Chapter 11 Energy Savings Performance Contracts
E. Performance of the ESPC Including
1. Design and Construction Once the scope of an energy-saving project is deter- mined and memorialized in an ESPC, the ESCO is responsible for designing and implementing the energy upgrades included in the project. Typically, an ESPC includes only incomplete outline specifications of the necessary work. These outline
specifications must be developed by the ESCO into construction-ready drawings and specifications. The client should be actively involved in the design process, since the implementation of energy-saving upgrades may involve trade-offs that adversely affect its use of a facility. If trade-offs are presented, the ESCO and client should work together to reach a resolution that maximizes both energy savings and the usefulness of the facility. If the project involves substantial on-site modifications, the client may also wish to assign or retain a person with relevant engineering and construction skills to track the progress of the work during construction and installation. Client involve- ment is critical to guiding a construction project to a successful conclusion, and knowl- edge gained during the construction process can be valuable to the client in understanding and properly fulfilling any operational responsibilities placed on the client after the project is completed.
Most ESPCs include a detailed commissioning process intended to ensure that any new systems have been designed, installed, functionally tested, and shown to be capa- ble of operation and maintenance in conformity with the project intent. Commissioning should include sufficient testing to verify the performance of new systems at the time construction or installation is completed, and to identify any deficiencies that might be corrected before commencing long-term use and operation. The commissioning pro- cess should culminate in the preparation of a commissioning report that describes the commissioning process, any operational deficiencies, and courses of action to remedy any deficiencies and bring the project back within the contractual specifications.
Records of operator training and any special instructions or observations regarding system performance and maintenance should also be preserved in the commissioning report. After commissioning is complete, the project should be ready for regular oper- ation and compilation of the information necessary for measurement and verification (M&V) of the energy-saving upgrades.
2. Measurement and Verifi cation As noted above, calculation of cost savings involves comparison of two components — the “before energy upgrade” energy cost referred to as the baseline and the “after energy upgrade” energy cost actually incurred by the client. M&V services are necessary to compute the second component of the cost-savings equation, gather the information needed for degree-day normalization, and make adjustments to the baseline. While every ESCO offers M&V services, there is great variation among M&V options in terms of incentives, scope, pricing, and methodology.
It should be noted at the outset that there is an inherent conflict of interest when an ESCO monitors and verifies the performance of its own work, especially if the results could trigger a payment by the ESCO under the guarantee for any shortfall in energy savings. Accordingly, a client should consider using a neutral third party to perform M&V services in most cases. Another ESCO, a dedicated verification organization and even some universities can provide M&V services. If the client elects for the original ESCO to also provide M&V services, then the client should require the ESCO to comply with the International Performance Measurement and Verification Protocol (IPMVP) published by the Efficiency Evaluation Organization, which sets out standards for the manner in which energy savings should be measured and verified.
ESPC FINANCING OPTIONS
The scope of M&V services varies greatly. The IPMVP sets out four options for quantifying energy savings, each differing in scope. Under IPMVP Options A and B, savings are determined by reference to partial field measurements of energy used by particular systems, separate from the energy use of the rest of the facility. These options are suitable for simple, limited retrofits such as lighting changes. IPMVP Option C measures energy use at the whole facility level and can be used for multifaceted energy management programs affecting many systems in a building. IPMVP Option D uses a calibrated simulation to determine energy use of either components or an entire facil- ity. Option D is particularly useful when no base-year data is available.
An important aspect of M&V services are their pricing and relationship to the cost- savings guarantee. Many ESCOs will request an annual fee for M&V services, which is not included in the up-front cost of the project. If the M&V service is terminated at any time, then the ESCO will typically take a position that the guarantee should be invalidated, since the ESCO can no longer verify that the facility is being run accord- ing to the stipulations set out in the ESPC. As an alternative, the ESPC may specify that the ESCO will provide M&V throughout the life of the ESPC, without additional charge. However, in this case, the ESCO could seek compensation for M&V services by significantly increasing the up-front cost of the project. Oftentimes, if upgrades perform as expected during the first few years after they are installed, a client will discontinue M&V services. If long-term costs for M&V services are included in the up-front cost of the ESPC, a client may find it has paid for services that it considers unnecessary a few years after the upgrades are implemented. 25
M&V arrangements also vary in the way they measure energy usage and savings.
Some ESCOs install meters that report real-time usage, while others merely take monthly measurements from the utility company meter or from utility bills. ESCOs typically reconcile energy savings at the end of each year. ESCOs that measure energy use more frequently are able to respond more quickly if savings are lower than expected.
For example, in the case of a building heated by a series of modular high-efficiency boilers, occupants might not notice any difference if one boiler malfunctions because the others still provide adequate heat. A boiler malfunction, however, can significantly increase energy consumption. An ESCO that monitors usage regularly will be able to note and correct malfunctions before they cause significant cost increases. The infor- mation derived from frequent monitoring may be especially valuable for a client who has assumed complete or partial responsibility for maintenance of equipment under the ESPC.
IV. ESPC FINANCING OPTIONS
In entering into an ESPC, a facility owner or operator must decide how to finance the upgrades. Financing arrangements significantly affect the overall financial results from
25 Some owners prefer an annual fee-based guarantee because, if savings are being achieved with ample room to spare in the fi rst few years, then the M&V can be dropped. However, this increases the risk over the remaining life of the contract.
the energy savings measures taken under the ESPC. Selecting among financing options depends both on project economics and the financial circumstances of the facility owner or operator.
To illustrate the various financial options that are available for financing an ESPC, we present a hypothetical case study. Our case study is a medium-sized factory located in the northern Midwest of the United States. The factory owner and factory operator are different parties. The plant currently uses natural gas boilers that consume 1 million cubic meters per year, at a price of US$0.40/m 3 . An upgrade to the plant’s boilers will improve energy efficiency by 25 percent, thereby reducing gas consumption by 250,000m 3 per year, at a total cost of US$300,000. We assume a 2 percent inflation rate for the price of natural gas, and that the retrofit boilers will have a twenty-year useful life.
The plant operator faces a decision whether to invest cash, take short- or long-term debt, request the plant owner to undertake the upgrades for an adjustment in the price of the lease, or engage an ESCO. For an ESPC contract, we present two variations of pricing. The first is an open-book cost contract with a 30 percent margin added to the cost of the upgrades to compensate the ESCO, and a loan at 8 percent for seven years, which is repaid entirely by the client. The second ESPC contract is a shared savings contract with 30 percent of the energy savings paid by the client to the ESCO, and a loan provided by the ESCO at 0 percent interest to the client for seven years. Both ESCO contracts also have an additional cost for verifying savings equal to 20 percent of the cost of the upgrades.
The decision of which financing option to select depends on a number of factors that are specific to the particular facility operator. These factors include the facility opera- tor’s immediate access to cash, its internal rate of return (IRR) on deployment of cash in its business, future capital needs (such as required equity payback period), and avail- ability of credit.
For a facility operator with cash on hand and access to credit, the long-term debt option offers the best return on equity with a pre-tax IRR of almost 92 percent and an equity payback period of 1.1 years The short-term debt option provides a less attractive, but still very healthy, pre-tax IRR of 61 percent and payback period of 1.9 years.
If the facility operator has cash but does not have access to credit, and does not have more profitable options for the deployment of equity, it may elect to finance the retrofit entirely with cash. In this case, the investment in energy upgrades achieves a 36 percent return on equity, which it might select if the return on the energy upgrade is better than returns on cash invested in ordinary operations.
If the facility operator has no cash or credit, or does not want to use these resources, the facility operator may request the facility owner to make the upgrades and adjust the terms of the facility lease, or hire an ESCO that is willing to provide financing. From the perspective of the facility operator, these options would probably not provide as high a dividend as the other options, however their advantage is that they involve no cash or credit from the facility operator.
Both the owner and ESCO would evaluate whether to finance the improvements based on the strength of the facility operator’s business. Assuming the cost of the
276 ENERGY AND ENVIRONMENTAL PROJECT FINANCE LAW AND TAXATION ESPC FINANCING OPTIONS
Table 11.2 Financing options for retrofi t of a factory boiler system Cash Short-term 70 %
debt 10 % for 5 years
Long-term 70 % debt 6 % for 15 years
Lease with loan at 12 % for 5 years
ESPC with 30 % margin on equipment cost to ESCO and loan at 8 % for 7 years
ESPC with 30 % of saving to ESCO and loan at 0 % for 7 years
Equity $300,000 $90,000 $90,000 $0 $0 $0
Pre-tax IRR — equity
35.90 % 61.20 % 91.80 %
Pre-tax IRR — assets
35.90 % 24.10 % 29.10 % 19.80 % 12.40 % 11.4 %
Simple payback 3 3 3 3 4.5 6.4
Equity payback 2.9 1.9 1.1 Immediate Immediate Immediate
Cumulative dividend 3 years
$312,200 $146,000 $247,300 $62,500 $52,900 $25,700
Cumulative dividend 20 years
$2,478,000 $2,201,000 $2,154,000 $2,062,000 $1,873,000 $1,800,843
Courtesy of RETScreen International Division, Natural Resources Canada
improvements is the same in each scenario, the decision between owner and ESCO financing depends upon the specific financing terms offered by each. In the case of owner financing, the facility operator must evaluate the increase in the cost of the leasehold and the period of the increase in cost. If the increase in the cost of the lease is permanent, as opposed to temporary to allow cost recovery by the owner, then the owner financing option could be less desirable than other arrangements.
The cost of facility owner upgrades under our lease example also provides a better return than an ESPC. Under the lease, the operator pays to the owner additional pay- ments equivalent to a five-year 12 percent interest rate loan, and owns the upgrades without any residual payment at the end of the term. In our examples, the ESCO- financed ESPC provides the client with the lowest financial return of all the options.
V. DISPUTES AND DISPUTE RESOLUTION UNDER ESCO AGREEMENTS
A well-drafted ESPC should set out all of the information, instructions, terms, and con- ditions needed to resolve any disputes that may arise between the client and the ESCO.
Ideally, the parties should be able to resolve any foreseeable disagreements between themselves by referring to the clear terms and conditions of the contract, and without intervention by a judge or arbitrator. Because an ESPC involves many complicated activities performed over an extended period of time — including a detailed energy audit, design, procurement, construction, commissioning, measurement, and verification — achieving this ideal can be particularly challenging for parties negotiating an ESPC.