Performance Risk an Important Factor in Picking Energy-Efficiency Financing
Second of a 4-part article on keys in selecting among energy-project financing options
Facility managers who plan to outsource energy efficiency or other sustainability projects have several options when considering how to contract for or finance such projects. Performance risk appetite is another of the five key factors facility managers should understand when deciding among third-party financing options such as lease financing, energy savings performance contracts, and efficiency service agreements.
PERFORMANCE RISK APPETITE
The next threshold question to examine is whether and to what extent the facility owner is willing to accept performance risk — i.e., the risk of how well the proposed energy efficiency and sustainability measures will perform over time and how much energy savings and efficiency will be achieved. Third-party financing options may be structured to shift this performance risk from the facility owner to the contracting third party to varying degrees.
Of the three main financing options — lease financing, energy performance contracting, and efficiency services agreements — lease financing allocates the least amount of performance risk to the third-party lease provider. The lessor owns the leased equipment and provides customary warranties for the leased equipment, but the lessor does not assume performance risk for achieving certain energy savings or efficiencies. A facility owner, however, may find an operating lease or capital lease attractive if the owner is comfortable assuming the performance risk and does not wish to pay for the project (or purchase the equipment) up front on its own balance sheet. Note that each facility owner would need to determine for itself how to account for a lease, whether as a capital expense or an operating expense, particularly as U.S. accounting treatment of leases gradually conforms to international practice. In addition, any existing debt financing that may be in place should be checked to make sure that the lease financing falls within any applicable debt covenants or restrictions.
Energy performance contracts allocate more of the performance risk to the ESCO. If the ESCO provides a performance guarantee of certain minimum savings, then the ESCO takes most of the performance risk up to the amount of such guaranteed savings, subject to the terms and conditions of the performance guarantee. These terms and conditions should be carefully reviewed, along with the energy baseline against which savings are measured. In some cases, excess savings above an agreed-upon minimum level of guaranteed savings may be split between the facility owner and ESCO. The facility owner owns the equipment and project that are installed, and often arranges financing for the project. The ESCO may also arrange its own financing for the project under certain circumstances. The energy performance contract is typically on the facility owner’s balance sheet.
A performance contracting approach can be particularly useful for large, complex projects, especially in the public or institutional sector. ESCOs have lengthy contracting experience and standardized processes. However, the often high transaction costs and long negotiating periods make performance contracting less realistic for medium-sized or smaller, less complicated projects.
Using a third-party efficiency services agreement (ESA) also allocates most of the performance risk to a third-party — in this case, the ESA provider. Under an ESA, the ESA provider owns the equipment and project through a special purpose entity, arranges for installation and implementation of the project, takes the performance risk, and obtains financing for the project. The facility owner does not pay up front for the project and equipment, but instead pays for the various efficiency services provided and energy saved as a service over time. The ESA payments may be structured as a percentage of the utility rate or as a fixed dollar amount per kilowatt-hour saved, based on the actual energy savings achieved. Depending on the project, the ESA provider may subcontract with an ESCO and other contractors or vendors, and a performance guarantee may be included. The ESA provider also handles measurement and verification services, along with ongoing operation and maintenance services after installation.
The ESA is a variation of the well-known power purchase agreement (PPA) third-party financing approach. One of the advantages of using an ESA is that it is a very flexible contracting tool, which can be adapted to the needs of a particular project and a particular facility. An ESA may be a relatively short and simple contract, focusing on a smaller set of energy efficiency measures and services, or it can also encompass larger, complicated projects. Where the project incorporates some renewable energy generation and optimization of energy generated and saved, an ESA can be adapted accordingly. The parties may also tailor the ESA’s end-of-term options.
The possible variations of an ESA are numerous. In some variations, the ESA provider may pay the utility bill directly to the utility. But perhaps the most important common thread among all ESA financings is that because the payments to the ESA provider vary based on the actual energy savings achieved, using an ESA incentivizes both the facility owner and the ESA provider to maximize actual energy savings or other performance metrics.
Because an ESA may often involve lower transaction costs, it can be a more realistic third-party financing tool for projects for which the ESPC approach is not cost-effective. Each facility owner will, however, need to make its own determination of the accounting treatment of an ESA — whether it should be treated as a service agreement, operating lease, or capital lease. This determination will vary depending on the facility owner’s circumstances and the ESA’s specific terms.