How does an Energy Performance Contract work?
An Energy Performance Contract is a form of ‘creative financing’ for capital improvements which allows funding energy upgrades from cost reductions. Under an Energy Performance Contract arrangement an external organisation (ESCO) implements a project to deliver energy efficiency. The cost savings achieved from the energy saving initiative is then used to repay the costs of the project. Essentially the ESCO will not receive payment unless the project delivers the targeted energy savings.
There are three main types of Energy Performance Contract:
- Shared savings: under a shared savings contract, the investment is assumed entirely by the ESCO, including investment financing, management and control of energy consumption.
- Guaranteed savings: under a guaranteed savings contract, the client assumes the entire investment required.
- Mixed savings: this kind of contracting is a highbred combination of the two previous models.
The contract adopted will depend on the type of project being implemented and the appetite for risk on both sides. Either way, an Energy Performance Contract is based on some element of the ESCO achieving the targeted energy savings.
How does an ESCO make money?
The contract adopted will dictate how an ESCO profits from an energy savings initiative. An ESCO may finance the capital for a project such as a combined heat and power (CHP) system, boiler, chiller, etc. Over the 5, 10 or 15 year period, the ESCO will receive revenue from the energy savings achieved. Additional revenue may also be achieved if the ESCO provides operational, planned and reactive maintenance services.
The following explains the various ways in which an ESCO profits from the type of Energy Performance Contract chosen by the client.
This mechanism is attractive for the ESCO providing it excludes penalties should the implemented measures perform poorly, or initial estimations prove to be too low. In return for providing financing, the ESCO undertakes comprehensive management. To compensate for this, the ESCO typically prefers large or medium-sized customers.
In this case, the ESCO ensures real savings are achieved. If the project fails to cover the debt service, then the ESCO might pay the difference. Conversely, if the savings exceed the guaranteed level, the customer may pay an agreed upon percentage to the ESCO.
This mechanism is typically used when the investment associated with the project is undertaken by the customer. Therefore, this type of contract is only suitable for clients with sufficient financing, typically large or medium size companies.
The ESCO guarantees the savings, and any additional savings beyond those agreed, are shared between the ESCO and the client. Thus, the ESCO provides the capital required for the works. The new equipment is then owned by the ESCO for the duration of the contract. Ownership of the equipment is transferred to the client at the end of the contract.
Usually, there is a fixed payment (investment amortization) a maintenance fee and a variable payment based on the savings achieved (shared savings). Both the ESCO and the client share the risk of performance, and sometimes, the risk of changes to energy prices. However, the credit risk is usually assumed by the ESCO.
Top Tips | ESCO Contracts
The steps below will go a long way to maximising the opportunity of an Energy Performance Contract.
- Internal buy-in from all key stakeholders should be sought before exploring the ESCO contract in too much detail. An Energy Performance Contract can be quite time consuming to draw up. Without senior management support, you could find the deal being scuppered at the last minute.
- Seek internal or external support when reviewing the technical aspects of the energy projects being proposed. This is essential to ensure that the services and assets being proposed are a correct fit for the site. Particular care should be taken to review the technology, sizing and operational performance of the proposed asset. The same holds from a contractual perspective. The client should ensure the ESCO is only rewarded when the targeted savings are achieved; all contractual clauses should reflect this.
- Measure the results during the operational phase of the contract and after completion. It is important that the ongoing savings or cost avoidance measures are tracked on an ongoing basis. Ideally, this should be undertaken by someone with M&V (measurement and verification) experience.
Is an ESCO worth it?
Energy Performance Contracts provide the means to realise significant energy savings on sites that are constrained by a lack expertise or capital. Sometimes sites will have both expertise and financial means, but the project paybacks fall outside of corporate guidelines.
In summary, Energy Performance Contracts that are created when appropriate levels of risk and reward are worth pursuing. They can result in long-term, sustainable relationships between the client and the ESCO when done correctly.
Questions about the types of energy performance contracts?
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