How can the government persuade the City to take a risk on the Green Deal?


Even the popular ogres of the day, bankers, would undoubtedly applaud the objectives of the government’s Green Deal scheme. Under the plans consumers should have lower energy bills, taxpayers will no longer have to fund home improvements and the construction industry gets a much needed £14bn boost with a deluge of eco-retrofitting work.

The problem is that in order to work the scheme needs more than moral support from bankers. Somehow the private sector has to be persuaded to loan the cash to pay for work up front - and at a reasonable price. With the scheme starting in October and the first Green Deal loans to homeowners expected to be available from January, it could hardly be more urgent.
Aware of the problem, Treasury chief secretary Danny Alexander this month announced that the Green Deal would be eligible to apply for state guarantees for private funding, under the government’s new £40bn Infrastructure Guarantees scheme.

But, rather than calming nerves, for some this announcement has merely confirmed suspicions that the Green Deal Finance Company (GDFC) - the organisation expected to be the primary funding source for the Green Deal - is struggling to raise the money required at an interest rate on Green Deal finance low enough. If the funding fails then all the potential £14bn of work for the sector won’t happen, and contractors that have bet on the success of the Green Deal, such as Carillion and Balfour Beatty, could be left seriously out of pocket.

Currently the GDFC does not have any cash to lend and no firm agreements in place, though it does have a £7m loan from the Department for Energy and Climate Change (DECC) to cover set-up costs. So, where will the money to lend come from and what stands in its way?

Where is the private finance?

The Green Deal - domestic energy efficiency work carried out at no up-front cost to the homeowner - has, ultimately, to be funded by private lenders. The GDFC maintains this is not a big problem in principle. But what is holding fundraisers back is a lack of the detailed information required by investors before parting with their cash.

Investors like to be able to quantify the chances of getting their money back. If that’s difficult to do they will demand a high return to ensure their risk matches with the reward on offer - which could render the promised savings for consumers impossible to achieve. The higher the risk, the higher the cost. Because the Green Deal is the first scheme of its kind in the world, the risks involved are difficult to quantify.

If you have got a product warranty scheme and one installation fails, it’s fine but if thousands fail then you have got the scheme going bust

Christopher Harwood, Marksman Consulting

This is a problem because the promise to consumers of the Green Deal is that the loan repayments for the improvement works - added on to your energy bill - should never be more than the saving you get from the effect of the improvements themselves on your household energy consumption. This is the so-called Green Deal golden rule. If the uncertainty means the money will come at a high price, the golden rule will be at risk.

For example, currently it’s not possible to give certain figures for the rate of default to expect on Green Deal loans or for the number of warrantee claims the Green Deal may face, because it’s not been done before. One potential investor who declined to be named said: “Bottom line, I think this is going to be challenging as they are really breaking new ground with retail finance and, it seems, without the benefit of the credit/default data that made this sort of finance possible in the mortgage market.”

The GDFC says it will model the default rate on that of the energy bills from which the payments will be taken, which is very low. But because this is still untested it may adversely affect the GDFC’s credit rating, and a lower credit rating means it will be forced to pay higher rates to borrow money from banks and investors.

Similarly, while the technology eligible for the Green Deal is largely well tested, the cost of offering them all on five-year warrantees is not certain - although it will undoubtedly be better than offering warrantees for the length of the plan as had originally been intended. “If you have got a product warranty scheme and one installation fails it’s fine, but if thousands of those fail then you have got the scheme going bust,” says Christoph Harwood, partner at environmental finance consultant Marksman Consulting.

The biggest concern is likely to be installations of solid wall insulation, which can cause costly damage if not fitted properly and the number of which are predicted to double to 147,000 between now and March 2015 under the Green Deal.

Standing behind the product warranty scheme is where the Infrastructure Guarantees may well be best placed to play a role, says Harwood. “I think that will be very useful because it would mean the rating agencies are not worried about warranty risk while at the moment the rating agencies will look at that,” he says.

It would take at least three months to take an investment decision to something we have not lent to before

Peter Morris, Greater Manchester Pension Fund

Experts say guarantees could also be used to isolate investors from either the first or last losses of the scheme, depending on which was judged to be best at lowering interest rates.
Supporters of the scheme say the problems caused by a lack of data are only for the short term, and that after a few years of running the data will be available to negotiate better terms from investors. Plus, Paul Davies, partner at accountant PricewaterhouseCoopers, speaking on behalf of the GDFC, says that even if finance costs are higher in the initial phases of the scheme, this won’t be passed on to consumers because his strategy is to “price Green Deals for the long term”. “That might mean that we run at a loss for a few years,” he says.

The finance plan

The GDFC’s financing plan rests on a number of different tiers of investment at a variety of interest rates (see box, opposite page) and it is in accessing the part of this that charges the lowest interest - the bond market - where a lack of data may hold it back. The people that buy bonds are generally looking for long term stable investments; they want a guaranteed return of 4% but aren’t interested in riskier products with a chance of a 10% return. Without the information to offer proof of that guaranteed return there could be problems.

“The GDFCs aim of refinancing tranches of the portfolio into the bond market is a good one, but the first tranches will need to have proven track records and the market would generally look for that to be at least three years,” says Julian Wheatland, chief executive of financial consultant Hatton International. “This means that refinancing at a low cost of capital is a medium to long term objective, not a short term one.”

However, Davies is not worried about this in the medium term. “You can set up your company so you can get more data as you go forward,” he says. Even this assessment, though, assumes there will be few teething problems and that the early experiences with the Green Deal loans will reassure the market.

The interest rate that consumers of Green Deals will be able to access will be determined by the mix of different forms of finance used over the lifespan of the Green Deal. The highest interest rates will be charged on the seed capital of around £50m, which will come from the government’s Green Investment Bank and private investors. The GDFC is already seeking some of this from its member organisations and other private finance funds (see box, below).


The final rate

The final interest rate that consumers will pay for Green Deals will determine whether the scheme can fund work while still meeting the golden rule, and will be a key factor in driving consumer demand. The rate will comprise a mix of the interest paid on six different types of lending used in the process. While some finance will take more risk and therefore require a higher interest rate to make it worthwhile, investors lending to the Green Deal Finance Company (GDFC) will come in later and take much lower risks and lower interest rates.

Set-up costs

The GDFC remains in discussion with the Green Investment Bank about borrowing £300m. Of this, £40m will be used to fund start-up costs including IT systems to ensure the company can operate. In August the GDFC also agreed a £7m loan from the Department for Energy and Climate Change to cover some of its set-up costs.

Junior capital

The GDFC has a target to raise £1bn of working capital for the scheme’s launch. A £260m share of the money it hopes to get from the Green Investment Bank will be used towards this goal. Of this, £20m-£25m will be earmarked as “junior capital”, which means it will be the last to be paid back to investors and will also incur a higher interest rate. The GDFC is seeking co-investors to put money forward on a similar basis.

Paul Davies, partner at accountant PwC, speaking on behalf of the GDFC, says: “It’s early stages, there are lots of sources of that finance. There are third parties and then there are members of the GDFC company. Sovereign wealth funds, infrastructure funds, etc.” Davies says that if the company is to remain a private sector entity, it will need some private investment at this level, although he is not clear how much will be required to satisfy European State aid rules, which ensure that government does not unfairly enhance an industry.

Working capital

Once the junior capital has been accounted for the remainder of the £260m will be used as working capital, which will take slightly less risk and therefore demand a slightly lower interest rate. But having a sizable amount of this is important to allow the GDFC to leverage money from the banks.

Bank money

The rest of the initial £1bn fund will need to be met from bank warehousing facilities - the name describing loans agreed in principle that are drawn down as and when needed, in this case to fund Green Deals. Davies says: “It’s not a big risk [for banks] because whenever they lend it to the GDFC it is to create new Green Deals. So, whenever they lend GDFC the money it is matched by a Green Deal that’s owed to GDFC.”

He says he expects banks to charge a “single figure” interest rate for this service but adds, “They will do it on what credit rating we get, what’s the likely time period of the loan and
what does the data tell us about the loan loss experience.”

Davies expects the GDFC to be rated A or above when it outlines its business to the ratings agencies.

The bonds market

Once the GDFC has sold a large number of Green Deal loans, “typically a few hundred million pounds” worth, it will then sell those Green Deal loans as a portfolio of assets to the bond market. Bonds are generally bought by long term investors that want to see stable returns over decades, not a fast buck, and so they will accept lower interest rates and lower gains in exchange for lower risk.


Selling bonds is not without some risks. “When you lend on a Green Deal, embedded in there is an interest rate and you will look to fund those with a bond with a matching interest rate so your cost of funds matches your income,” says Davies. “There is a danger that the interest rate changes [between selling the Green Deals and selling the bond]. What we have to do is have a hedging programme which removes that risk.” He says the GDFC will use standard interest rate swap products, where a firm is charged a small fee to forego this risk. When the bond is sold the money is used to pay back the banks and the Green Investment Bank and the process starts again.

A good proportion (the exact amount is not known) of this initial funding will need to be from the private sector to ensure that the government is not breaking strict EU state aid rules, which govern how much governments can help an industry.

But it looks unlikely that pension funds, an area in which the government has placed a lot of hope for infrastructure investment in recent months, will be among them. Peter Morris, director of pensions at the Greater Manchester Pension Fund, says, “Generally speaking it would take at least three months to take an investment decision to something we have not lent to before.” That’s a timescale which may well rule them out of the first wave of investment.

Despite the doubts hanging over the financial arrangements of the scheme there are reasons to be positive according to John Egan, chief executive of insulation installer Enact Energy which is a member of GDFC, “You can take the fact that they [the GDFC] have just got money from DECC that the model is assumed to work.”

“There are a number of world class firms involved so that gives it the best chance of an optimal and innovative solution” said one investor. “The Green Deal finance initiative is probably too important to fail.” Many in the construction industry waiting for the ogres to cough-up will hope he is right.


Previously the government has funded energy efficiency work in buildings, including peoples’ homes, through subsidy programmes and a charge on energy companies. But in opposition the Conservatives developed the Green Deal as a way of stimulating a market for energy efficiency driven by consumer demand hoping to accelerate its take-up and meet the UK’s carbon commitments to reduce emissions by 80% by 2050.

The key is the ability to make your home and business more energy efficient with no upfront cost and no requirement to pay back a loan once you have moved out of the property. Instead consumers can borrow money for the work, pay it back through a charge on their energy bills and when they leave the property the next inhabitant picks up the charge.

The government argues it will generate 60,000 jobs in the construction sector by 2015 through doubling the number of solid wall installations. However, there will be a drop in cavity wall and loft insulation work of 34% and 85% respectively as the current programme comes to an end.

Key to the scheme’s consumer appeal is the golden rule, which states that consumers can only get a Green Deal when an accredited assessor says doing the work on the property will deliver more in savings on your energy bill than it costs over the period of the loan.