December 3, 2012

High upfront costs are a primary obstacle preventing wide-scale adoption of home energy efficiency improvements. Even though energy retrofits can be sound financial investments, homeowners are hesitant to spend money on purchases they perceive as “discretionary.” To overcome this hurdle, several public/private partnerships have developed low-interest “loans” with creative repayment options whereby the energy savings offset the monthly “loan” obligations. These financial models allow homeowners to enjoy the many benefits of home performance without incurring additional financial burdens.

This 2-part post will explore two types of financial products: PACE financing and on-bill financing. Although neither have dominated the marketplace to date, both could help the energy efficiency industry gain an important foothold in American homes.

Overview of Pace Financing

PACE stands for “Property Assessed Clean Energy.” These programs provide property owners with low-interest “loans” to pay for energy efficiency and renewable energy improvements. The borrower, either a homeowner or a business owner, repays the PACE funds via a special assessment added to his or her property tax bill. Although functionally equivalent to loans, proponents of PACE programs carefully describe the debt obligations as a series of “assessments.”

To compel property owners to pay their taxes along with special assessments, municipalities put a lien on your property until your tax bill is paid in full. Since the local government always takes it’s slice first, tax liens enjoy priority status over other liens--meaning if you don’t pay your taxes, the city or county can foreclose on your property to repay itself in full before any of your other creditors.

The practice of using special assessments to pay for municipal projects, like new sewers and sidewalks, is nothing new and dates back to the 1700's. However, PACE programs are unique in that the assessments pay for projects completed on private property--not public property. State law governs what can and cannot be included in property taxes, so enabling legislation must be set in place prior to establishing a PACE program and collecting assessments.

How are PACE Programs Funded?

A common method of funding is for a city or county to issue bonds. Most often the bond proceeds are loaned out to homeowners or business owners at an interest rate slightly higher than the bond rate. The resident borrowers repay the “loan” via their tax bills, the proceeds of which are used by the municipality to pay off the bond at its date of maturity. As for the difference in interest rates, that goes to the municipality to cover administrative costs associated with the PACE program.

A second option for funding a PACE program, which is harder to do nowadays, is to apply for a grant. For example, many cities and counties received grants under the American Recovery and Reinvestment Act to establish revolving loan funds. Since the ARRA dollars had to be spent as part of the stimulus package, this option is not as widely available as it was a few years back.

A third option is for a city or county to work with third-party lenders. Some banks will loan directly to property owners participating in PACE programs, yet others require the municipality to act as an intermediary: The city or county borrows the money from the bank and loans it back out to property owners. Even though the town may charge an administrative fee, homeowners still benefit because municipalities typically have access to lower interest rates than do homeowners.

What should property owners know about PACE?

Beyond low-interest rates and convenient repayment options, PACE loans are particularly attractive for property owners who are on a tight budget. Since the loans are not dependent upon income, but rather upon the property's assessed value, you don’t have to be a member of the 1% to qualify--just a financially responsible person. And, if done correctly, the value of the energy savings should offset the cost of the assessments.

PACE loans are also attractive for homeowners who don’t know how long they’ll live in a particular house, since the loans are secured by the improved property and “run with the land.” This means that if you sell your home, the purchaser is responsible for paying the PACE assessments. Note, however, that PACE liens are an encumbrance on your property, which may make it more difficult to sell your home in the future.

FHFA and the Future of PACE Financing

As mentioned earlier, PACE loans have not been widely implemented (with the exception of California), despite being an attractive option for financing home energy retrofits. So, why is this? Over the past few years, the Federal Housing Finance Authority (FHFA) has prohibited the Federal Home Loan Banks, two of which are Fannie Mae and Freddie Mac, from purchasing mortgages encumbered by PACE liens. Since cities and towns don’t want to sacrifice borrowers’ ability to obtain loans for the purchase of new homes, many jurisdictions put PACE on the back burner.

To really understand what happened, it may be helpful to examine what the FHFA does and its relationship to Fannie Mae and Freddie Mac. The FHFA was created in 2008 pursuant to the Housing and Economic Recovery Act, and was tasked with regulating the Federal Home Loan Banks, two of which are Fannie and Freddie. Acting as their watchdog, the FHFA keeps an eye on these Fannie and Freddie, since they play such an important role in the economy: They purchase home mortgage loans from lenders, so the lenders can re-loan the funds to more home buyers.

Fannie and Freddie then bundle their newly purchased mortgages and sell interests in the revenue streams, which are known as “mortgage backed securities.” As part of the process, though, the banks make some level of guarantee that the loans will be repaid. You may recall that some states enacted legislation granting PACE liens first priority status, which made investors feel more confident they’d get their money back if individual property owners defaulted on their payments. The unintended consequence, though, was that it made the mortgages held by Fannie and Freddie more risky, because if there was a foreclosure, the PACE lender would get repaid in full before Fannie or Freddie recouped anything. Obviously, the FHFA was not happy with this arrangement, so it put the kibosh on Fannie and Freddie buying mortgages encumbered by a PACE lien.

In response to the FHFA’s directive, numerous states filed lawsuits attacking both the FHFA’s decision-making process as well as the merits of its position. Most of these cases have been dismissed with the exception of California. In this case, California claimed that the FHFA, in making its directive to Fannie and Freddie, acted as a regulator--and not a conservator--and, thus, violated the Administrative Procedures Act (APA) by not using a notice and comment period.

The United States District Court for the Northern District of California, whose decision is being appealed to the US Court of Appeals for the 9th Circuit, required the FHFA to deliver a final rule by May 2013 after inviting comments for a period of 45 days. Although complying with the Notice of Proposed Rulemaking (NPR) process, the FHFA is challenging whether the District Court can force it to establish a formal rule subject to judicial review.

Where do we go from here?

So, where does the litigation leave us? The FHFA is currently exploring risk mitigation measures that would allow PACE programs to proceed, although these measures may prove to be so cumbersome as to preclude adoption of PACE. If and when the FHFA issues its final rule, litigants will be able to challenge whether the FHFA acted arbitrarily or capriciously, given the record and comments. Another round of litigation is highly likely.

Meanwhile, Nan Hayworth (R-NY) sponsored the PACE Assessment Protection Act of 2011 and has been joined by 22 Republicans and 31 Democrats in the House of Representatives. This bill would preclude the FHFA from “adopting policies that contravene established State and local property assessed clean energy laws.”  However, experts are forecasting that this bill has little, if any, chance of passing, given the legislative climate in Washington.  Thus, we'll most likely have to wait and see what the FHFA's final rule entails and the ensuing litigation.