Energy Service Companies ESCO Monetization of Energy Efficiency

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Research note

February 2010

Analyst

Leonard Wagner, [email protected]

Table of ContentsIntroduction to the ESCO business......................................................................1

1.1. The ESCO business scope ............................................................................11.2. The ESPC business scope.............................................................................11.3 Comparison between ESPCs and ESCOs......................................................2

Historical perspective ............................................................................................22.1. Development in United States ........................................................................22.2. Development in Europe..................................................................................3

The European Union policy context .....................................................................33.1. Active EU member states ...............................................................................33.2. Drivers behind ESCO growth .........................................................................3

The ESCO business model....................................................................................44.1. Energy performance contracting ....................................................................44.2. Financing considerations................................................................................4

Conclusion..............................................................................................................6References ..............................................................................................................7

Energy Service Companies (ESCO)Monetization of energy efficiency



© Mora Associates Ltd, 2010 1

Introduction to the ESCO business

1.1. The ESCO business scope

An energy service company (acronym: ESCO or ESCo) is a professional business providing energysolutions including:

Designs and implementation of energy savingsprojects,

Energy conservation, Energy infrastructure outsourcing, Power generation and energy supply, and Risk management.

The ESCO performs an in-depth analysis of the property, designs an energy efficient solution, installsthe required elements, and maintains the system to ensure energy savings during the payback period.

The savings in energy costs is often used to pay back the capital investment of the project over aperiod of five to twenty years, or reinvested into the building to allow for capital upgrades that mayotherwise be unfeasible. If the project does not provide returns on the investment, the ESCO is oftenresponsible to pay the difference.

The following diagram shows the exchanged cash flows in a simplified ESCO project:

The energy efficiency improvements, as shown above, are typically coordinated under an EPC(engineering, procurement, construction) contract, in which the contractor will design the installation,procure the necessary materials and construct it. The contractor carries the project risk for scheduleas well as budget in return for a fixed price or stream of payments depending on the agreed scope of work (Loots & Henchie, 2009).

1.2. The ESPC business scope

The companies providing energy services to final energy users, including the supply and installation of energy-efficient equipment, building refurbishment, maintenance and operation, facility management,and the supply of energy, are referred to as Energy Service Provider Companies (acronym: ESPCs).They provide a service for a fee and take no risk.

In Europe, many ESPCs are well established and have offered energy services for a number of years.Recently, ESPCs have become active in three major ways:

Through regulation, in particular for the provision of heating in public buildings (e.g. provisionof degree days in Italy and France),

Via business ventures by large building control and equipment manufacturers, or




With the gradual restructuring of utilities seeking to provide energy services as addedvalue, especially given the low electricity/gas prices and the reduced profit margins in selling it(e.g. in Germany, where several municipal utilities were initially forced to offer energy

services, and later developed this as a business activity).

1.3 Comparison between ESPCs and ESCOs

The ESCOs also offer these same services; however, ESCOs differ from ESPCs in the following ways:

They guarantee the energy savings (as reflected in the contract), They can finance, or via energy savings guarantee assist in arranging financing for, the

operation of an energy system, and Their remuneration is directly tied to the energy savings achieved.

Therefore, ESCOs accept some degree of risk for the achievement of improved energy efficiency in auser’s facility and have their payment for the services delivered based (either in whole or at least in

part) on the achievement of those energy efficiency improvements.

Historical perspective

2.1. Development in United States

The energy savings business beginning can be accredited to the energy crisis of the late 1970s, asentrepreneurs developed ways to combat the rise in energy cost.

One of the earliest examples was a Texas-based company, Time Energy , which introduced a deviceto automate the switching of lights and other equipment to regulate energy use.

The primary reason that the product did not initially sell was because potential users doubted that thesavings would actually materialize. To combat this doubt, the company decided to install the deviceupfront and ask for a percentage of the savings that was accumulated.

The result was the basis for the ESCO model. Through this process, the company achieved higher sales and more return since the savings were large.

In the United States, there are only a handful of active players in the ESCO business today:

Company Industry Founded Website

Ameresco Energy efficiency 2000 www.ameresco.com

Honeywell Building Solutions Air conditioning 1906 www.honeywell.com

Carrier Air conditioning 1902 www.carrier.com Chevron Energy Services Oil & gas 2000 www.chevronenergy.com

The customer base of Honeywell Building Solutions includes most public institutions such as:

City of Tallahassee Ft. Bragg (U.S. Army) Indianapolis Public Schools Miami International Airport New York State Energy Research and Development Authority Sony DADCs U.S. Postal Service Baylor University




2.2. Development in Europe

While the initial ESCO concept started in Europe more than 100 years ago and moved to NorthAmerica, it is now showing some resurgence in the EU. The market for energy efficiency services in

Western Europe was estimated to be EUR 150 million per year in 2000, while the market potential wasestimated to be EUR 5-10 billion per year.

In Europe, energy utilities offered relatively low gas and electricity prices to customers. However, thisprocess could not be sustained in the longer term as prices reached very low levels. The mostentrepreneurial utilities understood that to retain customers, as well as to gain new ones, theyhad to offer services in addition to the supply of electricity and gas. In addition, equipment andcontrol system manufacturers, and installation and engineering companies, decided to enter this samemarket.

Energy services include a variety of activities, such as energy analysis and audits, energymanagement, project design and implementation, maintenance and operation, monitoring andevaluation of savings, property management, and energy and equipment supply.

The European Union policy context

3.1. Active EU member states

The table below shows the level of activity and recent market developments in major EU countries:

Countries Activity Market developments Market size

GermanyMost mature market in EU, totalinvestment of EUR 5 billion

70,000 service contracts by end of 2000, >200 EPC contracts, mostly onpublic buildings

Austria

Austrian Energy Agency claims to

be – together with Germany – theEPC pioneer in Europe

ca. 500-600 buildings improvedvia EPC

UK No regulation in place for ESCOs20 active ESCOs, most of them aresubsidiaries of control equipmentfirms

SpainESCOs are mainly active infinancing wind farms (Vine, 2001)

10 private ESCOs, as of 2005

HungarySurprisingly developed market withactive players

29 ESCOs or related firms

FranceCo-generation used as “Trojanhorse” for market entry

60 firms formed a trade associationknown as FEDENE (previously‘FG3E’)

SwedenHospitals, hotels and publicauthorities are targeted

No information available

ItalyEarly 80s: upgrade of boilers inpublic buildings, market isdominated by ESPCs

No information available

All other EU countries

No mature markets Few players

Source: Vine, E. (2005); Fédération des services energies environment (FEDENE).

3.2. Growth drivers in the ESCO industry

Two major drivers shape the European energy policy context in which ESCOs operate:

Restructuring and liberalization of electricity and gas markets, and Measures to combat climate change.




The effect of the market liberalization on energy efficiency is still under discussion. Falling and volatileprices are expected to have a negative impact on ESCO projects and short-term oriented suppliersmaximizing turnover and margins may be hostile to action beyond the consumer’s meter.

At the same time, improved efficiency at the demand side may be fostered by distribution companiestrying to retain consumers and attract new ones by offering energy services as ‘added value’ to anotherwise homogenous commodity such as electricity.

Under the European Commission’s THERMIE and SAVE programs, several studies and pilot projectswere implemented to promote ESCO and Third-Party Financing activities, mainly in public buildingsand combined heat and power (CHP) generation.

The ESCO business model

4.1. Energy performance contracting

Under the energy performance contracting (EPC) arrangement anexternal organization (i.e. the ESCO) implements a project to deliver energy savings, or a renewable energy project, and uses the stream of income from the cost savings, or the renewable energy produced, torepay the costs of the project, including the costs of the investment.

The approach is based on the transfer (to a greater or smaller extent) of technical risks from the client to the ESCO based on performanceguarantees given by the ESCO. In the EPC arrangement, the payment istypically based on performance; one measure of performance is the levelof energy savings.

4.2. Financing considerations

In general, there are three broad financing options for financing energy efficiency improvements:

1. Customer financing usually involves financing with internal funds of the energy user or customer-backed by an energy savings guarantee provided by the ESCO (for instance, auniversity can use its endowment fund to finance an energy project, in which the energysavings are guaranteed by an ESCO).

2. ESCO financing refers to financing with internal funds of the ESCO and may involve owncapital or equipment lease.

3. Third-Party Financing (TPF) refers solely to debt financing. There are twoconceptually different TPF arrangements; the key difference between them iswhich party borrows the money: the ESCO or the client. In the firstarrangement an ESCO may borrow the financial sources necessary for projectimplementation. In the second arrangement the customer takes a loan from afinance institution backed by an energy savings guarantee agreement with the ESCO; thepurpose of the savings guarantee is to demonstrate to the bank that the project for which thecustomer borrows will generate a positive cash flow, i.e. that the savings achieved willcertainly cover the debt repayment.

Large ESCOs with deep pockets and hence high credit rating start to prefer TPF to own financingbecause the cost of equity is higher. If an ESCO arranges TPF, then its own risk is smaller, whichallows for lower cost of money and hence higher size of the investment (Hansen, 2004). Local

practices, the inability of customers to meet financiers’ creditworthiness criteria and costs of equityfinancing are some of the factors that determine whether ESCOs will provide financing (Hansen,




2004). Small and/or under-capitalized ESCOs that cannot borrow significant amounts of money fromthe financial markets believe that their role is not to finance energy efficiency investment.

A scheme where the ESCO guarantees a certain level of

energy savings and in this way shields the client from anyperformance risk is known as guaranteed savings. Becauseunder a guaranteed savings contract the ESCO takes over theentire performance risk, it is unlikely to be willing to further assume credit risk; consequently TPF rarely goes along withguaranteed savings contract (CTI, 2003). The customers arefinanced directly by banks or by a financing agency. Thereforethe customer repays the loan and the credit risk stays with thelender (Dreessen, 2003). This scheme is likely to functionproperly only in countries with a well-established bankingstructure, high degree of familiarity with project financing and sufficient technical expertise, also withinthe banking sector, to understand energy-efficiency projects (e.g. UK, Austria, and more recently,Hungary).

Conversely under a shared savings contract the savings are split in accordance with a pre-arranged percentage: there is no ‘standard’ split as this depends on the cost of the project, the lengthof the contract and the risks taken by the ESCO and the consumer (ECS, 2003). As in this case theclient takes over some performance risk, it will try to avoid assuming any credit risk; hence a sharedsavings contract is more likely to be linked with TPF or with a mixed scheme with financing comingfrom the client and the ESCO (CTI, 2003) whereby the ESCO repays the loan and takes over thecredit risk.

Figure 1 – Primary savings structures (Source: Dreessen, 2003)

The shared savings concept is a good introductory model in developing markets becausecustomers assume no financial risk, however it does limit long-term market growth andcompetition between ESCOs and between financing institutions: for instance, small and/or newESCOs with no previous experience in borrowing and few own resources are unlikely to enter themarket if such agreements dominate (CTI, 2003; Dreessen, 2003)

The guaranteed savings concept is difficult to use in introducing the ESCO concept in developingmarkets because it requires customers to assume investment repayment risk. However, it fosters long-term growth of ESCO and finance industries (Dreessen, 2003): because newly established ESCOswith no credit history and limited own resources would be unable to invest in the project theyrecommend, they may only enter the market if they guarantee the savings and the client secures thefinancing on its own.




Conclusion

The ESCO business model is based on the monetization of the clients’ intangible energyefficiency improvements into tangible cashflows to the energy service company.

Equity finance is expensive, but necessary

In principle, it is possible to finance an ESCO project with debt when it has strong and predictablecashflows. In the ESCO industry, cashflows can be problematic because energy savings may fail tomaterialize. Moreover, even if energy efficiency improvements are realized, the exact energy savingsare difficult to measure. The uncertainty and variability of the realized energy savings translates into ahigher volatility of project cashflows and would typically require projects to be equity-financed. Thiscan easily turn a profitable ESCO project into a losing one.

Neither standardization, nor scalability

Another major drawback of the ESCO business model is its scalability. Every project needs to beassessed individually and potentially involves a large number of unidentified risk factors. This can becostly and does not allow for a simple copy & paste strategy.

No competitive advantage, but marketing strategy

There are very few pure-play companies in the industry (e.g. Ameresco). Most active players enteredor bought into the ESCO business to increase sales of their product lines. Those firms used theenergy efficiency improvements as a marketing strategy (a bait) to introduce new products to areluctant customer base. This is the only case where there might be a competitive advantage for a firmto enter the ESCO market. Companies like Honeywell “ put their money where their mouth is” whenthey install their equipment at their own expense and thus stand by the promises of their products.

Strengths and Opportunities

• Sell new products to doubtful customers(only for equipment manufacturers)

• Fragmented and uncoordinated industry• Little or no competition

Weaknesses and Threats

• Small customer base(mostly limited to public institutions)

• Financing decisions (debt may not be available)• Not easily scalable• No barriers of entry• Energy savings may not materialize• Risk factors may not be identified • Abstract energy savings are difficult to sell

(compared to the production of electricity from energy assets)

At a glance

By and large, the ESCO business offers more risks than rewards with regards to its activities. Eachproject comes with different business risks that need to be tackled, or may not be easily identifiable.

Moreover, a large proportion of the customer base is the public sector and municipalities. Whilesome projects with public institutions have been fruitful, this may discourage new market entrants.

Despite the lack of competition, the industry does not look attractive to new entrants. It is not clear why a company should enter , except for the launch of new equipment like the case of Honeywell.

In these circumstances, one can be doubtful about the possibility to expand this activity to theconsumer market. Most probably, wide-scale residential thermal rehabilitation, driven by various lawsin various EU countries, will not be financed by ESCO mechanisms. Or at least a suitable ESCObusiness model for private clients still need to be invented.




References

Bertoldi, P., Rezessy, S., Vine, E. (2005) Energy service companies in European countries:

Current status and a strategy to foster their development .

CTI (Climate Technology Initiative) (2003) Guide to Working with Energy Service Companiesin Central Europe. CTI Secretariat, Tokyo.

Dreessen, T. (2003). Advantages and disadvantages of the two dominant world ESCOmodels; shared savings and guaranteed savings. In: Bertoldi, P. (Ed.), Proceedings of theFirst Pan- European Conference on Energy Service Companies.

Farrell D., Remes J.K., (2008) How the world should invest in energy efficiency . Retrievedfrom The McKinsey Quarterly (subscription required).

Fédération des services energies environment (FEDENE). Retrieved on February 3rd

, 2010from http://www.fedene.fr/

Honeywell Building Solutions (SES) Get the Most From Your Facilities Without Paying TheMost . See Honeywell brochure for comprehensive list of customers.

Loots, P., Henchie, N. (2007) Worlds Apart: EPC and EPCM Contracts: Risk issues and allocation. Mayer Brown (November issue). Retrieved on April 15

th, 2009 from

http://www1.fidic.org/resources/contracts/epcm_loots_2007.pdf

Vine, E. (2001) An international survey of the energy service company (ESCO) industry .

Vine, E. (2005) Energy service companies in European countries: Current status and astrategy to foster their development .

Wikipedia – Energy service company. Retrieved on February 3rd

, 2010 fromhttp://en.wikipedia.org/wiki/Energy_service_company

Wikipedia – THERMIE (EU). Retrieved on February 3rd

, 2010 fromhttp://de.wikipedia.org/wiki/THERMIE_%28EU%29

Energy Service Companies ESCO Monetization of Energy Efficiency

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