What do we really mean by EPCs and ESCOs?

I have written before about ESCO (Energy Service Company) obsessions (read here) and how the Energy Performance Contract (EPC) may be part of the problem and not the catch-all solution that some people seem to think it is.

At a recent meeting organized by EASME (the Executive Agency for Small and Medium Enterprises of the European Commission) on the topic of energy efficiency financing, I was reminded once again about the difficulties of communication, both in general and specifically on the subject of EPCs and ESCOs. At the meeting there were representatives from several projects receiving both EC and European Investment Bank support, and many of these are involved in EPCs in some way, either in buildings or street lighting. It seems as if there are many different interpretations of EPC across Europe (and the rest of the world).

Energy Performance Contracts

Personally I tend to use EPC to mean the classical North American model which developed in the 1980s and was successfully exported around the world by USAID funded trade missions in the 1990s. In this the contractor (normally called an ESCO but we will come onto that term) provides a guarantee of energy savings. EPCs are most often talked about, and most often implemented, using external financing and in the US most of the market (80% plus) is public sector and is financed by municipal bonds or federal funds. We should not forget of course that the client can fund an EPC themselves – the best example being the Empire State Building retrofit in which the energy efficiency components were carried out under an EPC but financed by the owners of the building. To my mind the classical EPC has a number of problems including the fact that the contractor is motivated to maximize capex, the contract is complex and it is often a black box to the customer.

ESCOs

The term ESCO is also a minefield of confusion. I am on record as saying we should abolish the term. It is generally taken to mean a developer of energy efficiency projects which provides some form of guarantee of their performance. It is also often used to denote a company that both develops projects and provides, or more likely facilitates, financing for the projects from a third party.

We need to be more precise in our language – in my book “Energy Efficiency” I argued for distinguishing between the concept of shared saving, the entity and the contract form.

The concept – shared savings

The concept of shared savings is straightforward. It is what it says on the tin. Financial savings resulting from some form of energy efficiency improvement are shared over a period of time between the host and the party responsible for producing the savings. The energy efficiency improvement itself could be an investment in technology such as high efficiency lighting, new boilers and controls or a behavioural programme with no investment (less common). However, the implementation of this simple concept is fraught with difficulties in practice and can be effected by a range of different business models, contract forms and financial arrangements. This has led to the confusion around the ESCO and EPC/ESPC concept amongst policy makers, suppliers and customers.

The entity

The entity developing the projects is called a developer in any other field, and could be an ESCO, a Facilities Management (FM) company, a construction company, a consultant or a community group. The term ESCO is usually reserved for companies offering some kind of performance guarantee.

The contract form

The contract form can be one of several variants such as EPC, Energy Savings Performance Contract (ESPC), Managed Energy Services Agreement (MESA), Efficiency Services Agreement (ESA), or some other variant. All these types of contract encapsulate some form of energy services. In addition there is the form traditionally used in France and other parts of Europe, called ‘chauffage’ which involves the sale of heat at an all-in price which covers the capital costs of the boiler and distribution system, operations and maintenance costs, and fuel costs. Chauffage contracts, in their original form at least, do not inherently produce energy savings and in fact during the length of the contract the supplier is actually incentivized to sell the customer more heat, not less. It is true of course that the upfront installation of new heat generating plant, either a boiler or Combined Heat and Power (CHP), can result in an energy saving when it replaces an old inefficient boiler plant and distribution system. In this case the contracts can be said to be shared savings (in some cases) because the total outgoings including repayment of the capital costs during the contract were less than the total outgoings on energy and maintenance prior to the investment. In some cases however, total costs go up in order to pay for the capital expenditure, but these costs are transferred to operational expenditure. Much of the EPC business being done in the public sector such as the UK’s National Health Service involve this kind of infrastructure upgrade and catching up with maintenance backlogs.

Large providers of chauffage contracts in their home markets such as EDF and GDF-Suez in France traditionally used their large cash flows and balance sheets to finance projects, as well as start or acquire operations in new markets, although this is becoming more difficult for them. In the UK these operators entered the energy service market in the 1980s and dominated the market for many years, predominantly selling outsourced operations and maintenance of boiler houses and making savings mainly through automation and demanning. In the 1980s in the UK uniquely, this became known as Contract Energy Management (CEM).

As well as chauffage, selling heat, some energy service companies also expanded into the provision of multiple utilities including cooling, compressed air, treated water, effluent treatment and industrial gases. A leading example of this contract form is the series of Utility Alliance Agreements (UUAs) signed between Diageo and RWE Solutions UK (latter RWE npower) between 2002 and 2003 which were 15 year multi-utility agreements. Like some chauffage contracts, these multi-utility contracts produced large upfront energy and maintenance savings, which were split between the client and the contractor, with the contractor recovering all costs including capital expenditure over the lifetime of the contract. These UAAs are yet another contractual variation of the shared savings concept.

Increased confidence in performance will reduce the need for EPCs

The Investor Confidence Project is working to improve confidence in the performance of energy efficiency by standardizing the development process and documentation. As confidence in the performance of energy efficiency increases, the need for an ESCO to offer a guarantee is reduced – there is no point in a client paying for a guarantee – and they always pay for the guarantee somewhere – if they have confidence in the outcome. The advent of energy efficiency project insurance as offered by companies like Huber Dixon also reduces the need for performance guarantees and the Energy Performance Contract. In time we should move to a more “normal” market where developers develop projects, insurance companies underwrite them, delivery companies implement them and finance companies finance them – just like in the rest of the energy or construction sector.

Anyway in summary we all need to be careful when discussing EPCs and ESCOs. We always need to “mind our language” as it shapes our thinking. ¹ Also, never forget communication is hard – in any language.

As an aside on ESCOs we should not forget of course that as in many things the UK was the pioneer in sharing energy services – although not necessarily the best at exploiting the early lead. Boulton and Watt, using the more efficient Watt steam engine, made a lot of money from the 1770s by replacing the inefficient engines in tin mines and taking one third of the savings in fuel over a period of 25 years. For that they truly deserve their place on the £50 note. Although the “no cure, no pay” option offered by Boulton and Watt was successful even they encountered problems we would recognize today – specifically those of Measurement and Verification and baselining.

“There was some local resistance in Cornwall, where the new engines were certain to save costs in pumping out water from the tin mines, ….., the ‘no cure, no pay’ terms offered by Boulton and Watt – based on one third of the savings in fuel over a period of twenty-five years – saved the day.”

Thomas Crump, The Age of Steam, p58, London, Constable and Robinson, 2007