Hidden Cost of PACE Lending for Energy Efficiency Improvements

It can be hard to afford the up-front cost of green investments such as solar panels, efficient heating and cooling equipment, or energy-efficient roofs—even when these investments are guaranteed to pay for themselves in a few years. The traditional way to fund such investments is through taking out loans or (if you are a government or business) issuing bonds, but homeowners, small business owners, and local governments are increasingly debt-laden and cash-strapped, leading them to seek new sources of financing.

Property Assessed Clean Energy (PACE) financing is often advertised as a new way to get money up front for green energy investments—without down payments, without monthly payments, without a good credit score, and without increasing government spending. To many, this sounds like a good deal: Since their invention around 2010, PACE programs are now in use in 22 states and legal in 37 states, and total investment in U.S. PACE projects increased from around $3 billion in 2016 to $8 billion in 2019.

But there’s a catch: In exchange for PACE financing, the lender gets a "priority lien" on the borrower's home or business. A priority lien is similar to a mortgage, except that payments are made as increased property taxes (which are paid yearly, so technically there are no monthly payments). That means that missing a PACE payment is legally akin to not paying one's property taxes, and one's home can be seized for even a single missed payment, depending on local law. In addition, PACE financing is substantially more expensive than traditional financing, making nonpayment more likely: PACE interest rates are 2 to 4 percent higher than a standard mortgage, plus additional "administrative fees" of 4 percent  or more. Furthermore, while in principle PACE projects are supposed to pay for themselves through energy savings, in practice they often do not; PACE regulations do not include oversight mechanisms to ensure that the promised energy savings materialize, or even that the green energy technology actually functions.

Whether or not the borrower sees savings from their PACE project, they must pay the costs: "Priority" in PACE’s priority liens means that repayment will be extracted from the borrower with precedence over virtually every other financial obligation except property taxes, including mortgage payments, utility bills, and car loan payments. So, missing payments on even a minor home improvement project funded by PACE entitles your lender to foreclose on your home even if you have a mortgage with another institution, and even if you own your home outright. Indeed, advertising materials for PACE lenders tout the certainty of being repaid, guaranteed by the right to seize a debtor's home, as one of the primary selling points of PACE liens.

While some PACE borrowers may be fully aware of the unusually high interest rate, the administrative fees, and the fact that their home is at stake, some borrowers are not, leading to financial catastrophe. In the absence of national oversight or systematic data collection, the extent of this problem is difficult to estimate. However, a joint study by ProPublica with the St. Louis Post-Dispatch and The Kansas City Star of 2,700 PACE loans in Missouri found that 100 PACE loans (3.4 percent) had at least two years of missed payments, leaving homeowners in danger of foreclosure. For comparison, the St. Louis foreclosure rate among all residential properties was far lower, 0.43 percent in 2019. In predominantly Black neighborhoods, 28 percent of PACE borrowers were at least one year behind in payments, compared to 4 percent in predominantly white neighborhoods, indicating that PACE lending may be exacerbating racial wealth disparities.

The National Consumer Law Center (NCLC) writes that "legal services agencies throughout California have been overrun with complaints related to PACE, including fraud, forgery, identity theft, price gouging, undisclosed costs and fees, and unpermitted or uncompleted work." NCLC has recorded over 40 cases where borrowers unexpectedly lost tens or hundreds of thousands of dollars, and sometimes lost their homes, from what were represented as guaranteed money-saving investments: cases where construction contractors and lenders aggressively pursued PACE contracts with elderly people (including three diagnosed with dementia) and with non-English speakers (who in some cases signed contracts in English without translation); cases where lenders' signatures were forged; cases where the terms of the lien were misrepresented, or where construction costs were thousands of dollars higher than those agreed upon, or where costs exceeded savings by tens and in some cases hundreds of thousands of dollars; and cases where construction was shoddy, incomplete, or damaging to the home. In an ongoing series, the LA Times is investigating numerous possible PACE abuses that have left families in financial ruin.

Regulators are beginning to take note. Los Angeles County recently shut down its PACE program, saying that the program could not ensure "sufficient protection for all consumers." Missouri and California both added greater consumer protections and oversight to their PACE programs in 2021. It remains to be seen whether other states follow suit, and whether these reforms lead to better outcomes for people hoping to make green investments.

Gabriel Lewis
Research Assistant

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This is a part of the AEC Blog series

Uncertain about how much to discount the future? You're discounting too much.

Our most important decisions—about slowing climate change, funding childhood education, eating ice cream—often require weighing present costs and benefits against future ones. Crucially, we are usually pretty uncertain about how much, if at all, to discount the future in favor of the present. A federal Interagency Working Group (IWG) is about to pick a single number to try to answer this complicated question, a "discount rate." Whatever number IWG settles on, the U.S. government will use it to decide if the future benefits of green energy investments are worth the present costs.

The point of this blog post is to show, using a bit of math, that picking a discount rate while ignoring our uncertainty about the number we've picked makes us systematically undervalue future costs and benefits. Ignoring uncertainty makes us short-sighted.

Ask an economist about weighing present and future benefits, and they will give you an answer like this: if you received $100 now, you could invest it at some rate of return "r" (for example r might be 0.03 or 3 percent) and in a year you'd have (1 + r)*$100 (in our example, $103). But if instead you just received $100 a year from now, well, you'd just have $100. With some hand-waving, the economist concludes that a dollar benefit is worth 1 + r times more if we get it now, instead of getting it a year from now. Or turning things around, that same future benefit is worth 1/(1 + r) times less if we get it a year from now, instead of now; and if we get it t years from now, the value is further reduced to 1/(1+r)t. Here, r is the "discount rate": the bigger it is, the more we discount future benefits when considering them in the present; and the further into the future the benefits will occur, the more we discount them.

Source: IWG, 2021

Now, even if we buy this story (and the sneaky shift from "benefit" in general to "dollars" in particular), there's a catch: we don't really know what rate of return our investments will actually deliver. At best, we might have a range of plausible values for r, some values perhaps more probable than others.

For example, suppose we believe there are three equally probable values for r: 0.01, 0.03, and 0.05—this is roughly the range that IWG is considering for discounting future climate damages. If you are a policymaker considering a cost of climate change (e.g. $1 billion of storm damage) that will occur in 50 years, you need some way to turn $1 billion in 50 years into a what it's worth today, the expected present value of that climate cost. How should you do it?

It turns out there are two ways to calculate an expected present value: 1) the easy way, and 2) the easy and correct way. Both are just a matter of taking an average.

The first way is to calculate the average of the plausible values of r, then plug that average into our present value formula. In our example, the average value of r is 0.03, so we get ($1 billion)/(1.03)50 = $230 million. This method is simple, but wrong: it's equivalent to pretending we know r will be 0.03, ignoring our uncertainty about that prediction. It's not clear whether IWG will end up taking an average, but they do seem to be trying to pick a single number to use in any given analysis.

The second way, the correct way, is to plug each plausible value of r into the present value formula, one at a time, then take the average of the resulting present values. In our example, this is ($1 billion)*(1/1.0150 + 1/1.0350 + 1/1.0550)/3 = $310 million. That's 80 million dollars higher, or 35 percent higher, than the mistaken estimate.

The difference between these two estimates comes from uncertainty: the first ignores uncertainty about the discount rate, and the second correctly accounts for it.

This is just an example; a more realistic calculation would use more than three possible discount rates, giving greater weight to the more likely discount rates. But the phenomenon we've illustrated — that ignoring uncertainty necessarily leads to an underestimate of present values —is extremely general. It comes from a theorem of probability called Jensen's Inequality, which applies regardless of the form the uncertainty takes.

Underestimating the present value of future costs and benefits could be catastrophic. Such myopia may lead to the erroneous conclusion that the long-run benefits of green infrastructure investments are not worth their present costs, when they are; or that present inaction on climate change is cheap, when it is not. Such myopia endangers long-run prosperity and survival. To avoid the dangers of short-sightedness, the first step is to admit to uncertainty regarding how much to value things that will happen in the future. 

Gabriel Lewis Research Assistant

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This is a part of the AEC Blog series