Top 5 Reasons Why ESCOs Have Failed to Realize the Full Potential of Energy Efficiency – Part II

This audio was created using Microsoft Azure Speech Services

Studies and analysis conducted by organizations and think tanks such as Lawrence Berkeley National Laboratory, International Energy Agency, Global Building Performance Network, and McKinsey among others have repeatedly highlighted the importance and attractiveness of energy efficiency (EE) by showing the levelized cost of various energy efficient technologies to be lower than many power generation technologies. Barring a few success stories to scale up the potential of EE (see Figure 1 below), it has been a long and continuing battle to  implement and execute EE projects around the world that have fulfilled the potential of this sector in tackling climate change and helping develop a greener and cleaner economy. While this is a topic of immense interest for researchers and policy makers because of the complexity and multi-dimensional nature of the subject, there is no denying the fact that EE will continue to generate significant interest in the lead up to the COP15 meeting in Paris in 2015 and beyond.

Figure 1: Size of the current and projected ESCO Market in the US (source: Navigant Research)

What can we learn from success stories in Germany, Japan, California and New York, and also more recently in China and other parts of the world; that can allow developing countries to avoid the mistakes and tap the potential by unleashing all the benefits of EE on their economies? The slow pace of the realization in the face of the tremendous potential of this sector has also led to much hand wringing and frustration by businesses and also policy makers as the EE community has learned that “one size does not fit all” but has not yet been able to discover the magic formula. This is a follow up to the Part I of the blog that was published earlier this year. The 2^nd part of the blog (uses the same structure as the first blog) is focusing on the delivery mechanism for scaling up energy efficiency in different sectors with a focus on developing regions of the world and in the process provides insights and suggestions on overcoming the regulatory, financing, risk mitigation, measurement and verification (M&V), and project development cost related barriers faced by energy services industry.

1. Gap between technical payback estimates and techno-commercial ROI calculations

• Bundle the technical and financial risks and hold one company accountable for performance shortfall: Investment Grade Audits (IGA) or Detailed Project Report (DPR) must be developed by the ESCO that will ultimately also execute the project and provide performance guarantees. The proposal to the customer must distinguish between simple payback technical calculation (preliminary audit) or a cash flow based financial analysis taking into account the full cost of implementing the project (IGA), which will elicit significantly different levels of effort and expertise needed to put the different pieces of the performance contract together. The entire life cycle of ESCO projects along with the risks and responsibilities need to be better thought through in developing countries where the capabilities of the ESCOs, maturity and investment capabilities of the customers, the regulatory and incentive regime, and the ability to enforce contracts is vastly different from mature economies.
• Full Service ESCO Model Vs. Specialized and On-Demand Services Model: While the government and Development Organizations need to think about which model will work best for a region or country, ESCOs will also need a more agile and adaptive model when a region or a country is trying to develop its ESCO market. Issues related to capability or competency of key technical staff, using an alliance or partnership model to plug offer gaps, technology and solutions that will be critical to the success of an ESCO in a developing region will require strategic discussion and decisive decision

2. Return on Investments for ESCOs and Financial Institutions are not commensurate with the efforts and risks involved

• Target and qualify the right customer by focusing on these key questions:
  Does the company have an energy or carbon reduction target at the facility or, better still, at an enterprise level? Is the sector in which the company operates required to achieve energy savings targets under a national or regional regulation? Identify organizations having energy or carbon reduction targets, a culture of Energy Management and projects supported by top management through “executive sponsorship” and an internal champion who will be held accountable internally on successful execution and performance of the project.
  Does the company have a Key Performance Indicator (KPI) driven culture related to energy or carbon management? Do they have an advanced metering infrastructure or, better still, an advanced Energy Management System (EMS) that is being used by the facility or the enterprise to their advantage? As the sayings go, “energy efficiency starts at the meters” or “you can’t manage what you don’t measure” – a well designed and functional EMS can be a great tool during the assessment and planning phase of any energy efficiency project. This will not only reduce the cost of conducting IGA; but the quality and the reliability of the recommendations as well as the confidence in the M&V efforts will be far superior.
• Be strategic in selecting the right technology and sectors. This is a very critical component that ESCOs need to spend some time answering before venturing into the market. For instance, plug and play technology such as LED lamp replacements for existing lighting in commercial, industrial and street lighting sector is relatively straightforward and easy to implement. On the other hand, getting into an HVAC retrofit project involving equipment replacement, building controls optimization, etc. requires significantly more domain knowledge, appropriate selection and right-sizing of the equipment, commissioning and fine tuning advanced controls that are in turn dependent on many sensors and meters and finally on the outdoor and indoor environment parameters, which will all affect the operation and efficiency of the HVAC system. One doesn’t have to be a rocket scientist to figure out which project is simpler and likely to succeed and deliver verified savings. With respect to identifying the right sectors that can benefit from energy services, there are huge opportunities in municipal and small and medium enterprises in emerging countries because the existing infrastructure in towns and cities is inefficient and the technology and energy management systems deployed in the SME sector is obsolete leading to lots of wastage in energy and production.

3. Long project development cycle and high financing cost

• Focus on technology specific, replicable EE projects which will reduce the development time and project financing cost: Specific EE measures such as street lighting, water pumping, district heating/cooling, simple sub-metering and energy management systems in the SME sector and enterprise energy management system at building portfolio level, combustion efficiencies of furnaces, installation of variable frequency drives in varying load applications, etc. can deliver very attractive returns of investments for the customer and can help in creating an energy services market, where it is needed the most. It also helps the ESCOs in directing their focus where projects are likely to be funded and there is a higher probability of delivering the savings. Based on my personal experience of working in the sector in the US and in India, it is tougher to distinguish on the quality of “professional services” in the early stages of ESCO market development because of the absence of larger and more complex EE projects in emerging markets.
• Address Financing Provisions for EE Projects
  Low-interest financing for EE projects: As shown in Figure 2 below and because of the huge co-benefits that the ESCO industry can deliver (lowering the energy intensity of the economy, mitigating climate change through EE, creating green jobs that creates real and tangible benefits for economy and environment, help countries embrace latest technology, etc.), it needs to be supported by policy makers in a much more industry friendly and aggressive manner. This can be done either by capitalizing on the interest rate arbitrage between developed and developing countries or by making use of the capital being made available to the developing countries under the UN Green Climate Fund or other special vehicles that could be used for EE financing.

• 

  Figure 2: Co-benefits from EnergyEfficiency (Source: IEA)

  Work with a small number of financial institutions with specific mandate to provide EE financing: Lessons from around the world indicate that one needs to work with a smaller group of specialized financial institutions at the initial stages of ESCO market development. Financial institutions that are selected to participate in the initial pilot program should demonstrate a high level of commitment to EE financing at the top management level and there should be performance targets that should be given to the participating banks if they are likely to receive special considerations and low-interest capital to finance EE projects. There is a need to conduct capacity development of both EE and finance professionals in a much more serious and result oriented way so that one can start to see a pipeline / execution of EE projects approved for financing.
  Operationalize a Partial Risk Guarantee Facility: These schemes which are jointly developed by the government and multi-lateral and development banks must be more practical, light on the paperwork, and focused on making funds available where these are needed the most. ESCOs are constrained for capital and more support needs to be provided to ensure that working capital is not tied up in unproductive ways and that the ESCOs can receive full payments on time once it has been demonstrated that the performance criteria have been met.

• Provide project facilitation support to sign more contracts and close the deals: Development of a cadre of well-trained and experienced Project Facilitators – a concept pioneered by the Federal Energy Management Program in the US, who are well-versed in both the concepts and the details of performance contracting – technical, financial, and legal issues that both ESCOs and customers are likely to face – can be quite helpful in reducing the project development time and costs if their KPI is linked to the signing of contracts and the successful execution of projects. The project facilitators can help tremendously as they act as neutral 3rd parties with the necessary technical and practical understanding (very helpful to ESCOs) and an ability to evaluate, challenge, and make recommendations to the customers (very helpful for customers and financial institutions). The fact that they are neutral parties and paid by the government greatly helps in reducing the project development cycle and cost – a huge plus for the market.

4. Extremely narrow margin of error in critical facilities and the importance of simple and yet rigorous measurement and verification (M&V)

• More often than not, success in business and policy depends on identifying what NOT to do rather than what to do. There is clearly a case for simplifying the entire ESCO market development initiative and breaking it down into bite-sized pieces. I have argued earlier in the article to focus on simpler and easily replicable EE measures. For that reason, complex projects requiring detailed engineering, precise commissioning, and involving dependencies across different systems should be strongly discouraged in emerging ESCO markets. These projects need to be left to service providers with proven track records and expertise.
• Adopt/Adapt International Performance and Measurement Verification Protocol (IPMVP) and best practice M&V concepts to develop more prescriptive guidance for specific EE project categories: The foundation of any good EE program or project lies in good accountability. This is true irrespective of whether the context is developed or developing country, negawatt generation in buildings or industry, or quantifying the CO2 mitigation benefits from the implementation of EE programs and projects. The comprehensive and sound technical information that is informed by experiences in different countries around the world and based on the fundamentals of science and statistics must be deployed. There is a need to encourage and support efforts to adapt international best practices to the local context so that the benefits are accrued in the most cost-effective manner, without the need for re-inventing the wheel, in a way that it is immediately applicable and relevant to the local context and specific applications. This will help create a simple yet technically rigorous framework that will strike the right balance between the needs to grow the industry fast and to ensure the credibility of the ESCO market to deliver energy and cost savings based on sound M&V.

5. Key policy mechanisms necessary to make ESCOs successful missing in most countries

• Ask the question whether the ESCO model is the right instrument for the country or sector: This is not only a fundamental question for businesses but also for policy makers. If the answer is yes, significantly higher level of support – both through policy mechanisms and through a well-crafted incentive structure – must be provided during the market development stage. Policy makers need to better understand the needs and issues of the end customers and service providers and relate it to the policy and incentive structure. Experiences from around the world shows that it is extremely challenging for the ESCO industry to develop organically – at least during the early stages.
• Provide sustained program support and incentives to kick-start the industry: Unfunded and severely under-funded programs supporting ESCO market development have not helped the cause of the industry. Managing unrealistic expectations by pitching “Paid from Savings” model as the panacea for solving all EE implementation issues need to stop. While the concept of “performance contracting” is simple and very attractive, the devil is in the details – borne out of experience in national and regional programs. While there certainly are benefits such as awareness creation on the various market-based mechanisms to implement large scale EE projects, the absence of dedicated programmatic support and sustained EE project financing either through a government program or in partnership with a bi-lateral or multi-lateral program become crippling barriers that very few emerging market economies are able to overcome if left to their own devices.
• Developmental organizations and multi-lateral institutions and foundations need to raise the bar for providing technical assistance to governments: Armed with hindsight, a much better model would be to spend much more time identifying and supporting a country or region that is ready to embrace EE and energy services and is willing to commit and go beyond unfunded policy mandates. Otherwise precious time and effort is spent with little to show for spanning years and decades – more out of hope rather than substance.

This two-part blog has been an attempt to strengthen the business case for EE and help develop it as a planetary resource, with sustained involvement and support of policy makers and businesses, since EE continues to be the cheapest, fastest, and cleanest form of energy but which continues to face challenges and barriers in scaling up and becoming the 5th fuel.