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The economics of energy savings performance contracts.

INTRODUCTION

A fact that is virtually unknown among the general public is that over the past two decades, the US government and its agencies--civilian and military--have made dramatic improvements in the energy efficiency of their standard buildings (which include offices, barracks, museums, etc.). In response to a series of legislative mandates and executive orders, the US federal government reduced the energy intensity of these buildings by nearly 30%, from 139,840 Btu per square foot in 1985 to 98,171 Btu per square foot in 2006 (USDOE 2008).

The cost of achieving this result was approximately $7.3 billion, which represents the total investment in federal energy efficiency projects over the period. However not all of this funding came from U.S. taxpayers. To accelerate investment in cost-effective energy conservation measures, the same laws and executive orders that mandated increases in energy efficiency at federal sites authorized and encouraged the use of private sector financing to achieve the goals. Of the $7.3 billion dollar invested, private sector financing was responsible for $3.1 billion, or about 43% of the funding.

The federal government is not the only institution in the US that is making use of private financing to meet its energy goals. According to one study (Hopper et al, 2005), municipal/state governments, universities, schools and hospitals obtained somewhere between $12 and $16 billion in private financing to fund energy efficiency projects in the 20-year period from 1982 through 2002.

Governments in other countries are making more widespread use of private financing as well: privately financing is used to fund energy efficiency upgrades at government facilities in Canada, Australia, the United Kingdom and in several other European countries. One of the aims of European Union directive 2006/32/EC (see http://europa.eu/legislation_summaries/energy/energy_efficiency/l27057_en.htm) is to increase the use of private financing for achieving energy efficiency goals in all of the member countries.

This paper describes the financial analysis of privately financed energy efficiency projects as they are implemented through Energy Savings Performance Contracts (ESPCs) at US federal government sites. In an ESPC, an Energy Services Company (ESCO) obtains private financing to design and build an energy conservation project at a government site. The ESCO and the government agency agree on the utility and other savings the project will generate, and on the methods that will be used to measure and verify those savings. The ESCO implements the project, and the government pays the ESCO from the savings generated. At least once per year, the ESCO produces a measurement and verification (M&V) report detailing measurements and calculations the ESCO has made to determine the amount of savings delivered. The contract may call for the ESCO to perform other services during the performance period including operations and maintenance (O&M) on the installed equipment.

The financial analysis of an ESPC consists of building a project balance sheet that considers project revenues - which come from guaranteed energy and energy-related cost savings - and project costs, which consist of debt service on the loan and performance period services such as M&V and O&M. Simple techniques from engineering economics are used to determine future costs and revenues. The project is deemed feasible if the revenue stream is sufficient to fund the necessary performance period services and pay off the debt within a specified time frame. In the U.S., the project's post-acceptance performance period - i.e., the time from agency acceptance of the project until the debt is retired - can be up to 25 years. Higher energy prices in Europe and other parts of the world often result in much shorter terms.

ESPC IMPLEMENTATION PROCESS

This section provides a brief overview of the steps typically taken by a US federal agency to implement an ESPC at one of its sites. The process begins with a kickoff meeting during which site personnel present their objectives for the project and provide an overview of the buildings and energy systems they wish the ESCO to consider. Following the meeting, the ESCO begins a preliminary audit of buildings and systems to determine whether a feasible pay-from-savings project exists. Typically within two months, the ESCO presents a preliminary assessment to the site. If the site is satisfied with the general direction of project development, the preliminary assessment is accepted and the site issues the ESCO a notice of intent to award a delivery order.

With the notice of intent in hand, the ESCO begins a more in-depth audit of the site's facilities (the investment grade audit) with the objective of developing designs to 30% completion to support estimates of the costs and savings of the proposed conservation measures. When completed, the ESCO presents a final proposal to the site. The final proposal gives a complete description of the project, including the firm, fixed prices of all conservation measures to be installed, the energy and related O&M cost savings that will be guaranteed, and a schedule of the payments the site will make to the ESCO over the term of the contract. The proposal also provides detailed financial schedules that specify the amount of private financing the ESCO will obtain, the financing procurement price, the annual interest rate on the financing, and the ESCO's operating budget over the contract term for debt repayment and performance-period services. The site reviews the final proposal, and after a final round of negotiations awards a delivery order to the ESCO to implement the project. The ESCO completes the designs and then constructs and commissions the project. When the project is accepted, the site begins making monthly payments according to the negotiated schedule for the duration of the contract term.

FINANCIAL PARAMETERS

The feasibility of an ESPC project depends on several key parameters. The first and most important is the implementation price (IP) of the project. This is the turnkey cost of the energy efficiency project to be installed at the site. It includes the cost of all labor and materials required for the project, as well as overhead and profit charged by the ESCO.

In some cases, the federal agency may contribute an ancillary payment from savings (AP) to the project out of funding it has available for other energy efficiency projects. The legislation that authorized the use of ESPCs by the US federal government required that all payments to the ESCO be from savings associated with the project. Thus ancillary payments must come from a project or activity that is made unnecessary by the ESPC. As an example, suppose a site has funding available for an upgrade to a boiler plant. An ESPC project planned at the site includes the installation of ground source heat pumps, which will allow the boiler plant to be decommissioned. Since the ESPC project makes the boiler plant upgrade unnecessary, the available funds could be applied to the ESPC as an ancillary payment from savings. The ancillary payment reduces the amount the ESCO must borrow to complete the construction project, thereby reducing the amount of interest that must be paid, and reducing the overall cost of the project.

Since the ESCO receives no payments from the agency until the equipment is installed and accepted, the ESCO must overborrow in order to make interest payments on the loan during the construction period. This overborrowing is the primary component of what is termed the Financing Procurement Price (FPP). The FPP may also include fees for professional services required by the financier to complete the transaction.

The amount the ESCO must borrow to design and install the project is termed the Financed Amount (FA). It is equal to the implementation price, minus the amount of any ancillary payments, plus the finance procurement price. In terms of the variables defined above as FA = IP - AP + FPP.

The interest rate at which this amount is financed is known as the project interest rate. It is determined at the time of project award, and remains fixed throughout the life of the loan.

During the course of project development, the ESCO and the agency agree on how to determine the savings of various forms of energy that will result from the installed equipment. In most cases, the same savings are assumed to occur each year over the life of the project. The ESCO and the agency also agree on how these savings will be valued over the project life. The most common method of doing this is to use the current energy prices to value the savings in the baseline year, and to assume a constant rate of price escalation. A different energy price escalation rate may be chosen for each form of energy. The escalation rates are chosen based on historical rates of energy price inflation at the site, and on projections of energy price increases made by the Department of Energy's Energy Information Agency (EIA). These projections are included in an annual publication produced by the National Institute of Science and Technology (see Rushing and Lippiat, 2008 for an example).

The ESPC project may also result in other forms of savings. In the example of installing ground source heat pumps to replace a boiler plant, the entire cost of maintaining the boiler plant will be saved once the plant is decommissioned. Determining how to value these savings over the life of the project is also critical to the financial analysis of the project. As with energy prices, one way of doing this is to calculate the cost of labor and materials for maintenance in the baseline year, and increase the amount by some constant rate to account for inflation.

Once the project is constructed, commissioned, and accepted by the federal agency, the ESCO begins receiving payments from the agency for the savings delivered. It uses these payments to pay debt service on the loan, and to perform any performance services the agency has requested. At a minimum, this includes the cost of performing annual M&V to verify that the guaranteed savings have occurred. As stated above, the ESCO may also provide O&M services on the installed equipment. The contract usually takes into account the effect of general price inflation on the cost of performance period services. The rate of inflation is usually assumed to be fixed throughout the life of the contract.

During each month of the contract, the ESCO receives a fixed payment from the agency based on the cost savings achieved. The ESCO uses this payment to perform and required performance period services, and pays the remainder to the financier for debt service on the loan. These payments continue until the loan is paid off, at which time the ESPC project terminates.

The purpose of the annual M&V report is to verify that the cost savings guaranteed for the previous year were in fact delivered. If they are not, the agency can reduce payments during the following year by the amount of any savings shortfall. In this analysis however we assume that all savings guarantees are met.

Based on the above, there are three sources of payment from savings that can be made to the ESCO: Ancillary payments from savings made at the time of project award; energy cost savings; and maintenance cost savings. These ESCO uses these payments for four different categories: Principal payments, interest payments, M&V services, and O&M on installed equipment. Figure 1 is a Sankey diagram that shows the source of the payments, and the way the payments are distributed for the average project awarded between 2005 and 2009. It is seen that the majority of payments to the ESCO (78%) come from energy cost savings. Maintenance savings account for 20% of payments to the ESCO, and ancillary payments account for only 2%.

[FIGURE 1 OMITTED]

CALCULATING THE FINANCING PROCUREMENT PRICE

As stated above, in federal ESPC projects in the US, by law all payments to the ESCO must come from savings delivered by the installed equipment. Consequently, the ESCO receives no payments until the project is installed, accepted, and begins to deliver savings. For this reason, the ESCO must overborrow in order to make interest payments on the loan during the construction period. This overborrowing is the primary component of what is termed the Financing Procurement Price.

The financier provides a loan to the ESCO at the project interest rate. The loaned amount is immediately placed in a money market account that earns interest at the money market rate. As construction proceeds, funds are withdrawn from the account to pay for equipment and labor. In addition, the account must fund regular interest payments to the financier throughout the construction period. Since the ESCO receives no payments from the federal agency until the construction project is complete, the ESCO must overborrow in order to make the interest payments during the construction period.

The amount of overborrowing required is a function of the project interest rate, the money market rate, and the schedule of construction payments. In general it must be calculated iteratively. Consider a simple example of a project with a 20-month construction period. Labor costs are constant at $100,000 per month, and capital outlays of $4,000,000, $3,000,000, and $1,000,000 are required in months 1, 9, and 16 respectively. The project interest rate is 7% per year and the money market account earns 1.5% interest per year. Note that 7% annual interest is equivalent to (1.07)^(1/12) - 1 = 0.5654% per month and 1.5% annual interest is equivalent to (1.02)^(1/12) - 1 = 0.1241% per month.

In this case, the total capital required for the project is $10,000,000 and the amount of overborrowing is $1,162,182. Table 1 shows the balance of the money market account, the interest earned and the payments made each month. The financier provides a loan of $11,162,182 at the beginning of month 1. This is placed in the account to provide the initial balance. All payments are then assumed to be made at the end of each month.
Table 1. Cash Flow for Escrow-Financed Construction in an ESPC Project

Month   Beginning    Interest   Interest  Construction  Ending Balance
         Balance      Payment    Earned     Payment

   1   $11,162,182    $63,113    $13,858   $4,100,000     $7,012,928
   2    $7,012,928    $63,113     $8,706    $100,000      $6,858,521
   3    $6,858,521    $63,113     $8,515    $100,000      $6,703,924
   4    $6,703,924    $63,113     $8,323    $100,000      $6,549,134
   5    $6,549,134    $63,113     $8,131    $100,000      $6,394,152
   6    $6,394,152    $63,113     $7,938    $100,000      $6,238,978
   7    $6,238,978    $63,113     $7,746    $100,000      $6,083,611
   8    $6,083,611    $63,113     $7,553    $100,000      $5,928,051
   9    $5,928,051    $63,113     $7,360   $3,100,000     $2,772,298
  10    $2,772,298    $63,113     $3,442    $100,000      $2,612,627
  11    $2,612,627    $63,113     $3,244    $100,000      $2,452,758
  12    $2,452,758    $63,113     $3,045    $100,000      $2,292,690
  13    $2,292,690    $63,113     $2,846    $100,000      $2,132,424
  14    $2,132,424    $63,113     $2,647    $100,000      $1,971,959
  15    $1,971,959    $63,113     $2,448    $100,000      $1,811,294
  16    $1,811,294    $63,113     $2,249   $1,100,000      $650,430
  17     $650,430     $63,113      $808     $100,000       $488,125
  18     $488,125     $63,113      $606     $100,000       $325,619
  19     $325,619     $63,113      $404     $100,000       $162,910
  20     $162,910     $63,113      $202     $100,000          $0

Total               $1,262,252  $100,070  $10,000,000


At the end of the first month, the money market account earns interest in the amount of (0.1241%)($11,162,182) = $13,858. The financier receives a payment of (0.5654%)($11,162,182) = $63,113. A payment of $4,000,000 is made to the equipment supplier, and $100,000 is paid to the construction subcontractor. This leaves a balance of $7,012,928 at the end of the first month, which becomes the balance at the beginning of month 2.

At the end of month 2, the financier once again receives a payment of $63,113 since none of the principal has been repaid. The money market account earns 0.1241% on the balance of $7,012,928, or $8,706. The construction subcontractor is paid $100,000 and the balance remaining in the account is $6,858,521.

The overborrowed amount of $1,162,182 was just enough to ensure that the balance of the money market account would be zero at the end of month 20. The amount was determined by setting the calculations up on a spreadsheet and varying the overborrowed amount iteratively until the account balance at the end of month 20 was equal to zero. In most commercially available spreadsheet programs, iterative calculations like this can be automated using the "Goal Seek" function.

As stated above, the financing procurement price may include other fees associated with setting up the financing, but these are negligible compared to the capitalized construction period interest that must be borrowed to pay interest during the construction period.

FINANCES DURING THE PERFORMANCE PERIOD

Delivery of savings is assumed to begin once the ESCO completes construction and commissioning of the installed equipment, and the federal agency accepts the project. This begins what is called the post-acceptance performance period. It is only then that the agency begins making payments to the ESCO.

Continuing with the example of a project with implementation price of $10 million and a 7% project interest rate, let us assume that the site makes no ancillary payment from savings, so that the financed amount is $10 million plus the $1,162,182 in capitalized construction period interest, for a total of $11,162,182.

Let us further assume that the ESCO and the site have agreed that the project will reduce annual energy costs by $1,000,000, and annual maintenance costs by $300,000 in the first year of the post-acceptance performance period. Thus the guaranteed savings in the first year is $1,300,000. The energy savings will increase by 3% per year and the maintenance savings will increase by 2.5% per year. The site has agreed to pay the ESCO 99% of the guaranteed savings.

The final assumption is that the ESCO's performance period costs (which include M&V and O&M on the installed equipment) are $300,000 in the first year of the post-acceptance performance period. These costs increase by 2.5% per year.

Given all of the financial parameters of the project, it is most convenient to set up the project balance sheet in a spreadsheet program. Table 2 presents the balance sheet for the first 13 months and the last six months of the project. Again it is assumed that all payments are made at the end of the month.

At the beginning of month 1, there is an outstanding loan balance of $11,162,182. During the first month, interest in the amount of (0.5654%)($11,162,182) = $63,113 accrues on the loan. At the end of the month, the ESCO receives a payment of $107,250 which is 99% of the guaranteed savings of $1,300,000 divided by 12. The ESCO's O&M and M&V costs during this month are assumed to be $300,000/12 = $25,000. The remainder is $107,250 - $25,000 = $82,250, which is paid to the financier for debt service on the loan. The balance on the loan at the end of the month is then $11,162,182 minus the payment of $82,250 plus the interest of $63,113 accrued during the month, leaving a balance of $11,143,045.

The agency payments, the ESCO's performance period service expenses, and the payment to the financier for debt service are the same in each month of year 1. The amount of interest accrued each month decreases as more of the principal is repaid. In month 13, the monthly payments to the ESCO increase to $110,344 to account for increases in the value of the energy and maintenance savings. The ESCO's performance period expenses increase as well to $25,625. The difference is $84,719 so the payment to the financier for debt service also increases.

By month 177, the monthly payment to the ESCO has increased to $159,760 and the ESCO's performance period service costs have increased to $35,324. The payment to the financier is now $124,435 per month.

The payments increase once more in month 181, which is the first month of year 16 of the post-acceptance performance period. The agency pays the ESCO $164,378, and the ESCO's performance period services costs increase to $36,207 leaving $128,170 for the debt service payment. With the accrued interest of $1,236 the balance on the loan at the end of month 181 is $91,623.

In month 182, the ESCO would again be scheduled to receive a payment of $164,378 as in the previous month. However, the cost of the ESCO's performance period services, plus the cost of the debt service on the loan is less than this amount. Thus in month 182 the agency reduces the payment so that the ESCO receives just enough to cover its performance period service costs for the month, and to pay off the loan in its entirety. The loan balance at the end of month 182 is zero, and the ESPC is complete. At the beginning of month 183 the site begins performing maintenance on the equipment. In addition, cost savings from the installed ECMs now accrue to the site.

Table 2 shows that over the life of the project, the agency pays $24,031,433 to the ESCO. Of this, $5,451,993 or 23% goes toward performance period services, $7,417,258 or 31% goes toward interest. The cost to implement the project was $10,000,000 which is 42% of the total. The finance procurement price of $1,162,182 is about 5% of total payments made to the ESCO.

SENSITIVITY ANALYSIS

A spreadsheet such as that used to develop Table 2 is also useful for determining the sensitivity of project finances to the various financial parameters. As mentioned above, one of the most important parameters is the cost of designing and installing the project. Suppose that in the course of negotiations, the ESCO reduces the implementation price of the project by 2%. We will assume that this is achieved by reducing construction payments in each month of the construction period by 2%. The total of the "Construction Payments" column in Table 2 is now $9,800,000. This has several effects on project finances. First of all, the finance procurement price drops by $23,243. Along with the drop in implementation price, this lowers the financed amount by $223,243. Since the savings are the same, the lower financed amount results in the debt being paid off in 177 months instead of 182. This lowers interest costs by about $392,000 and performance period services by $178,388. Altogether, the cost of the project to the government is reduced by $793,595 or 3.3% of the original total.
Table 2. Cash Flow for the First 13 Months and the Last 6 Months of the
Example Project (Total Dollar Amounts Paid are Included)

Month     Agency      O&M, M&V  Debt Service   Accrued    Loan Balance
         Payment       Costs      Payment      Interest

   1     $107,250     $25,000     $82,250      $63,113    $11,143,045
   2     $107,250     $25,000     $82,250      $63,004    $11,123,799
   3     $107,250     $25,000     $82,250      $62,896    $11,104,445
   4     $107,250     $25,000     $82,250      $62,786    $11,084,981
   5     $107,250     $25,000     $82,250      $62,676    $11,065,407
   6     $107,250     $25,000     $82,250      $62,565    $11,045,723
   7     $107,250     $25,000     $82,250      $62,454    $11,025,927
   8     $107,250     $25,000     $82,250      $62,342    $11,006,019
   9     $107,250     $25,000     $82,250      $62,230    $10,985,999
  10     $107,250     $25,000     $82,250      $62,116    $10,965,865
  11     $107,250     $25,000     $82,250      $62,003    $10,945,618
  12     $107,250     $25,000     $82,250      $61,888    $10,925,256
  13     $110,344     $25,625     $84,719      $61,773    $10,902,310
 1/4        1/4         1/4         1/4          1/4           1/4
 177     $159,760     $35,324     $124,435      $3,983      $584,016
 178     $159,760     $35,324     $124,435      $3,302      $462,883
 179     $159,760     $35,324     $124,435      $2,617      $341,065
 180     $159,760     $35,324     $124,435      $1,928      $218,558
 181     $164,378     $36,207     $128,170      $1,236       $91,623
 182     $128,349     $36,207      $92,141       $518          $0

Total  $24,031,433  $5,451,993  $18,579,440   $7,417,258


Another parameter that has a large effect on project finances is the project interest rate. For example, if the interest rate decreases to 6.5%, with all other parameters being equal, the term of the project falls from 182 months to 173 months. Interest costs drop by 15%, saving more than $1 million over the life of the project. The cost of performance period services drops by $320,000 as well due to the shorter project term. The lower interest rate reduces the finance procurement price as well. Altogether, reducing the interest rate to 6.5% reduces the government's costs by about $1.5 million.

The assumed energy price escalation rate is another parameter that has a large effect on the project finances. In the analysis above, the energy escalation rate was assumed to be 3%. Raising it to 3.5% increases the guaranteed savings, resulting in higher payments to the ESCO over time. With all other parameters remaining the same, increasing the energy price escalation rate to 3.5% reduces the project term from 182 months to 175 months. The cost of interest payments and performance period services each drop by about $250,000 for a total reduction in cost to the government of $507,000. Despite the reduced cost, increasing the escalation rate of energy savings increases the risk that at some future time, energy savings could be valued at a rate higher than energy costs. This would occur if energy prices increased at a lower rate than assumed.

Ancillary payments also have a large effect on project finances. In the example above, no ancillary payment was made. If we now assume the agency is able to contribute $200,000 to the project - a mere 2% of the implementation price - several changes occur. The finance procurement price drops by about $25,000. Lowering the financed amount by $225,000 results in the loan being paid off in 177 months rather than 182. The shorter term reduces the cost of performance period services by $178,000. The shorter term combined with the lower financed amount reduces interest costs by $395,000. Altogether, making an initial ancillary payment of $200,000 reduces the cost of the project to the government by nearly $600,000.

CONCLUSION

An energy savings performance contract (ESPC) is one method of accessing private sector capital to implement energy efficiency upgrades at government sites. In the US, ESPCs are widely used at all levels of government, including the federal government. Government agencies in other countries make use of ESPCs as well to finance energy efficiency projects.

Developing the balance sheet for an ESPC project is a simple exercise in engineering economics. In this paper we illustrated the cash flow for a typical project, and showed how to determine the project term.

The spreadsheet model developed for this exercise allowed us to determine the sensitivity of project cash flows to various financial parameters. It was shown that four key parameters in ESPC economics are the implementation price, the project interest rate, the escalation rate of energy savings, and the amount of the ancillary payment from savings. For the example problem, a 2% reduction in implementation price resulted in a 3.3% reduction in total project costs over the term of the project. For this reason, it is beneficial for government agencies to negotiate the best price they can for the project.

Total payments over term is also very sensitive to the project interest rate. For the example project, reducing the interest rate from 7% to 6.5% reduced total project costs by more than 6%. Thus it is also in the government's best interest to ensure that the ESCO obtains the best financing possible.

Increasing the assumed rate of energy price escalation reduces the government's costs in ESPC. For our example, raising the escalation rate from 3% to 3.5% reduced costs by about 2%. Nevertheless, increasing the escalation rate of energy savings increases the risk that at some point in the future, energy savings could be valued at a rate higher than energy costs. This would occur if energy prices increased at a lower rate than assumed.

Finally, we showed that up-front, ancillary payments from savings can result in large reductions in costs as well. For the example project, an ancillary payment of just 2% of the project implementation price reduced total project costs by 2.5%. Thus if such funding is available, it is always beneficial to make an ancillary payment.

REFERENCES

Hopper, N., Goldman, C., McWilliams, J., Birr, D., Stoughton, K., 2005. Public and Institutional Markets for ESCO Services: Comparing Programs, Practices and Performance . LBNL-55002, Lawrence Berkeley National Laboratory, March 2005.

U.S. Department of Energy, 2008. Annual Report to Congress on Federal Government Energy Management and Conservation Programs Fiscal Year 2006. November 26, 2008. Downloaded from http://www1.eere.energy.gov/femp/pdfs/annrep06.pdf.

Rushing, A., Lippiat, B. 2008. Energy Price Indices and Discount Factors for Life-Cycle Cost Analysis - April 2008. U.S. Department Of Commerce Technology Administration, National Institute of Standards and Technology. May 2008. Downloaded from http://www1.eere.energy.gov/femp/pdfs/ashb08.pdf.

DISCUSSION

Lawrence Markel, Fellow ASHRAE, Sentech, Inc., Knoxville, TN: Energy saving performance contracts (ESPCs) are a way for the government to implement cost-effective energy savings measures when there are not appropriated funds. However, government operations and maintenance (O&M) budgets are also chronically under-funded. ESPCs are a way to lock in adequate O&M, not just for the energy efficiency measures, but also sometimes to ensure adequate O&M for the existing facility and equipment, paying for the necessary O&M using future energy savings.

Jitendra B. Singh, Fellow ASHRAE, President, J&P Engineers, P.A., Linwood, NJ: It was an excellent presentation. It described very efficient methodology to implement the measures for securing energy efficiency.

John Shonder is a staff member at Oak Ridge National Laboratory in Oak Ridge, TN.

John Shonder

Member ASHRAE
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Geographic Code:1USA
Date:Jul 1, 2010
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