If the 2008 mortgage meltdown did anything to educate Americans about the complicated world of finance, it was to teach them about securitization.
Securitization is the practice of pooling disparate sources of debt and selling it as a package to investors on the secondary market. The practice has grown immensely over the last few decades and has been used for packaging all kinds of debt -- mortgages, credit card debt, auto loans and student loans being some of the more notable. And now renewables like solar are starting to reach the scale needed to securitize projects and sell them on the secondary market.
Securitization has been demonized because of the abuses that mortgage-backed securities eventually fueled among lenders and borrowers. But the practice is crucial for improving liquidity and stimulating demand, providing new opportunities for emerging industries like solar by expanding the number of institutional investors that can put money into projects.
The practice could be one of the most effective tools for unlocking the vast potential of energy efficiency as well. And institutional investors -- banks, pension funds, mutual funds and insurers -- are expressing a lot of interest in efficiency as a pooled asset class.
The problem, according to a new white paper from the sustainable business group Ceres, is that the industry is still too small to make securitization a real option. That's leaving billions of dollars on the sidelines.
"The scale of investment will be too large for bank balance sheets alone and will therefore require broader capital markets participation, as it has for other forms of consumer and commercial debt," wrote the report authors. "Thus far, however, opportunities for investment in such pooled vehicles are nearly non-existent for large institutional investors."
The report materialized after Ceres gathered nearly 30 experts from insurance companies, mutual funds, pension funds and project development companies to talk about the barriers preventing the creation of robust secondary markets in energy efficiency.
"We need to focus on the capital markets," said Brandon Smithwood, manager of the policy program at Ceres and lead author on the report, in an interview. "Growth will come from getting beyond the typical way of playing in this market -- and creating these pools is a great way to do that."
Securitization typically requires a package of loans worth $100 million or more. That's still a difficult task in the efficiency space. The problem, said Smithwood, is that there isn't sufficient project volume to create robust pools of energy efficiency projects. And the project volume is too low in part because large institutional investors aren't able to leverage those pools.
Thus, the energy efficiency industry faces a conundrum that plagues many growing markets.
"This really is the classic chicken-and-egg problem," said Ken Locklin, managing director for North America at Impax Asset Management, in an interview. Locklin was one of the participants in the roundtable. "This requires maturity in the market itself, but the ecosystem just hasn't developed yet."
The poor pipeline of projects is due to common problems in the market: utility disincentives to promote efficiency, landlord-tenant splits, limited information for consumers and high upfront costs. In the financial markets, the lack of standards for efficiency loans and limited information on project performance are also holding back securitization.
"There’s definitely an appetite out there, but there are a lot of barriers to fulfilling it," said Natasha Lamb, senior vice president of shareholder advocacy at Trillium Asset Management, in an interview. Lamb also participated in the investor discussions.
The answer, according to Lamb, Locklin, Smithwood and every other person consulted for the white paper, is crafting better policy to stimulate a greater volume of projects and encourage financial innovation. (Ceres is holding a webcast next month on how to do that.)
"We've been stuck with poor policies. But policy helps create demand for new financial instruments. If you create that wheel, there's big opportunities for lots of players," said Lamb.
The group of investors created a list of top policies that could help drive the market. These include energy disclosure laws, stronger building codes, improved equipment efficiency standards and state-level energy efficiency targets that require utilities to invest. On the finance side, approaches like property-assessed clean energy, master limited partnerships, on-bill repayment and credit enhancement tools like loan guarantees are all top priorities for investors.
According to Deutsche Bank Climate Advisors, the U.S. efficiency market represents a $279 billion yearly investment opportunity. But that potential will not be tapped without more financial innovation that would bring more institutional investors into the market.
"We believe that the application of institutional capital can act as a catalyst for significant growth and speed of development," wrote Deutsche Bank in a 2012 report.
Although the market is still nascent, institutional investors are playing in energy efficiency. Some fund managers are making straightforward investments in public energy efficiency companies. Others with large real estate holdings are setting efficiency targets for their buildings or requiring energy disclosure across their portfolios. However, these efforts only scratch the surface of what's possible through secondary markets of pooled investments.
"In order to achieve this scale of investment, policy must drive demand for efficiency, [...] public policy will be essential to several aspects of energy efficiency finance: leveling the playing field in utility regulations, driving demand for energy efficiency retrofits, and enabling innovative energy efficiency finance mechanisms," concluded the report authors.
Come join us at Avant EE, our one-day efficiency conference in San Francisco on July 29th. We'll be featuring a panel discussion on this topic to detail exactly what needs to be done to encourage financial innovation in energy efficiency.