Is Philly Building a $438-Million Stormwater Market?

This is the second in a two-part series.   You will find Part One, Philadelphia Taps Stormwater Fees to Finance Green Infrastructure, here.

11 May 2012 | Alisa Valderrama was working on energy efficiency projects when she heard about what her colleagues in NRDC’s Natural Resources Defense Council’s (NRDC) Water Program were working on in Philadelphia.

More precisely, Valderrama, who is a Senior Project Finance Attorney with NRDC’s three-year-old three-year-old Center For Market Innovation, was identifying finding ways to monetize long-term energy savings so that building owners could either borrow against them or offer them as future income to finance energy-efficiency retrofits to their buildings when she heard that the city of Philadelphia was offering financial rewards to property owners who retrofitted their parcels with green infrastructure like rooftop gardens, absorbant sidewalks, and grassy parking lots like the one at right.

“That’s when it just clicked,” she says.   “We were thinking, ‘Hey this sounds like the way we think about energy efficiency finance,’ and we started to take a closer look.”

Philadelphia’s plan, which we outlined last week, grew out of the city’s need to upgrade its ageing sewage system – much of which is devoted to handling stormwater runoff from parking lots and roofs.   The first thing the city did was work to re-align financial incentives for non-residential property owners.   Instead of charging stormwater fees based on the amount of water the property owner buys from the city, the city is phasing in a stormwater fee structure that is based on the amount of impervious surface area on a given parcel. Under the new system, property owners can get a substantial “credit” against their fee for impervious square feet that they replace with “green” infrastructure – meaning anything that can absorb up to an inch of rainfall all at once.

When companies with lots of concrete balked at the hefty new fees, the city offered to let them write off their upgrade costs against future stormwater fees.   That takes out some of the sting, but still leaves companies with a hefty up-front cost and benefits that take years to materialize.     If they wanted the green discount, they’d have to dig into their own pockets now or borrow.

NRDC had already been working with the Philadelphia Water Department on the new stormwater policy, and to help think more precisely opportunities for private investors in Philadelphia, given the new incentives to install green infrastructure,   NRDC called in EKO Asset Management Partners.

The topic of financing green infrastructure retrofits was also attractive because the issues Philadelphia is facing are not unique.

“We knew that lots of cities like Philadelphia are facing enormous challenges when it comes to improving water quality in their communities, and it is all the more challenging at this moment- when grant funds from federal or state governments are scarce, and cities are less willing – or less able – to rely on their credit rating for the financing of long-term investments in traditional stormwater solutions,” says Valderrama. “So we decided to see what we could come up with in terms of private capital solutions for green infrastructure.”

A Financing Smorgasbord

The result is “Financing Stormwater Retrofits in Philadelphia and Beyond”,  which – as the name implies – bases its analysis on the Philadelphia case but aims to look beyond the Philly program and offer initial suggestions for how private capital can be leveraged in cities looking to utilize green infrastructure to manage stormwater.   policy

“It’s really become a much broader and, I think, very exciting project,” says Valderrama. “What’s exciting about it is that we also managed to expand our scope beyond just looking at cities where the policy environment is perfectly right.”

She cites pay-for-performance as one way that a green-minded property owner can develop green infrastructure efficiently.

“This would be an arrangement where a private third party gets compensated to mitigate stormwater runoff, but only gets paid upon performance,” she says. “This is really a private-public-partnership approach that doesn’t require any sort of specific billing structure in order to function.”

Better Than Energy

The energy efficiency space hasn’t grown as quickly as expected, but Valderrama believes green infrastructure will be different.

“The primary problem with energy efficiency is that, in many cases, building owners can’t be bothered,” she says. “Sure, there is some 2% or 5% of commercial ‘Class A’ building owners who are ahead of the curve and realize   energy efficiency is about being a smart owner, or because they are trying to attract blue chip tenants, but for the most part commercial building owners are worried about a lot of other problems before they start thinking about an efficiency retrofit to their building.”

Energy cost, she points out, rarely top 10% of a building’s net operating expenses, and any benefits go to the tenants in the form of lower energy costs and not to owners under the lease structures that prevail in many commercial leases.

But there’s also the fact that those savings come at the whim of the energy sector – and those prices can change over time, as well as being subject to fluctuations in user behavior.

“With green infrastructure, at least in Philadelphia, you have a case where property owners have seen their fees go up several times over in many cases through the conversion to the new parcel-based billing,” she says. “These are new costs to building owners, so there’s going to be a more finite and concrete appetite to get those new costs down.”

Not only are they more visible, but the risk of failure may be lower, because green retrofits are low-tech and their performance doesn’t change with occupancy rates or lazy tenants. They are also easier to predict — in Philly’s case, once the owner shows the city that they have “greened” their parcel, the fee reductions are set for four years.
The Potential

Philadelphia’s new fee structure impacts roughly 90,000 commercial properties, and the report examined just two categories: the 100 that pay the most in stormwater fees under the new pricing structure, and the next 1300 – which are all those that pay $1,000 or more each month.

They estimate that it will cost $115 million to retrofit the top 100 and $470 million to retrofit the other 1300.   That’s a total of $558 million for all properties that pay over $1000 per month.   Following the industry standard for commercial real estate finance, if 80 percent of the retrofit cost were financed and 20 percent of the costs were covered by cash from the property owner, the top 100 properties would need $92 million in third-party investment, and the others would need $376 million – a total of $438 million.

That, the report argues, represents an opportunity for financiers who are able to measure and manage the risks associated with such projects.

The Challenges

Like any opportunity, this one has many potential pitfalls.   To begin with, you’d have to convince lenders that the loans are secure – and that’s no easy task.   First, commercial real estate properties tend to be owned by limited partnerships, which means there’s limited security from parent companies. Because they would likely become fixtures on the property once installed, the green infrastructure installations themselves are weak collateral.

Also, there’s the fact that most commercial property mortgage covenants make it hard if not impossible to attach additional debt to a property. That means the current owner would be stuck holding the debt if he wants to sell the building, while any potential buyers or their tenants would receive the benefits.

That leaves the future avoided costs as the only asset, but stormwater fees aren’t necessarily written in stone, either.   Yes, they may be more predictable than energy prices, but they do change.

Proposed Solutions

The paper offers a series of solutions which are too long for us to go into here, but here’s a sampling:

• Off-balance sheet “project developer” financing. This mechanism gets around the difficulty of burdening a property with debt by explicitly defining the payments as a portion of the stormwater fee savings.
  
• Land-secured financing through commercial PACE (Property Assessed Clean Energy) programs. These programs were developed explicitly to fund renewable-energy upgrades, and usually involve a municipality issuing special revenue bonds and loaning the proceeds to property owners.   The repayment is made in the form of an assessment on property taxes.
• Utility-enabled financing and repayment. In this mechanism, the utility provider pays for the upgrade, and the property gets a monthly line-item listed on its utility bills.
  
• Performance Contracting (ESCO) model. Energy Services Companies (ESCOs) aren’t mechanisms, but are specialized companies that deliver reduced stormwater fees as a product.   They do this by handling the entire upgrade and then earning a fee based on each month’s fee reduction.
• Credit enhancement facilities. These entities provide capital to cover defaults, and are often private-public partnerships.
• Project aggregation and private-public partnerships.   These entities lump several projects together to reduce transaction costs and spread risk.
• Offsite mitigation with tradable credits. A property owner could go so green that his property is able to absorb runoff from other properties or from, say, city streets.   If that happens, he might be able to earn credits from that he can sell to other providers who aren’t in a position to do the same.

Additional resources