Affordability can be thought of as different than “how do I pay for it”.

Affordability is used here to mean that the cost as reflected by accounting in the period P&L is equal to, less than, or perhaps not meaningfully and materially more (from an entire cost perspective) than the avoided alternative cost.

• How do I pay for it: Where is the funding coming from and under what requirements/terms and under what time period?
• Two types of financial statements – income statement (financial success of current operations); balance sheet (reflects balance between assets and liabilities).
• Affordability is generally reflected in income statements over time and “How do I pay for it” is reflected in balance sheets over time.
• Why it matters – your choice of technologies and structures has to fit your organizational financial goals in both of these dimensions.

While our topic generally relates to cost, affordability is related to GAAP accounting policy. There are differences in GAAP Practice for Not for Profits as opposed to corporates. Further, there are differences for Hospitals, Insurers and HMO’s. For example, if a healthcare system is required to follow HMO accounting, which places investment and interest income and interest expense below the Operating Margin line, then only net income is impacted, not operating income and operating expense, with changes in investment income and interest expense. This can become a factor when looking at various financing/leasing/purchasing options. While all cash flow is used in economic analysis, a constraint on period cost will be impacted by whether the focus is operating margin or net income.

All organizations have a performance metric for financial reporting. For example, public corporations use net income as a performance metric. Most Not for Profit organizations use “change in net assets” (net worth) as a performance metric, but others have adopted net income as the performance metric. This is sometimes different than the real focus of the organization in its market, its pricing and its sustainability planning. It is important to know where the organization's focus is.

Capital is a word with multiple meanings, even within the context of sustainability finance.

Capital in its broad sense means the net worth plus debt of an entity. Often the term is used to refer to how the funds are deployed – capital spending.

On a balance sheet, financing leases are considered capital, and their expenditure is recorded as additions to property plant and equipment. Operating leases are not considered additions to capital, although the leased assets are shown, and lease liability is shown at its discounted value on the balance sheet.

Capital budget reflects the amount of the organization's capital that can be expended on additions to assets in during a period. So, purchases of assets (or construction) are an addition and capital expenditure if it is owned or financed with a financing lease. An operating lease does not get recorded as a capital expenditure.

Some organizations require that an item must be “capital budgeted” before it can be acquired with an operating lease, so that the operating lease does not result in bringing in more operational assets than approved in the budget. The operating lease does not then create a capital expenditure, but the capital budget is reduced to reflect that an item was acquired as an operating lease that had been approved as a purchase. In this view, the capital budget is intended to gait the flow of assets/equipment into the organization, regardless of how and when they are paid for.

An asset is recorded at cost, and the cost is amortized or depreciated over the economic life of the asset. The depreciation expense is used as part of the analysis of cost versus avoided cost. A project could be financially viable but not affordable, while financing may result in poorer overall economics but lower period expense and therefore passes an affordability test.

Organizations typically articulate a minimum return requirement for projects – a hurdle rate. The hurdle rate can reflect the entities weighted cost of capital, sometimes with an additional requirement – cost of capital may be x% but the hurdle is x+3% or so. Or it might be a rationing tool, with projects sorted by internal rate of return and a line drawn at the return threshold that exhausts available budgeted capital. Or the hurdle rate itself can be used as a discount rate with projects evaluated as to Net Present Value.

Many enterprises allocate a capital charge to their operating units – this gets eliminated for public reporting but can be an important metric for management. This charge reflects the use of actual capital (real money) during the period and can increase what is viewed as the expense of owning, and theoretically equates ownership to financing. This can be thought of as placing the required hurdle rate return into the expense.

Organizations typically articulate a minimum return requirement for projects – a hurdle rate. The hurdle rate can reflect the entities weighted cost of capital, sometimes with an additional requirement – cost of capital may be x% but the hurdle is x+3% or so. Or it might be a rationing tool, with projects sorted by internal rate of return and a line drawn at the return threshold that exhausts available budgeted capital. Or the hurdle rate itself can be used as a discount rate with projects evaluated as to Net Present Value.

The analytics used by an organization can impact their view on viability of a project.

Further and more challenging, different parts of an organization may use different metrics at different stages of evaluation – facilities may use payback and the capital approval committee may use IRR or NPV. Very often there are multiple criteria.

In any analytic approach, it is important to know if the objective is to maximize/optimize or to satisfice. An example might be something like a PPA may be below avoided cost, but ownership has better NPV/IRR over the life of the project – an organization may prefer the PPA as simple, preserving capital etc., or may prefer the optimized approach.

Payback is a simple approach using cash flows only. While the faster funds are returned the more projects can be completed with the same funds, payback ignores the extent that savings are generated after the initial return of capital. It is a heuristic non-financial approach. Imagine a contract that has little return in the first six or seven years, and then free power for 25 years. Payback would reject the project.

The IRR (internal rate of return) is a classic metric though it has its own problems. It assumes that cash generated by the project can be re-invested at the same return as the project (this can be corrected with modified IRR), and the more the IRR diverges from the cost of capital, the less meaningful it becomes – when comparing two projects, one might have both a higher IRR and a lower NPV at the firms cost of capital. NPV is more accurate.

The analytic modeling projects financial returns, time value of money etc. But it always needs to look at the accounting expense of differing scenarios – some organizations focus on operating margin, some on net income, some on change in net worth.

Bond Ratings are very often cited as a constraint in deploying and financing renewable energy and carbon footprint reduction.

Ratings Agencies use bond ratings categories to reflect the risk of default of the enterprise. However, most healthcare systems are investment grade (above BBB) and the increased default risk in moving from, for example, A to A+ or vice versa is very small, and the increase in borrowing expense is generally small as well. A major initiative like an expansion may lower the bond ratings a bit because expansion has risk, but that is not intended to mean the entity is worse off for the initiative. But, in the NFP healthcare world, Boards often view rating as a report card on the business, and CFOs carefully guard their rating. For most hospitals, the key ratings metrics are debt/capital, debt service coverage, days of cash and margin. The first three combine to give a view as to capacity for additional debt.

Entities will plan their capital expenditures to maintain target or current ratings. Implicit in the suggestion that ratings are a constraint is the notion that core capital for medical technology and new facilities crowds out capital for decarbonization.

Buying for cash reduces days of cash. Financing through debt increases debt/capital and reduces debt service coverage. Leases incorporated by ratings agencies to calculate equivalent debt.

Power purchase agreements, when structured so as not to qualify as a lease, are off balance sheet. Because the future output of an installation is not absolutely certain, the purchase commitments are contingent and do not have to be disclosed in financial statements.

In any of the financing structures, the provider of financing uses a mix of debt and equity to set up the project company for the asset. An offtaker (hospital) can be the lender to the project company. Because the risk of the loan to the offtaker is far less than to a financial party (right of offset on power payments if debt service is not made), the appropriate risk return interest rate can be far lower, and covenants relaxed in exchange for lower price per kW. The loan to the project company continues to be reported as part of the investment portfolio.

Note that providing funds from the investment portfolio to lend to the project company may reduce investment income – while the yield may reflect the risk, the funds may be moved from higher risk fixed income, eroding net income. This is one area where it is important to understand the accounting and which metric the offtaker focuses on – operating income and expense, or net income.

United States Healthcare provider CFOs and Financial leaders have an immensely challenging job. The US Centers for Medicaid and Medicare Services (CMS) reimburses approximately 43% of healthcare expenditures;[1] is growing;[2] and covers approximately 80% of the cost of services provided.[3] The healthcare systems are constantly struggling financially, with much of the industry with thin, and even negative margins.[4]

Among the pressures faced by these financial leaders are demands from credit markets. Healthcare providers must maintain access to the capital markets and for Not for Profit entities this is limited to issuance of debt or merger as there is no stock to issue.  This requires a bond rating, and various covenants with respect to their financial positions. NFP Boards and leadership are extraordinarily sensitive to bond ratings, and often relate to them as if they were report cards on performance, rather than assessment of small differences in risk.  Key to both is the total of cash and investments on the balance sheet.   Many systems and stand alone facilities have more than half of their lifetime earnings sitting in investments unrelated to the provision of healthcare. (insert median doc for systems and stand alones)

The irony, then, is that many healthcare organizations are sitting on significant amounts of cash, but cannot spend it (to protect covenants and bond ratings),  often they are simultaneously unable to make money from operations.  At all ratings levels, entities are constrained on using their cash, and constrained from issuing more debt.  And at all ratings levels, organizations aim to be at or above median industry levels.

These challenges make it extremely difficult for healthcare organizations to invest cash even into investments that could improve operating margins and cash flow. And investments that do NOT improve operating margins and are not mandated are essentially impossible. Similarly, operational margins are so thin as to allow virtually no flexibility for re-directing funds that do not immediately result in at least an equivalent improvement in margins.

Healthcare organizations then, who wish to decarbonize by investing operational dollars, or capital, including available cash, have few options. Direct ownership of projects provides the lowest operating expense by far, but the internal rate of return on the investment is often below that of revenue generating or other core investments with which it is competing for scarce capital dollars, often with longer payback (but longer life) than other facilities projects as well.  Using PPAs and other financing structures, which wrap financing costs into operating expense can push operating expense above avoided do nothing cost.

Third party financing/ownership of the project (be it generation, storage or efficiency) often includes the use of project companies created for the transaction.  These project companies are funded with a mix of equity, tax credits and debt.  The project companies are not rated (ratings agencies) and therefore the debt carries a higher interest rate and is accompanied by covenants which require increased expensive equity in the financing.  Off takers have successfully lowered the cost of the agreements (PPA, VPPA, ESA etc.) by being the lender to the project company.  The loan to a third party is reported as an investment on the balance sheet, such that cash and investments is not depleted.  In this case, the offtaker/lender can offer better terms (lower rate and relaxed covenants on the project company) because of the lien n on the assets and the fact that their own cash flow services the debt.  This produces a more efficient, less costly structure with the savings passed to the offtaker, along with interest income.  This also can produce a trade-off – less investment income but lower operating expense, which is often a good thing.

Similar results can be obtained with prepayment of expense, although in this case cash is depleted but another asset – prepayment , is increased both long and short term.

Another avenue is to use the investment portfolio to invest in assets that generate carbon and/or renewable energy credits, and to take as part of the investment return the environmental attributes And, if such investments yield both a financial return and ownership of Environmental Assets, that investment will provide an economic return, will protect the operating margin from the needs to buy Renewable Energy Credits (RECs) or Carbon Offsets in order to achieve a decarbonization goal. And, it allows the healthcare organization to then, achieve its decarbonization goals.   

[1] See, United States Congressional Research Service, U.S. Healthcare Coverage and Spending, Feb. 6, 2023, https://crsreports.congress.gov/product/pdf/IF/IF10830.

[2] See Neha Patel and Shubham Singhal, What to expect in US healthcare in 2023 and beyond, McKinsey, Jan. 9, 2023, at https://www.mckinsey.com/industries/healthcare/our-insights/what-to-expect-in-us-healthcare-in-2023-and-beyond.

[3] See, e.g. American Hospital Association, Fact Sheet: Underpayment by Medicare and Medicaid, Feb. 2022, at  https://www.aha.org/fact-sheets/2020-01-07-fact-sheet-underpayment-medicare-and-medicaid.

[4] See KaufmanHall, National Hospital Flash Report, Jan. 2023, at https://www.kaufmanhall.com/sites/default/files/2023-01/KH_NHFR_2023-01.pdf.