Financing and Performance Contracting for Energy Efficient Projects

Energy University Course Transcript

Slide 1
Welcome to Financing and Performance Contracting for Energy Efficiency Projects.

Slide 2
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Slide 3
At the completion of this course, you will be able to:
 List the main ways to pay for energy efficiency projects, and define the main characteristics of each
 Explain the concept of performance contracting and describe different ways of structuring the
approach, and you will be able to
 Explain the importance of measurement and verification to performance contracting

Slide 4
Increasing energy costs are making saving energy more and more attractive. Customers want to implement
energy efficiency projects, but are concerned about the risks. What if the investment that you make doesn’t
perform as expected? How can you invest with confidence? And where will you find the money? The
economy is tight and banks are becoming more and more cautious with regards to lending.

The good news is that you have a variety of options!

The purpose of this course is to discuss general funding alternatives including ways that you can share the
risk and increase your confidence through performance contracting.

Let’s begin with a discussion of the four basic ways to fund a project.

Slide 5
There are four basic ways to fund a project, these include:
 Cash
 Borrow
 Lease
 And Rebates / Grants / Stimulus which are all types of ―free money‖.

Performance contracting can potentially be combined with any of these funding methods to reduce your risk.
The exact situation will depend on the specific project.

Let’s discuss each one of these in more depth, beginning with cash.

Slide 6
Cash is the simplest way to pay for an energy efficiency project, and is often the most profitable, since the
company keeps all the revenue from savings without diverting any funds towards interest.

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However, many companies are simply not in a position to exercise this option for anything but small projects,
typically because their cash reserves are in short supply or they cannot justify the result on their cash flow.

Slide 7
Borrowing is an alternative to using cash. The return using this option may not be as attractive as interest
has to be paid. It’s preferable for the borrowing rate to be less than the return on the investment—in which
case, we’ll make money on the net return of the borrowed money. However, the advantages of this option
are that we’ll save our in-house cash for other purposes and the interest on our loan is tax deductible.

If you do choose to borrow, take a moment to consider how much time you are prepared to spend in
financial planning and making your case to someone else to secure funding.

Slide 8
Leasing is another popular way to provide funding for your energy efficiency projects. The advantage of a
lease is that you don’t have to find money up-front. Leases generally fall into two types:

A true Lebyase—also referred to as a ―rental‖—is tax deductible, however you won’t own the asset at the
end of the lease. That can be an advantage, because you do not have to commit to the full purchase price
of the equipment. Another advantage is that a true lease can be declared as part of your operating
expenses. It therefore, would not appear in analysis of your return on capital employed.

The other type is a Capital Lease whereby you declare the asset on your balance sheet, and apply
depreciation. You have the option of purchasing the leased item at the end of the term. This type of lease
is also called ―rent to own‖.

Note that true leases are typically subject to strict financial regulations, which will likely require that the
equipment is a temporary installation, and place limits on the total lease length and value. Financial
auditors may require any lease that does not meet regulations to be re-stated as a capital lease.

Slide 9
The fourth way to fund a project is through rebates, grants and stimulus programs. Numerous sources of
funding for energy efficiency and green buildings are available at the national/state/local levels for
homeowners, industry, government organizations and nonprofits.

Most rebates and grants are connected to a specific project and require an application process and some
level of reporting of actual results.

You can often find information regarding rebates and grants by conducting an online search.

Slide 10
It is important to understand that funding options like cash, borrowing, and leasing are almost always
available, but that rebates, grants and stimulus funding are not.

Rebates, grants and stimulus funding options are typically only available for a short time and applicants
compete for the funding, making them more difficult to acquire.

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Slide 11
Rebates, grants and stimulus funding can reduce the amount of money you need to find to implement your
project. Whether you finance the remainder using cash, borrowing or leasing can dramatically affect your
life cycle costs (LCC) and after tax cash flow. For example, borrowing has tax implications, and tax
advantages exist with true leases and with municipal bonds (where appropriate).

A financial professional should assist you in comparing your options and determining the most effective
approach for life cycle cost and tax.

Slide 12
We have seen that there are a variety of ways that you could pay for an energy efficiency project. Each of
these methods has their advantages and disadvantages. But in each case, you are typically in the driving
seat regarding the risks and the rewards. If the project works well, you get the savings. If the project
doesn’t work; well, you bear the loss.

If you’re not comfortable with that, performance contracting could be a solution to manage your risk.

Slide 13
What is Energy Performance Contracting? It is a construction vehicle and financial tool which uses the cash
flow from energy savings to pay for the improvements.

Simply put, you enter into a agreement with a private energy service company—also commonly referred to
as an ―ESCO‖. An ESCO can be a utility company, a manufacturer, or an independent contractor.

The ESCO agrees to research, design, build & support capital improvements which are expected to save
utility and operational costs. The improvements can range from new lighting technologies to boilers and
chillers, to energy management controls, just to name a few.

Slide 14
The owner pays the ESCO for those improvements from the savings obtained during the contract period.
The ESCO must "perform‖ and deliver energy and operational savings or write a check for the shortfall. The
ESCO will identify and evaluate energy-saving opportunities through an investment grade audit and then
design a turn-key package of improvements to be paid for through savings it generates.

Note that the ESCO may perform routine maintenance via an agreed upon maintenance contract or you
may opt to handle maintenance separately. In either case, be sure to record the details and responsibility
prior to entering into the contract.

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Slide 15
As with any venture, there are benefits and there are risks. Let’s take a look at these from the owner’s
perspective versus cash.

The main benefit is that neutral or positive cash flow will be generated. For many owners, performance
contracting is the only way they can afford to implement a capital improvement plan. Instead of having to
find capital, performance contracting allows you to obtain necessary upgrades using your operational
budget. There is also a strong incentive for contractor performance, and long-term maintenance provides
added value.

Conversely, the main risks of performance contracting include an unfamiliar process and a long-term
commitment.

Slide 16
Performance contracts are often attractive to owners who lack the cash to pay for projects. The ESCO is
frequently paid upfront by a third party lender: then the owner pays the lender back from the savings
realized throughout the contract period.

The ESCO may also assist the owner with obtaining financing, whether from a lender or from grant or
stimulus packages.

Slide 17
There are four classic structures for performance contracting. These are:
Guaranteed Savings—with this structure, energy savings are guaranteed. The project is structured so that
the savings provide a sufficient income stream to pay for the improvements. Most state or country laws
require the ESCO to guarantee project savings meet or exceed annual payments to cover all project costs-
usually over a contract term of 10 to 20 years (depending on state law). If savings don't materialize, the
ESCO pays the difference, not you. If there are surplus savings, they are kept by the customer.

Next we have Shared Savings—whereby the savings are documented but not guaranteed and the client
shares some pre-determined portion of the savings with (pays) the ESCO. This is now a very rare option
and has been largely superseded by guaranteed savings contracts.

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There’s also the option of Vendor Financing. With this structure, a vendor may be willing to finance the
project because the majority of the improvements will be items manufactured by that vendor. Similar to
Guaranteed Savings, however, it typically does not involve a comprehensive energy retrofit. These are also
becoming rare.

And the fourth classic structure is Chauffage, also known as managed utilities. This is a type of contract
most often found in Europe. The ESCO assumes responsibility for providing an agreed set of energy
services; for example space heat and comfort, illumination or lighting, etcetera. It is, in effect, utility out-
sourcing with the ESCO assuming responsibility for procuring utilities in addition to savings; the ESCO may
also become the facilities manager and operator in a chauffage contract.

Since Guaranteed Savings is the most common variant, we will use it as the basis for the rest of our
discussion.

Slide 18
The Performance Contracting Process involves:
 Initial business case
 Planning
 Project approval
 Implementation and commissioning
 Measurement and verification of performance
 Settlements and reconciliations
 And finally, the end of the contract

Let’s take a look at each of these points in more depth, beginning with the business case.

Slide 19
The initial business case step is used to determine if sufficient opportunity and mutual interest exists to
proceed with developing a more detail proposal.

To create the business case the ESCO will usually collect benchmark data from the owner and conduct a
site walkthrough. A brief evaluation of likely opportunities, costs and benefits is discussed. If the business
case meets the criteria of the ESCO and the owner, the project will proceed to the next step—which is
planning, so let’s discuss that next.

Slide 20
The purpose of planning is to fully describe the project so that it can be approved, and subsequently
achieves its goals. There are several topics to address:
 Scope, benefits and risks, so that both the owner and ESCO are clear on what is included and not
included
 Short term and long term payback, any hazards that are present and their possible consequences
 Measurement and verification must be planned so that it is clear how the project performance will
be monitored and evaluated
 This also allocates the risks between the customer and supplier
 Commissioning should be described to establish what actions and documentation are needed to
achieve a working project, especially documentation of properly installed/configured systems

©2011 Schneider Electric. All rights reserved. All trademarks provided are the property of their respective owners.
Typically, the ESCO will lead the preparation of the plans, and work with the customer to collect information
and preferences. A customer who is familiar with the content of a strong plan will be able to participate
effectively and maximize the likelihood of project success. So let’s take a look at each of these planning
aspects in turn.

Slide 21
When the project is scoped, the ESCO will perform a detailed audit to identify:
 Equipment condition and efficiency
 Operation and maintenance practices
 Baseline energy consumption

Factors that affect the energy use of the facility, including:

 Occupancy
 Schedules
 Weather
 Production levels
 Set points, etcetera

Slide 22
The ESCO will develop a package of energy conservation measures (ECMs) including not only equipment
upgrades but also improvements to operations or maintenance if required. For each measure the ESCO will
estimate the costs, energy impact and potential savings as well as risks of each measure, taking into
account future energy costs. Those measures should be clearly prioritized with payback period or other
financial criteria required by the owner.

Slide 23
Another key aspect of the planning process is to develop a measurement and verification (M & V) plan. A
well developed M & V plan will be based on a recognized standard such as the International Performance
Measurement and Verification Protocol (IPMVP) and will include:
 Definition of the measurement boundary for each ECM
 Identification of interactions between ECMs
 Description of how the ECMs will be measured and evaluated, including what measurements will
be taken, by whom, how often, and how they will be used

Slide 24
Here are some questions to answer while you are planning measurement and verification :
 Will the project save demand, energy—or both?
 Are there cost avoidance measures that are not conservation measures?
 Have performance tests been performed?
 How accurate does the measurement and verification need to be?
 What time length should the performance be measured?
 Will the expenses of longer measurement and verification yield sustained performance?
 Will the performance deteriorate with no measurement and verification?
 Will there be an expense of meter installation?
 Can I meter the entire facility or do I need to know the effect of each ECM (energy conservation
measure)?

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  Are new meters of benefit; can they serve an additional purpose?
 What about tenant billing or
 Utility billing verification?
 What effect will rates have on measurement and verification?
 Is the company changing operations, facilities or re-organizing?

Take the class ―Measurement and Verification with IPMVP‖ for additional guidance on how to effectively
organize this important activity.

Slide 25
The next step is project approval and signing the contract.

How can the ESCO and the energy manager for the owner maximize the chances of project approval?
Here’s how:
 Know who is the decision maker for the project
 If they use particular methods for financial evaluation, ensure the paybacks in the plan use the
same methods
 Ensure the plan provides an executive summary of the energy conservation measures in order of
priority, with clear description of financial impact
 That would include the short term and long term paybacks as well as the risks
 As far as possible, ensure the risk profile corresponds to a risk level the decision maker will be
willing to accept
 Ensure the executive summary provides a precise explanation of the measurement and verification
plan
 Be sure to detail the commissioning steps briefly and clearly, listing the responsibilities on both
sides
Slide 26
Once the project is approved, the implementation and commissioning phase of the project can begin.
Implementation is the installation of the required equipment or adjustments to existing equipment.
Commissioning in its fullest sense is the process of ensuring that systems are designed, installed,
functionally tested and capable of being operated and maintained to perform in conformity with the design
intent. It ensures that the customer’s operational needs are met, and that a facility performs efficiently,
including proper training for the building operators. Ideally, commissioning starts during design, and
continues throughout the life of the facility, to ensure that the facility is maintained to continue meeting the
needs of its occupants. Changing needs are identified and the facility systems are adapted accordingly.

Slide 27
In the context of performance contracting, commissioning ensures that the implementation meets the
definitions that were set out in the performance contract. Some important things to keep in mind include:
 Energy/utility savings begin when implementation of an energy conservation measure is complete
 However, ―implementation complete‖ does not necessarily mean that the measure is providing
peak performance or providing an adequate level of comfort
 Commissioning ensures full completion of the measure, including any additional tuning that may be
necessary to improve the performance/comfort/response of the measure
For this reason, it’s important to manage the measurement and verification process during commissioning.

©2011 Schneider Electric. All rights reserved. All trademarks provided are the property of their respective owners.
Slide 28
Put very simply, measurement and verification shows where you are and reduces your risk. Not only that,
but in order to qualify for performance contracting financing, the law or the lender may require that energy
savings be measured and verified.

Measurement of performance is simply measuring the change in energy and quantifying the savings with
the energy conservation measure (ECM) in operation as agreed upon in the approved measurement and
verification plan. The savings are expressed in both the units of energy and the financial impact of the
savings.

Slide 29
Savings cannot be measured directly, because factors that affect energy consumption change over time, as
seen in this equation:
Savings = (Baseline Period Use – Reporting Period Use)
± Adjustments

Where savings are equal to the difference between the baseline energy use, measured before the
improvements, and the post-retrofit energy usage, with adjustment for changes in the operating conditions.

The adjusted baseline is what the energy costs would have been if the retrofit had not been implemented.

Slide 30
What do we mean by adjustment? Adjustments bring energy use in the two periods to the same set of
conditions.

Let’s imagine the performance contract was targeting improvements in HVAC. Simply measuring the
energy consumption of the HVAC system will not give you the full story. For example, if the weather has
been unusually hot or unusually cold, the HVAC system will be using more energy.

Slide 31
The question is, how much would it have used if you had not done anything? Adjusting the baseline
provides a method to compare the energy use while taking into account other variables that affect the
energy consumption of a facility.

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The methods of making those adjustments must be described in the agreed measurement and verification
plan. This is one reason why the measurement and verification plan is so important. If the plan is poorly
defined, you will have difficulty establishing if the contract is meeting your expectations.

Slide 32
Conditions commonly affecting energy use are:
 Weather
 Occupancy
 Plant throughput
 Renovations or additions to facilities
 Changes in use of facilities
 Adding or removing equipment, and
 Equipment operations required by these conditions

It’s extremely important to be clear on how information will be gathered and processed as well as how it will
be interpreted and evaluated, because in many cases thousands—if not millions in compensation are at
stake.

See our class on Measurement and Verification with IPMVP to learn more about this important topic.

Slide 33
Reconciliation is the process of qualifying and reviewing the savings and finalizing the financial impact of the
project. It is the step at which the fruit of the contract becomes tangible. As a customer, your objective in
engaging in a performance contract is to obtain energy efficiency savings while sharing the risks.

Slide 34
The reconciliation step combines these elements:
In a guaranteed savings contract, if the savings are less than the guaranteed level, the ESCO and client
finalize the amount of the shortfall check. As a customer, this means that if the contract did not achieve
expectations, the ESCO pays you so that you still get the minimum guaranteed amount.

Slide 35
Measurement and verification, as well as settlement and reconciliation continue until the contract period
ends. This cycle may be annually, quarterly or monthly, depending on the contract, but a very common
arrangement is monthly analysis of measurements, a quarterly status report, and annual settlement and
reconciliation.

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Slide 36
Let’s take a moment and bring everything we’ve discussed today together by comparing the different ways
of paying for an energy efficiency project.

Our first option is to pay with cash. This option often provides the best ROI since no funds have to be used
to pay interest. However, lack of cash reserves and effects on cash flow mean that many companies can
only pay for small projects using cash.

Borrowing from a lender may not be as attractive as interest has to be paid. However, the advantages of
this option are we’ll save our in-house cash for other purposes and the interest on the loan is tax deductible.

Leasing is the next approach. Leases may offer some tax benefits, and allow us to avoid long-term
investment. However that means the lessor is providing us that additional flexibility, and so typically the
total lifecycle costs are greater than when using cash.

Finally any rebate, grant or stimulus payment will simply act as a down payment in any of the other
scenarios using cash, borrowing or leasing. One reminder: free money often comes with strings attached,
so be sure you are able to comply with any reporting requirements.

Slide 37
Performance Contracting can, and often does, include several of the financing options we’ve just
discussed—in fact, Performance Contracting can be just about anything the ESCO and you desire.
Performance contracting is often a good—if not the only—option when you can’t raise funds through other
methods.

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Slide 38
Whether or not a project is given the green light often comes down to the issue of financial considerations.
Here are some basic financial considerations to assess prior to embarking on any project:
 If you can borrow for a lower interest rate than you are earning on your fund balance, you should
borrow
o Liquidity is king, so don't tie up cash if you can access cheap money
 Project ROI or annual rate of return is often better than earnings on fund balance—so always look
at the big picture
 The longer the payback: the more improvements you can make
 You must consider your debt ceiling, you may not be able to add more debt to your balance sheet
 Your financing should be less than or equal to the average life of the project
 Large capital items justify longer financing terms
 Savings projects (Performance Contracting) allow you to raise "Capital Dollars" from your
"Operational Budget"
 Don't just look at the interest rates, you also need to consider: closing costs, first payment due date,
pre-payment penalty, etcetera
 Think about your Project Goal—it’s typically either to maximize payback or maximize
improvements

Slide 39
There are some characteristics that affect which option is best for you. These include things like your
company characteristics—availability of rebates or grants/stimulus money; tax status (tax free; low interest
bonds); paybacks and discount rate requirements, company strategy (support for maintenance, desire to
concentrate on core objectives, support of energy manager); and cash flow status.

The best option will also be affected by the project characteristics. Things like project risk; depth and
breadth of skills required; project needs for management and maintenance; equipment life and time horizon
of need are all part of the project characteristics and both company as well as project characteristics must
be carefully considered prior to making a decision.

Slide 40
Let’s end our discussion with a brief summary. Today we listed the main ways to pay for energy efficiency
projects, and defined the main characteristics of each. We’ve reviewed the concept of performance
contracting, described the different ways of structuring the approach, and explored the process from
planning through to reconciliation.

Slide 41
Thank you for participating in this course.

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