ESCO Obsessions

The ESCO (Energy Service Company) industry appears to have a number of obsessions that result from its history and don’t help to advance the cause of energy efficiency and third party financing, something that the industry actually does – or should – want to advance. Here are some thoughts that may cause controversy.

The ESCO/EPC industry grew out of good work in the US public sector and even to this day 85% of EPC deals in the USA are in the Municipal, Universities, Schools and Hospitals (‘MUSH’) market and the Federal government. Most of these deals have been funded by the clients issuing bonds or some form of municipal lease, which in the US have tax advantages which make them a cheap source of finance – for more details see here.

Back in the 1980s and 1990s the US government, through agencies such as USAID, and the US ESCO industry did a great job of selling the ESCO/EPC model around the world. As communism collapsed in Central & Eastern Europe (C&EE) and the Former Soviet Union (FSU), many missions were organized to promote the concept and they were very successful. I saw them first hand when I was working in Romania in the mid- to late-1990s. As well as in C&EE and the FSU the concept was promoted in China, Asia, Africa and Latin America. In Western Europe the EPC concept was promoted as a solution to improving energy efficiency. Unfortunately the model was exported without the access to the long-term low cost finance provided by muni bonds.

Now, in many markets we seem to have a situation where the ESCO industry, and its supporters are confused. Typically there are two refrains; one – ‘why don’t customers buy EPCs when it is a no brainer’ and two – ‘we need to bolster the balance sheets of ESCOs’. This is then overlaid by government or IFI support schemes trying to address these ‘market failures’. (I should say that there has been some great work going on, particularly by the EBRD, who really do understand these issues, in providing debt through local banks and building capacity in local banks to understand and evaluate energy efficiency investments). In all markets the ESCO/EPC market has not achieved its perceived potential.

Maybe the ‘market failures’ referred to by the ESCO industry are not market failures at all – but rather poor marketing (and I mean marketing in its true sense – really understanding the market and providing what it needs – not advertising and communications).

To be fair the ESCO industry in the MUSH market has consistently delivered, and over-delivered, on savings but it has also made large margins on front-end capital. For all the talk of ‘shared savings’ the traditional ESCO/EPC deal is designed to produce maximum capex (on which the ESCO makes a healthy margin), and a small stream of net savings after financing to the client. So we have a situation where the client:

may not be confident about the savings (despite an ESCO guarantee)

• is being asked to sign a long-term, complex deal (10-15 years plus in many cases)
• is paying a high price for capex and development
• receives a small stream of savings relative to energy bills
• has high transaction costs.

Just maybe EPC is not such a good deal as the ESCO industry presents. It maximizes the return to the ESCO but not the host – incentives are not truly aligned. At the same time most ESCOs design and develop projects in a very traditional way – there is much talk but little delivery of holistic, integrated design which has been proven to increase energy savings and reduce capex requirements time and time again.

When the ESCO industry has tried to move into the commercial sector it has hit a number of barriers including the fact that commercial organisations are better at procurement than the public sector and typically demand a high level of transparency – something that the public sector has not done. The level of margins made by ESCOs in the MUSH market has not been acceptable. This is in addition to other well-known issues such as the split incentive.

Some other obsessions of the ESCO industry and IFIs and government departments interested in the sector which I have heard recently include the following.

ESCO balance sheets and how to strengthen them.

ESCOs are developers of projects, they could be two men and a dog as long as they are good. They don’t need balance sheets to develop projects – consultants can do it as well as ESCOs and may ESCOs use consultants anyway. Implementers of projects, i.e. contractors, do need balance sheets but they don’t have to be an ESCO – all an ESCO usually does is sub-contract the implementation piece to ‘ordinary’ contractors. In the renewables industry, or even the conventional power sector, project developers do not need balance sheets. Typically they are either consultants working for a site owner or are parlaying time and expertise spent on development, along with option agreements, into a small proportion of the project equity on financial close. The ESCO industry seems to think it is different – as I have said before, the very term ESCO adds to the confusion and it is time to drop it. We don’t talk about ‘Wind Energy Service Companies’ – we talk about:

developers who pull together the technical and commercial aspects of the project

• contractors who build things
• investors who fund the construction and benefit form the uplift of value by funding construction risk
• O&M companies
• and long-term owners who like long-term stable income streams without construction risks
• and of course there are specialist insurance companies, which will under-write different aspects of performance.

What is the difference between wind/solar/conventional power and energy and energy efficiency? We need to un-bundle the ESCO proposition.

Given this there is no need to bolster the balance sheets of ESCOs, this seems to be based on the belief that ESCOs will fund projects off their own balance sheets. Even the big guys don’t want to do this.

Project financing and asset financing

At first glance energy efficiency financing has similarities to both project financing and asset financing. However, typical projects are far too small for project finance and project finance departments in most banks rightly won’t get out of bed to look at them. Asset financing has been done for energy efficiency but it is best applied to single, stand-alone assets such as Combined Heat and Power (CHP) plants which can be taken away if the client stops paying for any reason. It is very difficult to take away most energy efficiency projects such as low energy lighting, Building Energy Management Systems (BEMS), software or insulation, all of which are embedded in the building and have little or no value if removed.

Energy efficiency financing is all about cash flow financing – not project finance and not asset financing.

Payback period

We often hear about the fact that most organisations have a two or three year payback period on energy efficiency investments and this is inhibiting ESCO/EPC deals. It is true that for self-funded projects a two or three year payback criteria is normal (as well as understandable). Self-funded projects have to compete in the capex budget with projects that are central to the organisations core purpose – making widgets, selling tins of beans or developing new software. We can, and should argue that CEOs and CFOs can profitably increase the level of self-funded projects, as well as improve energy management generally, but the same payback period can’t be applied to a third party financed energy efficiency project as it is being funded by a different investor with different criteria. The only important thing for the project host is, how much does this deal reduce their cash operating expenses (quantified as NPV)? The payback is important to the third party investor but much of the point of third party finance is to be able to fund longer-term projects by accessing the kind of money that likes long-term, low-risk income at lower rates of return.

On/off balance-sheet. Traditional EPC contracts were usually on balance sheet but a number of structures and regulations could affect that, depending on geography and sub-sector even within the public sector. The accounting standards bodies, the IASB and the FASB, are now harmonising a position on leasing and off-balance sheet financing which will affect energy efficiency financing. Off-balance sheet leasing is likely to be stopped by 2016/17 and all structures will be subject to more scrutiny. The ESCO industry does need to worry about this and evolve new, service based structures as has happened in the US with Metrus and the Efficiency Services Agreement (ESA).

The global ESCO/EPC industry and its boosters need to recognize the realities of the situation and develop new models – continuing to push a model that isn’t very attractive to potential customers will be frustrating and un-productive. There needs to be innovation.

A historical note

It is often thought that the ESCO ‘shared savings’ concept originated in the US in the 1970s. I was recently reminded that it was in fact introduced by Boulton and Watt when they joined forces in 1775 to commercialise Watt’s steam engine which was far more efficient than the prevailing technology. The application was pumping water out of mines and Boulton and Watt sold the engine on the basis of taking a share of savings. Interestingly enough they often had Measurement and Verification problems due to the variability of coal quality and got into disputes with the project hosts. So, shared savings, another British invention commercialised by others! If you can find one the current Bank of England £50 note commemorates Boulton and Watt.