Energy Service Companies
At the heart of innovative financing models for efficiency
Energy service companies (ESCOs) deliver energy efficiency projects that are financed based on energy savings. Given the need to rapidly and significantly increase financing for energy efficiency, interest in ESCO business models is growing.
Energy performance contract models
Most agreements between customers and ESCOs are underpinned by energy performance contracts (EPCs). The EPC commits the ESCO to installing the necessary equipment, provides a performance guarantee and establishes the terms of any upfront or ongoing payments, which are intended to be less than the financial savings realised by the project. The two most common types of EPCs are referred to as a (1) shared savings or (2) guaranteed savings model.
The EPC provides the customer with a guaranteed level of energy savings and the ESCO with a reliable source of revenue. EPCs typically last from two to 20 years, depending on the measures implemented. Depending on the customer’s preference and access to capital, the customer, the ESCO, or a combination of the two can be responsible for securing the finance for the project. A direct loan agreement with a third-party lender is an option for both parties.
National policy and accounting rules, which vary between countries and regions, determine which type of EPCs are preferred within a country. The Asian market is the most diverse: Japan and the Philippines use the Shared Savings model for over 75% of their contracts, while other Asian countries use Guaranteed Savings for over 80% of their performance contracts. In North American, European, African, Middle Eastern, and Australian markets, Guaranteed Savings EPCs are heavily utilised. South American ESCOs, specifically in Chile, show a 60/40% split in favour of Shared Savings.
Several additional factors contribute to choosing one contract type over the other: generally, guaranteed savings models are used in more developed markets, with an established banking structure. However, where an ESCO might not have lending ability, they may need to use a guaranteed savings model, where the customer is responsible for financing the project (JRC, 2019).
Guaranteed savings model
Energy Performance Contract Guaranteed Savings model (EPC GS): the ESCO guarantees a certain savings on the client’s energy bill. The ESCO takes on the technical risk. The client obtains a bank loan, or uses their own equity, to pay contractually determined fees to the ESCO and the bank, and keeps the difference.
Shared savings model
Energy Performance Contract Shared Savings model (EPC SS): the ESCO can provide financing, as well as project development and implementation costs, with the energy savings shared between the ESCO and the client over the contract period.
In this situation, the ESCO is assuming both the technical and the credit risk (of the client), which can be of value to the client as it avoids the need for upfront capital costs, with ongoing payments to the ESCO based on the savings obtained. The project would therefore be off-balance sheet. However, this is not the case in the United States, where under the Generally Accepted Accounting Principles, EPCs are often structured as operating leases, which are also not accounted for on a company’s balance sheet. Reporting an EPC on balance sheet indicates an increase in debt or liabilities held by that company, and is therefore an unattractive prospect for an organization considering investment in energy efficiency improvements.
This model requires the ESCO to have the capacity to borrow and to have projects with revenue streams that will ensure the loans can be repaid. Examples of countries where this model is used are India, Chile, and Greece.
Energy savings insurance and credit risk guarantee
Uncertainty associated with the performance of efficiency measures inhibits third-party energy efficiency financing globally. In response, energy savings insurance (ESI) has emerged as a solution offered by a small number of financial institutions, private companies and insurance companies, as a way to reduce the risk of an energy efficiency project. ESI is particularly useful for ESCOs or smaller enterprises with poor credit or who lack the means to secure third party financing. Scaling up ESI will require more providers to enter the market, increasing competition and availability, which depends on widespread understanding among insurers of energy efficiency projects risks.
Typically, there are two types of insurance packages offered by insurers: technical and credit. Under the technical package, the insurance provider covers the ESCO or technology provider in the event that promised energy savings are not achieved, assuming the technical risk associated with efficiency projects. In the credit package, the insurance provider assumes the credit risk of a project, thereby ensuring that repayments owing to the ESCO can continue to be made, in the case of customer credit default.
Credit Risk Insurance
Technical Risk Insurance
Super ESCOs are governmental entities created to serve the public sector, develop the capacity of private ESCOs, and facilitate project financing. Super ESCOs are useful because existing programmes designed to engage clients with ESCOs, such as energy audits programs, rebates, direct install programs, demand side management bidding, or standard offer approach, rarely provide the full amount of funding required to cover implementation costs such as engineering, procurement and installation costs. Clients may have the means to finance energy efficiency projects, but experience has shown that energy efficiency projects are not an imperative investment priority for many businesses. Easing access to external financing increases EE project implementation rate (SRC 2010)
Super ESCOs address multiple factors that increase the appeal of ESCO projects for external financiers. ESCO projects must be large while minimising transaction and development costs. Super ESCOs help aggregate projects and drive down transaction costs through standardisation. Project managers must be knowledgeable about the state of the industry, aware of financing options and capable of measurement and verification of energy savings. Super ESCOs provide training. The risk profile of the specific (national, sub-national) ESCO industry must be developed. Super ESCOs track and monitor ESCOs through accreditation to develop risk profiles.
Barriers to implementing energy efficiency projects in public sector fall into three categories: awareness, budgeting, and contracting. To raise awareness of the importance of energy efficiency in public agencies Super ESCOs may dedicate a portion of their budget to marketing campaigns. Once interest is piqued, public agencies will scrutinise budgets and may find little capital reserved for ‘optional’ energy efficiency improvements. Super ESCOs meet this budgeting barrier by providing incentives or financing tailored for the public sector. Once financing is secure, public agencies may confront lack of procurement regulations or understanding of energy performance contracting with private sector ESCOs. Super ESCOs anticipate this inexperience and provide standard contracts that are customisable for public agency requirements.
Barriers to implementing energy efficiency projects in the private sector fall into three categories: awareness, standardisation, and financial. To raise awareness in the private sector the Super ESCOs may conduct a marketing campaign, aggregate case studies, or finance exemplary projects to provide success stories. Super ESCOs encourage new ESCOs to enter the market, creating competition that leads to better and more standardised practices. Standardising project development and formalising measurement and verification practices are a couple examples of the technical assistance Super ESCOs can provide. Once project management is standardised, Super ESCOs are in a position to provide capital, credit enhancement guarantees, risk management products or leverage funds from financial institutions.
Digitalisation within the energy sector will drive energy efficiency improvements through increased use of building controls, automation and analytics, which will ultimately lead to greater reliability in energy savings estimates through more streamlined measurement and verification protocols.
For example, the deployment of smart meters in the buildings sector, increased penetration of active energy management systems in industry, and advancements in remote monitoring platforms should aid ESCO market development in the future.