Energy performance contracts offer higher efficiency at lower costs, but there are risks

Energy performance contracts might sound like the new kid on the block. They’re not. They’ve got a very mixed track record. Better for big institutions such as RMIT and the NSW hospital? Certainly. Suitable for green bonds and environmental upgrade agreement? Probably. But they’re full of traps for the smaller contractor, and could leave little room for continual improvement. An interesting point. We speak to four companies in this space, AECOM, Honeywell, CarbonetiX and COzero

Energy Performance Contracts offer a fairly attractive proposition – scope out a bundle of energy-efficiency measures, leverage the financing, and contract the energy services company to deliver the works. And it comes with a guarantee that the investment will be repaid by the savings in energy spend within five to eight years.

But it’s never so simple. There is a range of risks, including unforseen changes to the client’s energy footprint, shifts in pricing for plant items and the potential for a “rest on the laurels” approach that can reduce a client’s commitment to ongoing improvements.

The other major issue for ESCOs is that at the end of the day, they are contractually obligated to “carry the can” and compensate clients if the projected energy savings do not measure up.

Ed Brown

Ed Brown, AECOM associate director – property consulting, says the model, which originated in the US, is “very biased towards the public sector”.

“The challenge facing private operators [of facilities] is very different in terms of the challenges of managing assets,” Brown told The Fifth Estate in a recent interview.

“For large portfolio holders it is a large opportunity. EPCs are not risk-free, and the risk and reward is different across sectors.”

Currently the only government-funded EPC scheme is in New South Wales. Brown says the Federal Government’s Direct Action policy is proposing a similar model, but that while a standard EPC uses utility costs as the measuring stick in terms of savings, the DA proposal will potentially use kilowatt hours.

The advantage of the model, Brown says, is that it allows projects to combine numerous smaller initiatives that facility managers may have found it difficult to convince management to invest in into one project.

“That means having one conversation instead of lots of them, and the project is underpinned by savings guarantees.

“EPCs also tend to be a larger contract than business as usual, and as it is a larger and more intensive program, ESCOs can engage the top end of the [subcontractor and supplier] market.”

He says an EPC can set up a good delivery with security of supply founded on long-term client relationships that extend from the initial install plus the seven to eight year measurement and verification period.

“It’s not the traditional tender-build-leave [approach]. The supplier is engaged in defining the scope, delivering, and having a long term relationship across the verification.”

This does mean, he says, that an EPC can only really be successful if it is a “trust-based” agreement.

“The client is passing a lot of control over to ESCO in terms of scoping and framing and delivery, the mechanisms aren’t set up to allow you to fight over how to achieve it,” Brown says.

Another upside of the model is there has been little sign of a “race to the bottom” on pricing, as the model is based on a simple seven to eight year payback.

“The larger the project the more attractive it becomes [to clients] because of greater payback, in principle the fundamental mechanism says the more you can do and meet payback, the more likely you are to win the tender.”

Private lenders are keen to be involved

Where projects are not government-supported, clients still need to develop a business case for financing, but it is one Brown says has a “reduced risk incentive” because of the performance guarantee.

“Large lenders are aware of this and are keen to lend against it. It comes down to the client’s credit rating, and becomes a case of securing debt.”

Green bonds potentially could offer another means of financing.

“In principle EPCs and green bonds are a perfect marriage. EPCs want finance, and a green fund wants to find well structured, low risk investment opportunities with a strong environmental set of credentials.”

The biggest challenge here is probably scale, Brown says. Funds tend to want large investments so whilst large single EPC might work, the market might require an aggregation mechanism.

“We should be looking to learn from the US here as the investment market is more mature,” he says

Russell Evans

Russell Evans, AECOM project director on the largest EPC being undertaken in Australia, the RMIT Sustainable Urban Precincts Program, says the EPC model is a reflection of the journey of the Australian energy efficiency market.

New goes is to de-risk ageing infrastructure

Initially, he says, the key goal was reducing greenhouse gas emissions, whereas now as the market has matured, it has become “a model to de-risk ageing infrastructure.”

“A major driver for an EPC is to accelerate improvements in failing infrastructure,” Evans says.

His experience on a major EPC project in the US for a large university showed that the consistency aspect of working with one contractor for a number of projects within a single contract created standardisation. It also allows the client to bundle together the “low hanging fruit” with other items.

Another challenge is the need for clients to align their own behaviour around the new model as opposed to the traditional design and build contract.

But clients also need to scrutinise ESCOs in terms of the company’s track record and capabilities.

There’s a request for proposal stage, when an ESCO will carry out a sample audit of a few buildings, and present the findings.

A detailed facility study that precedes the actual contract may take an ESCO between four months and a year. During that time, the ESCO will explore the range of technologies and options that will fit within the client budget.

Ultimately, clients are looking for “the right partner”, but they also need to understand the products involved.

“The challenge of the ROI model is the need for an understanding of the investment and the maintenance required to service that investment within the M&V period,” Evans says.

“All parties need to share information about trying to find that balance.”

Evans says the strong business case built by an EPC can help building managers and services engineers overcome the challenge of demonstrating to upper management that a suite of measures are an investment the company should be making.

“There is a lot of information behind an EPC,” Evans says.

How ESCos carry risk for government – the CarbonetiX view

Lou Bonadio, chief executive of CarbonetiX, one of the ESCOs on the Victorian Government’s EPC provider panel for the Efficient Government Buildings Program told The Fifth Estate although there were some strong elements of the EPC model under the program the firm was supportive of, there are some “areas of deficiency” that proved problematic in the design and execution of projects.

The way the program is designed, initially three short-listed ESCOs need to deliver a comprehensive request for proposal study in response to an invitation to bid for a EGB project. Bonadio said this entails multiple site visits and applied expertise in order to properly scope out projects, estimate costs and assess risks and may take several months to complete. The sore point and inevitable commercial reality is that only one of three ESCOs would see that intensive effort rewarded with a contract to carry out a DFS. Bonadio suggests perhaps the selection of the successful ESCOs could be made earlier in the procurement process.

There is a further complication, Bonadio says, in that it can be a prolonged wait from when the DFS with its comprehensive pricing of plant, labour and equipment for proposed works is completed, and the point when project works commence. He said additional contingency costs to accommodate exchange rate fluctuations or approval delays can compromise viability of the EPC versus other project delivery models.

Project works under the EGB Program require the approval of the client (the government agency that is the building or site tenant), the relevant government department with jurisdictional control of agency operations and Treasury before the DFS is accepted.

“Nominated contractors and suppliers cannot be reasonably expected to hold their fixed pricing for extended periods. So when approval delays extend into two years or more, the inevitable price increase on original tender pricing must be absorbed by the ESCO,” Bonadio says.

The bottom line, Bonadio says, is that the EPC model under the EGB program means ESCOs are shouldering the majority of risk on behalf of the government and for smaller organisation like CarbonetiX the risk can be highly risky and prohibitive.

“The other problem [in our experience] was that the stipulated payback period of seven years, that may be applicable for commercial buildings, may not be for other types of infrastructure the government owns and operates. For example, we have been upgrading pumping stations under an EPC for Grampians Wimmera Mallee Water, where investments for capital upgrades and allowance for depreciation is much longer.

“It is a credit to our engineers that were able to identify deep cuts to energy consumption and emissions and still meet the seven year payback criterion. They was done through extensive analysis of the extensive and complex water distribution network and carefully designed pump replacement and improved operational controls,” Bonadio says.

“In most cases the traditional Design and Construct is a better model and proven to work best for these type of projects.”

Big ticket energy-efficiency moves slide off the menu

Bonadio says the EPC model also encouraged the ESCO industry to continue to gravitate towards the “low hanging fruit” of simple projects such as lighting upgrades.

“Measures such as HVAC upgrades and optimisation, replacement of process and building controls, facade upgrades, double-glazing etc. could not be considered as part of your solution suite,” he says.

“Inevitably to win EPC work, the selection and balance between measures providing energy and therefore GHG emissions reduction was dictated by S&I costs per unit of GHG emissions saved and not simply dollars saved. The extent of GHG emissions reduction was a key selection criterion in the assessment of EPC proposals, so the implementation of low emission technologies such as solar PV installations was given a strong impetus under the program.

“In the absence of a commercial driver for carbon or GHG emissions reduction as existed with the EGB Program, there is no financial incentive for investment in low emissions technologies (LET) over and above utility savings. The cost-effective gains for energy efficiency are around technologies such as upgraded control systems, and these cannot be seen in the same way, and can be harder to have ESCOs and clients include in an EPC project.”

As for deep whole-of-facility retrofits, where the majority of ageing plant is overhauled or taken out and replaced, “this would be out of the question with an EPC dictated by a seven year payback. But that [lack of uptake] is not unique to EPCs,” Bonadio says.

“In the current climate of phasing out a carbon price, the incentive for implementation of LETs comes down to our clients’ long term corporate aspirations and voluntary commitments to address carbon abatement and sustainability across the board”

Bonadio says the depth of knowledge and abilities in terms of Measurement and Verification on the part of the ESCO are keys to successful outcomes on both sides of the contract.
“It’s not about the size of the ESCO, it’s about their depth and breadth of knowledge, the quality of its people and their auditing and project management processes and their ability to make quick assessments of opportunities and associated risks that are not always of a technical nature,” he says.

Overall, he says if EPCs are to be reinstated as an effective procurement model for commercial buildings or other projects, ERF or otherwise, it would be “worthwhile and highly advisable” for the governments, both state and federal, to engage with and undertake broader consultation with ESCOs and representative bodies and building owner/operators on a workable EPC model.

Honeywell’s global perspective

Honeywell has undertaken numerous EPCs in the USA, New Zealand and also in Australia, and are currently undertaking one of the works packages for the RMIT project. The firm was one of the founding members of the Australasian Energy Performance Contracting Association in 1998.

In 2009, AEPCA evolved into the Energy Efficiency Council. The EEC continues to provide resources around EPCs, including AEPCA’s Best Practice Guide for EPCs, in addition to a broader suite of policy, advocacy and support for the energy efficiency sector.

John Boothroyd

John Boothroyd, Honeywell’s global service and energy marketing leader says that one risk it is important to manage is ensuring the assumptions on the use of a facility – and therefore its energy footprint – are clear. Should a facility’s energy use change considerably, there is a risk the ESCO may find itself liable for a shortfall in contracted energy savings.

“EPCs are founded on a well thought through measure and verification plan and these, in turn, are founded on a strong baseline – the measurement of energy use before the project – and a solid understanding on what drives changes in energy use,” Boothroyd told The Fifth Estate.

“If it is known that a facility’s use is going to change considerably, this can be factored into the base-lining and measurement approach.”

In terms of the commercial property sector, Boothroyd says that it is probably one of the easiest sectors in terms of predicting facility use, as while tenants may come and go, overall density changes are manageable, if they occur.

“The NABERS rating scheme includes mechanisms that give you a handle on how changes to occupancy can make a difference,” he says.

The big risk in this sector would be extended periods of non-occupancy.

Some of the types of assets where facility use can change dramatically are prisons, which can one year function as a prison, and the next as a detention centre, and this changes the energy footprint substantially.

Boothroyd says that ultimately, for an EPC, it is best to choose facilities that are stable in their use. Hospitals are another example of facilities where this is the case.

NSW is mobilising

The NSW Government is currently mobilising a program for EPCs starting with the health sector under the NSW Treasury Loan program.

Boothroyd says that environmental upgrade agreements can also use EPCs as the contract and delivery mechanism.

“An EPC brings together skills and funding under a contract with skin the game, and with that guarantee, clients can look bigger and more long-term,” he says.

It is a market that has had its ups and downs, and still remains the domain of the bigger players, as it does require a depth of ESCO experience and financial backing to deliver successfully.

“[The ESCO] does need to have a balance sheet to take the risk aspect, as an ESCO commits to a contract that during the monitoring phase obligates them to pay any shortfall in savings,” Boothroyd says.

“For smaller potential clients, such a single school, an aggregator would generally be required to put together a package of numerous similar clients. This is a common model in the United States – the $26 million, 92-building project for Worcester City Council, Massachusetts being a case in point.

“There’s a bit of effort required to structure the contract, and a minimum project size to make it worthwhile.”

One of the factors that is reducing ESCO and client risk is the increasing sophistication of monitoring and submetering equipment.

Boothroyd says that in the past, installing metering throughout a building would generally form part of the scoping phase. However, with the “massive streams of data” now being produced by BMS systems, and by meters in some plant items, this data can also be used to track performance.

Honeywell’s ATTUNE Continuous Commissioning technology, for example, can pick up something that’s not working as soon as it happens. Boothroyd says this means both the ESCO and the client can be very confident that savings are being delivered and reduces risk considerably during the Monitoring and Verification phase.

The “set and forget” trap – COzero on EPCs

Geoff Alexander, executive director of COzero, says the company had experience servicing clients with existing EPCs and found they had real difficulties for both clients and for the contractor.

“When you break it down, it is hard to establish who is responsible for what,” Alexander says.

“It’s a good concept, the idea is right, but the execution has been difficult. We prefer to take the approach of a simple fee for service that delivers maximum savings to the customer while reducing consumption on an ongoing basis.”

One of the limitations he observes is that an EPC presupposes there will be a specific package of works, and then essentially the client will undertake no further activities to reduce energy during the five year monitoring and evaluation period.

“EPCs can act as a barrier to implementing further initiatives, creating arguments about where the savings should be apportioned. It’s more a once-off ‘everything’s fixed, it’s all good now’ approach, where ‘set and forget’ is seen as enough.”

Another issue is that while energy performance may be excellent in the initial post-works period, things then “drift”. This creates an issue for the contractor in that they become financially liable for the shortfall in energy savings.

Logically, this suggests that monitoring alone is not sufficient, but that ongoing re-tuning, re-commissioning and potentially further upgrades to items of plant of specific systems could be required during the post-works period – potentially adding a further cost burden to the contractor.

“I like EPCs in theory, but in practice, the line becomes blurred in terms of who saved what.”