Energy Performance Contracting: an alternative financing scheme

Written by Eurac Research

Energy Performance Contracting (EPC) is an alternative financing scheme for capital improvement which allows funding energy upgrades from cost reductions. Under an EPC arrangement an external organization (ESCO) implements a project to deliver energy efficiency, or a renewable energy project, and uses the stream of income from the cost savings, or the renewable energy produced, to repay the costs of the project, including the costs of the investment. 
The remuneration of the ESCO depends on the achievement of the savings. The ESCO stays involved in the measurement and verification process for the energy savings in the repayment period. Energy performance contracting are mostly found in the public sector and to a lesser extent in the industrial and commercial building sectors (Hilke and Ryan, 2012). 

The approach is based on the transfer of technical risks from the client to the ESCO based on performance guarantees given by the ESCO. In EPC ESCO remuneration is based on demonstrated performance; a measure of performance is the level of energy savings or energy service. EPC is a means to deliver infrastructure improvements to facilities that lack energy engineering skills, manpower or management time, capital funding, understanding of risk, or technology information. Cash-poor, yet creditworthy customers are therefore good potential clients for EPC.

In the European countries, the major performance contracting models are:

1. First out
  • ESCO investment is 100% paid by achieved energy savings
  • Contract duration depends on level of savings, but will last until ESCO is fully repaid

2. Guaranteed savings
  • ESCO guarantees performance, customer has credit risk and repays loan by achieved savings
  • If guaranteed savings are not achieved, ESCO has to pay for debt difference
  • If guaranteed savings are exceeded, customers pays negotiated fee to ESCO
3. Shared savings
  • Customer takes over some performance risk, ESCO takes customer’s credit risk
  • If ESCO takes full financial risk, EPC is considered as off-balanace sheet at the customer

4. Chauffage (form of energy management outsourcing)
  • ESCO only takes responsibility for energy service (e.g. space heat)
  • Different forms possible: pure chauffage model may only include efficiency measures on the supply side, whereas integrated models combine measures/physical investments on the supply and demand side
  • Customer pays as much as before minus a percentage saving for defined contracting time (up to 25 years)

In general EPC have many benefits, such as:
  • (immediately possible) reduction of operating costs;
  • facility improvement, solution to a specific need such as heating system refurbishment;
  • alternative source of facilities funding - budget relief and financial risk relief; if ESCO takes over financial risk the EPC is considered as off balance sheet for public customers (no increase of public debt)
  • outsourcing of non‐core activities to focus on mission;
  • simplicity of having a single source provider;
  • technical risk management and guaranteed performance
  • environmental benefits including improving the quality of the indoor environment and GHG emission savings induced by the energy savings.

Especially for bigger institutions EPC is an adequate method to shift the technical risk of an efficient operating (energy) facility to the contractor. Some experts recommend to evaluate the EPC method if the annual energy costs exceed € 20.000 - € 25.000 or 160 MWh. Then the EPC can cause cost advantages.

A core element of the EPC is the contract negotiation. If the contract tends to prevent incentives of the contractor or the host-institution, it can lead to the double-moral hazard problem. 
The double-moral hazard problem is caused because of the host institution is not interested in energy savings, when paying a fixed fee to the contractor. In this case the contractor has the greater risk to run the facility properly. Therefore, the negotiation of the contract is a crucial step within the EPC method. For example, the shared savings concept lead to positive influence onto the energy facility not only coming from the contractor, but the host institution.

To sum up, EPC can be an appropriate way to manage energy facilities with benefits for both parties. Although, as mentioned before the parameter-setting of the contract is a necessity to create incentives to save energy (and money) for both parties involved in the EPC process.

Within eCentral, EPC will be tested in the renovation of ‘Pestszentimrei Vackor Óvoda’, a kindergarten placed in the XVIII District of Budapest. The goal is to deep-refurbish the building and turn it in a nearly Zero Energy Building (nZEB). The EPC model that will be implemented is the Guaranteed Savings (GS), as a predominant model. This kind of financing scheme is not common for Hungary, where no other public buildings have ever been renovated this way. Aim of the project is to develop a best practice to be replicated and transferred to other public buildings.