Energy Service Companies (ESCO) Monetization of energy efficiency

Transcription

1 Energy Service Companies (ESCO) Monetization of energy efficiency Research note February 2010 Analyst Leonard Wagner, Table of Contents Introduction to the ESCO business The ESCO business scope The ESPC business scope Comparison between ESPCs and ESCOs...2 Historical perspective Development in United States Development in Europe...3 The European Union policy context Active EU member states Drivers behind ESCO growth...3 The ESCO business model Energy performance contracting Financing considerations...4 Conclusion...6 References...7

2 Introduction to the ESCO business 1.1. The ESCO business scope An energy service company (acronym: ESCO or ESCo) is a professional business providing energy solutions including: Designs and implementation of energy savings projects, 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, installs the 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 a period of five to twenty years, or reinvested into the building to allow for capital upgrades that may otherwise be unfeasible. If the project does not provide returns on the investment, the ESCO is often responsible 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 schedule as well as budget in return for a fixed price or stream of payments depending on the agreed scope of work (Loots & Henchie, 2009) 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. provision of degree days in Italy and France), Via business ventures by large building control and equipment manufacturers, or Mora Associates Ltd,

3 With the gradual restructuring of utilities seeking to provide energy services as added value, 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 a user 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, as entrepreneurs developed ways to combat the rise in energy cost. One of the earliest examples was a Texas-based company, Time Energy, which introduced a device to 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 the savings would actually materialize. To combat this doubt, the company decided to install the device upfront 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 Honeywell Building Solutions Air conditioning Carrier Air conditioning Chevron Energy Services Oil & gas 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 Mora Associates Ltd,

4 2.2. Development in Europe While the initial ESCO concept started in Europe more than 100 years ago and moved to North America, 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 was estimated to be EUR 5-10 billion per year. In Europe, energy utilities offered relatively low gas and electricity prices to customers. However, this process could not be sustained in the longer term as prices reached very low levels. The most entrepreneurial utilities understood that to retain customers, as well as to gain new ones, they had to offer services in addition to the supply of electricity and gas. In addition, equipment and control system manufacturers, and installation and engineering companies, decided to enter this same market. Energy services include a variety of activities, such as energy analysis and audits, energy management, project design and implementation, maintenance and operation, monitoring and evaluation 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 Germany Austria UK Spain Hungary France Sweden Italy All other EU countries Most mature market in EU, total investment of EUR 5 billion Austrian Energy Agency claims to be together with Germany the EPC pioneer in Europe No regulation in place for ESCOs ESCOs are mainly active in financing wind farms (Vine, 2001) Surprisingly developed market with active players Co-generation used as Trojan horse for market entry Hospitals, hotels and public authorities are targeted Early 80s: upgrade of boilers in public buildings, market is dominated by ESPCs No mature markets 70,000 service contracts by end of 2000, >200 EPC contracts, mostly on public buildings ca buildings improved via EPC 20 active ESCOs, most of them are subsidiaries of control equipment firms 10 private ESCOs, as of ESCOs or related firms 60 firms formed a trade association known as FEDENE (previously FG3E ) No information available No information available Few players Source: Vine, E. (2005); Fédération des services energies environment (FEDENE) 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. Mora Associates Ltd,

5 The effect of the market liberalization on energy efficiency is still under discussion. Falling and volatile prices are expected to have a negative impact on ESCO projects and short-term oriented suppliers maximizing 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 companies trying to retain consumers and attract new ones by offering energy services as added value to an otherwise homogenous commodity such as electricity. Under the European Commission s THERMIE and SAVE programs, several studies and pilot projects were implemented to promote ESCO and Third-Party Financing activities, mainly in public buildings and combined heat and power (CHP) generation. The ESCO business model 4.1. Energy performance contracting Under the energy performance contracting (EPC) arrangement an external 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, to repay 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 performance guarantees given by the ESCO. In the EPC arrangement, the payment is typically based on performance; one measure of performance is the level of energy savings 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, a university can use its endowment fund to finance an energy project, in which the energy savings are guaranteed by an ESCO). 2. ESCO financing refers to financing with internal funds of the ESCO and may involve own capital or equipment lease. 3. Third-Party Financing (TPF) refers solely to debt financing. There are two conceptually different TPF arrangements; the key difference between them is which party borrows the money: the ESCO or the client. In the first arrangement an ESCO may borrow the financial sources necessary for project implementation. In the second arrangement the customer takes a loan from a finance institution backed by an energy savings guarantee agreement with the ESCO; the purpose of the savings guarantee is to demonstrate to the bank that the project for which the customer borrows will generate a positive cash flow, i.e. that the savings achieved will certainly cover the debt repayment. Large ESCOs with deep pockets and hence high credit rating start to prefer TPF to own financing because the cost of equity is higher. If an ESCO arranges TPF, then its own risk is smaller, which allows 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 equity financing are some of the factors that determine whether ESCOs will provide financing (Hansen, Mora Associates Ltd,

6 2004). Small and/or under-capitalized ESCOs that cannot borrow significant amounts of money from the 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 any performance risk is known as guaranteed savings. Because under a guaranteed savings contract the ESCO takes over the entire performance risk, it is unlikely to be willing to further assume credit risk; consequently TPF rarely goes along with guaranteed savings contract (CTI, 2003). The customers are financed directly by banks or by a financing agency. Therefore the customer repays the loan and the credit risk stays with the lender (Dreessen, 2003). This 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 (e.g. UK, Austria, and more recently, Hungary). Conversely under a shared savings contract the savings are split in accordance with a prearranged 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 (ECS, 2003). As in this case the client takes over some performance risk, it will try to avoid assuming any credit risk; hence 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 (CTI, 2003) whereby the ESCO repays the loan and takes over the credit risk. Figure 1 Primary savings structures (Source: Dreessen, 2003) The shared savings concept is a good introductory model in developing markets because customers assume no financial risk, however it does 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 (CTI, 2003; Dreessen, 2003) 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 longterm growth of ESCO and finance industries (Dreessen, 2003): because newly established ESCOs with no credit history and limited own resources would be unable to invest in the project they recommend, they may only enter the market if they guarantee the savings and the client secures the financing on its own. Mora Associates Ltd,

7 Conclusion The ESCO business model is based on the monetization of the clients intangible energy efficiency 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 predictable cashflows. In the ESCO industry, cashflows can be problematic because energy savings may fail to materialize. Moreover, even if energy efficiency improvements are realized, the exact energy savings are difficult to measure. The uncertainty and variability of the realized energy savings translates into a higher volatility of project cashflows and would typically require projects to be equity-financed. This can 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 be assessed individually and potentially involves a large number of unidentified risk factors. This can be costly 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 entered or bought into the ESCO business to increase sales of their product lines. Those firms used the energy efficiency improvements as a marketing strategy (a bait) to introduce new products to a reluctant customer base. This is the only case where there might be a competitive advantage for a firm to enter the ESCO market. Companies like Honeywell put their money where their mouth is when they 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. Each project 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. While some 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 the consumer market. Most probably, wide-scale residential thermal rehabilitation, driven by various laws in various EU countries, will not be financed by ESCO mechanisms. Or at least a suitable ESCO business model for private clients still need to be invented. Mora Associates Ltd,

8 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 Companies in Central Europe. CTI Secretariat, Tokyo. Dreessen, T. (2003). Advantages and disadvantages of the two dominant world ESCO models; shared savings and guaranteed savings. In: Bertoldi, P. (Ed.), Proceedings of the First Pan- European Conference on Energy Service Companies. Farrell D., Remes J.K., (2008) How the world should invest in energy efficiency. Retrieved from The McKinsey Quarterly (subscription required). Fédération des services energies environment (FEDENE). Retrieved on February 3 rd, 2010 from Honeywell Building Solutions (SES) Get the Most From Your Facilities Without Paying The Most. 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 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 a strategy to foster their development. Wikipedia Energy service company. Retrieved on February 3 rd, 2010 from Wikipedia THERMIE (EU). Retrieved on February 3 rd, 2010 from Mora Associates Ltd,