclear. a. In and of itself (i.e. Absent a cash neutral/cash positive requirement –

discussed below) it could have a positive impact on affordability as a result of extended amortization periods. It is likely that payments tied to the meter would increase rates, because rates for longer-‐term notes are typically higher than short-‐term notes. Further, to the extent that tying a payment to the meter would require additional underwriting, transaction costs could increase.

3. Tying a payment to the meter could have a negative impact on availability of capital.

a. Capital tends to be easily available for terms of 3-‐5 years, often available for 7 years, and sometimes available for 10 years or longer – at least for a traditional unsecured financial product. Because tying a payment to the meter creates an uncertain repayment structure (how to address changes of occupancy and resultant changed credit profile, for instance), large-‐scale capital sources may not be available.



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b. However, it may be quite possible to develop a pilot program for a specific market sector (e.g. rental markets) using either ratepayer capital and/or non-‐traditional capital sources. Further, it may be possible to structure a product with greater recourse to the utility balance sheet for this product.

c. Because OBR tied-‐to-‐the-‐meter increases the perceived risk of non-‐payment any method of reducing that risk will be helpful in attracting outside capital. Therefore, OBR tied-‐to-‐the-‐meter will likely be most successful if it is also tied to a threat of disconnection.

Bill Neutrality

1. Bill neutrality/positive requirements could be attractive to customers and would seem at first glance, therefore, to build volume.

a. However a requirement for bill neutrality would likely be detrimental to building volume (effectively eliminating many HVAC and emergency replacement projects that tend to dominate most efficiency retrofits), and would likely discourage more comprehensive retrofits.

2. Bill neutrality/positive projects will increase affordability but for a limited number of projects—but, again, only possible for certain project types that will tend to be less comprehensive retrofits. One way to increase affordability of the most comprehensive projects is to extend the term of the financing from the fairly typical 36-‐60 months to 120 or even 180 months. This longer term amortizes principal over an extended period, thus reducing monthly payments and enabling energy savings to approach or exceed principal and interest charges. The challenge with this strategy is that capital providers view long terms as higher risk than short terms. As a result capital providers will be unlikely to proffer long terms, absent significant credit enhancements (see below).

3. Bill neutrality/positive requirements are likely to have two countervailing effects.

a. they could decrease overall attractiveness of a project to capital markets because it restricts the number of projects that qualify, thus reducing overall volume.

b. they could make some projects more attractive to capital providers that incorporate the effect of a reduction in utility bills on the ability to pay debt service. As a rule, most consumer lenders do not incorporate the reduced energy bills in to underwriting. However, this effect may be more valuable in commercial lending – where paybacks are shorter and lenders tend to spend more time underwriting and analyzing each individual loan.



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4. See above section: the rental sector may be most appropriate for a bill-‐neutrality requirement if the payment obligation transfers with the meter.

Pari Passu Pari Passu payment allocation refers to allocation of a consumer’s payment to different obligors, when that payment is made through a single bill – as would be the case when the utility bill is used to collect energy and finance-‐related charges. It is particularly relevant in the case of a partial payment that must be allocated to the utility and to the investor. A pari passu structure is one in which any payment is paid proportionally to the utility and the investor. Investors prefer a pari-‐passu structure to one in which energy bills are paid before any investors.

1. Pari passu will in general not have a material effect on volume or comprehensiveness of retrofits since it is largely invisible to the customer.

2. Pari passu structures will decrease the cost of capital because investors will not be required to price the uncertainty of repayment in the event of a partial payment.

3. Pari passu structures will increase availability of capital because investors will be more willing to provide capital when they can better predict the flow of that capital in the case of partial payments.

Operational Issues It will be important, no matter what type of OBR structure that Commission elects to pursue, to be aware of relevant lending laws – TILA, holder in due course, etc. Credit Enhancements Credit enhancements can shore up any weakness that a financial institution perceives in these structures. Credit enhancements and OBR are not mutually exclusive, and in fact a credit enhancement can be used to bridge the knowledge, confidence gap as financial institutions assess the value of OBR and other mechanisms described above. In a sense, credit enhancements can layer on to any of the above mechanisms and could, over time, be phased out as the above mechanisms gain a foothold. Broadly, there are three types of credit enhancements here:

1. An interest rate buydown (IRB) that simply reduces interest rates by paying a financial institution for the difference between market and target rates. Although not always viewed strictly as a credit enhancement, this mechanism can nonetheless make loan payments more affordable to more people or reduce rates for new financial products. A rate buydown therefore



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provides them rates (or terms) only available to borrowers with a better credit profile.

2. A loan loss reserve (LLR) that sets money aside in a special account to cover potential losses. An LLR is a loss sharing mechanism and is not a guarantee.

3. Balance sheet support uses the utility balance sheet to support a loan portfolio. It is likely the least expensive type of credit enhancement because it does not require that actual cash be set aside that exceeds expected losses. Instead, it is a promise from a creditworthy entity to pay for some amount of projected losses. The financial institution prices the financial product on the basis of the strength of the underlying balance sheet. In the case of a utility balance sheet support, that pricing would be based on the utility bond rating.

Each of the above credit support mechanisms could be used, sometimes in combination with one another to achieve the following (note that the specific broad goal of volume, affordability or capital attraction is listed after each):

1. Achieve bill neutrality (building volume and attracting capital to specific markets):

a. Achieving bill neutrality will, for many customers, only be feasible by a combination of low rates but (more importantly) long terms. Credit enhancements could be provided for the markets that are most in need of bill neutrality, such as rental markets or mid-‐income customers, especially in multi-‐family properties.

2. Reaching deeper into credit buckets: a. Credit enhancements can be risk-‐adjusted, with larger credit

enhancements set aside to cover losses from loans made to lower credit individuals or other hard-‐to-‐reach markets.

3. Providing temporary rate discounts (building volume): a. An interest rate buydown for a specified period of time could be used

to offer a “no-‐no” product – no interest no payments for 6-‐12 months. Some contractors use these products now as an enticement to customers.

4. Overcome in ability to provide pari-‐pasu payment allocation structure (attracting capital and affordability):

a. To the extent that financial institutions will price the risk that they are unable to be assured of a pari-‐passu repayment and to the extent that the Commission does not grant pari-‐passu repayment, then a credit enhancement could be established to compensate for that risk.



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5. General rate reduction or term increases (volume, affordability, attracting capital):

a. Credit enhancements have been used in numerous other states, including for local governments in California, to attract participation of financial institutions, simply because the product is new. Note that the credit enhancement structure will vary depending on the type of capital that it is trying to attract. As a rule:

i. Institutions investing depositor capital (especially credit unions and some community banks) will likely be most responsive to a credit enhancement, and will respond to credit enhancements in the range of 10-‐20%.

ii. Capital markets have a broader array of uses for their capital and absent OBR with disconnection (which they will often view as a substitute for security/credit enhancement) may require a credit enhancement approaching 30%.

Conclusions Perhaps the best way to summarize is to review (a) what we know we know and (b) what we think we know but really don’t know for sure.

1. What we know we know

a. OBR in any form will help to build volume. b. Volume will attract capital and create competition to supply capital. c. More capital will eventually reduce the cost of capital. d. But that will take time. e. Pari-‐passu structures are much more attractive to financial

institutions than non-‐pari-‐passu structures. f. Bill neutrality requirements will generally reduce the number of

eligible projects and decrease volume – absent credit enhancements. g. Credit enhancements could help to bridge this gap in time and the

uncertainty over pari passu. However, collecting the data to demonstrate the gradually decreasing need for credit enhancements would be critical. Strong credit enhancement structures can be developed to enable long-‐term capital to come to the table to enable long amortization periods and transfers with the meter, and provide for a broad array of projects to qualify even in the face of bill-‐neutrality requirements.

2. What we think we know but really don’t quite know for sure



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a. OBR with disconnection threat will reduce the cost of capital and will attract capital.

b. OBR with disconnection will therefore also increase volume. c. Financial institutions may be able to live with non pari-‐passu

structures, but will price that additional uncertainty in to their financial offering.

d. To the extent that financial institutions are uncertain of the value of disconnection, credit enhancements can help to bridge that uncertainty gap.

e. Those credit enhancements will be smaller (perhaps significantly so) than would be required in the absence of a threat of disconnection.

hb&c workshop summary final

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