Energy Performance Contract (EPC): its Real Value
Many of you surely came across with another type of EPC, which is a whole different story, and it’s not what this post is about.
A few of you probably heard of an Energy Performance Contract.
My experience says that even those few have not fully grasped the potential of it.
In my opinion it is the Holy Grail of Energy Efficiency, the type of arrangement that every energy manager should strive to sign.
For public institutions, most of the times it is the only way to perform a deep renovation without affecting their budget.
If you are a private company, it gives you some guarantees that no other agreement can give you.
As a professional I always tried to take different angles to look at an EPC to make sure I could convey its full value to my counterparts.
Bear with me if you want to know more about it.
The classic definition of energy performance contract
Under an EPC, an external organization (an Energy Service Company – ESCO) implements a project to deliver energy efficiency over a certain number of years (the duration of the Energy Performance Contract).
The cash from achieved energy savings is used to repay the costs of the project, including the initial investment.
If such level of savings is not achieved, the ESCO pays a penalty.
The latter is the fundamental brick of the Energy Performance Contract.
A less traditional interpretation of an EPC
The first challenge for an ESCO is to identify all cost savings that the proposed solution will bring to their client.
In other words the ESCO has to deeply analyze the Total Cost of Ownership (TCO) of every alternative solution.
TCO is made up by Investment costs, service costs, operational costs, insurance costs, energy costs and other fees for the whole duration of the Energy Performance Contract.
The ESCO needs to compare the TCO with the overall savings which can guarantee with the chosen solution.
And here’s the tricky part.
There are costs which are known and visible (investment, spare parts, etc.).
There are other costs which are hidden and must be made explicit. Typical example are the maintenance activities performed by the client’s employees or the energy consumption.
I often use a picture of an Iceberg to explain this concept.
The solution which ensures the best results not necessarily is the one requiring the lowest initial investment (the emerged part of the Iceberg).
The best solution is the one represented by the smallest Iceberg as a whole.
The importance of contractual penalties
Some companies which pretend to be ESCOs offer something they call EPC but miss the most important element of an Energy Performance Contract: the guarantee of achieving the designed savings.
Why is it is important?
First of all it is very important from a commercial point of view.
As a client, I feel much safer in buying such solution, because I know I am contractually covered against negative results.
Secondly, and in my opinion most importantly, it is an implicit form of control put on the ESCO.
No ESCO will be risking to pay penalties by guaranteeing impossible savings. No project manager will promise extra fast returns on investment unless it is 100% sure of the technical solution proposed.
The client has the assurance that what proposed by the ESCO is achievable, affordable, reliable and financially viable, for the whole duration of the Energy Performance Contract.
A Trusted Control System
There is one risk though. The client might feel that the ESCO is not being transparent in measuring the results of the EPC.
To avoid disputes on the data provided, it is of the utmost importance to share and agree in which way EPC data are made available and verifiable by the client.
An efficient and transparent control system is the basis to reinforce the trust bond between the ESCO and its client, and it constitutes the basis for evaluating the success of the Energy Performance Contract.
Chief Financial Officers love EPCs
An Energy Performance Contract does not necessarily imply that the needed investment is financed by the ESCO.
It is true though that most of the time financing constitutes an essential component of it.
By carefully crafting the duration of the EPC with the savings achieved against the ESCO’s monthly fee, it is possible to ensure that the given solution creates positive cash flow from day 1.
And CFOs love projects creating positive cash flows.
The second thing which CFOs consider very valuable in an Energy Performance Contract is a direct consequence of contractual penalties: costs predictability.
If contractually defined savings are not achieved, the ESCO will pay penalties making up for the financial value of the missed savings.
This means that CFOs can put a safe number in their budget, regardless of the actual results delivered.
The shared bonus for extra savings
In Energy Performance Contracts it is good practice including a clause which entitles the ESCO to invoice half of the financial value of savings exceeding the ones contractually defined.
Let’s say that in a lighting modernization project 500 MWh savings per year are guaranteed and the real savings are 550 MWh. The ESCO will invoice the shared savings bonus for 25 MWh times the electricity price.
Why should the client agree to such clause?
It’s easy to say.
If I am financially motivated to achieve higher savings than contractually agreed, I will tweak and adjust the technological system in order to maximize such savings.
If I do not have any motivation, i will just do the needed minimum just to be sure I won’t have to pay any penalty.
A relief for the Energy Manager
Another professional who, for different reasons, looks at the Energy Performance Contract with satisfaction is the Energy Manager or the Chief Operational Officer.
By signing an EPC on a given system upgrade they basically outsource the technological risk embedded in any modernization project.
I wrote in a separate post how companies are still finding hard to overcome some barriers on the energy efficiency path. Well, one of these barriers is the uncertainty on the optimal technical solution to be adopted in an energy efficiency project.
An EPC allows the Energy Manager to hedge such uncertainty against the contractual penalties described earlier.
EPC is a win/win/win solution
As you probably noticed I am a huge fan of the Energy Performance Contract.
You cannot find another business model which manages to satisfy the needs of so many stakeholders without impacting on the final result.
Even if EPCs are mostly popular within the Public Sector, I believe there is a big potential also in the private sector, especially in times of volatility and rising energy prices.
The latest issue of the European Energy Efficiency Directive has given to ESCO companies delivering EPC projects many tools to be successful in the market.
In general, EPCs are regarded as one of the best models to lower energy consumption without impacting on public debt.
Do you have experience with Energy Performance Contracts? Are there other advantages that you believe should be stressed and that i did not mention?
Please feel free to leave a comment or contact me in case you would like more information on EPCs.