City Council
Staff Report
From: City Manager
Report Type: CONSENT CALENDAR
Lead Department: Public Works
Meeting Date: November 17, 2025
Report #:2508-5088
TITLE
Climate Action and Sustainability Committee Recommendation to Approve Program Design Guidelines for the Advanced Packaged HVAC Pilot Program; CEQA Status – Categorically Exempt Under CEQA Guidelines Section 15302 (Replacement of Existing Facilities)
RECOMMENDATION
The Climate Action and Sustainability Committee and staff recommend the City Council approve the Program Design Guidelines for an Advanced Packaged HVAC Pilot Program to guide development of a large-scale program to help non-residential community members replace packaged HVAC units.
EXECUTIVE SUMMARY
As part of the City’s Sustainability and Climate Action Plan (S/CAP), staff launched a pilot program in summer 2024 to encourage commercial customers to replace gas-fired packaged HVAC units with electric heat pump HVAC systems.1 To date, 14 customers have enrolled in the pilot, six projects have secured permits, and three projects have been completed.
Preliminary results confirm that heat pump replacements are technically feasible and ranged from an 18% savings in up-front cost to a 40% additional cost compared to like-for-like gas system replacements. When there is additional cost, voluntary adoption can be difficult without financing options. Early projects also highlighted permitting challenges that add to overall project costs and complexity. While these requirements are necessary for safety and compliance, they can discourage voluntary adoption. A study of non-residential building equipment performed by a City consultant indicated heat pump replacements may result in bill savings, but this is yet to be confirmed by the projects in progress. 1https://www.paloalto.gov/Departments/Utilities/Electrification/Business-Electrification/Commercial-Heat- PumpHVAC-Program
Building on these lessons, staff proposes an Advanced Commercial Heat Pump HVAC (HPHVAC) Pilot Program. The goal of the program would be to replace direct incentives with scalable financing options while providing optional technical assistance. The program is designed to reduce barriers to adoption while maintaining compliance with all applicable permitting requirements.
The Climate Action and Sustainability Committee (CASC) reviewed these design guidelines at its October 17, 2025 meeting and unanimously recommended approval. $1.1 million was approved in the Utilities Department budget in the FY 2026 budget for the Advanced Commercial HPHVAC Pilot Program, funded by Gas Cap and Trade funds.
BACKGROUND
The City’s S/CAP identifies building electrification as a primary strategy for achieving community-wide greenhouse gas (GHG) reductions. Commercial buildings account for 16% of the City’s total natural gas use, with packaged HVAC units representing about 70% of commercial space-heating systems.
In summer 2024, staff introduced a pilot program to incentivize early adoption of heat pump HVAC systems funded by up to $1.2 million in Public Benefits (Research and Development) funding. Incentives were temporarily increased for the first 10 complete projects. The program was designed to generate cost and performance data, inform customer decision-making, and identify barriers to broader adoption.
Results to date show:
•14 customers enrolled in the pilot
•6 projects permitted
•3 projects completed
While technically successful, the pilot demonstrated that incremental costs remain a major adoption barrier for property owners. On average, cost estimates for electric heat pump HVAC systems were approximately 22% higher than comparable gas system quotes, ranging from 18% below to 40% higher. Among the three completed projects, the average increase in final cost relative to the initial estimate for electric heat pump HVAC installations was $34,024, and the average project cost was $244,751. The average price per ton for the installed heat pump HVAC units was $9,819.
Contractor and customer feedback further indicated that, outside of the program, many customers replacing gas packaged HVAC units do not obtain permits.
Permitting requirements identified through the pilot included:
•Structural engineering studies on roof integrity for rooftop units. •Sound studies to demonstrate compliance with noise standards. •Visual screening/line-of-sight reviews.
•Fire Department permits, including hazardous materials documentation and equipment labeling.
Because participation in the pilot required securing all necessary permits, this added an average of $3,118 in permit costs plus a variable amount of cost in consulting and contractor fees to comply, sometimes in the tens of thousands of dollars. Since only three participants in the program have completed projects so far, staff has limited data points. One community member was quoted over $10,000 to complete a sound study, while another completed the study for a negligible increase to their overall project quote. One community member incurred a $5,000 cost for hazardous materials services. Another was looking at potential increases of over $10,000 related to roof structural calculations related to the HVAC roof attachment method.
Staff is continuing to gather information on how these additional consulting and engineering services needs increase project costs, and ways to help community members comply at lower cost. These requirements are necessary to ensure safety, compliance, and community standards, but the additional project costs and time can sometimes create uncertainty and frustration for customers. Two customers withdrew from the program due to the cost and permitting requirements, despite the enhanced rebates.
ANALYSIS
Staff drew on its experience with the current HVAC enhanced rebate program,3 research done as part of the S/CAP Funding Study and corresponding Non-Residential Building Sector Study (which are not yet final), and some interviews (participants, contractors, a financing provider, and a consultant) as detailed in the Stakeholder Engagement section below, to develop the Program Design Guidelines for the Advanced Commercial Heat Pump Heating, Ventilation, and Cooling (HVAC) Pilot Program (Program Design Guidelines) in Attachment A. Staff has learned from its existing program how to navigate the permitting process and the associated costs. The studies gave staff indications that packaged space heating electrification should provide long- term utility bill savings. In the participant and business partner interviews, staff found potential interest in financing, particularly on-bill financing, and especially if it enabled the cost of improvements that benefit tenants to be passed through to them based on the bill savings they would realize.
Customers consistently noted that they would not have been able to pursue these projects without the boosted incentive, underscoring the importance of strong financial support for large-scale upgrades. They noted the short payback period needed for a property investor to do these projects. They also appreciated the technical guidance provided by the third-party electrification engineering consultant, Prospect Silicon Valley, highlighting the value of ongoing 3 https://www.paloalto.gov/Departments/Utilities/Electrification/Business-Electrification/Commercial-Heat- PumpHVAC-Program
technical assistance for complex projects such as heat pump HVAC. In addition, customers valued the hands-on support and direct communication offered by Utilities and Planning and Development Services staff on permitting matters, which further facilitated successful project completion.
The Program Design Guidelines generally address the following topics:
Financing and Incentives
One of the main challenges in the non-residential sector is the short payback period (2-4 years) required by most private investors before making a building or energy investment. Based on staff modeling using information from the S/CAP Funding Study and Non-Residential Building Sector Study (not yet final), the payback period for electrification of packaged HVAC units that cost 10% to 15% more than gas units would be 12 to 17 years. This means that even though these projects potentially provide a net benefit, they will not get done without some assistance.
To date, staff has primarily used incentives. Incentives work if they are high enough, but high incentives are not a scalable solution for electrifying all of Palo Alto’s packaged HVAC units. In an Advanced HVAC Pilot Program staff would explore other approaches, primarily financing with on-bill repayment. Staff is in talks with a potential provider and has built the functionality in its billing system for on-bill repayment. Building owners prefer on-bill repayment, which they treat as an operating expense. They may be more willing to engage with this type of financing than traditional financing.
Building owners also hesitate to make significant energy investments that save money for their tenants rather than themselves. Staff is exploring a potential tool called “electrification as a service” to address this. Modeled on “efficiency as a service” programs some energy efficiency companies run, an “electrification as a service” feature would involve the customer repaying some or all of the financing provided by the City or a 3rd party with a charge that does not exceed their utility bill savings. This may enable the placement of the charge on commercial tenant utility bills, with the right agreements in place, enabling the recovery of some of the costs for energy improvements from tenants, who experience utility bill reductions as a result.
Funding sources and program structure are still being explored, though as noted in the Fiscal Impact section, some money is set aside for a program like this from Gas Cap and Trade revenues in the FY 2026 budget.
These financing and “as a service” features, if feasible, may lead to more financially efficient, attractive commercial energy programs, that minimize the use of incentive funding.
Technical Assistance
The technical assistance envisioned for the Advanced Commercial HPHVAC Pilot Program is similar to that provided in the existing HP HVAC Pilot Program. These services included:
•Evaluating electrification project designs, including conducting preliminary reviews of project designs for Heat Pump HVAC installations and performing limited design checks on equipment, engineering plans, and project specifications. •Providing electrification technical guidance, including offering non-biased, expert technical advice to CPAU commercial customers and validating equipment selections to ensure projects meet technical standards.
•Providing electrification cost guidance, including performing savings calculations and general project cost evaluations, assessing financial feasibility, and providing cost insights for customer projects.
The consultant, Prospect Silicon Valley, provided electrification technical advisory services to three commercial customers to support their Heat Pump HVAC projects. Without the consultant’s guidance, these projects would likely have been delayed for years, potentially causing the customers to miss rebate opportunities or drop out of the program entirely.
To support the successful adoption of commercial Heat Pump HVAC projects, there is also a clear interest in some form of assistance finding qualified contractors. The guidelines envision some form of complementary contractor list, and possibly even providing services to contractors, such as the ability to use a City financing program or a contact for trying to understand common permitting pitfalls.
Permit Assistance and Streamlining
Early projects in the current enhanced rebate HVAC pilot have highlighted several permitting- related challenges that informed the design guidelines and will inform program design:
•Many gas-for-gas replacements proceed without permits, avoiding compliance costs that are unavoidable for heat pump projects participating in a City program. •Noise reports are required for all projects (per PAMC 18.42.190(B)(iii)). Equipment must be no louder than 15 dB above local ambient noise levels at 25 feet. Hiring an acoustical engineer can cost thousands of dollars and adds time to the overall project timeline. •Structural engineering analysis is required for all rooftop packaged HVAC projects. These studies incur a cost and sometimes trigger additional work that needs to be completed for safety reasons.
•Screening requirements add cost, and may result in additional roofing loads, which could then incur the cost of a roof structural analysis. If a roof upgrade is required, that can be prohibitively costly and can stop a project.
•Fire Department requirements related to HVAC and hazardous materials permits, equipment labeling, and integration with fire alarm systems need more communication to applicants up front.
Planning and Development Services and the Fire Department have been active in helping the Climate Action Team understand permitting requirements and discussing potential approaches to ease compliance costs and workload.
FISCAL/RESOURCE IMPACT
$1.1 million was approved in the Utilities Department budget in the FY 2026 budget5 for the Advanced Commercial HPHVAC Pilot Program, funded by Gas Cap and Trade revenues (Gas Utility Funds), which will support incentives if needed, outreach, technical assistance, and 3rd party program operation. Launch and operation of the program is expected to require approximately 0.75 FTE, which will be performed by existing staff and will include program design and operation, outreach, customer care, and establishment and operation of a financing and on-bill repayment program if implemented. Staff will continue to explore opportunities to leverage State and Federal funds if available.
STAKEHOLDER ENGAGEMENT
Staff engaged with pilot program participants, HVAC contractors, property managers, and lenders to inform program design. Key feedback highlighted the need for financing options, accessible technical expertise, and contractor familiarity with permitting processes. Detailed notes from the program are included in Attachment B.
Staff reviewed the guidelines with the Climate Action Working Group on October 15, 2025.
There were many questions about the current pilot program, including questions about feedback the City has received on permitting, the reasons for cost disparities between electric and gas units, impact on operational expenses, and the drivers for owner action. There was a suggestion that outreach on what types of permits are required for replacements might lead to higher levels of compliance with permit requirements.
The CASC reviewed these design guidelines at its October 17, 2025 meeting and unanimously recommended approval. There were questions about the current pilot program, the permitting process and costs of compliance, whether financing would help with landlord-tenant split incentive issues, and details of the guidelines, such as how staff would do outreach and how staff would engage with making permit compliance easier. Committee members recommended learning from other agencies and looking for creative outreach opportunities, such as engaging business groups.
Further stakeholder engagement will be needed as staff develops more detailed program designs.
5 https://www.paloalto.gov/Departments/Administrative-Services/City-Budget
ENVIRONMENTAL REVIEW
The proposed program is categorically exempt from the California Environmental Quality Act (CEQA) under CEQA Guidelines section 15302 (Replacement of Existing Facilities). Replacement of existing HVAC equipment with more efficient units constitutes a minor alteration to existing facilities and is consistent with the S/CAP adopted in June 20237 and Comprehensive Plan adopted in November 2017.8
ATTACHMENTS
Attachment A: Design Guidelines for Advanced Commercial Heat Pump HVAC Program Attachment B: Summary of Results To-Date from HVAC Enhanced Rebate Pilot Program APPROVED BY:
Brad Eggleston, Director Public Works/City Engineer
7 https://www.paloalto.gov/City-Hall/Sustainability/SCAP 8 https://www.paloalto.gov/Departments/Planning-Development-Services/Housing-Policies- Projects/2030Comprehensive-Plan