Green neighbourhoods as a service

Bankers without Boundaries (BwB) is a not-for-profit financial advisory firm working with EIT Climate-KIC on its Healthy, Clean Cities Deep Demonstration, a programme that’s helping European cities like Milan mitigate and adapt to climate change. Read on for a lightly edited extract from BwB’s original blog post exploring how to reduce net energy consumption in the built environment, which contributes 30-40 per cent to a city’s total CO2 emissions. 

A challenging problem

Reducing emissions in the built environment is an extremely complex problem with multiple components. Many of these complexities arise from an underlying assumption, in nearly all jurisdictions, that solving the problem is the responsibility of individual property owners. Multiple individual actors must make independent decisions leading to a fragmented response to the challenge.  

Even ignoring this fragmentation, targeting individual property owners with economic incentives alone is failing anyway due to two interlinked problems:

1. The value of returns (energy savings) is not connected to the capital spend. Returns occur over many decades and a building owner must be confident that they will enjoy those benefits for at least 30 years to have a hope of creating a positive economic case. Most building owners cannot commit to owning the property over that period; therefore, the net present value of energy savings is undervalued by the capital spender relative to its true worth.
2. Even assuming the building owner can commit to 30 years of ownership, the economics of delivering deep decarbonisation in a way that is attractive to citizens (deep community retrofit) has poor economic returns (negative IRR) even assuming a 30-year investment period.

If economic rationale alone is not enough, decision making and financing must balance competing goals–economics, decarbonisation, community benefits and social and health impact, which requires a broader viewpoint than an individual building owner.  

As a result, current solutions, which are frequently designed to be adopted by property owners, are failing. This has led to the paralysis we see in the market with negligible levels of building level improvements which improve energy efficiency (“retrofit”) occurring, despite various subsidy schemes being offered and financing costs being at historically low levels for some time. 

Most existing solutions start with a premise that, since it is down to individual property owners to commission work on their own properties, it is also therefore assumed that the energy and maintenance savings benefit accrues to them too and that this should form the economic rationale to carry out the project.  

Even after discounting other barriers to entry (complexity of deciding what work to commission, project managing multiple trades, applying for subsidies, the misalignment of landlord and tenant incentives in the rental sector) the economic returns are not high for ambitious retrofit and require the property owner to remain in the property for decades to realise them. Therefore, the net present value of these savings is not being leveraged to solve the problem in the most effective way. 

The sheer scale of retrofit that is required to improve inefficient buildings is also often touted as a problem. The costs of an ambitious retrofit programme are huge and go well beyond the public purse. To compound the problem, the energy savings that can be achieved are not high enough for traditional financing on its own. Public finance will need to be blended with private capital in some way to provide the level of finance needed to achieve the scale required. In addition, retail investment and citizen engagement need to play their part in the equation to increase visibility and feasibility.  

An interlinking issue for many countries is that of regional inequalities. Governments, such as the UK, have made levelling up regional differences a key policy initiative. Existing retrofit plans stand to exacerbate this issue. In the UK for example average house prices in London are £661,000, but only £200,000 in the Northeast and Northwest. Average loan to value ratio is 82 per cent. Retrofit costs are broadly uniform across the country, so a deep retrofit at £40,000 would equate to 6 per cent of property value or one third of average equity in London, but 20 per cent of property value or 110 per cent of equity in the North. Clearly a policy led strategy that forces retrofit debt onto house owners would be deeply regressive for the North.

Any scalable solution must address the fragmentation of the problem which arises from individual decision making, allowing more systemic decision making to happen, economies of scale to materialise and progress to finally be made. This requires a fundamentally different approach. 

Yet, there is also real opportunity in this space.

Green neighbourhoods as a service – A proposed solution

To address the mismatch between ownership of the capital spend and of the value of benefits, tackle the fragmentation issue, overcome barriers to entry, allow aggregation of projects and matching of different types of finance that will be needed, we propose a new more centralised model which we call ‘green neighbourhoods as a service’ (GNaaS). 

GNaaS envisages the establishment of a central entity in a city or region which designs, commissions, manages and funds deep energy retrofit on a street-by-street scale with incremental community investments at no cost to the property owners, regardless of ownership and usage typology. 

• By centralising the design process, more systemic energy decisions are made, for example around local energy systems and integration with district heating.
• By centralising procurement, greater economies of scale are realised, improving economics and providing a lead market to the supply chain creating an environment for investment.
• By operating at a community scale, additional projects such as resilience building, co-working spaces and green infrastructure in the shared spaces can be implemented at lower marginal cost. This drives greater impact and citizen engagement, changing the process from a “retrofit programme” to a “neighbourhood greening and investment programme”.
• By centralising funding, projects can be aggregated on a neighbourhood scale allowing access to completely different types of funding and crucially removing the requirement of indebtedness for individual property owners, which is a key barrier.

 To fund the work, a mechanism is needed to attach the long-term energy and maintenance savings to the centralised funding source. The proposal is that this takes the form of a long term (30+ year) comfort and maintenance contract with the resident. The contract would be embedded into the property deeds so that it automatically novates to whoever lives in the property and does not follow the individual when they move away. Alternatively, the resident would be offered the option to contribute the funding for their property directly in which case they would receive the full benefits of reduced energy requirement going forward without any need to engage in the design, procurement and delivery process.  

This is not an Energy Service Company (ESCO)–a company that provides energy to customers and services to improve efficiency–model. (An ESCO typically sits between the consumer and the utility providers). The resident would retain their relationship with existing utility providers for any grid power that they require post retrofit. The significant reduction of energy use achieved through demand mitigation measures and maximising localised heat and electricity generation would create the financial space for the payment of the comfort and maintenance fee at no aggregate increase in cost to the resident.

Contracting all the energy and maintenance savings to the GNaaS organisation would maximise the potential for return-based finance in the funding model. Implementing governance structures that align the decision-making processes with the overall goals of the city could create a mechanism for social outcome goals to be included in contractual terms.

This mechanism could provide a theoretical lever to the public authority to leave part of the savings with the resident enabling the mechanism to become a powerful tool in tackling fuel poverty. 

The capital stack that will be needed

From the modelling work we have done with several cities, the internal rate of return (IRR) provided by the energy savings from this blended set of neighbourhood interventions is consistently negative, even assuming a 30-year payback period. But by considering a large enough layer of various non-repayable funding sources, or impact finance, we can move the IRR for the remaining funding requirement into positive territory. Furthermore, adding returns from other sources, e.g. health improvement, can further improve the pay-out profile. 

The resulting model creates a potentially multi-billion, stable and low returning financial investment opportunity for sources of patient capital that also value a robust set of impact metrics such as decarbonisation, healthcare improvement, fuel poverty abatement, educational outcomes, air quality improvements or biodiversity gains. We would argue this could be a good fit for sources of capital such as pension funds and insurance companies, which are increasingly demanding products which offer impact related benefits in addition to a financial return, under pressure from underlying asset owners and regulators.  

Further, it is a structure that can take in repayable, but zero or ultra-low coupon, finance from multilateral or development finance institutions seeking climate change impact and/or post-COVID recovery funding.

In addition, there is an opportunity to offer participation for local communities to invest through a community bond type structure allowing direct participation in the returns.

For the non-repayable layer of finance, various components will need to be combined:  

• Funnelling existing municipal budgets earmarked for improving energy efficiency of public owned properties into the mechanism
• Repurposing existing subsidy schemes into the mechanism
• Additional national/supranational grant funding schemes aimed at decarbonisation and/or post-covid recovery; the work is labour-intensive and community wealth building activities relating to asset maintenance and green infrastructure can be incorporated.
• The potential to incorporate other outcome seeking pools of funding, for example allocation of healthcare budgets into what would become a preventative programme reducing future burden on the health care system, biodiversity improvement funding etc.
• An option for building owners to fund the work themselves and have the occupant benefit from the energy savings. They still benefit from the centralised orchestration, better economics and broader impact.
• Exploration of the potential to accredit such centralised and scaled retrofit programmes as sources of carbon credits for voluntary carbon offset schemes allowing corporates to achieve their own net zero targets by buying credits that directly improve the communities they operate in and their employees live in.

There are significant governance issues to solve in designing how this entity would operate and to align its actions with those of the public sector. We propose it would be a not-for-profit organisation using a standard return-based fund management fee structure to cover its own operating costs, with involvement from public sector officials in supervisory committees etc to ensure alignment. 

We are not claiming that this proposal is yet a finalised solution; there are many complexities to work through (several which are being tackled in pilot projects planned in Milan and Zagreb). However, we are convinced that this concept has the potential to unlock the scaling of improved energy efficiency in the built environment in a meaningful way. 

Read the full blog post on the Bankers without Boundaries website. 

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