Aggregating Residential Energy Efficiency Investments Via Qualified 501(c)(3) Bonds

Brian D. Buckley Vermont Law School JD/MELP/Energy Certificate Candidate 2013

I. INTRODUCTION AND JUSTIFICATION Energy efficiency is considered by many to be the low-hanging fruit of the green economy.1 Yet, high upfront costs and low public awareness prevents many homeowners from taking advantage of this low hanging fruit which, if picked, would provide increased comfort, a cleaner environment, and lower energy bills. Energy efficiency retrofits offer stable financial returns and would be a great opportunity for institutional investors like banks and pension funds. Various types of energy services companies (ESCOs) have begun to reach for this fruit, but few reach into the residential efficiency market. Such inaction is largely based on a lack of capital due to high per-project transaction costs associated with the ESCO business model. This paper will outline an approach intended to attract liquidity to the residential efficiency market through the bundling and distribution of energy efficiency investments in the form of 501(c)(3) conduit bonds. The main advantage of such bonds is their exemption from state and federal taxation, which is based upon their furtherance of charitable purposes. The body of this proposal is divided into three parts. The first part will present a general discussion of energy services companies and their potential to aggregate residential efficiency investments. The second part will explore the sphere of private activity bonds with a focus on 501(c)(3) conduit bonds. The third part will examine the use of program-related investments as a means of credit enhancement for a nonprofit energy service company. Finally, the paper will conclude with recommendations formulated from the analysis. It is the hope of this author that the following discussion will bring a secondary market for residential efficiency investments a little closer to its already low-hanging reality.2
1 Ball, Jeffrey. How to Make a Bundle on Energy Efficiency: Wall Streets New Strategy for Investing in Good Deeds. Slate Magazine. November 30, 2012. Accessed 3/2/13. Page 1. Available at: http://www.slate.com/articles/health_and_science/the_efficient_planet/2012/11/invest_in_energy_efficiency_how_bundling_lots_of_ small_improvement_projects.html. 2

Id. (stating that CitiGroup aims develop a secondary market for residential efficiency investments in 2013).

II. ENERGY SERVICES COMPANIES Energy service companies (ESCOs) are organizations that develop, install, and arrange financing for projects designed to lower building operating costs through energy and water efficiency improvements, peak demand reduction, and combined heat and power projects.3 In order to best understand an ESCO for this discussions purposes, one must examine how they function, their current industry trends, and a specific type of ESCO referred to as a C35. Such an examination will best explain how this business model might aid in the creation of a secondary market for energy efficiency investments. An ESCO begins to fulfill its function when a building owner issues a request for proposals of energy conservation measures and/or combined heat and power solutions for their building.4 Such measures almost always include lighting retrofits, heating/ventilation/air conditioning modifications, and building envelope alterations. After an initial walkthrough of the facility to identify possible cost/energy saving measures, the ESCO then presents a proposal to the building owner. If the owner chooses to move forward with the ESCOs proposal, the ESCO next performs an investment grade audit from which a final contract will be drawn. The ESCO provides a guarantee that the chosen energy conservation measures will limit energy consumption at the facility, usually to the extent that invested revenue is returned in the near term.5 Such a guarantee often allows clients to obtain financing for the retrofits at a lower

3 Vermont Energy Investment Corporation, An ESCO for Underserved Markets: Developing the Roadmap for Public Purpose Energy Service Companies. (2010). 4

National Association of Energy Services Organizations. Resources: What is an ESCO? Accessed 3/4/13.

Available at: http://www.naesco.org/resources/esco.htm.

5

Id.

interest rate than without a guarantee. Throughout the duration of the guarantee, the ESCO performs regular measurement and verification services to ensure the newly implemented measures are operating according to their guarantee.6 Some also offer maintenance services to ensure that the retrofits continue to work as intended throughout their life-cycle. Current ESCO industry trends revolve around MUSH sector retrofits performed by privately owned energy services companies. The MUSH sector is composed of municipalities, universities, schools, and hospitals. This sector represents roughly 70% of the ESCO market because such organizations often have large balance sheets and assured incomes, allowing them to amortize the up-front cost of their investment over a number of years at no detriment to their credit.7 The retrofit industry is often dominated by subsidiaries of large private corporations because the sunken costs of an investment grade audit often require large capital outlays with no assurance of a return on investment. Some examples of todays largest ESCOs include ConEdison Solutions (a subsidiary of ConEdison), Johnson Controls (a subsidiary of Johnson and Johnson), and Chevron Energy Solutions (a subsidiary of Chevron).8 Some ESCOs, such as Transcend Equity, also offer financing to their clients in exchange for an energy services agreement. An energy services agreement is an agreement between an ESCO and a private building owner for the provision of energy services rather than the delivery of energy conservation measures.9 Energy service agreements are based on the power purchase agreement

6 7

Id.

Andrew Satchwell (et. al.). A Survey of the US ESCO Industry: Market Growth and Development from 2008-2008. Lawrence Berkley National Laboratories. June 2011. Page 11. Available at: http://www.naesco.org/resources/industry/documents/ESCO%20study.pdf .
8

National Association of Energy Services Companies Member Snapshot

Available at: http://www.naesco.org/organizations/companies.aspx?CatID=3. Charlotte Kim (et. al.) Innovations and Opportunities in Energy Efficiency Finance. Wilson, Sonsini, Goorich, Rosati. May 2012 Page 14-15. Available at: http://www.wsgr.com/publications/PDFSearch/WSGR-EE-Finance-White-Paper.pdf.
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pioneered for renewable energy. Such agreements remain off balance sheet for most building owners and cost virtually nothing up-front. One narrow subset of organizations bearing some semblance to the ESCO is based upon a nonprofit business model Ill refer to as the C35.10 C35 is a classification that guidestar.org gives to 501(c)(3) organizations whose exempt purpose is the furtherance energy resource conservation and development. These organizations are tax exempt because Section 501(c)(3) of the internal revenue code provides that any organization organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes,11 is excluded from the payment of federal income taxes. More specifically, the Internal Revenue Service defines charitable as constituting: Relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of Government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency.12 Accordingly, if willing to negotiate the associated constraints,13 an energy service company would qualify for 501(c)(3) status if it were organized and operated in furtherance of charitable purposes, such as the maintenance of public buildings and/or lessening governments burdens.14 These organizations often contract directly with states or large municipalities to administer funds gained through a system benefits charge to offer incentives for large electricity
10

Guidestar.org. National Taxonomy of Exempt Entities.

Available at: http://www.guidestar.org/rxg/help/ntee-codes.aspx.

11 12 13 14

26 U.S.C.A. 501(c)(3). 26 C.F.R 1.501(c)(3)-1(d)(2). Chief amongst them is the prohibition on private benefit, which prohibits the use of equity financing by a 501(c)(3).

For arguments justifying the environmental costs of energy consumption as a governmental burden and therefore protecting a PPESCOs 501(c)(3) status from UBIT during retrofit of buildings not owned by the government, see generally, Presidents Council of Advisors on Science and Technology, Sustaining Environmental Capital: Protecting Society and the Economy (describing governmental burdens resultant of environmental deterioration as a governmental burden).

users to manage demand through efficiency retrofits.15 Some examples of C35s are the Wisconsin Energy Conservation Corporation, the Vermont Energy Investment Corporation, the Energy Trust of Oregon, and the Conservation Services Group. Unlike private ESCOs, these organizations often operate on tight balance sheets and cannot devote capital to an investment grade energy audit that may not come to fruition, or tie up money in any one investment for several years. One rarely explored manner of attracting capital to the C35 business model is through the use of bonds. II. Qualified 501(c)(3) Bonds Qualified 501(c)(3) bonds are a mechanism through which a 501(c)(3) organization can acquire capital to finance property purchased in furtherance of its exempt purposes.16 In order to best understand qualified 501(c)(3) bonds for the purposes of this discussion, one must understand the use of private activity bonds, and the constraints of qualified 501(c)(3) bonds, and the advantages of qualified 501(c)(3) bonds. 501(c)(3)s organizations often face capitalization constraints due to the prohibition on private benefit they endure in exchange for exempt status.17 The prohibition on private benefit essentially means that no outside investor can buy a piece of a 501(c)(3) and expect their investment to appreciate in value, as they would with an investment in a regular corporation. However, outside parties can loan a 501(c)(3) money in the form of bonds and expect an interest payment in return. Bonds are a debt instrument which municipalities and organizations use to

See generally Mark Wolfe, The Role of System Benefit Charges in Supporting Public Benefit Programs in Electric Utility Restructuring. Energy Programs Consortium. (stating that states levy systems benefit charges on the distribution of all electricity collected by the regulated distribution company and included in the bills distributed to all customers. The company collects fees and transfers them to the appropriate administering agency(s)).
16 26 U.S.C.A. 145 (defining qualified 501(c)(3) bonds as any private activity bond issued as part of an issue ifall property which is to be provided by the net proceeds of the issue is to be owned by a 501(c)(3) organization or a governmental unit).

15

26 U.S.C.A. 501(c)(3) (stating that exemption may be granted and retained only if no part of the net earninginures to the benefit of any private shareholder or individual).

17

raise capital. An investor who buys bonds temporarily contributes capital to an organization, and in return, receives a market value interest payment from that organization for the use of their capital.18 The bond most commonly issued to a private organization on behalf of government is a private activity bond. Private activity bonds are bonds issued to support projects that benefit private entities but also serve some public purpose (e.g., airport improvements, water facility upgrades).19 Qualified 501(c)(3) bonds are a type of private activity bond utilized by hospitals and municipal utilities for asset or facility acquisition. Five important constraints are associated with qualified 501(c)(3) bonds: (1) maturity limitations; (2) approval requirements; (3) arbitrage restrictions; (4) a bonding cap; and (5) distribution prohibitions. First, statutorily required maturity limits require that a private activity bonds duration not exceed 120% of the average reasonably expected economic life of the facilities being financed.20 Second, private activity bonds are often subject to public/governmental approval requirement which limit their use to facilities located within the jurisdiction of the issuing government.21 Third, organization utilizing qualified 501(c)(3) bonds must abide by certain arbitrage restrictions which, amongst other things, dictate that funds earned through efficiency must go into a general endowment rather than directly paying their bond back.22 Fourth, nonhospital qualified 501(c)(3) issuances are limited by a statutorily imposed

18 19

19 C.J.S. Corporations 751.

Robert Puentes Promoting Public Infrastructure Investment Through Private Activity Bonds. Brookings Institution. Published October 25, 2012. Accessed 3/15/13. Available at: http://www.brookings.edu/blogs/the-avenue/posts/2012/10/25-pabs-puentes .
20 21 22

26 U.S.C.A. 147(b)(1)(B). 26 U.S.C.A. 147(f). Ice Miller. Fundamentals of Tax Exempt Financing for 501(c)(3) Organizations. Accessed 3/12/13.

Available at: http://www.icemiller.com/publications/30/787557.htm.

cap of $150 million.23 Fifth, the distribution prohibitions are governed by a complex series of tests, and in fact, deserve more in-depth treatment than the above mentioned constraints. The Internal Revenue Service uses two tests to enact a distribution prohibition on bonded capital: (1) the ownership test; (2) and the private business use test.24 The ownership test is the first test applied. The ownership test states that all property which is to be provided by the net proceeds of the issue is to be owned by a 501(c)(3) organization or a governmental unit.25 A C35 ESCO would pass this test because, according the terms of the typical energy services agreement between client and ESCO, the ESCO retains ownership of the retrofits and instead provides the energy services provided by the retrofit. This accounting method has traditionally been applied so that the retrofits can remain off-balance sheet for the client, but it also comes in handy when applied against the ownership test. The private business use test is the second test applied. The private business use test is actually comprised of two tests: (1) the modified private business use test; and (2) the private payment/security test. To pass the modified private business use test, no more than 10% of the bond capital may be used to finance private business.26 To pass the private payment/security test, no more than 10% of the payment of principle/interest is made/secured by payments on property used for a private business interest.27 While these tests might seem to put the proposed issuance in peril, they do not. First, to pass the private business use test, one need only pass either one of the two subsequent tests. Second, the modified business use test contains explicit language stating that bond proceeds can be used to finance the working capital expenditures of a

23 24 25 26 27

26 U.S.C.A. 145(b). Id. 26 U.S.C.A. 145(a)(1). 26 U.S.C.A. 145(a)(2)(B). Id.

501(c)(3) organization so long as such use furthers its exempt purpose. In the present case, such use furthers the goal of energy conservation and therefore passes the private business use test. Limiting the burdens of government through demand side management and energy efficiency unquestionably falls under the category of charitable, as exemplified by existing C35 organizations. Such a program would bring broad societal benefits including lowering of electric rates, reduction of greenhouse gases, and job creation. Furthermore, if the program is all state residents, then it surely could not be described as private. Any private benefit would unquestionably be qualitatively and quantitatively incidental to the organizations exempt mission.28 Is a qualified 501(c)(3) issuance really worth all of this trouble anyway? Yes. Why? Qualified 501(c)(3) bonds are a type of private activity bond that investors will treat more favorably than regular private activity bonds for two reasons. First, and most obviously, the interest paid on such bonds is tax exempt. Since investors do not pay Federal income tax on interest payments received on these bonds, those investors are willing to accept an interest rate lower than the interest rate on comparable taxable bonds.29 The second advantage of such bonds has to do with security regulation and reporting requirements. Stocks and bonds are treated as securities for federal purposes under the Securities Act of 1933 and the Securities and Exchange Act of 1934.30 These acts mandate that most businesses issuing stock, bonds, or other investment interests are subject to special reporting and registration requirements.31
28 To find validation for this assertion, one need look no further than hospitals or municipal utilities, each of which is explicitly mentioned as qualifying in 26 USC 145. In fact, one might even characterize the suggested 501(c)(3) as a municipal energy efficiency utility. 29

Ice Miller. Fundamentals of Tax Exempt Financing for 501(c)(3) Organizations. Accessed 3/12/13.

Available at: http://www.icemiller.com/publications/30/787557.htm.

30 15 U.S.C.A. 77b; See also S.E.C. v. W.J. Howey Co., 328 U.S. 293, 300 (1946). (defining the test of whether an investment is a security as: (1) An investment of money; (2) Existence of a common enterprise; and (3) An expectation of profits from the work of others). 31

Id. At 77b.

Additionally, most states also have their own reporting requirements, known as blue sky laws, which supplement federal securities regulation. One major advantage of the 501(c)(3) energy service company is that any interests they issue are explicitly exempted from such requirements.32 After an introduction to private activity bonds, and an explanation of the constraints placed on their sibling, qualified 501(c)(3) bonds, it becomes obvious that exemption from taxation and security reporting requirements would diminish costs of capital to a serious extent. In fact, this paper proposes that the repetition and streamlining of a qualified 501(c)(3) bonding process could result in a market for such bonds not only in private bank placement, but also in secondary markets. Theres only one real question left to ask now: Who is going to buy the first round of debt instruments from a nonprofit with no proven track record, no credit, and no collateral? III. Program-related Investment as a Credit Enhancement A company with no credit rating, track record, or profit motive would find it difficult to find willing investors for large amounts of debt instruments on its own. If the suggested organization were a for-profit ESCO, it could start small and sell equity interest to capitalize its business through its initial growth, but that option isnt available to a nonprofit because of the constraints placed on it in exchange for tax exemption.33 Fortunately, a nonprofit ESCO would have unique access to patient capital, waiting to be put toward exempt purposes, being held by the billion dollar lockbox that is the 501(c)(3) private foundation.34
32 James P. Monacelli (et. al.) Bond Practice: Overview of Private Activity Bond Financing and Incentives. Smith, Gambrell, Russell LLP. Published March 30, 2012. Accessed 3/14/13.

Available at: http://www.sgrlaw.com/resources/briefings/bond_practice/456/.

33 34

26 U.S.C.A. 501(c)(3). (describing the non-distribution constraint).

See Generally, Guidestar.org (Showing that the largest private foundations have roughly $5 Billion worth of assets each, and must distribute 5% those assets each year.).

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A private foundation is a tax exempt entity defined as any 501(c)(3) organization not having the characteristics of a public charity.35 For the purposes of this discussion, private foundations have two important aspects: (1) the must abide by minimum distribution requirements; and (2) they can make program-related investments (PRIs) to satisfy those requirement but also reap a return. The minimum distribution requirement dictates that a foundation faces tax penalties if it fails to distribute at least 5% of its assets annually toward charitable purposes.36 PRIs are contributions to an organization by a private foundation meant to further the exempt purposes of that foundation, while also satisfying the private minimum distribution requirement. They can take the form of a debt, equity, or even a credit enhancement arrangement.37 A recent rulemaking has explicitly identified the prevention of environmental deterioration as an acceptable purpose for a PRI.38 Ideally, a private foundation would provide a generous grant for the initial administrative costs of the new nonprofit ESCO. Such a grant could then be followed by a credit enhancement in the form of a PRI through which the private foundation places a sizable chunk of money into bank accounts at a series of local banks. Those banks could then place the qualified 501(c)(3) bonds, using program-related investments as credit enhancing collateral. Over time, that collateral could then be replaced with a loan loss reserve fund, derived from energy savings that begin to flow from retrofits every month. Should any of the ESCOs clients default on their payment,39 the organizations balance sheet would be covered by such a fund. This process
35 26 U.S.C.A. 509 (Yes, believe it or not, as a testimony to the unique style of the IRC, the Service chose to define a private foundation by what it is not, rather than by what it is.). 36 37

I.R.C. 4942.

Examples of Program-Related Investments, 77 FR 23429-01 (April 2012); See also Clean Energy and Bond Finance Initiatives Clean Energy Bond Finance Model: Industrial Development Bonds. 2013. Page 1. (stating the need for credit enhancements when attempting to issue/place bonds).
38 39

Id.

Kim (et.al.) supra note 9, at page 22. (Stating the default rate similarly structured on-bill repayment plans is %0-2).

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bears some similarity to the Property Assessed Clean Energy system already used by some municipalities to finance energy efficiency retrofits,40 except that it skirts the recent subordinated lien problem by using PRI money as a separate source of collateral.41 A young nonprofit ESCO will find it difficult to obtain capital for energy efficiency investment. One possible source of capital could be bond placements which use capital obtained from private foundations as collateral. Such an arrangement would be appreciable for both parties because it would catalyze access to capital for the nonprofit ESCO and satisfy the private foundations distribution requirement while earning it money. III. Recommendations Many people consider the creation of a securitized market for energy efficiency investments the next step toward a greener economy.42 At least two state treasuries have made headway in a similar aggregation of energy efficiency loans. Pennsylvania accomplished secondary market placement two weeks ago and New York plans to use private activity bonds to accomplish the same purpose during summer 2013.43 The difference between their bundling of efficiency investments and the method proposed above is ownership. In the case of energy efficiency loans bundled for investors, the homeowner owns the property and simply owes a debt to investors. Such a transaction would be incompatible with qualified 501(c)(3) bond financing because the exempt asset (insulation, efficient appliances, solar panels, etc.) are owned by the homeowner- a non-exempt entity. However, if a state or 501(c)(3) instead used an energy
40

See Generally, PACENOW! Financing Energy Efficiency: Residential PACE.

Available at: http://pacenow.org/about-pace/residential-pace-2/.

41 US Department of Housing and Urban Development. Mortgagee Letter 2009-49. Home Equity Conversion Mortgage Program: Subordinate Lien. November 18, 2009 (stating that PACE liens are null in the eyes of the federal government). 42 Think auto or mortgage loan markets, but more reliable because energy prices are not likely to sink beyond the floor recently created by the natural gas glut. 43 Freidrich, Kat. Energy Efficiency Loans Encounter Obstacles in the Secondary Market. Clean Energy Finance Center. Published 3/8/2013. Accessed 3/15/2013. Available at: http://www.cleanenergyfinancecenter.org/2013/03/energy-efficiency-loans-encounterobstacles-in-the-secondary-market/.

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services or power purchase agreement, it would be entitled to such tax exempt financing because the 501(c)(3) retains ownership of the asset and offers the homeowner its energy services instead. This paper discusses several unique ideas intended to push the energy efficiency market in direction of securitization. First, it discusses using the C35 evolution of the traditional energy services company as means of aggregating and distributing tax exempt residential energy efficiency investments. Such organizations rarely seek capital from private markets, but instead acquire capital from a kw/h tax on the electric ratepayer. Such tax exemption would provide much needed liquidity for a broader stream of efficiency investments by making non-taxable interest more attractive for investors. Second, it discusses aggregating such efficiency investments in the form of qualified 501(c)(3) bonds. This method of bonding is normally only used to finance hospitals and municipal utilities, but offers a great way to securitize energy service agreements for what is basically a municipal energy efficiency utility. Third, it recommends a start-up grant and PRI based credit enhancement as a route for tackling the startup costs of the nonprofit ESCO while still aggregating specifically intended investments into a special-purpose nonprofit entity. Such an entity should be able to achieve a decent credit rating to ensure the value of securitization. If one wanted to catalyze creation of a secondary market for energy efficiency investments it should be by: (1) packaging them as energy service agreements with a special purpose vehicle 501(c)(3); (2) aggregating them through qualified 501(c)(3) bonding; (3) enhancing their credit worthiness through the use of a private foundations PRI; and (4) placing them either privately or publicly with willing investors.

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