Internal Revenue Service Issues Guidance on Qualified Energy Conservation Bonds

By Elizabeth Bellis

IRS Circular 230 Disclosure: This information was not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax law.

Note: Nothing contained in this article should be construed or relied upon as legal advice.

In 2008, Congress authorized the issuance of subsidized Qualified Energy Conservation Bonds (QECBs) to finance energy efficiency, renewable, and related projects. However, many wouldbe issuers found it difficult to use their allocations due to legal uncertainties. The legislation required 20% energy savings on certain types of projects but did not explain how such savings should be measured or predicted. It also said the bonds could be used to finance “green community programs” but did not define the term. In late June, the Internal Revenue Service published a notice that clarified many of these questions, which could lead to an uptick in the usage of QECBs.

QECBs effectively function as a federal interest rate buy-down program for state and local bond issuances. The bonds are tax credit bonds, but issuers can elect to receive a direct cash subsidy payment from the Treasury in lieu of providing a tax credit to bondholders. Although eligible for a wide variety of projects, the bonds are commonly used for renewable energy production and to finance capital improvements to public buildings to reduce energy consumption by at least 20%. In 2009, the total funding for states, territories, and “large local governments” (cities, counties, and tribes with populations of more than 100,000) was increased to $3.2 billion. As of July 23, 2012, at least $673 million of QECBs have been issued.

Notice 2012-44 resolved some many of the uncertainties that hindered issuances. First, the Notice confirms that Congress intended to give state and local governments “wide” and “broad” discretion in issuing QECBs, and it provides guidance on determining whether an expenditure is a “capital expenditure” for purposes of the QECB rules—helpful clarification for issuers of any type of QECB. It addresses how state and local governments can measure reductions in energy consumption due to improvements financed by QECBs. The Notice also addresses what types of programs are considered “green community programs” eligible for QECB financing.

“QECBs offer a tremendous opportunity for state and local governments to finance clean energy projects,” said Richard Kauffman, the Department of Energy’s senior advisor to the Secretary of Energy. “This is intergovernmental action at its best, where state and local levels of government develop clean energy projects and the U.S. Treasury provides limited interest rate subsidies to support their viability. The recently released guidance by the U.S. Treasury should help to clarify approved uses of funds and provide state and local governments with the necessary confidence to move forward on issuing these securities, creating thousands of clean energy jobs while reducing the use of fossil fuels.”

The “20% Test”

Notice 2012-44 provides pages of information on how issuers can properly estimate projected reductions in energy consumption to public buildings and meet the requirement that they reduce energy consumption by at least 20% due to improvements financed by QECBs. First, it explicitly distinguishes the rules applicable in the context of Internal Revenue Code section179D, another section that provides tax benefits for reductions in energy consumption in government buildings.

Energy savings can be measured building by building or across all the buildings improved with the QECB proceeds. They can also be measured by a component or multiple components of the energy system of the building or buildings in question (e.g., HVAC, hot water, lighting, building envelope, or “plug load” due to items plugged into outlets, such as refrigerators). The issuer must “reasonably expect” that the capital expenditures to be financed with the bond proceeds will result in a 20% or greater reduction in energy consumption for the selected building, buildings, or building-system component using a “common energy unit,” such as a MMBtu (1 million British thermal units).

To determine whether the issuer’s expectation was reasonable, Treasury will look at whether the issuer or its engineer used such tools as an ASHRAE Level 3 audit, building energy use simulation techniques and estimating software (including the DOE-2- based Quick Energy Simulation Tool, eQUEST), or other qualified computer software for calculating commercial building energy and power cost savings that meet federal tax incentive requirements as listed by the DOE’s Building Technology Program (http:// apps1.eere.energy.gov/buildings/ tools_directory).

The issuer must use a “reasonable and consistently applied” method to measure (actual or projected) energy savings over a “reasonable and consistent time period” of at least one year (e.g., energy use in the year before the improvements were made and in the year following the improvements). The issuer need not subsequently demonstrate energy savings. An issuer may rely on an engineer’s certification (an example is provided in the notice) if the actual capital improvements financed by the QECB proceeds are substantially similar to those contemplated as the basis for the certification.

Reactions to the 20% test guidance have been generally positive. For example, Jeff Pitkin, Chair of the National Association of State Energy Officials Finance Committee, and Treasurer of the New York State Energy Research and Development Authority (NYSERDA), commented: “Enough was provided and addressed that I would be surprised if this revised guidance wouldn’t provide enough clarity for issuers to proceed with trying to finance energy efficiency reduction in public buildings. . . . I’d be surprised if issuers would still needed substantive clarification.” At the same time, Pitkin said, “it’s a question of judgment and having people recognize there are no guarantees.”

The guidance comes in time for NYSERDA’s developing partnership with the New York Municipal Bond Bank Agency and the Association of Counties to facilitate county-level issuances through a pooled financing program. This effort would likely be open to all qualified uses of QECBs, but would focus on improvements to reduce energy in public buildings by at least 20%.

Green Community Programs

To qualify as a “green community program” for QECB purposes, the Notice provides that a program must both promote “energy conservation, energy efficiency or environmental conservation initiatives related to energy consumption, broadly construed” and either involve property that is available for “general public use” (such as replacing streetlights on public roads with LED bulbs) or loans/ grants that have “broad public availability” (including residential housing or private building energy efficiency initiatives that provide grants or loans that are broadly available for homeowners or businesses). The Notice incorporates the frequently cited conference report language specifically identifying retrofit loan and repayment mechanism programs as examples of the intended scope of the provision

“The guidance . . . was perfect because it basically validated what we did and what our bond attorneys ruled,” said Anne Klein, director of sustainability, and assistant director of parks, for St. Louis County, Missouri, who developed the St. Louis SAVES QECB issuance for residential retrofit loans. “I’m pleased that . . . it gives clear guidance to many communities going forward; because that was really the hangup . . . in seeing this program replicated on a national level, because so many bond attorneys were hesitant because they didn’t have that clarification.”

The green communities guidance is important to a number of other past or planned issuances across the country, including New York State (Green Jobs Green New York), Las Vegas, Nevada (LED streetlights), and Boulder, Colorado (commercial Property Assessed Clean Energy). For example, according to Pitkin, NYSERDA is expecting to use the state’s QECB allocation of about $20 million, plus $4 million of allocations that have been waived back to the state, to issue bonds by the end of the year to fund green community program expenditures to support energy efficiency loans that have been issued through the Green Jobs Green New York program to date. Pitkin commented that Notice 2012-44 was “helpful” and “removed doubt as to what NYSERDA was proposing to do for statewide energy efficiency loan financing.”

The guidance is the product of months of outreach by a group of stakeholders led by Colin Bishopp, then of the Clean Economy Development Center and now deputy director of public engagement in the Office of the Secretary of Energy. The stakeholders (including state and local governments, energy officials, and representatives) worked with representatives from the DOE, the White House Council on Environmental Quality and Council of Economic Advisers, as well as Treasury to discuss issues and concerns.

NYSERDA was one of the stakeholders. “We were able to express some of the challenges that . . . prospective issuers were facing over uncertainly about issuing the bonds, which may have been contributing [to the reality] that only a small percentage of the amount allocated had been issued to date,” said Pitkin.

Questions and Issues Remaining

A number of questions remain unanswered, however. For example, the stakeholders had sought guidance on how large local governments might waive allocations back to the state or pool allocations to achieve economies of scale. “Part of the challenge here has been for counties to try to issue relatively small amounts,” Pitkin said. Many bond counsel have interpreted the legislation to require an act of the full relevant governmental body to effect a waiver. The lack of guidance simplifying the waiver process was a “little bit of disappointment,” said Pitkin.

Others hope for guidance on the possibility of multistate QECB issuances and other pooling issues, such as the one considered by the Hawaii legislature earlier this year, or for guidance regarding the application of ancillary rules and requirements, such as Davis- Bacon, Buy American, and the relationship between the National Environmental Policy Act and the Historic Preservation Act. Crossreference to guidance from the relevant agency or authority would be helpful.

In addition, the Notice does not provide specific guidelines for determining whether a loan or grant program has the “broad public availability” required of a green community program. What is broad public availability exactly? Bond counsel will need to determine what prudent credit requirements may be acceptable within this new framework for green community programs. On a recent DOE webinar on QECBs, Treasury Associate Tax Legislative Counsel John Cross suggested that standards used in other areas of tax-subsidized municipal finance might be applied to QECBs as well.

Some officials also expressed frustration at the lack of public availability of official Treasury data about remaining allocations. Finally, questions remain about the circumstances in which the Secretary of the Treasury might grant an extension to issuers that issued large allocations of QECBs for loan programs but are unable to spend the full amount within three years, despite diligent efforts and steady (if slower-than-expected) uptake. Normally, QECB proceeds must be fully spent within three years. If they are not, the issuer effectively loses the ability to utilize the unspent volume. The Internal Revenue Code provides that an extension for use may be granted, but no issuer is known to have requested or received one to date.

“I thought demand would be higher so I wouldn’t have done our whole allocation,” Klein said. “I still would have done the program absolutely but not necessarily gone for all $10 million.” Despite the challenges and uncertainties, “I completely recommend . . . the QECB program,” Klein said.

Mark Zimring, a member of the Electricity Markets and Policy Group at Lawrence Berkeley National Laboratory, and a DOE QECB technical assistance provider, commented: “The new QECB guidance goes a long way to reducing this uncertainty in key areas, and I expect to see a meaningful increase in QECB utilization in the coming months. In addition to clarifying how cities and states should measure expected energy savings in their own buildings, the guidance makes clear that a wide range of energy conservation projects, including street lighting upgrades, public transit improvements, and residential and commercial energy efficiency loan programs are acceptable uses of QECB proceeds. As ARRA grant monies run out, I hope that this guidance will shine a spotlight on QECBs as a compelling tool to help state and local governments continue their efforts to reduce energy use and create jobs.”

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