YieldCos have gotten a lot of coverage lately, especially in residential solar. But there’s a new financing mechanism in town, and it’s based on energy efficiency.

So what is a YieldCo? It’s an investment opportunity that provides safe “yield” for the investor, much like a bond provides a coupon. However, unlike a bond, the investor goes in on a portfolio of assets, like solar panels on a roof, that produce cash flow from homeowners like you and me as we pay for our solar electricity. Aggregated over millions of roofs with a solar payback of ten to fifteen years, solar YieldCos can be a reasonably safe investment­.

Safe, maybe. But are they lucrative investments? Not necessarily, because although these solar YieldCos represent an important starting point for the industry, they might not attract the high-net-worth, institutional or family office investors that typically require a 10 percent return on investment.

So how do we as an industry leverage the YieldCo model to develop a similar option in energy efficiency -- one in which investors experience reasonably secure returns, but with the potential for substantially higher yields than in solar? The key is the underlying instrument. While a typical solar project has a payback of ten to fifteen years, an energy efficiency project that uses established technologies returns the original investment in only four to five years. Compared with rooftop solar, achieving significant returns should be even easier with energy efficiency projects.

As it turns out, the energy efficiency opportunity is vast. McKinsey has estimated that the energy efficiency investment opportunity is close to $1 trillion in the U.S. alone. Market structures in Europe are also budding due to the growing institutionalization of energy efficiency and demand response, making the global opportunity tremendous. Returns on energy efficiency are so promising that energy efficiency investors should be able to do quite a bit better than they can in solar.

So how does an investor make sure his or her money is as safe with a portfolio of efficiency projects as it would be with a portfolio of solar projects?

Many new insurance instruments ensuring that projects yield savings are now coming to fruition, thereby securing returns. Companies like Metrus are using these insurance products combined with engineering expertise to give investors comfort. Hannon Armstrong and its peers have raised efficiency investment funds, and municipalities are attaching efficiency loan obligations to the property through property-assessed clean energy (PACE), rather than to the individual. 

At Joule Assets, we’re taking a page from the solar YieldCo playbook, providing upfront financing to energy efficiency vendors and cycling returns and monetized energy savings back to investors in a private equity fund. The YieldCo-like structure generates base returns of 6 percent to 10 percent to investors, while providing additional options like mezzanine returns of 5 percent to 15 percent and the opportunity for equity participation. This gives investors an attractive low-risk entry point to the previously closed energy reductions assets market.

There are three key considerations for a safe and lucrative energy efficiency investment vehicle.

1. Don’t target buildings for financing; target the contractors. By providing pools of capital to the firms that provide the technology, project installation and integration, you speed deployment, shorten time to market and make it easy for contractors, buildings and financiers to align. Most financing vehicles are targeted at the buildings that intend to install the efficiency upgrades, but it’s best to offer pools of capital to the firms that provide the technology, project installation and integration: the contractors.

2. Mitigate risks through a system of checks and balances. Energy efficiency financing can provide a pool of funds to back up projects led by installers. If any of the installer’s customers fail to pay the financing fee, that pool of money keeps investors whole. Because energy efficiency vendors are closest to the customer, they have the most impact on customer satisfaction. And because they will be the first to lose if the customer fails to pay, they work the hardest to vet and service their customers who have bought “energy efficiency.” Investors will not face a loss unless inordinate numbers of these projects fail.

3. Earn high returns through expertise in energy efficiency markets. How is it possible to build on a base of YieldCo-like returns in energy efficiency? Only a few firms understand how to monetize energy reductions, but those who do are able to capitalize on untapped cash flows. Control systems allow a site to earn money by dialing back consumption when the power grid is under stress. Some energy markets actually pay consumers who document the energy efficiency they achieve. Expertise in energy efficiency finance and regulatory frameworks will be the most critical aspect of securing exceptional returns for investors, above and beyond the base returns that a traditional YieldCo would provide.

Right now, who is investing in energy efficiency? At this early stage, informed high-net-worth individuals, family offices and impact investors are taking advantage of the outsize returns that many of these instruments are offering.

Institutions tend to wait longer; they need to analyze years' worth of statistics on failure rates. Institutions also seek tried-and-true investments, but they are exposed when the foundations of an industry shift. That’s why they work hard to spot an early trend, but wait for a short while to make sure new structures are solidly in place. That’s the moment for the more dynamic investors to step in -- and this moment is now for energy efficiency.

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Mike Gordon is founder and CEO of Joule Assets, Inc. the leading finance provider for the energy efficiency and demand response industries and manager of the Joule Assets ERA Fund, a first-in-kind private equity fund targeting Energy Reduction Asset markets.