Energy Efficiency Policies around the World: Review and Evaluation

3.6 ESCOs

3.6.1 The concept of ESCOs

ESCOs, Energy Services Companies offer energy efficiency improvement services including a guarantee of the savings.  The remuneration of ESCO is linked to the projects' performance (concept of performance- based contracting) , which means that the ESCO's payment is directly linked to the amount of energy saved.

While ESCOs are not a policy instrument per se, they are often discussed among policy instruments because they are, similarly to policy tools, important vehicles to capture energy-efficiency potentials and the business model they use, energy performance contracting, helps overcome a number of market barriers.

ESCO's usually offer the following services: development and design of energy efficiency projects; installation and maintenance of energy efficient equipment involved; finally, measurement, monitoring and verification of the project's energy savings. Financing for the investment can either be provided by the ESCO from its internal funds or by the customer, or by a third party funding (TPF), in which a financial institution allows a credit either to the ESCO or directly to its client; the loan is then backed by a guarantee for the projected energy or cost savings given by the ESCO (Figure 3.10).

There are two main models for energy performance contracting: the shared savings model and the guaranteed savings model. Under the first model, the cost savings are shared by the ESCO and the client at a pre-determined percentage for a fixed number of years (Figure 3.11). In the guaranteed savings model, the ESCO guarantees a certain level of energy savings to the customer: this model has the advantage that interest rates are usually much lower. In contrast, in the shared savings model, the ESCO assumes both the performance and the credit risk.

Development and current situation of ESCOs worldwide

ESCOs emerged in the United States in the 1970s, after the first oil crisis. Then, the concept spread to Europe where the ESCO industry has successfully developed in some countries, such as Germany, but not in others. In the 90s, the first ESCOS were created in developing countries. Today, the ESCO concept has spread with varying success to most industrialized countries, to several economies in transition and to the biggest developing countries.

The USA has always been the leading ESCO-country with a total number of about 500-1000 ESCOs today achieving an annual turnover estimated at about 5 billion US$. In the rest of the world, the success of the ESCO-industry varies widely, even within the European Union: Germany, Austria and the United Kingdom are often considered as ESCOs champions, while the Netherlands and Denmark have seen little commercial EPC, due to mandatory DSM programs and strong public involvement in project implementation. By contrast, Hungary is proud to have more ESCOs than some of the old EU-member states. According to an international ESCO-survey in 2001 , the total value of ESCO-projects outside the United States was highest in Germany with US$150 million, followed by Brazil US$100 million, Japan US$62 million, Canada, China, Poland, Sweden, Australia, Korea and others. ESCO success is not only concentrated in developed countries, but also in some developing countries. In relative terms, the USA has the highest value of ESCO projects per capita (6US$/capita), followed by Sweden (3.3US$), Germany and Switzerland (1,8 US$) and Canada. 

ESCOs are active in different sectors depending on the country. In industrialized countries such as the United States and Germany, the public sector is one of the most important ESCO clients and has even often triggered the development of the national ESCO-industry through projects in public buildings as well as through favourable legislation and financial support. The commercial sector is an emerging ESCO-client, especially in developing countries such as Brazil or India. ESCO-activity in the industrial sector often seems to be higher in developing or transition countries . The residential sector is the least important for ESCOs in most countries . This is due to the expected low profits, to legal complications between owner and tenant as well as to other factors such as difficult decision-making due to the often high number of stakeholders.

3.6.2 Barriers to the ESCO development

Some barriers are country-specific, whereas others are common for several or even all countries. Since they differ somewhat in the various sectors, sector-specific barriers will be presented first followed by general barriers.

Barriers to EPC in the public sector

Although the public sector was a trigger for the ESCO market development in many countries and remains one of the most important sectors in the ESCO activities, numerous barriers prevent the implementation of more projects.

In some countries, public authorities are cautious about outsourcing through EPC, because job losses and a loss of control over outsourced systems. Administrative procedures are often burdensome allowing for only large projects. If the energy costs are reduced through EPC the budget will also decrease, so incentives for the public authorities to use less energy are missing. In addition, if the public authority provides the financing for EPC, long-term EPC contracts are considered as a credit, which is a constraint if there are credit limits.   In most countries, many municipalities have to pay energy efficiency investments from their investment budget whereas the resulting savings are credited to the operational budget (see Annex 1). This separation of budgets does not allow cost savings to be invested into new energy efficiency improvements. 

Energy performance contracting in the public sector almost always requires public procurement and therefore needs to follow public procurement rules, such as a tendering obligation. Unfortunately, public procurement decisions are often focussed on assets rather than energy services and based only on the best price without taking into account the lifecycle costs of new equipment. It is therefore very difficult to consider EPC in public procurement.

An important barrier for EPC, mainly in developing countries, is the inadequate energy service level. If satisfactory comfort standards are not met prior to the intervention (e.g. under-heated or low lighting), this complicates the development of baselines and inevitably results in some savings absorbed to reach acceptable comfort levels.

Barriers to EPC in the industrial sector

In the industrial sector, EPC is much less spread than in the public sector since numerous problems hinder ESCO activities. In many countries, including China and India, big companies that would be the most profitable clients for ESCOs consider that they can implement and finance energy efficiency improvements themselves since they have sufficient funds and technical in-house expertise.

Therefore, they might only need an energy audit. In the United States, numerous companies do not allow ESCOs to check the core industrial processes because of fears about trade secrets and because specialized expertise and interruptions of the production would be necessary to implement changes there. For these reasons, ESCOs concentrate on standard applications such as boilers, pumps etc, in the industrial sector rather than on processes.

One of the major problems for EPC in the industrial sector is that the time spans considered in many companies are shorter than the payback-periods for many ESCO-projects: managers accept payback-periods longer than 3 years only when investments in the production area are concerned, but not for "inputs" such as energy.

In developing countries, many companies prefer to modernize their outdated manufacturing processes rather than invest their small revenues in energy efficiency.

Finally, ESCOs often consider it more risky to invest in the private than in the public sector because industrial sites might be moved to another country or location or the company can go bankrupt before the end of the EPC contract, or change production processes or lines. In addition, in developing countries where the credit system is not well developed, the private sector often involves higher credit risk, which also makes ESCOs more willing to cooperate with the public sector.

Barriers for EPC in the residential sector

The residential sector is the most problematic and the smallest part of ESCO activities. In this sector, the major barriers are the high relative transaction costs, the low level of information and lack of interest for this mechanism among building owners as well as the complexity of the decision process.

First, energy and cost saving possibilities of a single project/site are usually small compared to the transaction costs, especially in cases when ownership of buildings is shared by many private owners. Secondly, transaction costs and the complexity of projects implementation are usually high.

Many building owners also mistrust the projected saving potentials, mainly because the EPC mechanism is not understood. In Brazil, a survey was conducted among consumers, ESCOs and utilities to identify barriers for EPC in the residential sector . Building owners with higher incomes showed interest in energy savings, but not in ESCOs since they can implement energy efficiency improvements on their own as measures are simple and the amount to be invested insignificant to their budgets.

In the UK where the Energy Efficiency Commitment obliges energy suppliers to achieve energy savings with their customers, several programs were aimed at increasing the interest of consumers in EPC, but with limited success: consumers could not believe that energy suppliers were interested in reducing energy use and feared that the energy audit would be used to sell other products.

Furthermore, they judged EPC to be too complicated and not even free since they are paying a premium. Since the price for cavity insulation is very low in the UK, energy performance contracting is not considered necessary and effective. Other barriers to EPC in this sector include initial capital constraints and fiscal/VAT barriers. In Hungary, for example, EPC projects only enjoy reduced VAT rates if the ESCO operates the equipment and the project is therefore classified as an energy service project .

Barriers to EPC in the commercial sector

Barriers to EPC in the commercial sector resemble those in the residential sector. Building owners often lack awareness about the possibility of EPC or knowledge on how to implement it, but they cannot or do not want to hire an expensive adviser.  Some building owners are bound to running service contacts, others are reluctant to engage in multi-year contracts and large companies owning many buildings often have sufficient funds to implement energy efficiency upgrades themselves.

Barriers related to financing of EPC projects

Lack of financing is probably the major barrier to EPC in developing countries. Whereas ESCOs in developed countries concentrate on the technical and energy-saving efforts since a mature financing sector usually takes care of the investment, ESCOs in developing countries have to exert significant efforts to secure funding for the ESCO projects. Sometimes this means that they co-finance energy efficiency improvements as the ESCO industry is still young and unknown and the banking sector is too conservative.

Since numerous banks and financial institutions lack information about energy efficiency potential and especially experience in lending to ESCOs, they often consider EPC as a risky business, or do not fully understand the financial model involved in EPC. This is further complicated by the fact that the banks need to evaluate their clients' credit-worthiness - either the ESCO's or the client's. For this reason, they often either do not want to lend any money to ESCOs or demand high interest rates.

However, in principle sufficient money is available in the international markets: a plethora of financial support mechanisms (e.g. grants, loans, credit facilities) are offered to countries in transition and developing countries by multilateral organisations or banks (e.g. the European Bank for Reconstruction and Development (EBRD), the World Bank, the Global Environmental Facility (GEF), IFC) . However, in many other countries, the main problem seems to be the missing link between these possible sources of funding and ESCOs.

Finally, funding for EPC competes with explicit or implicit energy price subsidies, which still exist in many developing and transition countries, and other energy efficiency support mechanisms such as subsidies and soft loans provided by the governments.

To summarise the barriers; ESCOs as well as their partners (banks, clients etc.) face numerous risks when engaging in EPC (technical, financial, operational, credit risks etc.).

3.6.3 Enabling factors for a successful ESCO industry

General context

A wide variety of factors has enabled the development of a successful ESCO industry in various countries. Some of these factors, such as favourable legislation are generally important ; however, other factors are more specific to certain countries or groups of countries than others.

High energy intensities, as in Central and Eastern Europe (CEE) or in developing countries such as India, usually imply high potentials for energy savings and thereby for EPC.

General programmes and policy tools for energy efficiency even if not targeted specifically at ESCOs can still help them, including building codes, energy efficiency obligations or energy audits, since their implementation usually increases the demand for energy service providers such as ESCOs. 

 As the example of the US shows, a requirement or at least incentive to improve the energy efficiency in public buildings can be an important ingredient of success for the ESCO industry.

Demonstration projects by the public sector may be essential to increase awareness about EPC as well as trust in ESCOs among other potential clients.

Since high transaction costs are a major barrier for EPC projects, bundling projects in a pool, e.g. several buildings into one project, can be a solution in the municipal and commercial sector for lowering transaction costs . Bundling of buildings is especially important since many ESCOs and banks do not accept projects below a certain value.

Providing information and raising awareness about the importance of energy efficiency and measures to improve it is vital.  Communicating the role and potential of ESCOs in public campaigns as soon as the first EPC projects have taken off, helps to sustain the nascent ESCO industry.  Public communications about ESCOs can be done for instance by energy agencies.

Developing countries and economies in transition: special need for financial instruments

Access to financing of energy efficiency is a major barrier in many developing countries and specific support mechanisms have to be developed.

Co-financing is especially important at the beginning of ESCOs' activities in a country, since at that stage the ESCO industry is largely unknown, but subjected to similar, or even stricter treatment when seeking financing than other customer. Since ESCOs in developing countries often are not set up by utilities or other large companies, but independently, they need guarantees enabling them to receive credits from banks as well as financial support.

The Brazilian government for example has created a guarantee facility for energy efficiency projects, called PROESCO, where the Brazilian National Development Bank (BNDES) shares up to 80% of the credit risk and the remaining 20% is assumed by the intermediary bank (see Annex 1). The Hungary Energy Efficiency Co-Financing Program (HEECP2) aims at enhancing the energy efficiency financing capacity of domestic Hungarian financial intermediaries and thereby at facilitating the development of energy efficiency projects . A similar guarantee fund initiated by the World Bank and Global Environmental Facility also exists in China. Other financial support mechanisms may include partial risk guarantees, loan loss reserve funds, special purpose funds or interest credits. 

Because of limited budgets, many developing countries may not be able on their own to create guarantee funds and other support mechanisms for ESCOs. Financial support from multi-lateral banks and other agencies such as EBRD, the World Bank, the GEF and UNDP has therefore been very important.  Grants are widely used as a mechanism for supporting ESCOs as well as, more rarely, loans e.g. in China and in the UK (Carbon Trust). They may be issued as unsecured interest-free loans for SMEs.

Since international or national funds are usually not granted for a long term, it is of crucial importance to create a local banking system open for EPC financing. A mature financial industry that understands and supports EPC, or perhaps even considers it a good business opportunity (e.g. Hungary), can enable a sustainable ESCO industry.

As presented above, the major problems for banks in developing countries are lack of knowledge about EPC, high initial costs and uncertainty about the credit-worthiness of ESCOs and their clients, limited understanding of the logic of ESCO projects. Therefore, information and capacity building are important for bankers to help them understand EPC. ESCOs need also to understand how to deal with banks or financial institutions.  Energy agencies or other entities can organise training workshops and provide manuals for stakeholders (e.g. India).

The transition from public funding through subsidies or loans to commercial financing is however not easy since the former can usually give better conditions than the latter, and they might even compete with each other. For this reason, withdrawing public loans or funds as soon as the commercial banks are able and willing to engage in EPC is very important otherwise, the support programmes will only finance less profitable projects, which banks do not want to take on. One option is not to give loans or grants not ESCOs, but to set up guarantee facilities for (local or national) banks and financial institutions .

Standardisation of contract procedures and measurement and verification

End-users' and the financial community's concerns about the reliability of ESCOs can also be addressed by standardisation of contracts or key contractual provisions. Standardisation also improves time and cost effectiveness, and promotes competition and transparency (such as in Germany for instance). Standard contracts can increase the trust of customers, especially in the public sector, and thereby their willingness to engage in EPC.

They can also simplify and accelerate the negotiation process. However, ESCOs often prefer not to be bound to fixed standard contracts but develop their own unique contract approaches instead (e.g. Germany). For this reason, standardisation of key contractual provisions is often more helpful than complete standardized contracts) .

Development of Accreditation systems

Since mistrust is often a major barrier, information about ESCOs needs to be complemented by measures confirming their reliability for the potential clients. This is especially important in countries with a large number of ESCOs (e.g. accreditation system by the US ESCO association, NAESCO or the Chinese ESCO association). Similarly, the European Standardisation Organisation CEN is currently developing criteria and mechanisms for an EU-wide certification system.

Special measures to promote EPC in the residential sector

In the residential sector, new efforts such as special incentive programs are currently supporting ESCO activities and helping to achieve a breakthrough as for instance in the UK. Improving the information about energy use of buildings and introducing smart metering and billing in more buildings could also raise the consumer awareness about energy use and therefore their interest in EPC .

Other supportive policy measures include demand-side management or energy efficiency obligations (e.g. UK with the Energy Efficiency Commitment ). Furthermore, the EBRD has created a credit line for EPC in the residential sector in certain countries.

Special measures to promote EPC in the commercial sector
Since large building owner companies frequently outsource the building management and operation to facility managers, combining EPC and building management by the ESCOs or the facility managers is a new and promising model. Similarly, EPC is increasingly combined with leasing, which companies prefer due to its balance-sheet benefits.

Necessity of country-specific approaches

Although experience can be shared and lessons learned from others, measures rarely fit all countries, especially since barriers are often country-specific. International donors and governments have to adopt a country-specific approach in each case. When choosing the ESCO business model, for example, some countries or sectors might favour the shared savings, others the guaranteed savings model. Building owners with little experience in energy efficiency often prefer the guarantee of savings, whereas industrial facilities are more interested in the shared savings model. The choice should finally be made by the local market.