Energy Service Company Project Financing
An Energy Service Company (ESCO) is a business that develops, engineers, and installs projects designed to reduce the energy usage and maintenance costs for facilities, equipment, and infrastructure in a variety of end-user sectors. An ESCO often provides operations services, monitors savings, and assumes certain performance warranties and risks for its projects.
ESCOs use a range of business models and contract structures. ESCOs, and the financial institutions providing ESCO finance, could potentially be good finance aggregation partners for government programs targeting energy efficiency projects in the commercial buildings sector. A number of ESCOs have strong interest and sales potential in the commercial sector and are looking for financing solutions in that sector.
ESCOs are a well-established industry. Facilities owned by municipalities, universities and colleges, schools, and hospitals (the “MUSH” market) and the federal government are the market segments most successfully penetrated by ESCOs to date. Institutions in those markets typically have stable energy loads and generally good credit; they also have well-developed procurement methods. Further, some state governments already operate energy performance contracting procurement programs (through which ESCOs can be hired) serving state and local government agencies.
Many strong ESCOs exist as subsidiaries of major equipment manufacturers (e.g., Honeywell, Siemens, Johnson Controls) or of utilities. Other ESCOs are independent. State and local governments and private, nonprofit institutions are permitted by law to access tax-exempt bond and lease financing for their projects. As a result, most MUSH market ESCO projects are financed with loans or leases directly to the energy user, with the ESCO providing turnkey project development, installation, services, and performance guarantees.
The ESCO either arranges or provides financing for clean energy projects. When the ESCO arranges the financing, the customer is the borrower of project debt. When the ESCO provides the financing, the ESCO or its financial partner borrows the project debt and incorporates repayment of that debt into the energy service fee pricing. For most ESCOs, finance is a cost center or something they must procure. It is not a profit center because financing is simply a means of facilitating their project sale, which is the basis for their earnings. That is why many ESCOs develop partnerships with financial institutions to provide financing solutions.
Two basic options are illustrated in the diagrams below.
Model Option 1 has the end-user as the borrower of the financing. This may be the best approach for public and nonprofit institutional sector customers who can access tax-exempt financing, e.g., tax-exempt lease purchase or bond financing. Option 1 is also applicable to some commercial properties, but generally is not as attractive in the commercial building sector.
Energy end-user is borrower. This is typically a direct, full faith and credit payment obligation, on balance sheet.
ESCO provides turnkey project development, engineering, construction, commissioning, services and performance guarantees, as applicable.
Financing is arranged by ESCO with a financial institution partner. ESCO may arrange a multiproject finance facility where the financial institution partner agrees to look at a series of projects.
Construction period financing arranged, as needed.
ESCOs can establish programmatic relationships with financial institution partners who want to provide financing to the ESCO’s target market (customers). The ESCO markets the financing at the point of sale with the customer, and the financing increases the ESCO’s sales. The financial institution receives a flow of business with relatively lower transaction costs because the ESCO can perform many of the duties related to financing/loan origination.
Model Option 2 has the ESCO borrowing the project debt. For the commercial sector, many customers will require an ESCO financing solution, with customer payments treated as an operating expense under a performance contract and payments made from or matched to energy cost savings.
ESCO enters into the energy services agreement (ESA) with customer. Several variations are possible. The energy end-user payment obligation is typically based on achieved savings, with many variations possible.
ESCO provides turnkey project and services to customer, same as under Model 1.
Financial institution must approve customer credit, ESA, project economics, etc.
Several challenges are inherent in the Model 2, ESCO as borrower, structure. ESCOs market their services based on an energy efficiency project’s ability to pay for itself from savings. And performance-based payments are often preferred by customers, as the payments are linked to savings. However, when payments are performance based, they can vary. This uncertainty introduces risk, which makes performance-based transactions more difficult to finance. There is a fundamental tension in energy efficiency finance between (a) creating a secure payment structure for financing purposes, and (b) allowing customers to make payments based on actual savings.
Many creative contract methods have been developed to balance these competing interests, such as:
Combining fixed payment commitments from the customer with extended equipment warranties and/or performance and savings guarantees by the ESCO
Defining “savings” based on a one-time verification of project performance, and thereafter, fixing the customer payments based on those “verified savings”
Using variable term energy service agreements, where the term is extended as needed until the customer’s savings-based payments fully amortize the ESCO’s investment.
In lending to the ESCO, the financial institution is exposed to both (1) end-user credit risk (indirectly, because the ESCOs ability to repay its debt depends on the payment performance of the end-user), and (2) the ESCO’s performance. The financial institution must, therefore, perform analysis and due diligence at both levels, the ESCO and the end-user.
New variations and innovations in performance contracting are continuing to be developed, especially for the large commercial buildings sector. Those options offer 100% financing, tie end-user payments to monitored energy savings, and structure payments so they are treated as an off-balance sheet operating expense of the energy user. For example, Transcend Equity assumes payment of its customers’ energy bills and integrates payments for EE investments into the energy bill payments. Metrus Energy finances and owns EE assets and has developed a performance contract method whereby its customers pay based on avoided kWh or unit of energy, like a power purchase agreement, with no up-front capital outlay. Those structures have strong market appeal but are also new and developing at this point. They are typically financed with private equity sources. They aim to allow the energy user to treat their ESCO payments as an operating expense and not incur a balance sheet debt obligation, so that borrowing capacity is preserved for other purposes.
Developing ESCO Finance Programs
Local governments seeking to promote ESCO financing in the commercial sector can partner with ESCOs and with financial institutions that provide financing solutions to ESCOs. Structuring a program requires understanding the business methods and contract structures the ESCO uses, understanding the target market, and performing due diligence on the ESCO and its track record. This information can be collected using a request for proposal (RFP) or request for qualifications (RFQ) process.
Grantees can form partnerships with the ESCO directly or with its financial institution partner. The uses of ARRA funds described in the section on Uses for ARRA Funds to Support Large Commercial Energy Efficiency Finance can all be applicable to an ESCO finance program.
The following are examples of emerging ESCO finance programs.
The Chicago Metropolitan Agency for Planning has allocated $10 million in Energy Efficiency and Conservation Block Grant funds for a large commercial sector program and will be conducting an RFP process, seeking proposals for the use of those funds. ESCOs and their financial partners will be eligible to respond. The RFP will remain flexible for creative responses, covering the range of uses of ARRA funds as discussed in the section on Uses for ARRA Funds to Support Large Commercial Energy Efficiency Finance.
The Alabama Department of Economic & Community Affairs has allocated $25 million of State Energy Program (SEP) funds to finance energy efficiency and renewable energy retrofits on commercial and industrial real estate throughout Alabama. The program will be available for energy cost-saving projects on existing buildings, which are expected to meet or exceed loan repayments.
A request for information process to select financial institution partners, including those partnered with ESCOs, is underway (as of October 2010). The program is administered by Abundant Power Solutions, LLC. Selected financial institutions will receive an allocation of up to $2 million in SEP funds to supplement interest rate payments and to “credit enhance” their lending, using the range of structures discussed in the section on Uses for ARRA Funds to Support Large Commercial Energy Efficiency Finance. Loans are expected to range from $250,000 to $4 million, with terms of up to 10 years and eligible borrowers ranging from commercial facility owners to ESCOs.
For more information about ESCOs, see the National Association of Energy Service Companies website.