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Part 1: Making ESCOs Pay
By Greg Zimmerman, Executive Editor
May 2009 -
On the surface, an energy performance contract seems like a fairly straightforward idea. A third-party energy services company (ESCO) pays for and installs energy-efficient equipment for an organization that pays the initial capital outlay back over time with the money harvested from the energy savings the new equipment brings. It’s a common way to fund energy efficiency upgrades when organizations are strapped for cash.
But savvy facility executives know that even supposed slam dunks require a fair amount of due diligence to produce the best results. An energy performance contract is no different. The experience of facility executives who have successfully managed an energy performance contract holds valuable lessons for facility executives considering a similar approach. From overcoming skepticism within the organization to measuring and verifying results, several facets of energy performance contracting require more time and thought than simply scrawling a signature at the bottom of a contract and then sitting back to watch the savings roll in.
Even before the contract is signed, facility executives may face resistance from financial folks who are leery of having to pay interest on what they view as a long-term loan. But facility executives can make the argument that a performance contract can actually create positive cash flow not just for the length of the contract, but forever. Contracts are usually structured to require either quarterly or monthly payments over a fixed period, anywhere from six to 15 years.
“Our financial people wanted to find the money and do a little bit at a time,” says Rick Sizemore, director of the Woodrow Wilson Rehabilitation Center, a 500,000-square-foot, 11-facility health care complex in Fisherville, Va. Sizemore made the argument that waiting to upgrade the equipment, some of it 30 years old, left money on the table because savings would be delayed. Sizemore and his ESCO negotiated a $2.6 million contract to do 22 energy upgrades. Sizemore says his organization makes a quarterly payment of $54,000, but even after that payment, last year, there was still a $73,000 surplus compared with before the upgrades were made. Those savings wouldn’t have existed if improvements had been done piecemeal over time.
Improving cash flow was also a goal for an energy performance contract at the 4 million-square-foot Ottawa Hospital in Ottawa, Ontario. Brock Marshall, director of engineering and operations, says the ESCO with which the hospital contracted guaranteed a savings of $2.7 million per year in utility costs on $17 million worth of upgrades. That means it could’ve paid the contract in just over six years. Instead, the organization decided to lengthen the contract to 15 years, and take up to $1 million per year from the savings as positive cash flow for its operating budget.
Financial folks may not like interest, but they really hate debt. Performance contract veterans say the best advice is to show that the ostensible debt of a performance contract isn’t actually debt because any ESCO worth its salt will guarantee the savings from the upgrade. Facility executives should just make sure the guarantee is part of the contract. When that provision is in the contract, money to make payments will always be available, and nothing has to be paid out of pocket. If savings aren’t realized, the ESCO is contractually obligated to write a check for the difference.
Steve Jalowiec, administrative director for facility operations for Waterbury Hospital in Waterbury, Conn., signed a $6 million performance contract, to be paid back over 10 years. He says that his CFO actually suggested an energy performance contract because it involved “off-balance-sheet funding.” The organization had done its own audit, but, according to Jalowiec, realized there were “capital availability issues” when it came time to actually fund the upgrades, especially a cooling tower replacement. So a performance contract was a way to roll several different types of facility upgrades into one, big, off-the-balance-sheet project.
Tom Reinsel, coordinator, energy management for Virginia’s Fairfax County Public Schools, took a similar tack. “Fairfax has a conservative policy about the amount of debt,” he says. A committee made up of both financial and facilities folks reviewed the options, one of which was business as usual — waiting until renovations were due to do the upgrades. “But that would have put our timeline into decades and wasted enormous amounts of energy over time,” says Reinsel.
The school district finally decided on an energy performance contract broken into six phases, or bundles. With more than 100 buildings and about 10.4 million square feet of space, the goal of this approach was twofold: to make the huge project manageable, and to keep the ESCO continuously engaged in a standard cycle of work, such as completing energy audits, suggesting projects and completing installations.
This highlights a critical consideration in selecting the right ESCO. Simply put, facility executives should put in the same due diligence on each ESCO as would be required to qualify an outsourcing provider, architect or any other third-party contractor. Send out the RFP with very specific criteria, narrow down the choices, and then invite the two or three finalists to make on-site presentations.
Check the ESCO’s references and make sure they have the project management and engineering expertise on staff to handle the project. Check the financials to make sure the company is strong and future-focused. Reinsel says that from the time the school district started with its performance contract to the time the last upgrade was completed about four years later, four of the six companies on its original short list had gone out of business. “And that was our qualified list,” says Reinsel. A critical part of the vetting process is to make the ESCO prove exactly how it will achieve savings.
How an ESCO identifies projects may also be a good indicator of whether it’s on the level or not. “In the performance contract, the ESCO may want to include everything from soup to nuts,” says Sizemore. “Don’t get too far away from the fundamentals.” Sizemore tells a story of how one of the bidders on his energy performance contract proposed that they would harvest gas from a local landfill to use as an energy source in the facility, but provided no details on an agreement with the landfill owner or how the gas would actually be harvested and transported the five miles to the site. Sizemore decided to pass on that proposal and go with a more realistic contract.
An energy audit is the first step to identifying the specific projects to be completed. Get staff involved in the energy audit to set the tone for a collaborative relationship with the ESCO early on.
“The more you can involve facility staff in negotiations, the better,” says Sizemore. He also suggests structuring the contract so that projects with the best paybacks are done first. This means money starts flowing back immediately, and can help ensure that there’s cash in-pocket to make that first payment to the ESCO.
“We did our worst performing schools first,” says Reinsel. “That way, we get the highest savings first.”
The specific equipment that is installed in the building depends on the parameters of the contract. The ESCO may insist on specifying the types and brands of equipment that goes into the facility so that it can be sure to achieve the savings it promises. For all intents and purposes, the ESCO owns the equipment until the contract is paid in full. But facility executives should provide standards and input on what is acceptable and what’s not.
“Like any construction contract, you have to really know what you’re buying,” says Reinsel. “Specify what kinds of products or brands are acceptable. The ESCO can’t use lower quality materials than we’re willing to accept.”
Ultimately, the ESCO has the responsibility for achieving, and then measuring and verifying the savings. Still, it’s important to make sure that the equipment has been installed correctly and is working properly — basically, this means completing a commissioning process. Performance contract veterans suggest designating a single person, whether the facility executive or someone on staff, to manage the entire process, including oversight of the installation and commissioning. Because the best contracts are partnerships, and the ESCO makes money only when promised savings are achieved, they are unlikely to throw curve balls on purpose. But problems arise, and calculations aren’t always perfect. So whether a county inspector is on site, as was the case for Reinsel, or whether independent third-party commissioning agents are hired, triple-checking the installation of the equipment is important.
Most contracts will stipulate that an ESCO send a representative to monitor and measure savings at an agreed-upon interval and issue a report verifying that those savings are actually happening. Facility executives should make sure that the measurement and verification standards specified in the contract conform to the standard International Performance Measurement and Verification Protocol (IPMVP).
One commonality of a majority of performance contracts that makes this measurement and verification easier is the installation of a building automation or energy management system — facility upgrades that reap rewards for both parties involved.
“The performance contract has helped us be proactive, rather than reactive,” says Marshall. “We can see a system start to slip. Without a BAS, the problem could go on for weeks. The amount of time it saves us is a huge benefit. The performance contract has allowed us to be recognized as a contributor to the health of the bottom line of the organization.”
Energy Performance Contracts