Examining the suitability of Private Equity for Energy Efficiency Projects

June 2010 Austin Whitman Consultant awhitman@mjbradley.com

2

Why carbon investment firms are moving beyond carbon

Note: Data from EIA and EPA. Assumes $93.50/MWh average retail electricity price and 0.6 tonne CO2/MWh emission rate; $2.15/gal fuel oil and 22.4 lbs/gal emission rate

$0

$10

$20

$30

$40

$50

$60

$70

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$90

$100

$5 $15 $25 $35 $45 $55 $65 $75 $85 $95 $105 $115 $125 $135

$/tonne

$/M

Wh

Carbon Value Power

$0.00

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$1.00

$1.50

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$5 $15 $25 $35 $45 $55 $65 $75 $85 $95 $105 $115 $125 $135

$/tonne

$/g

allo

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Carbon Value Heating oil

Even with low energy prices, a unit of energy savings is worth more than the associated carbon reduction

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The natural cycle of efficiency projects fits with the familiar guidelines of private equity

Investments begin yielding cash early in their lifecycle

Technology is proven, reducing risk

Most investments are self-liquidating

Investments supported by intrinsic asset value

Attractive risk-adjusted returns

Unlevered potential for 12-14% returns

Potential for leverage to boost returns by 4-6%

Provides portfolio hedge against rising power prices

Efficiency gains reduce exposure to base load price increases

Also gain long exposure to carbon prices

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The efficiency opportunity: large, diffuse, and immediate

ACEEE estimates a current $269 billion annual spend on (non-transport) energy efficiency, two-thirds of which is spent on efficiency in buildings

McKinsey estimates an NPV-positive opportunity to save 9.1 quadrillion BTUs per year (final energy) by 2020 in non-transport sectors (equates to 25% of 2008 demand)

40% in industrial

35% in residential

25% in commercial

$126 bn in potential energy savings at U.S. average industrial prices

Resulting energy savings would reduce carbon output by 1.1 Gt CO2e/year by 2020 (approximately 15% of total current yearly emissions)

The opportunities are immediate, on both supply and demand sides

Many investments have positive NPV and don’t depend on a U.S. GHG cap or the ensuing rulemaking period

Energy efficiency gains increase the yield on energy in order to:

Produce more final energy per unit of primary energy

Reduce the final energy input required for a unit of output

Otherwise improve resource output:input ratio

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Cheaper reductions tend to be found in industrial and commercial applications

Industrial projects cluster at the

cheaper end of the spectrum

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To access the opportunity, private equity almost certainly needs leverage to improve IRRs

The classic energy efficiency funding model lacks flexibility

ESCO + client arrange lenders, find grants, use asset owners’ capital, or finance equipment on balance sheet

New funding model:

Mosaic of financing sources: utilities, public benefit funds, bonds, banks, government general funds

Private sector loan

Public loan guarantee

Private sector lender administering public capital

Utility loan to consumer

Banks offering interest rate buydowns

PACE loans

Grants

Added possibility to employ PRI loans and developer’s capital

Result: energy efficiency projects should become increasingly attractive to private equity investors either directly or as part of a larger portfolio

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The power of low-cost leverage – a simplified example

-$150

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$0

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1 2 3 4 5 6 7 8 9 10 11

Year

100% PE 75%/15%/7%/3% 50%/20%/20%/10% 25%/25%/33%/17% 5%/35%/40%/20%

4%

7%

11%

16%

20%

WACC

[ PE / market rate loan / subsidized loan / grant ]

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mu

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uity in

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• 25% energy savings • annual energy costs : capital costs = 0.5

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Private equity is not always the right capital source

PE/VC expects complicated situations and needs to get paid accordingly

20-40% return expectations or more

PE has a limited time horizon, with investment lives of 3-5 years

Deals need to be of a certain minimum size for the economics to work out

Efficiency projects often have good downside protection but limited upside potential

ESCOs have a large market presence and present formidable competition to developers

Cheap capital in the market has the potential to crowd out PE/VC

Financial engineering, historically a centerpiece to PE strategies, is not always necessary

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ESCOs: high industry concentration but limited scope

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1

9

60

0

10

20

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< = 100 101 - 500 501 - 1,000 1,001 - 2,500 2,501 - 5,000

2008 Revenues ($ million)

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Sector revenues indicate the typical ESCO focus:

MUSH (58%)

Federal (22%)

Industrial (6%)

Commercial (9%)

Residential (5%)

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VC/PE Efficiency Investment -

North America, 2009 ($1.1 bn total)

Smart Grid, 340.8 (31%)

Transportation, 438.3

(38%)

Supply Side, 6 (1%)

Industry, 44.2 (4%)

Built Environment, 286.3

(26%)

VC/PE Clean Energy Investment -

North America, 2009 ($3.6 bn total)

Carbon, 1 (0%)

Services, 45 (1%)

CCS, 50 (1%)

Energ

y S

tora

ge, 315 (9%

)

Efficiency, 1,115 (31%)Renewable Energy,

2,051 (58%)

Efficiency already accounts for nearly one third of the $3.6 bn invested in clean energy companies

Source: Bloomberg NEF. All figures in $m, as reported. Asset-based financings not a significant share of the market.

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Second only to renewables, efficiency captured a large share of private capital invested in 2007-2009

Source: Bloomberg NEF.

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0

50

100

150

200

250

300

350

400

Jan-07 Jul-07 Feb-08 Aug-08 Mar-09 Sep-09

$ m

illi

on

Buildings Smart Grid Industrial Supply side Transportation

…And the steady investment flows bucked the capital market slowdown

Investment amounts by sector

Average Total

Transportation 25.6 million 1,792.3 million

Smart Grid 19.9 million 1,113.1 million

Supply side 16.3 million 455.4 million

Buildings 11.5 million 1,043.8 million

Industrial 9.6 million 114.6 million

Source: Bloomberg NEF.

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Putting it all together: projected cash flows & IRR for a real-world energy efficiency investment

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Fund IRR-4,000,000

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Initial capital costs repaid through electricity savings

Upside secured through rights to carbon credits

Contracts with host entities help insure against credit quality weakness

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Conclusions

Efficiency is more than ready for private equity, but PE may not be ready or suitable for all efficiency projects

Private equity and venture capital has historically chosen buyouts and seed-stage investments in companies rather than projects

As the market for energy savings gets more liquid, PE gains more exit options and will probably get more involved at the project level

Policy mechanisms and grants need to facilitate PE involvement but avoid making it too easy or flooding the market with cheap capital

Critical success factors

Ability to forecast energy savings, and then monitor and verify them, is essential

Counterparties may need to be comfortable signing contracts on the basis of projected energy savings or productivity gains

Supplemental low-cost financing works as an important catalyst where payback periods are longer

Need the ability to mitigate risk, hedge energy price exposure, secure (and securitize) cash flows

Investors will always require a well-defined exit strategy

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Contact

M.J. Bradley & Associates LLC

47 Junction Square Drive

Tel: +1 978 369 5533

www.mjbradley.com

Austin Whitman

Consultant

Tel: +1 978 405 1262

awhitman@mjbradley.com