Billions of dollars’ worth of commercial building energy efficiency upgrades are proposed each year, but more than 75% of projects that are proposed do not get approved. To understand why, it’s helpful to first discuss why projects do get approved. Contrary to what many think, it’s not ‘saving the environment’ or ‘being green’. There are environmental benefits, to be sure, but the main reason why commercial building owners are approving these projects – such as upgrading lights or replacing aging boilers is to reduce operating costs, which in turn generates cash flow; and, as all building owners know, any reduction in the building owner’s costs increases Net Operating Income, increasing the value of the building itself. Yet, with such compelling economics, why do three quarters of the proposed projects not move forward?
There are three main reasons for why this happens: no budget, no trust in savings, and not meeting internal hurdle rates.
1) No Budget
Most energy efficiency projects don’t get approved because there is not a budget. This should not be a surprise to anyone. Why? Because unless the equipment is broken or at is end of life, the building owner has no reason to budget for it. Upgrading lighting, installing building controls and replacing a functioning chiller are often unplanned investment opportunities. The majority are unforeseen and therefore unbudgeted.
Until recently, financing to overcome a lack of budget has proven to be difficult for two reasons. First, standard asset-backed equipment financing firms have had difficulty leasing equipment that cannot be repossessed – who’s going to remove and resell lights? Second, taking small to mid-sized loans from banks can be time-consuming and expensive (for example, if they require a new appraisal). Today, these loans are much easier to get, as well as those from leasing firms who understand the compelling economics of energy efficiency projects. As this lending becomes more accessible, ‘lack of budget’ will be a much easier obstacle to overcome.
2) Lack of Trust
The truth is you really can’t blame building owners for not trusting the forecasted savings in energy efficiency equipment proposals. Presented with a proposal to purchase more efficient equipment, the building owner is asked to (a) replace equipment that’s most likely not broken and (b) make a decision based on the IRR that’s computed by the person selling the equipment.
Recent studies show that the answer “too good to be true” is one of the key reasons building owners don’t trust their forecasts. Yet, the products are that good; the technologies are that much better. Did you know that many boilers and chillers were installed before Microsoft Windows was introduced? Technology has come a long way in 30 years. These IRRs are real and can be trusted. Fortunately, there are companies who help energy efficiency equipment companies analyze and present their proposals and economics, providing a 3rd party appraisal of the project. In addition, many vendors and contractors are committing to measuring the savings after the first year and, in some cases, refunding a percent of the project cost if the savings aren’t achieved. These efforts go a long way to developing confidence with the building owner, resulting in more projects getting approved.
3) Meeting Internal Hurdle Rates
Before the recent trend to finance energy efficiency improvements, most purchase decisions had to pass a single test: the payback test. How long will it take the building owner to get their cash back? Every building owner has a hurdle rate for payback. If the project didn’t meet the internal hurdle rate, there was no chance it was getting approved. To be sure, payback hurdle rates are important because cash on hand is extremely valuable to business operations.
However, if 3rd party financing is used, payback is irrelevant - because it’s not the building owner’s cash, it’s the lender’s cash. And, because these projects have such compelling economics, most of these projects can be cash flow positive from day one, even with interest rates for less-than-prime credits. Financing should make overcoming internal hurdle rates a relic of the past – like those 30-year old chillers!
There is a tremendous opportunity to improve America’s aging infrastructure, but it’s not because it’s simply the ‘right thing to do.’ These improvements make economic sense. They generate incremental cash flow and increase the value of the underlying building itself. Getting building owners to think of these projects, as value-creating investments and not unwanted and unnecessary expenses is the key to unlocking tremendous amounts of energy savings and new cash flow.
Scott Harmon is the CEO of Noesis, reach him at: firstname.lastname@example.org.
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