Three broad options for financing energy efficiency improvements can be distinguished.
ESCO financing refers to financing with internal funds of the ESCO and may involve own capital or equipment lease. ESCO rarely use equity for financing, as this options limits their capability of implementing projects on a sustainable basis;
Energy-user/customer financing usually involves financing with internal funds of the user/customer backed by an energy savings guarantee provided by the ESCO (for instance, a university can use its endowment fund to finance an energy project, in which the energy savings are guaranteed by an ESCO). Energy-user/customer financing may also be associated with borrowing in the case when the energy-user/customer as a direct borrower has to provide a guarantee (collateral) to the finance institution.
Third-party financing (TPF) refers solely to debt financing. As its name suggests, project financing comes from a third party, e.g. a finance institution, and not from internal funds of the ESCO or of the customer. The finance institution may either assume the rights to the energy savings or may take a security interest in the project equipment. There are two conceptually different TPF arrangements associated with EPC; the key difference between them is which party borrows the money: the ESCO or the client.
Ø The first option is that the ESCO borrows the financial sources necessary for project implementation.
Ø The second option is that the energy-user/customer takes a loan from a finance institution, backed by an energy savings guarantee agreement by the ESCO. The purpose of the savings guarantee is to demonstrate to the bank that the project for which the customer borrows will generate a positive cash flow, i.e. that the savings achieved will certainly cover the debt repayment. Thus the energy savings guarantee reduces the risk perception of the bank, which has implications for the interest rates at which financing is acquired. The ‘cost of borrowing’ is strongly influenced by the size and credit history of the borrower.
When the ESCO is the borrower the customer is safeguarded from financial risks related to the project technical performance because the savings guarantee provided by the ESCO is either coming from the project value itself or is appearing on the balance sheet of the ESCO; hence the debt resides on someone else’s balance list (ESCOs, finance institution’s). Both public and private customers benefit from off-balance sheet financing because the debt service is treated as an operational expense and not a capital obligation; debt ratings are therefore not impacted. For highly leveraged companies this is important because the obligation not showing up on the balance sheet as debt means that company borrowing capacity is freed up. However, different countries apply various conditions that need to be met in order financing to be viewed as an operating lease, for example; unless conditions are met financing is automatically considered e.g. capital lease. Therefore parties seeking financing need to first inquire the country-specific conditions for operational financing.
Large ESCOs with deep pockets and hence high credit rating start to prefer TPF to own financing because the costs of equity financing and long-term financing are too high: the weighed capital costs for internal funds are often much greater than what can be accessed on the financial markets. If an ESCO arranges TPF, then its own risk is smaller. This would allow for lower cost of money and hence for the same level of investment more money would be assigned to the project. The cost associated with non-recourse project financing by a third party – e.g. one where project loans are secured only by the project’s assets – is the highest as it entails more risk and hence higher interest rates.
Furthermore, as already mentioned, equity contributions from the ESCO are often deemed undesirable by ESCOs as they tie up capital in a project. Local practices, the inability of customers to meet financiers’ creditworthiness criteria and costs of equity financing are some of the factors that determine whether ESCOs will provide financing. Small and/or under-capitalised ESCOs that cannot borrow significant amounts of money from the financial markets believe that their role is not to finance energy efficiency investment.
EPC is risk management and effective ESCOs have learned to use project financial structure to help manage the risks. For this reason the two sections to follow look at contracting models and the elements of an ESCO project, placing a special focus in the latter section to investment grade audit.
Figure 1. Third Party Financing with ESCO borrowing and TPF with energy-user/customer borrowing: summary of relations
Source: ECS 2003
Third Party Financing (TPF) with ESCO borrowing
Third Party Financing (TPF) with energy user/customer borrowing