Energy Performance Contracting

Energy Performance Contracting (EPC) is a form of ‘creative financing’ for capital improvement which allows funding energy upgrades from cost reductions. Under an EPC arrangement an external organisation (ESCO) implements a project to deliver energy efficiency, or a renewable energy project, and uses the stream of income from the cost savings, or the renewable energy produced, to repay the costs of the project, including the costs of the investment. Essentially the ESCO will not receive its payment unless the project delivers energy savings as expected.

The approach is based on the transfer of technical risks from the client to the ESCO based on performance guarantees given by the ESCO. In EPC ESCO remuneration is based on demonstrated performance; a measure of performance is the level of energy savings or energy service. EPC is a means to deliver infrastructure improvements to facilities that lack energy engineering skills, manpower or management time, capital funding, understanding of risk, or technology information. Cash-poor, yet creditworthy customers are therefore good potential clients for EPC. Figure 1 illustrates the concept.

 

Figure 1.  Energy Performance Contracting

 

 

 

 

 

 

 

 

 

 

Source: Berliner Energieagentur GmbH

Contracting models

Guaranteed savings and shared savings
Figure 2 illustrates the relationships and risk allocations among the ESCO, customer and lender in the two major performance contracting models: shared savings and guaranteed savings. Brief descriptions are also given.

Figure 2. Major types of performance contracting models/repayment options
 

 

 

 

 

 

 

 

Shared savings: Under a shared savings contract the cost savings are split for a pre-determined length of time in accordance with a pre-arranged percentage: there is no ‘standard’ split as this depends on the cost of the project, the length of the contract and the risks taken by the ESCO and the consumer.

 

 

 

 

 

 

 

Guaranteed savings: Under a guaranteed savings contract the ESCO guarantees a certain level of energy savings and in this way shields the client from any performance risk.

Source: Dreessen 2003

An important difference between guaranteed and shared savings models is that in the former case the performance guarantee is the level of energy saved, while in the latter this is the cost of energy saved

Under a guaranteed savings contract the ESCO takes over the entire performance and design risk; for this reason it is unlikely to be willing to further assume credit risk. Consequently guaranteed savings contracts rarely go along with TPF with ESCO borrowing (CTI 2003). The customers are financed directly by banks or by a financing agency; an advantages of this model is that finance institutions are better equipped to assess and handle customer’s credit risk than ESCOs. The customer repays the loan and assumes the investment repayment risk [1]. If the savings are not enough to cover debt service, then the ESCO has to cover the difference. If savings exceed the guaranteed level, then the customer pays an agreed upon percentage of the savings to the ESCO [2]. Usually the contract also contains a proviso that the guarantee is only good, i.e. the value of the energy saved will be enough to meet the customer debt obligation, provided that the price of energy does not go below a stipulated floor price [3]. A variation of guaranteed savings contracts are pay from savings contracts whereby the payment schedule is based on the level of savings: the more the savings, the quicker the repayment. 

The guaranteed savings scheme is likely to function properly only in countries with a well established banking structure, high degree of familiarity with project financing and sufficient technical expertise, also within the banking sector, to understand energy-efficiency projects. The guaranteed savings concept is difficult to use in introducing the ESCO concept in developing markets because it requires customers to assume investment repayment risk. However, it fosters long-term growth of ESCO and finance industries: newly-established ESCOs with no credit history and limited own resources would be unable to invest in the project they recommend and may only enter the market if they guarantee the savings and the client secures the financing on its own. In the US the guaranteed savings model evolved from the shared savings model in response to drop in interest in fuel savings and attempt of ESCOs to make value-based offerings for cost – rather than energy – savings.  

Conversely under a shared savings the client takes over some performance risk, hence it will try to avoid assuming any credit risk. This is why a shared savings contract is more likely to be linked with TPF or with a mixed scheme with financing coming from the client and the ESCO whereby the ESCO repays the loan and takes over the credit risk. The ESCO therefore assumes both performance and the underlying customer credit risk – if the customer goes out of business, the revenue stream from the project will stop, putting the ESCO at risk. In addition such contractual arrangement may give raise to leveraging problems for ESCOs, because ESCOs become too indebted and at some point financial institutions may refuse lending to an ESCO due to high debt ratio [4] In effect the ESCO collateralizes the loan with anticipated savings payments from the customer, based on a share of the energy cost savings. The financing in this case goes off the customer’s balance sheet [5].

A situation where savings exceed expectations should be taken into account in a shared savings contract. This setting may create an adversarial relationship between the ESCO and customer, whereby the ESCO may attempts to ‘lowball’ the savings estimate and then receive more from the ‘excess savings’ [6].

Furthermore, to avoid the risk of energy price changes, it is possible to stipulate in the contract a single energy price. In this situation the customer and the ESCO agree on the value of the service upfront and neither side gains from changes in energy prices: if the actual prices are lower than the stipulated floor value, then the consumer has a windfall profit, which compensates the lower return of the project; conversely if the actual prices are higher than the stipulated ceiling, then the return on the project is higher than projected, but the consumer pays no more for the project. In effect this variation sets performance in physical terms with fixed energy prices, which makes the approach resemble guaranteed savings approach.    

The shared savings concept is a good introductory model in developing markets because customers assume no financial risk [7] From ESCO’s perspective the shared savings approach has the added value of the financing service. However this model tends to create barriers for small companies; small ESCOs that implement projects based on shared savings rapidly become too highly leveraged and unable to contract further debt for subsequent projects. Shared savings concept therefore may limit long-term market growth and competition between ESCOs and between financing institutions: for instance, small and/or new ESCOs with no previous experience in borrowing and few own resources are unlikely to enter the market if such agreements dominate. It focuses the attention on projects with short payback times (‘cream skimming’). 

Another variation is the ‘first out’ approach whereby the ESCO is paid 100 % of the energy savings until the project costs – including the ESCO profit – are fully paid. The exact duration of the contract will actually depend on the level of savings achieved: the greater the savings, the shorter the contract.  

Table 1 summarizes the features of the guaranteed and shared savings models.

Table 1. Guaranteed savings and shared savings: a comparison

Guaranteed savings Shared Savings
Performance related to level of energy saved Performance related to cost of energy saved; the ESCO bills upon actual results
Value of energy saved is guaranteed to meet debt service obligations down to a floor price Value of payments to ESCO is linked to energy price; betting on price of energy can be risky
ESCO carries performance risk

Energy-user/customer carries credit risk

ESCO carries performance and credit risk as it typically carries out the financing
If the energy-user/customer borrows, then debt appears on its balance sheet Usually off the balance sheet of energy-user/customer
Requires creditworthy customer Can serve customers that do not have access to financing
Extensive M&V Equipment may be leased
ESCO can do more projects without getting highly leveraged Favours large ESCOs; small ESCOs become too leveraged to do more projects
More comprehensive Favours projects with short payback (‘cream skimming’)
  How to share the ‘excess’ savings
Sources of data: Dreessen 2003, Hansen 2003 and 2004, Poole and Stoner 2003

Other contracting models

While there are numerous ways to structure a contract and hence any attempt to be comprehensive in describing EPC variations is doomed, other contractual arrangements deserve attention. Here we describe the ‘chauffage’ contract, the ‘first-out’, the Build-Own-Operate-Transfer (BOOT) contract and leasing contract.  

A very frequently used type of contract in Europe is the ‘chauffage’ contract, where an ESCO takes over complete responsibility for the provision to the client of an agreed set of energy services (e.g. space heat, lighting, motive power, etc.). This arrangement is an extreme form of energy management outsourcing. Where the energy supply market is competitive, the ESCO in a chauffage arrangement also takes over full responsibility for fuel/electricity purchasing. The fee paid by the client under a chauffage arrangement is calculated on the basis of its existing energy bill minus a percentage saving (often in the range of 5-10 %). Thus the client is guaranteed an immediate saving relative to its current bill. The ESCO takes on the responsibility for providing the agreed level of energy service for lower than the current bill or for providing improved level of service for the same bill. The more efficiently and cheaply it can do this, the greater its earnings: chauffage contracts give the strongest incentive to ESCOs to provide services in an efficient way.

Such contracts may have an element of shared savings in addition to the guaranteed savings element to provide incentive for the customer. For instance, all savings up to an agreed figure would go to the ESCO to repay project costs and return on capital; this figure they will be shared between the ESCO and the customer.  

Chauffage contracts are typically very long (20-30 years) and the ESCO provides all the associated maintenance and operation during the contract. Chauffage contracts are very useful where the customer wants to outsource facility services and investment.

A BOOT model may involve an ESCO designing, building, financing, owning and operating the equipment for a defined period of time and then transferring this ownership across to the client. This model resembles a special purpose enterprise created for a particular project. Clients enter into long term supply contracts with the BOOT operator and are charged accordingly for the service delivered; the service charge includes capital and operating cost recovery and project profit. BOOT schemes are becoming an increasingly popular means of financing CHP projects in Europe. Figure 2 shows the relationships between parties in a BOOT contract.

Figure 3. Build-Own-Operate-Transfer (BOOT) model

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: Dreessen 2003

Leasing can be an attractive alternative to borrowing because the lease payments tend to be lower than the loan payments; it is commonly used for industrial equipment. The lessee makes payments of principal and interest; the frequency of payments depends on the contract. The stream of income from the cost savings covers the lease payment. The ESCO can bid out and arrange an equipment lease-purchase agreement with a financing institution. If the ESCO is not affiliated to an equipment manufacturer or supplier, it can bid out, make suppliers competitive analysis and arrange the equipment. There are two major types of leases: capital and operating. Capital leases are installment purchases of equipment. In a capital lease, the client (lessee) owns and depreciates the equipment and may benefit from associated tax benefits. A capital asset and associated liability appears on the balance sheet. In operating lease the owner of the asset (lessor – the ESCO) owns the equipment and essentially rents it to the lessee for a fixed monthly fee; this is off-balance sheet financing source. It shifts the risk from the lessee to the lessor, but tends to be more expensive to the lessor. Unlike in capital lease, the lessor claims any tax benefits associated with the depreciation of the equipment. The non-appropriation clause means that the financing is not seen as debt.
 
[1] The financing institution (FI), of course always has some risk for loan non-payment. The assessment of customer’s credit risk is done by the FI; it is one of the factors that define interest rates.

 [2] However, changes in energy consumption – e.g. business expansion and/or changes of processes ort production lines are likely to bring increased energy that can deteriorate the targets. Conversely, a contraction of business (e.g. an empty hotel) or a smaller production output will results in energy savings. Therefore crucial issues to consider involve setting the baselines and associated growth projections, setting the system boundary and conditions, as well as avoiding leakages.

[3] Performance contracting is risk management and dropping fuel prices, such as those experienced in North America in 1986, gave rise to this provision. We are indebted for this clarification to Shirley Hansen.

[4] Experience in the US shows that lenders tend to require a variety of credit enhancements for this type of financing, such as bonding or insurance.

[5] Under off-balance sheet financing, also called non-appropriation financing, financiers hold title to equipment during the term of the agreement.

[6] Deliberate estimation of lower value of savings also is however not only restricted to the shared savings model; it is a standard practice for the ESCO to secure itself for the guaranteed performance with some buffer. The real questions are how big this buffer/cushion is and how the ‘excess’ savings above the estimated ones are split between the client and the ESCO.

[7] The customers may have different reasons to be reluctant to assume financing, even if the cost of capital is higher for ESCOs than for customers. Among the reasons are adversity to assuming debt, borrowing limits and budgetary restraints.