The financial value of financing onsite energy lies in the difference between the wholesale energy price and the cost of the financing option. In an era with annual energy cost increases as high as 45% for some and continued volatility – getting to a state of control is essential. Financing an onsite system continues to present a strong business case for nearly all companies – read on to understand the most common and financially sound options.
POWER PURCHASE AGREEMENT
A Power Purchase Agreement (PPA) is a long-term financing contract with a third party that owns and operates an onsite energy system, such as solar or energy storage. Under a PPA, the company agrees to purchase the electricity generated by the system at a predetermined rate. A PPA contract allows the business to lock in a transparent kilowatt-per-hour electricity price for up to 25 years. In the face of unpredictable utility rates, a PPA can be an attractive option for business owners seeking a hedged position as energy costs escalate. Plus, the maintenance and operation of the system are managed by the asset owner for the duration of the agreement.
Understanding key elements of a PPA term sheet:
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What is the term of the PPA?
PPAs typically span 20 to 25 years, although in states like New Jersey and Hawaii, a 15-year term is also common. While PPAs are often likened to “solar as a service,” implying an on/off switch capability, they more closely resemble a long-term lease. This financing model is known as zero-down or fully financed, requiring no upfront costs from the customer but rather a long-term commitment. The agreement establishes a fixed price-per-kilowatt rate over the contract term, usually with an escalator that increases the price annually.
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What is the rate?
The PPA sets a fixed per-kilowatt-hour price that remains constant throughout the contract’s duration. Investors generally aim to provide the business customer with a compelling savings opportunity, often targeting a rate that guarantees a minimum 10% margin of savings. However, larger customers, particularly in certain areas of California, have experienced savings margins of between 25% and 30%.
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What is the escalator? What is that annual increase going to be?
An escalator is a specified and agreed-upon annual percentage increase for the kilowatt-hour rate. It is ideal to have an escalator between 0-2%. For instance, while utility rates may rise by an average of 4-5% per year over the long term, a 1% or 2% escalator in a PPA would still be delivering a large margin of savings.
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What happens at the end of that term? How does the business get ownership of the system?
Customers must ask this question upfront: when it comes time to buy out, how will it work? Typically, agreeing to a determination process is to the customer’s benefit. When trying to exit the agreement, having visibility for what it will look like is very important—it is not a simple principle scheduled paid out at any point in time.
ENERGY SYSTEM LEASE
A lease model, akin to a PPA, involves the business leasing the energy system instead of purchasing the electricity directly. Typically, a lease is a straightforward fixed payment over a defined period—usually seven to ten years, which is much shorter than a PPA. However, the system’s lifespan is likely to exceed the lease term, allowing customers to plan for an early buyout, take full ownership, and capitalize on the long-term benefits of direct ownership.
One other significant difference between these two financing options is the operational obligation. With the PPA the entire system performance is wrapped into the financing, so there are operational costs baked into the agreed-upon electricity rate. Whereas with a lease customers must be more comfortable taking on the risk of ownership and responsibility of ensuring the system produces—cleaning, maintenance, and operation (or hiring others to perform these tasks).
COMMON DEBT & PACE FINANCING
Debt is the most familiar and most common financing structure for commercial onsite energy systems. In this scenario, a business finances the energy system with cash reserves, traditional loans, or energy system-specific PACE (property-assessed clean energy) financing. While businesses might describe this as ‘self-financing’ or ‘paying cash,’ the capital typically comes from an equity line or a mortgage. With debt financing, the business owns the energy system outright and is responsible for its ongoing operation and maintenance.
One of the essential differences between debt for business-owned systems and a PPA or lease for investor-owned systems is the treatment of tax credits. In a PPA or lease, the investor receives the tax credit, reducing the financing cost on an ongoing basis. In contrast, with ownership-based structures of debt, the business retains the value of the tax credit. Whether a business opts for a third-party ownership model like a PPA or lease, or chooses direct ownership financed with a loan, the installed energy system will generate power, offsetting the electric bill.
Here is a closer look at the most common debt financing options:
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Equity Line or Commercial Mortgage
In this case, the capital comes directly from the business’s own bank. This approach offers the advantage of potentially securing long-term financing at a highly competitive rate, as commercial mortgage rates are generally lower than those for unsecured loans and PACE financing. However, in the current market conditions, obtaining onsite energy financing from an existing mortgage lender often means accepting a reset of the interest rate, which has increased historically. Moreover, there could be various reasons why it might not be beneficial to seek additional debt from an existing senior or mortgage lender.
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Unsecured Loan
This product is commonly offered by banks and occasionally by non-bank entities, but it is subject to thorough underwriting. It typically requires the business to provide several years of financial statements and demonstrate property ownership. One advantage is that the business does not have to place an additional lien on the property, and there are few or no covenants. Here the lender takes on a different level of risk, which is why the terms are often out to 20 years, and the rate may have a nine-handle vs a six- or seven-handle on a commercial mortgage.
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PACE Financing (Secured Loan)
Historically, PACE financing has been used for standalone solar projects or combined projects involving solar, roofing, and energy storage. However, going forward, it is expected to be utilized more often in conjunction with other aspects of building finance, such as new construction or rehabilitation. PACE financing is based on a special tax lien on the property, which enables the customer to access long-term sources of capital. While PACE financing was once thought to be solely based on property value and loan-to-value (LTV) ratios, it is actually a highly underwritten product that considers factors such as financials and debt service coverage, especially in the current interest rate and credit environment. It is often used as a mezzanine finance tool for commercial real estate, particularly when wrapped with HVAC or roofing projects. Business owners should be aware of PACE financing as a potential solution, particularly if they have non-solar items they are looking to finance alongside energy projects. However, due to the nature of the special tax lien, it requires careful consideration and discussion before implementation. In most states, it requires express written permission from the customer’s existing mortgage lender or senior lender in order to implement
Ultimately, when choosing partners to build and finance onsite energy systems, it is always key to do due diligence—ask the basic questions and get the project history. While many companies and contractors offer financing and installation services, it’s essential to work with experienced partners who have a track record of successful projects. Asking for project track records, reading contracts carefully, and understanding the roles and responsibilities of each party are crucial steps in choosing the right partners.
For more on the financing onsite energy topic, listen to VECKTA’s CEO and Head of Sales talk with James Coombes, Director at Painted Rock Capital Group here.
