Here is my latest guest blog on the 2 degrees network:

“Energy performance contracts, too good to be true?”

On the 5th June I spoke at Ecosummit 2013 on “The Magic of Energy Efficiency” and here is the talk on Ecosummit TV and some photos.

It was good to be back in Berlin (even though I was there only the previous week!) and I am looking forward to Ecosummit London at The Crystal on 15-16 October 2013. It is a different format to most events and a great way to bring together start-ups and early stage businesses and investors.

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.

No sooner than I had published ‘A roadmap for energy efficiency financing’ outlining the different ways to finance efficiency projects then another new route on the road appears – the MEETS or Measured Energy Efficiency Transaction Structure. The MEETS relies on EnergyRM’s DeltaMeterTM which measures the difference between the baseline energy consumption and the actual consumption i.e. the energy not used – or negawatt hours – to a standard accepted by the client and the utility – in this case NEEA, the North West Energy Efficiency Alliance, which includes 140 utilities in the Pacific North West plus the Energy Trust of Oregon and the Bonneville Power Administration.

The saved energy is metered and paid for per unit saved. This provides a cash flow which can both payback investment in upgrading the building and pay a ‘rental’ to the building owner for the right to exploit the energy efficiency resource – analogous to paying a landowner rent for a wind farm or a shale gas well. Involving the utility means that the utility has a degree of control and information about its load pattern that it wouldn’t otherwise have, knowledge that has value in itself. The price paid per unit of energy saved will depend on the retail energy prices plus any incentives that are available but the base line should be the retail price as a building owner can effectively get this price by doing the project themselves.

EnergyRM is providing the meter technology, not the finance, and the investor could be the utility or a third party investor.

Energy efficiency financing has been stuck in a rut for a long while, with most people obsessing about Energy Performance Contracts – a contract form that works reasonably well in the US public sector but has a number of failings in other markets. MEETS, like the Efficiency Services Agreement from Metrus, is another innovation that offers the prospect of scaling up investment in energy efficiency.

The energy efficiency financing scene is evolving quickly, especially in the USA where three main types of financing now exist:

• PACE (Property Assessed Clean Energy – click http://pacenow.org for more information)
• traditional Energy Performance Contracting (EPC) – usually financed by leasing or municipal debt
• and the emerging Efficiency Services Agreements (ESA) and Managed Energy Services Agreements (MESA).

On-bill repayment (OBR), where the repayment of capital is added to utility bills, is also growing but this is more of a collection mechanism than a type of financing, as it can be tied to various contract forms. The UK Green Deal is a form of OBR with external financing provided through the Green Deal Finance Company.

Of course organizations also have the option to self-finance energy efficiency projects but this approach is most often single measure driven, usually in response to vendors selling specific equipment, and limited due to capital constraints and competition for scarce capital with the organization’s core business activities. Bringing in the right specialists and outside finance can lead to a more optimized set of projects designed and developed in a more holistic way that leads to greater savings.

PACE has been stopped in the residential sector because of a ruling by the Federal Housing Finance Agency (FHFA) but commercial PACE, so called C-PACE, is growing rapidly (see here for a primer). C-PACE has the potential to reach $2.5 billion to $7.5 billion by 2015 according to Pike Research, even $2.5 billion would be a great step forward.

Traditional EPC contracts have been mostly in the public sector, the MUSH market as it is known in the US, and mainly financed by issues of low cost, tax-exempt debt by the client or by leasing. The traditional ESCO/EPC approach has a number of problems in the commercial sector and as the FASB and IASB move towards harmonizing the balance sheet treatment of leases, the use of leasing to get energy efficiency projects off balance sheet is likely to be stopped. (I spoke about this issue at the recent IFC ESCO Financing conference in Johannesburg – see here)

The emergence of ESAs and MESAs is very interesting as the contract form appears to have many advantages. In the MESA the service provider takes over the relationship with the utility and the client pays the service provider what it used to pay, taking the difference resulting from energy saving projects – whereas in the ESA the client keeps paying the bills and pays the service provider a price per unit of energy saved. In both forms they are service contracts with payment for energy saved, negawatt hours, rather than equipment which helps get any associated capex off the client’s balance sheet.

The various types of energy efficiency financing can be confusing, and the pioneer of ESAs, Metrus Energy, has issued a useful and neat infographic: Which Financing Vehicle Gets You on the Road to Energy Efficiency. It is worth checking out and can be found here.

As well as its useful content I like the cartoon vehicle choices, a US style school bus and what looks to be a 1970s Cadillac for the ‘traditional’ and what looks like a VW Beetle and a Mini for MESAs and ESAs. Neat.

If you want more information on the ESA structure Metrus are hosting a free webinar on 27th June at 11am PST, details can be found here . In what must be a world first Metrus is offering 100,000 free negawatts to one customer who signs up for the webinar and then implements a project in 2013.