Office of Science

Alternative Financing White Paper

March 31, 2003

*(with summary of Positives & Challenges on last page)*

![](media/image1.png)

***1-Facilities***

1.  **Quick Summary --** The Pacific Northwest National Laboratory
    (**PNNL**) is comprised of both owned and leased facilities of the
    Department of Energy (DOE) and Battelle Memorial Institute
    (Battelle). While most facilities are located in Richland,
    Washington (WA), there are other noteworthy facilities in Sequim WA,
    Seattle WA, and Washington DC, that support DOE missions of PNNL.

+-----------------------+------------+-------------------+------------+
|                       | #########  | ###               | #####      |
|                       |  DOE Total | ## Battelle Total | PNNL Total |
+-----------------------+------------+-------------------+------------+
| **Owned Square Feet** | *          | **496,000**       | **1        |
|                       | *901,000** |                   | ,397,000** |
+-----------------------+------------+-------------------+------------+
| **Leased Square       | **76,000** | **509,000**       | *          |
| Feet**                |            |                   | *585,000** |
+-----------------------+------------+-------------------+------------+
| **Total Gross Square  | *          | **1,005,000**     | **1        |
| Feet** (GSF)          | *977,000** |                   | ,982,000** |
+-----------------------+------------+-------------------+------------+
| *(Note: 300 Area GSF  | *689,000*  | *0*               | *689,000*  |
| included above)*      |            |                   |            |
+-----------------------+------------+-------------------+------------+
|                       |            |                   |            |
+-----------------------+------------+-------------------+------------+
| **Replacement Plant   | **\$401M** | **\$80M**         | **\$481M** |
| Value^1^**            |            |                   |            |
+-----------------------+------------+-------------------+------------+
| ![](med               |            |                   |            |
| ia/image2.wmf){width= |            |                   |            |
| "5.663194444444445in" |            |                   |            |
| height="3.540277777   |            |                   |            |
| 777778in"}^1^Includes |            |                   |            |
| buildings and other   |            |                   |            |
| structures and        |            |                   |            |
| facilities, but not   |            |                   |            |
| excess facilities.    |            |                   |            |
+-----------------------+------------+-------------------+------------+

**DOE-Owned Active Facilities**

![](media/image3.wmf){width="2.6847222222222222in"
height="1.9972222222222222in"}

**2.** As noted in the PNNL Institutional Plan the majority of the
**DOE-owned active buildings** are 1950s vintage, with an average age of
34 years (excluding the Environmental Molecular Sciences Laboratory).
Over three quarters of DOE owned facilities are located in the 300 area.
Under proposed acceleration of the River Corridor Clean-up Project, many
of these facilities are expected to be shut down as early as FY 2008.
Therefore, replacement facilities outside of the cleanup zone will be
required in order to continue programs currently dependent on this
space.

![](media/image4.wmf){width="4.166666666666667in"
height="2.2916666666666665in"}

3.  **Alternative financing has helped improve the condition of
    Battelle-owned space on the PNNL campus.** Approximately 500,000
    square feet have been added via third party financing. Battelle
    initially provides funding for the capital maintenance and
    modification of Battelle's private facilities and subsequently
    recovers much of it from DOE to the extent these facilities are used
    to perform work under the operating contract. Battelle suggests a
    more liberal approach allowing direct use of government funds when
    the government is the direct beneficiary would be more effective.

***2-Alternative Financing Experience at PNNL***

PNNL operates and provides related facility services for approximately 2
million gross square feet of laboratory (double filtered/special, wet
lab, and dry lab), office, storage, and common space. The U.S.
Department of Energy (DOE) owns approximately 50 percent of the square
footage, Battelle owns about 25 percent, and the remaining 25 percent is
leased by Battelle or DOE. Alternative financing has been one of several
methods PNNL has employed as a result of its benchmarking efforts. These
efforts have resulted in identification and use of best commercial
practices, outcome-oriented performance measures, and elimination of
low-value-added activities.

**1. Experience at PNNL has shown that privately constructed
facilities** *may* be built at lower cost than government constructed
facilities, so the lower construction cost can offset the higher
financing cost of leasing over owning. The examples below are all
operating leases, but there is the potential to reduce cost even further
through the use of a Lease-to-Own (LTO) approach, which will be
discussed in the section on future plans.

Battelle's efforts to utilize third party investments resulted in the
more timely addition of about 500,000 gross square feet of additional
modern space (or 25 percent of PNNL's total space). Some of the larger
and newly "constructed to lease" buildings, by name, gross square feet
and initial occupancy date, include the following:

-   Information Sciences Building 1 (ISB1) -- 50,200 Gross Sq. Ft., June
    1990

-   Information Sciences Building 2 (ISB2) -- 60,080, December 1991

-   National Security Building (NSB) -- 100,358, May 1993

-   Environmental Technology Building (ETB) -- 100,364, September 1994

-   Applied Processing Engineering Laboratory (APEL) -- 43,340 of 95,000
    total, April 1998

-   User Housing Facility (UHF) -- 29,000, June 2001

-   Consolidated Information Center (CIC) -- 31,020 DOE-RL + 19,836
    Washing State University (for total of 50,856 w/RL 61% w/PNNL part &
    WSU 39%), \~September 1997

An important enabling feature at PNNL is a large, 240-acre block of land
owned by Battelle that is ideally located adjacent to DOE property at
the north end of the city of Richland, bordered by the Hanford Site and
the Port of Benton properties. In all but the APEL and CIC facilities
bulleted above, Battelle owned the land on which the developer
constructed-to-lease. Additionally, to allow these construction projects
to attract the necessary private financing, Battelle (not as the M&O
contractor at PNNL, but as a separable and distinct entity with no
guarantees from DOE) entered into initial 10 year non-cancelable leases,
with 5-year renewal options that are also non-cancelable during the term
of the lease. Hence, Battelle assumed a noteworthy risk from the initial
facility lease term that extended beyond the 5-year term PNNL M&O
contract. However, this is not something most M&O contractors will
consider when faced with 5 year contract terms, and in fact Battelle is
unlikely to continue to make these lease guarantees in the future.

In the **CIC**, GSA entered into a 20-year lease with Washington State
University for space utilized by DOE-RL, of which PNNL utilizes part.
Rent is paid by the benefiting entities (i.e., DOE-RL and PNNL). PNNL
uses their space to operate the Hanford Technical Library and Reading
Room, which shares some common space with WSU's library. PNNL was able
to vacate a 1940's era building and move to the new CIC at no additional
rent. So quality of space and service to our customers went up, with no
increase in cost.

**APEL** is a building owned by Energy Northwest that was
modified/modernized by the Tri-Cities Industrial Development Council
(TRIDEC) contributing \$3.5M, and the Port of Benton putting up a \$1
million bond, with Battelle committing to a 5 year lease and \$250K for
equipment. Battelle leases portions of the building for PNNL. Addition
of this space allowed PNNL to vacate an aging Category 2 Nuclear
Facility (i.e., 324 Bldg) and transfer it to deactivation.

**2. Energy Saving Performance Contracts (ESPCs)** and Energy
Conservation Projects (ECPs) have been a source of additional cost
savings at PNNL.

Battelle has used alternative financing for a variety of projects,
including Energy Saving Performance Contracts (ESPCs) and Energy
Conservation Projects (ECPs). These mechanisms provide the contractor
alternative means to modernize and enhance facility capabilities without
DOE capital investment. Three examples follow:

-   **DOE-Richland Steam ESPC** with Johnson Controls Inc (JCI): \$23.4M
    Hanford investment project, of which \$7.3M was for energy savings
    equipment in DOE 300 Area facilities and infrastructure operated by
    PNNL. Savings repays loan principal and interest, plus savings that
    have exceeded original estimate. Implementation was completed April
    1998, with repayment over the following 10 years.

Through the DOE-Richland ESPC, PNNL also financed for its 300 Area
buildings a Hot Water ESPC for \$525K in FY01 and a Standby Power ESPC
for \$782K in FY02.

-   **Environmental Molecular Sciences Laboratory** (EMSL), Energy
    Conservation Project (ECP) of \$1M investment in FY 1996 to be
    repaid over the following 10 years. Interest free loan from
    Bonneville Power Administration (BPA) to City of Richland to DOE-RL,
    with payments from PNNL.

-   **Battelle private facility ESPC** of \$2.2M in FY 1997 and \$1.0M
    in FY02 through 3^rd^ party 10-year operating lease. Savings cover
    principal and interest of energy equipment installed in Battelle
    private owned facilities. Savings have exceeded expectations.

In addition to the above investments, frequently additional savings can
be achieved through "Buy-Downs" or prepayments of the energy loans. The
opportunity to make advantageous prepayments arises from favorable
variances in annual facility operating costs:

-   **DOE-RL Steam ESPC**: Prepaid all \$7.3M investment by FY02 year
    end. Avoids future principal and interest, reducing annual operating
    cost \$1.3M. Avoided 8.3% interest cost, which added to savings.

-   **EMSL ECP**: Prepaid all \$1M in 1^st^ year with \$0.2M discount on
    no interest loan (i.e., so paid only \$0.8M on \$1M loan), reducing
    future annual operating cost \$0.1M/year for 9 years.

**3. PNNL Lessons Learned:**

[Square footage and cost trend at PNNL]{.underline}:

The chart below shows the relationship between square feet and cost from
FY 1994 through FY 2003. Space chargeback to users started in FY 1996,
and was a driver for lower cost space as well as a reduction of lower
quality space. As noted by the light red colored portion of the bars,
the quality of space has increased with new buildings replacing old.
Cost in constant dollars has decreased while quality of space has
increased. Overall cost of facility operations has been declining at
PNNL as a result of selective use of alternative financing and applying
best commercial practices to generate operating cost savings and
efficiencies.

![](media/image5.wmf){width="6.833333333333333in"
height="3.5930555555555554in"}

#### 

A lesson learned with ESPCs is to allow the ESPC provider (like Johnson
Controls Inc in the case of DOE-RL's Steam ESPC) to allocate costs on a
predetermined equitable basis directly to the benefiting entities (like
PNNL, Fluor Hanford Inc, etc in the case of the Steam ESPC). Having DOE
perform that allocation split is an extra step (creating extra work for
DOE).

Interpretation of the legislative language supporting ESPCs can be
limiting. Would be good to clarify in interpretation of the ESPC
language that any facility operating cost savings can go toward
pre-payment of an ESPC as long as it is to the federal agencies
financial advantage.

A beneficial change/expansion of the basic ESPC principle would be to
allow the same concept to apply to building replacement. That is, if old
existing buildings can be replaced by new, alternative financed
buildings at no incremental cost increase (i.e., the operating cost
savings pays the added financing and related costs), then allow all
lease cost to be allowable. The proposed clarification of the ESPC
language/applicability will need to be coordinated with GC-HQ (Lawrence
Oliver is the GC-HQ attorney with the lead for ESPC issues).

To optimize a facility financing structure and attract private sector
funding in a manner that best meets the needs of the Federal government,
the following items are pertinent. No statutory changes are needed to
apply these considerations.

1.  Recognition of the true cost of money to the M&O contractor (i.e.,
    facilities cost of capital reimbursements for M&O contractors may be
    less than their actual borrowing costs);

2.  Recognition of and payment for risk on a causal/beneficial
    relationship;

3.  Accounting rules (OMB A-11) for Operating Leases vs.
    Capital/Financing

> Leases;

4.  Appropriate balance of DOE needs vs. financial investor needs
    regarding

> lease terms;

5.  Use of a successor contractor clause to reduce risk (only when a
    long term commitment is needed); and

6.  Provide lease continuance preference for new long-term leased
    facilities.

***3-Alternative Financing Plans under consideration at PNNL***

**1. Reducing Cost of Existing Battelle Leases (on Battelle Land):**

In an effort to further reduce facility operating costs at PNNL and
applying some of the recent alternative financing knowledge gained at
ORNL, Battelle is considering an innovative facility acquisition and
financing program to acquire and reduce the cost of currently leased
facilities on Battelle owned land. This improved approach could also be
used for adding a new building on Battelle land. The Site Office and
DOE-RL have begun preliminary analysis of this proposal.

> **Proposal:** DOE and Battelle would enter into a separate contract
> for the leasing of facilities to DOE to support the operation of PNNL.
> This separate contract would run parallel to the exiting M&O contract
> held by Battelle. Battelle would exercise an option to buy the current
> leased facilities and finance them under a lease to own arrangement.
> This "leasing" contract would essentially make Battelle equivalent to
> our current landlord, but at a lower cost based on a shared risk
> proposition between DOE, Battelle and a financing institution. This
> shared risk proposition is explained in more detail in the sections
> below.
>
> **Savings:** The following graph illustrates the kind of savings that
> could be achieved compared to a commercial lease approach.
>
> ![](media/image6.wmf)
>
> **Financing Terms:** Financing would be for 20-25 years and may be via
> a private financing institution or possibly by the sale of bonds.
> Security would be the lease on its own and a mortgage on the facility
> itself. The strength of the lease will be based on the "essentiality"
> of the facilities to the mission of PNNL/DOE and the high probability
> of the lease being renewed at least for the duration of the financing.
> Contract language between DOE and Battelle (see below) would be
> obtained to provide reasonable assurance to a financing institution
> that a continued income stream to cover the debt is likely in all but
> the most extreme circumstances. If DOE should exercise their right to
> withdraw from covering the cost of a financed facility, a reasonable
> attempt would be made to find other tenants. If unable to find a
> tenant, then the property would be sold and the proceeds used to
> satisfy any remaining obligations to the providers of the financing.
> Should proceeds from a sale be insufficient to satisfy the debt the
> financing institution is at risk for the difference.
>
> **Lease Terms between DOE and Battelle:** The lease would be
> considered a government lease entered into by DOE for PNNL. Lease
> provisions would include:

1.  An initial 10 year term, with multiple 5-year renewals.

2.  The facility lease rates would be specified for the duration of the
    lease and be based on the actual repayment amounts including
    interest plus a shared savings amount (based on a percentage of the
    savings between this approach and a commercial lease).

3.  Lease cost is fully allowable (e.g., the full lease payment as
    determined above including interest).

4.  If DOE should exercise the right to withdraw from covering the cost
    of a financed facility (with 12 months notice), this would carry
    forward to the financing institution. PNNL would make payments for
    12 months from the date of the notice and vacate the facility within
    this time frame.

> **Contract Assurances:** There would be a shared risk approach between
> DOE and Battelle that would include the following provisions in the
> leasing contract. These provisions are intended to meet the
> limitations imposed upon DOE by Congress while offering reasonable
> assurances to Battelle of a continuing commitment to cover the cost of
> the financed facilities. These assurances not only limit Battelle's
> risk but the risk transferred to the financing institution.

1.  Battelle, as the contractor for PNNL, is responsible for effective
    management of the portfolio of facilities. DOE can exercise a right
    to terminate cost allow ability for a specific Battelle facilitated
    lease (requires 12 months notice) only if they can demonstrate
    Battelle is not adequately fulfilling this management responsibility
    as a result of the lease.

2.  A stated preference for keeping Battelle provided facilities in the
    event of a downturn where there is a long-term lease commitment by
    Battelle (including a Battelle SPE).

3.  A successor contractor clause that in the event the contract for
    operation of PNNL is put up for competitive bid, Battelle has the
    option to either retain a facility covered under a long-term leasing
    arrangement or pass this obligation onto the successor contractor
    (who must then assume Battelle's position in the SPE and either buy
    or rent the land from Battelle). DOE would be required to make it a
    condition of a bid to assume the obligations identified by Battelle
    unless it can be established that adequate funds are not being
    appropriated or otherwise available for the operation of PNNL in a
    configuration that would include the leased facility.

> **2. New Facilities not Appropriate for Line Item Funding:**
>
> There are instances where a new facility is needed that would not be
> appropriate for line item funding either because it is general purpose
> in nature (i.e., not specific to the mission of a single DOE Assistant
> Secretary) or the need is immediate. There would be two possible
> approaches: 1) follow the above approach by building a new facility on
> Battelle land, or 2) follow the ORNL approach and build a new facility
> on DOE provided land. For the DOE land option, Battelle would create a
> separate LLC, as a Special Purpose Entity (SPE), for the purpose of
> acquiring facilities and leasing them to DOE/PNNL. DOE would do a
> quitclaim deed for government land assigning ownership to the SPE. The
> SPE would obtain both construction and long term financing and
> construct the facility on a "build to suit" basis. (It is anticipated
> that the SPE would purchase services from PNNL to accommodate the
> construction and administration of the SPE). The SPE would lease the
> facilities to DOE/PNNL (probably direct to DOE to avoid any related
> party transaction concerns) in support of Battelle's M&O contract with
> DOE. The lease rate would include some fee to the SPE based on
> agreement with DOE, at a minimum to cover the operating cost of the
> SPE. The agreement would have the land (with the building) revert back
> to DOE contingent on DOE's continuity of the lease for the entire
> term. At the end of the land lease the SPE would be dissolved and the
> facilities abandoned to DOE. If lease continuity is broken, the SPE
> retains ownership of the land (no reversion) and may rent out the
> facilities to other parties.
>
> This new facility approach would require the same financing terms,
> lease terms and contract assurances as noted above in the section on
> "Existing Battelle Leases". The savings would also be roughly
> equivalent assuming the cost of construction using DOE provided land
> would remain the same as for a building on Battelle land. It is likely
> that DOE would favor a DOE provided land approach to attain ultimate
> government ownership unless it invokes government requirements that
> significantly increase the construction cost of a new facility. Then a
> Battelle provided land approach, which will allow use of commercial
> construction requirements, would be advantageous.

**3. Bioproducts, Sciences, and Engineering Laboratory:**

> PNNL is working with Washington State University (WSU) to be an
> occupant of a new laboratory facility they are working jointly on
> designing and building, with PNNL to be a tenant of this new WSU
> facility. This arrangement will be similar, although not directly
> like, the CIC facility previously constructed by WSU with DOE and PNNL
> as tenants through GSA. This proposed new facility arrangement is not
> planned to include GSA as the lease is planned to have the government
> 365 day cancellation clause. Details are currently being worked on the
> exact structure to be proposed. This project has not received DOE
> approval beyond a conceptual level.

**4. Institutional General Plant Projects (IGPP):**

> *IGPP - Business or new capability development investments that
> enhance the Laboratory's portfolio including investments aimed at
> operational savings.*

We are encouraged with the Department's proactive approach in
implementing the Infrastructure General Plant Project (IGPP) program. We
believe an IGPP program is a way for DOE to address the pressing issue
of inadequate funding for critical infrastructure improvement(s). This
strategy requires significant DOE investment, and Landlord GPP and this
companion IGPP program are critical elements of that investment since
those funds are used to build the infrastructure supporting the larger
new building.

At this point, PNNL has not implemented any IGPP projects, but the
policy is in place and planning has begun.

Summary of **Positives & Challenges** PNNL is Experiencing with
Alternative Financing

[Positives]{.underline}:

-   Over a decade of experience with alternative financing of facilities
    and energy saving facility equipment.

    -   Alternative financed facilities (ie, constructed to lease) is
        about 25% of PNNL's 2M gross sq ft complex.

    -   6 ESPC projects at \$13.5M, of which 4 projects of \$10.2M have
        been paid off, so currently yielding significant savings.

-   Enabling feature at PNNL is Battelle owned 240-acres ideally located
    (adjacent to DOE and Port of Benton properties at North end of city
    of Richland).

-   Attempting to apply lease to own financing knowledge recently gained
    at ORNL to reducing cost of currently leased facilities on Battelle
    owned land and to provide a future new facility need at PNNL.

[Challenges]{.underline}:

-   Need mechanisms to facilitate a leased to own approach as it results
    in substantial savings over a commercial lease if the need for a
    facility is long term. The mechanism(s) need to address:

    -   Minimizing risk to financing institution/investors to provide
        access to cost effective financing. To reduce risk for both the
        contractor and financing institution need to provide assurances
        of obligation passing to a successor contractor and lease
        continuance preference for long-term lease agreements.

    -   Making lease to own cost fully allowable (ie, including interest
        in lease payment).

    -   To the extent contractor has taken on risk/exposure to attain
        reduced lease cost beyond that normally expected under an M&O
        contract, need to compensate contractors for this financial risk
        (essentially contractor becomes a developer which is a scope
        outside a normal M&O contract) .

-   ESPC evaluation criteria and approval rules, as provided by
    DOE-HQ-EERE-FEMP-Departmental Energy Management Program, need to be
    known in advance. Additionally, more flexible interpretation of the
    ESPC rules by the Department could facilitate alternative financing
    approaches under consideration.

If questions on this report, please contact Mark Coronado, DOE-RL, at
(509) 372-4100, or Peter Smith, PNNL, at (509) 376-4673.