Creating a market for energy efficiency investment: Why securitization doesn’t matter (at least for the next 10 years)

If only we could just consistently originate and securitize loans for building energy efficiency retrofit projects, we could flood the energy efficiency market with cheap capital, overcome the aggregation problems we’ve covered here, and put the market well on its way toward scaling building energy efficiency. And thus many market participants seem to be on the quest for the holy grail of securitization. But I think embarking on that quest today is misguided.

Now, let me be clear. I do think that secondary markets for energy efficiency loans would be beneficial to energy efficiency for a number of reasons. Because a secondary market would provide additional liquidity for lenders in building energy efficiency projects, this would reduce the required return hurdle for energy efficiency projects, theoretically boosting the number of projects that would meet that hurdle. Moreover, since we know that on average building retrofits perform quite well but individual projects can vary somewhat widely around an average, the diversification provided by a portfolio or package of energy efficiency loans should reduce risk and lower required returns. Pooling energy efficiency loans together to make a larger security to sell to institutional investors would help overcome the “too small to care” problem. Sounds great right? After all, isn’t lowering the barriers to capital investment in energy efficiency what we’re all about here at Financing Efficiency?

Well, yes, of course. But the point of this post today is not to deflate the idea that securitization is a good idea or that it will one day play an important role in the energy efficiency finance market, but merely point out that the road between today’s energy efficiency finance market and a future where the energy efficiency finance markets are liquid enough to securitize packages of energy efficiency loans is a long and arduous one.

We can start by looking at the historical precedent for securitized markets. The first and most famous (or infamous at this point) securitization market is the residential mortgage backed security market, the biggest securitization market globally.*

The development of the securitized mortgage market really depended on three things:

1) Historical data for housing defaults. Given the massive volume of mortgages that had been written in the post-World War 2 era, there was plenty of data for investors, rating agencies, Government Sponsored Entities like Fannie Mae and Freddie Mac, banks, mortgage brokers and others to convince themselves that securitization of mortgage backed loans was a safe investment (or at least that the risk of a set of loans could be accurately priced). Now, while it turned out that a lot of this risk was severely mispriced, the historical default data was still a critical first step in establishing the market.

How does this apply to energy efficiency? The efficiency industry is clearly making progress toward standardizing the data around energy efficiency investment returns through a number of efforts, including the Living Cities / Deutsche Bank project, the DOE project to produce an actuarial quality database showing historical retrofit project performance, and continually improving Measurement & Verification programs from groups such as IPMVP.

This important progress notwithstanding, it is still difficult today to get primary lenders comfortable with energy efficiency, and it will certainly take even more time to get institutional investors in the secondary market comfortable.

2) Standardized mortgage documentation. Most mortgages look pretty much the same. And that’s important, because in order to tranche together a pool of mortgages to be sold to investors, the documentation should be substantially similar across the entire portfolio. Otherwise it’s too hard for investors to evaluate the risks of the portfolio.

Standardized energy efficiency investment documentation? Not so much. MESA, EPC, ESA, ESPC, etc, etc. Thankfully, many organizations are making progress on this front as well, like BOMA (standardized ESCO contracts) and Empire State Building (freely publishing their performance contracts). But broadly speaking, the market has yet to settle on standard documentation that works for all involved parties, and until that happens, it will be very difficult to securitize large packages of energy efficiency investments.

3) Balance of supply and demand for the product. Mortgage backed securities made for a great securitization market because of huge amounts (trillions of dollars a year) of supply coming from mortgage originators on the one hand, and voracious demand from pension funds, hedge funds, insurance companies, etc for the securities on the other hand.

Based on conversations with a number of secondary market investors, demand for investment in energy efficiency definitely exists today. The key bottleneck here though is supply. All it takes is a look around at the number of programs that have way too much money to spend (DC’s $250 million program – $5 million spent to date; Con Edison’s financing program of $100+ million – $5 million spent to date) to see evidence that supply of energy efficiency investments remains paltry at best.  Additionally, most of these programs sweeten the deal for existing retrofit projects rather than helping to create actual retrofit securities. Until a category of investments that pay returns purely through the success of a retrofit project emerges, securitization will be impossible. And because most arrangers of securitization products require at least $75 – $100 million of minimum size before they could be sold to the secondary market, this will be a serious hurdle to overcome in the near term.

The Path Forward

 In our view, the barriers to securitization can all be overcome by increasing supply. More origination of energy efficiency investments means more data points to help investors price the risk. More energy efficiency investments will also help to standardize documentation as building owners, third party capital providers, and energy efficiency developers work out the kinks and come to agree on a set of contracts that works for stakeholders.

So my advice to energy efficiency securitization advocates is not to ignore the potential benefits of securitization, but rather to avoid putting the cart before the horse – the market will need to see a lot more energy efficiency loans and investments before a working secondary market can develop. Driving primary investment in energy efficiency projects should be the focus now.

*This post will largely ignore the huge structural difficulties the crisis exposed, and instead focus on how the RMBS market got built in the first place. I’d be happy to discuss the crisis and how that would affect building energy efficiency securitization in more detail in the comments.


One Response to Creating a market for energy efficiency investment: Why securitization doesn’t matter (at least for the next 10 years)

  1. Yes, there’s still some barriers to investments in energy efficiency but, as you said, it is mostly because it’s a (relatively) new thing primary lenders are not very comfortable with it. We hope this barriers will disappear soon. After all, energy efficiency pays well and a lot of investments are often done into less profitable fields.

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