Question

As a certified energy manager working for EnerCom, you have been assigned to carry out the energy performance contract (EPC) with a local Energy Service Company (ESCO). Your subordinates would like to understand how EPC works. Illustrate to your subordinates how EPC works and how EnerCom can benefit from energy performance contracting.

[10 marks]

Answer 1

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’).