Energy efficiency plan: Hire someone else to pay the bill?

@FortuneMagazine July 22, 2011: 12:17 PM ET

Transcend Equity's energy project at 125 Maiden Lane in New York City.

FORTUNE -- For owners of older office buildings, the promise of smaller energy bills is a big enticement, but the way to better energy systems is a big mystery. And it's this confusion that's got Steve Gossett working hard to become the overwhelmed landlord's best friend.

Gossett's company, Transcend Equity, pays all the landlord's energy bills. It also devises and pays for major capital investments to make a building more energy-efficient. In return, building owners pay a fixed fee to Transcend.

The company just scored an equity infusion from Mitsui, the Japanese conglomerate, to set up a 10-year joint venture worth at least $10 million to work in existing buildings. Transcend promises to soon use this capital to take on meaningful debt. This money will test whether Transcend's business model, which is called a "managed energy services agreement," or MESA, can deliver as much as 30% cuts in energy use in its customers' buildings, as its contract provides.

The market for the kind of services Transcend is offering could be worth at least $200 billion within the next 10 years, according to the Urban Land Institute. And Transcend intends to get a critical share of that market by promising to take on all associated risk - one confused landlord at a time.

So, say you're a landlord. You hear your tenants are itching to be as green as the office across town. You hear bureaucrats warning you to use less energy. In many cities, you also have lawmakers warning that you'd better hire an "energy auditor" to measure how your building wastes fuel in heat and lighting, because future building codes could get you fined if you don't retrofit your space.

Well, since tenants want to live in green buildings anyway, you're on board. But while you know your fair share of profits and losses, you don't really know what an energy audit entails. And in most cases you know your mortgagor won't let you take on new debt to replace your boiler or put in new windows.

What do you do?

According to Gossett, a tall Texan with a close-hewn beard, you call up Transcend and sign up for a MESA deal. Transcend will then re-equip your building ("We're doing heart transplants," says Gossett, before cringing a bit at his own melodramatic metaphor) so that you use energy more efficiently.

This avoids what energy-finance types call the curse of the "split incentive" in which an owner pays for heavy equipment that lowers energy bills only to have the tenant benefit. The MESA arrangement could also work for condo-style buildings, like one on Maiden Lane in Manhattan's Financial District that just signed with Transcend this summer. In that building, says Transcend executive Sean Neill, the energy systems are so old that "on a hot day, someone has to go turn on the chiller at 4 or 5 a.m."

Very slowly, banks are beginning to figure out ways around the split incentive and realize that their borrowers can find better uses for cash than the salary of the guy turning on the chiller. According to Urban Land Institute vice president Uwe Brandes, some lenders on the West Coast are even calling on engineering analysts to clarify how a more energy-efficient building might constitute a more valuable asset than a conventional one. And while this is an exception to industry norms, the idea that an owner who pays lower energy bills is a better credit risk can't stay secret for very long.

So why is Mitsui investing in Transcend now? And why is Gossett not silly for having outsize growth expectations for the company?

The answer is that, across the United States, landlords can see a switch flicking. Lawmakers in New York, Seattle, San Francisco and other burgs have told building owners they must disclose how much energy and water they use. If you are going to do business in those cities, you have to first learn those energy standards and often beat them to attract high-quality tenants.

Even a landlord who can please local lawmakers with energy performance struggles to finance the heavy equipment involved. And in the absence of a clear set of energy incentives, it is much more plausible that an owner will give a building an energy tune-up than slap a windmill on it. For that reason, Transcend and its investors bet that using energy more efficiently, rather than getting it from a cleaner source, will drive new laws and startups.

Much bigger companies like Johnson Controls or Trane, which are called energy-services companies or "escos," have been handling public and institutional landlords' energy strategy for years. They guarantee a certain savings per month and then get paid out of the savings.

Transcend's flat fee might be more attractive to landlords with thinner margins and a smaller amount of real estate. And, indeed, it's this kind of building owner that seems to make up Transcend's sweet spot. Its marquee clients right now include the Manhattan condo mentioned above and an Ohio college; it is mulling a move into hospitals.

Gossett stresses that his company doesn't sell the kind of software -- programmable thermostats and such -- that will take off if the federal government creates incentives for digitally-managed electric power. "There's a lot of software out there that is the answer to a question nobody has been asking," says Gossett.

Instead, Transcend focuses on quickly reducing an owner's energy expenses. It's selling security to landlords (and their creditors) who know that energy regulations are going to become more stringent but who don't know how to make them profitable. "People view energy efficiency from an investment perspective like they never have before," Gossett says.

Transcend is not the Microsoft (MSFT, Fortune 500) of energy finance because, eventually, the most sophisticated building owners will want to decide exactly how they want to retrofit their properties and pocket their own energy savings.

Constantine Kontokosta, a professor at NYU who studies sustainable real estate, argues that as energy laws become more widely understood, building owners might be interested in customizing their energy efficiency projects. "When knowledge gaps shrink, owners will choose more innovative projects," Kontokosta says.

But for the next five to 10 years, the universe of building owners who can't afford a crash course in energy efficiency will grow dramatically. In a high-stakes, fragmented market, lots of owners who don't have the spare time to become energy experts can appreciate the simplicity of paying a fixed fee for access to a limited menu of options.

So maybe Transcend is the Apple (AAPL, Fortune 500) of energy finance. To top of page

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