Financing hospital energy sustainability

Hospitals are intended to serve without end regardless of the circumstances. For this reason, they must look at sustainability as the ability to remain resilient in perpetuity.

However, figuring out how to fund the necessary equipment, staff and infrastructure to achieve this is no small feat. To help, the American Society for Health Care Engineering (ASHE) recently released a new monograph called “Best Practices for Financing Energy Sustainability,” from which this article was excerpted and edited.

Building on the previous ASHE monographs “Energy Procurement: A Strategic Sourcing How-To Guide” (2017) and “Best Practices in Business Planning for Energy Resiliency” (2018), the document sets forth best practices for financing energy sustainability.

Financing projects

There are two main pathways to reducing scope 1 and scope 2 emissions (see sidebar on page 33 for scope definitions): reducing the need for dirty energy (a demand-based approach) and ensuring the energy being used is coming from increasingly cleaner sources (a supply-based approach). Neither should be ignored at the expense of the other. 

There are three categories of action that will allow facilities professionals to reduce a hospital’s scope 1 and scope 2 greenhouse gas (GHG) emissions. They usually are taken in the following order:

Step 1: On-campus energy reduction. Reducing the demand for energy is one of the best understood solutions for reducing campus emissions. There are a variety of ways to reduce the need for energy, including more efficient equipment and software as well as architectural and design choices.

To ensure a hospital has a high-quality project or portfolio of projects, professionals can follow the guidelines discussed in the sidebar on page 34, which addresses problematic analyses. Assuming a project has a well-performed analysis that accurately states the savings potential, what are ways to successfully finance the project?

Health facilities professionals usually are trained to identify projects that produce a return on investment (ROI) in less than three years. They may assemble a list of these projects and become frustrated when they are repeatedly turned down by the chief financial officer (CFO). The reasons are found in the details of health care finance and accounting.

First, ROI analysis is suited to projects funded via capital expenses and designed to answer: How long is the payback? This helps determine whether to invest capital in the proposed project or to invest capital elsewhere. Short payback time frames of less than three years may gain momentum within an institution, while projects with longer break-even horizons can be difficult to move forward.

These ROI or simple payback analyses are popular with engineers because they are relatively straightforward. However, ROI calculations rarely convince the CFO to approve a project. ROI only compares the new project to current operating conditions and costs. From the CFO’s perspective, energy is not reimbursed by Medicare and thus does not contribute to top-line revenue. 

As a supplement to ROI, engineers should consider how a project impacts the hospital’s financial situation or, more specifically, its gross margin and net operating margin (NOM).

When hospital profit margins are low, even modest decreases in NOM can affect the institution’s ability to borrow. In more extreme cases, low NOM can reduce the hospital’s credit rating. Thus, hospital CFOs are wary of the ramifications of taking on even small indirect expenses and debt, despite a relatively short ROI.

Facilities professionals must look at their organization’s overall priorities and trace how the energy equipment impacts the larger operation. Then, they should ask what happens to the organization’s revenue and NOM if the project is installed. Does it allow for decreased staff time, increased patient revenue or improved regulatory compliance? Are there other financial benefits like deferred maintenance, delayed equipment replacement and increased uptime?

Additionally, it is worth noting that $1 saved on a bottom-line energy expense at a 2% operating margin is worth $50 billed in top-line Medicare revenue.

Next, facilities professionals can reverse the analysis and consider what might happen to the organization if the project is not completed. At times, such as for regulatory compliance, the cost of leaving the project undone is unacceptable. In other cases, it would be cheaper to avoid the proper maintenance required of backup generation and equipment. 

However, what happens if a major boiler failure occurs in winter? Under resiliency requirements established by the Centers for Medicare & Medicaid Services, this could entail evacuation of patients and cancellation of medical procedures, which leads to lower revenue and reduced community confidence. 

Another important financing strategy is to operationalize the capital costs, moving them off the hospital’s balance sheet. There are a variety of options for achieving this. While each has important nuances, the objective is the same: An external party bears the capital cost, while the system pays for the project out of its operational budget.

If the project is classified as an operational cost, it may be viewed as a “direct” cost rather than a “financed” cost, and it will not affect the hospital’s cost of borrowing.

Operational strategies also can offer immediate cost reductions. With another party taking on the capital cost, the hospital can enjoy lower energy rates as soon as the project is completed, with no capital outlay. Operational strategies can be deployed in several forms, including energy as a service (EaaS) agreements, operating lease structures and on-bill financing. 

Another financing option is an energy savings performance contract (ESPC). These agreements shift operational responsibility to a third-party equipment operator, but the hospital still pays the capital cost of the equipment. Under this model, an energy services company (ESCO) installs and operates the equipment that may continue to be owned by the hospital or transferred to the ESCO at some point.

The equipment delivers a specific amount of savings via reduced energy bills, ensured by a contractual “performance guarantee.” If the operation does not produce the savings, the ESCO pays the customer the difference.

ESPC performance contracts are well-suited to combining multiple projects or technologies into one agreement. They also ensure savings and relieve hospital staff of operational responsibility. Due to their similar “pay-for-service” structure, ESPC performance contracts often are compared against EaaS contracts. Both can offer significant operational savings, but there are key differences. 

If the ESPC contract will place capital costs on the hospital balance sheet, it may reduce the project’s appeal to administrators. Also, performance contracts often require the hospital to make a fixed monthly payment, which is adjusted later based on a monthly calculation of savings. The additional scrutiny required by ESPCs in terms of auditing and verification of savings may erode the saved staff time coming from the shift in operational duties. 

Under the EaaS model, the project asset is not owned by the hospital and therefore is not placed on the hospital’s balance sheet. In addition, the EaaS service provider must confirm energy and financial savings before billing monthly energy costs to the hospital. Thus, EaaS contracts often are marketed to hospitals as being “paid for directly out of savings.”

One factor to consider is inertia: Will the hospital become locked into a particular solution or supplier with little chance to change in the future? Any situation in which the hospital must pre-commit for decades merits extra scrutiny. 

Another consideration is matching the contract type to the project type. Energy services agreements (ESAs), a form of EaaS, fit well for projects that reduce a facility’s energy use, especially if those projects also reduce energy demand charges. If the project is instead generating power, an ESA option might still be used, but it is more common to utilize a power purchase agreement (PPA). 

The approaches share similarities, but the savings protection of an ESA may be more necessary for energy efficiency projects. PPAs are well-suited to procuring renewable power generation either on-campus or off-campus. 

Once a project has been completed, it often will yield recurring cost savings. In general, the savings are returned to support patient care. In some cases, a system may choose to devote the savings that have been created to fund future equipment needs.

Those that reinvest savings from initial successes into future projects have a “rolling green fund.” This provides for an easier approval process, increased organizational savings, better equipment performance and higher staff productivity. 

Without a rolling green fund, each project has its own process and internal communication, and alignment can be more difficult. If a facilities professional must operate without a rolling green fund, they should aggregate projects as much as possible to mitigate these challenges.

Utility rebates create an excellent alternative revenue stream for energy-reduction projects. Facilities professionals should develop a dialogue with the utility or find an external consultant to do so to maximize the potential benefit of the projects being considered.

Nonprofit hospitals often are unable to take advantage of tax incentives. However, for-profit partners often can do so. Thus, an external financing option may have a lower effective cost of capital than an internal debt service, even if the internal option had a lower interest rate. Similarly, external partners can have a lower effective cost of labor or equipment. 

All hospitals have a treasury management function to ensure sufficient cash to meet financial obligations. Health care treasury funds are intended to provide long-term financial stability. This means that investment strategies must balance obtaining high returns while not taking unreasonable risks. A certain portion of the fund income may be used each year to support operations.

“Impact investing” means making investments that provide a significant financial return and a positive social impact. As investments in renewable energy are becoming more profitable, opportunities are opening for facilities to engage in impact investing. One way to encourage impact investing is to identify projects that benefit the hospital and community and to engage the finance and treasury departments in a dialogue. 

Lastly, tying a project to new or increased revenue sources can be a strong argument for it being approved.

Step 2: Buying clean energy produced off campus. If reducing the need for energy is the typical starting point for hospitals, looking to procure clean energy follows closely behind. The benefits of starting with off-campus renewable procurement rather than on-campus projects are that it:

• Does not interfere with existing infrastructure such as rooftops and parking facilities.
• Avoids locational constraints such as tree cover or utility interconnect limitations.
• Allows access to larger aggregations and improved economies of scale.
• Offers purchasing that fits into existing procurement frameworks of market hedging.

The costs of renewable generation have decreased dramatically. Many types of renewable power generation, including wind and solar, have now become cost competitive with fossil fuel alternatives in many parts of the country. But how can a hospital benefit from these trends?

PPAs are among the most flexible contract agreements available to energy developers and buyers. Under a PPA, a hospital would engage with a renewable energy developer and agree to buy a specified amount of power produced by a specific energy asset at a certain rate for a certain length of time.

There can be other contract terms that distinguish projects, such as an energy production guarantee, which internal supply chain and legal professionals may help to analyze. PPAs have become common for procuring on-site and off-site generation. However, there are some distinctions between how electrons flow based on where the generation is located.

Under an on-site PPA, the energy produced by the asset will typically flow directly into the facility to power on-campus equipment. Because the hospital is supplying some of its own power, the utility provides less power to the campus. Therefore, from the utility’s perspective, the energy load is reduced. Under an off-site PPA, the energy produced is being delivered to the grid on the hospital’s behalf. The energy that flows off the renewable asset goes into the pool of electricity that all energy users access. From the utility’s perspective, the campus energy needs are unchanged.

Two common types of off-site PPAs are physical PPAs and virtual PPAs (VPPAs).

Under a physical PPA, the generation asset connects to the utility grid that serves the hospital campus. Under a physical PPA and a VPPA, the generating asset delivers power to the grid at large. 

However, under a physical PPA, the hospital is said to take ownership of the electricity once it enters the hospital’s utility load zone. Hence, while the agreement is financial, money is being exchanged for a commodity: electricity. Physical PPAs are typically available only to hospitals that operate in jurisdictions with competitive electricity markets. 

A VPPA is open to hospitals regardless of location. Under this agreement, the transaction is purely financial, and the buyer never takes ownership of the electricity. It also is known as a contract for differences, a financial PPA, a synthetic PPA or a fixed-for-floating swap. These function similarly to wholesale PPAs, but the settlement is only financial and under a separate invoicing structure. 

VPPAs are especially great options for hospitals that want renewable energy but do not have access to a competitive market. They are generally used to purchase energy from a renewable energy project at a fixed price and, like all PPAs, that price may or may not include the project’s renewable energy certificates (RECs). The power is sold in an energy market that could be in another state or jurisdiction from the hospital making the purchase. 

The VPPA is an investment in renewable energy that can create revenue (but also risk potential losses) for the hospital. VPPAs are treated as financial instruments under generally accepted accounting principles. Thus, the hospital must calculate the VPPA’s fair value based on current forward energy pricing and report that value on the hospital’s balance sheet as either a profit or loss. This is different from ordinary energy market purchases for electricity or natural gas, which are operating expenses and are not on the balance sheet.

Perhaps the most important concept when entering a PPA is how the project is “shaped.” This means comparing the project’s energy generation profile with the corresponding grid pricing profile. This comparison must be made at an hourly level for each month in a shaping analysis. 

Another consideration when entering into an agreement to procure off-site renewable energy is whether to take ownership of the RECs. Each renewable energy project creates RECs, which take the form of a certificate verifying the source and quantity of the renewable power generated. RECs come in different types or vintages, depending on the year, generation technology and location from which they were produced.

While the REC and the renewable electricity are generated at the same time, the electricity and the REC are separate things. The electricity and the REC can each be bought and sold separately — and often are sold to different parties. 

Just as there is a market for electricity, there is a market for RECs. Private and nonprofit organizations buy and sell RECs. Many states also allow (or even require) utilities to purchase RECs to comply with renewable generation targets.

One newer option is called “community solar,” though each state might provide its own name for its program. Community solar can be considered a hybrid of on-campus and off-campus generation. The solar panels are installed off campus, but they operate under many of the on-campus rules.

In addition to being a hedge against utility delivery rates, community solar can, if contracted correctly, offer guaranteed savings. This is possible through a “fixed-discount” contract type.

One type of community solar contract structure that should be avoided is when the hospital is offered a fixed discount that also includes a price floor. These are not structured as true fixed-discount contracts and do not offer the same savings profile. 

Step 3: Producing on-campus clean energy. When considering on-campus generation, it is important to assess how the project would impact daily operations, who will maintain and own the asset, and how the location would impact long-term campus planning.

On-campus clean energy production often takes the form of solar panels on a rooftop or carport or via ground mount. This is called “behind-the-meter” (BTM) solar because the electricity flows from the solar panels directly into the facility. Any financial analysis should treat energy and demand charges separately.

On-site BTM solar can offset the energy and delivery rates found on both the hospital’s utility bills and on any third-party energy supplier invoices as well. However, a solar project is limited to hours when the sun is shining and therefore cannot be relied upon to consistently deliver savings during more expensive peak energy demand. 

By pairing a solar project with battery storage, the hospital may be able to discharge the stored energy at peak hours and reduce demand rates as well. In some areas, discharging storage for non-demand services such as energy arbitrage or ancillary services is also lucrative, in which case those revenues should be accurately stated in any analysis.

In some states, a hospital may be allowed to sell excess energy produced on campus through self-generation equipment. This is commonly called “exporting energy to the grid.” State regulations and utility tariffs governing the exported energy — including the rates a hospital is paid for energy — will vary based on location.

The financial benefit of on-campus renewable power generation depends in part on the available resource (e.g., hours of sunshine). The benefit also varies based on building constraints, local utility incentives and state support. 

Another factor is the readiness of the space: the less alteration and construction a site needs, the more cost-effective the solar installation will be. Hence, it is important to consider on-campus generation during any project design phase.

On-site solar generation tends to make the most sense when the health system is in a utility zone with high electricity delivery rates. If the delivery rates have high demand charges, it is worth examining solar plus battery storage. If the local utility includes high energy charges in its delivery rate, it is typically worth exploring stand-alone solar. 

The most common payment structure for on-site solar is a PPA. On-site PPAs have many of the same price risks as off-site PPAs. However, on-site PPAs replace a different set of costs than off-site PPAs and therefore have a higher cost-to-compare. While off-site PPAs only provide energy and not the non-energy costs provided by traditional energy market suppliers or the delivery rates charged by the local utility, on-site PPAs will offset charges on both the supplier and utility delivery bills and should be analyzed accordingly. 

Any on-site project may introduce the need for additional compliance efforts. To produce RECs that a hospital can monetize or retire, the project needs to be registered with the appropriate entity. 

Some sort of maintenance contract or EaaS is typically necessary for the system to derive the maximum benefit from an on-site project. In many cases, this is included in the PPA, but if the system were to purchase the panels outright, a separate agreement would be necessary.

Many of the financing strategies appropriate for on-site energy efficiency also are appropriate for on-site supply. BTM solar can be financed directly through a loan, a lease or through an EaaS agreement.

On-bill financing through the hospital’s energy supplier is uncommon, primarily because this type of financing works best for short-term loans. As a result, most hospitals prefer a third party to provide solar energy charged as an operational cost rather than paying upfront to own the installation.

For hospitals seeking to own the solar directly, federal tax incentives will provide 20% or more of the project’s value as a tax write-off. Thus, monetizing that tax credit is beneficial in completing a BTM project. Assuming a nonprofit health system does not have a need for the tax credits, it is worthwhile to find a partner.

One unique way to participate in on-campus generation is to act as a landlord for a solar developer.  

Getting started

While many health care organizations wish to begin the transition to a more sustainable energy future, financial constraints often prevent progress.

These three steps offer methods for getting started and for continuing this important work. 

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Avoiding financial analysis pitfalls

It is important to accurately analyze projects under consideration for financing. To avoid common problems, health care facilities professionals should avoid the following pitfalls:

• Analytical pitfall 1: Not incorporating knowable market information. Energy sustainability planning requires professionals to consider current and future conditions. A common developer approach to selling a project to a hospital is to create savings calculations that look back at energy costs over the past 12 months, then project consistent 2% to 3% growth (also called an “escalator”) for the next two decades. However, while volatile, the energy markets produced a long-term decrease in costs from 2008 to 2021. Thus, projections should be independently analyzed.
• Analytical pitfall 2: Using escalators blindly. A hospital should be skeptical of any proposal that requires them to pay a monthly rate for energy that will escalate at a fixed rate each year. Compounding the problem, generic fixed escalators often are applied to every cost component. The longer a project’s expected life, the more skepticism a fixed escalator deserves. Similarly, if any project’s savings value depends on the energy market escalating significantly, the hospital should be very skeptical. 
• Analytical pitfall 3: Comparing apples and oranges in project cost analysis. Accurately analyzing a long-term energy project requires professionals to avoid combining costs that are not relevant to the ultimate project value. For example, many hospitals have a natural gas utility delivery bill and a natural gas supplier bill. These two components ought to be modeled separately in any financial analysis. Sometimes bill components from one source need to be separated even further. For instance, electricity delivery bills have “energy” components and “demand” components. The hospital will pay both costs, but different projects may impact only one component or may impact both together. 
• Analytical pitfall 4: Not accounting for all the correct costs and benefits. While many analyses attempt to capture the savings associated with “option A” versus “option B,” it is important to make sure the underlying scenarios are appropriately described by creating a “value stack” for each one. Properly accounting for all cost items is called “total cost of ownership.”
• Analytical pitfall 5: Ignoring likely regulatory change. The movement toward decarbonizing buildings is very active. Along with regulatory requirements, there also is an increase in how government incentives are being allocated. Cities, utilities and states are considering requirements and incentives for building electrification. A good energy sustainability business plan will review these regularly.
• Analytical pitfall 6: Ignoring how projects impact other projects. One challenge is deciding how to move forward when presented with multiple project options. When there are relatively few options, and the options have little interplay, each project can be approved or denied separately. A challenge arises when projects have significant overlap. Therefore, hospitals should adopt the “prioritizing the highest value” method. 

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Ben Walker is director of market analytics and Mark Mininberg is founder and president at Hospital Energy, Manchester, N.H. They can be reached at bwalker@hospitalenergy.com and mark@hospitalenergy.com.