Pick up an energy efficiency conference brochure and chances are there will be a dedicated session on Energy Service Companies (ESCOs). Talk to a top-level policy maker in any country or region where energy security and energy prices are national issues and once again developing the energy services market remains one of the top demand side initiatives. Against such backdrop, what are the reasons why we still, barring limited success in the US and China, largely seem to be talking only about the “potential” of ESCOs to scale up the energy efficiency project implementation at a national or sectoral level. Here are my top five reasons:
- Gap between technical payback estimates and techno-commercial ROI calculations: Quite often, the customers expectations are based on a previous energy audit or an internal study which typically uses a simplistic calculation to show paybacks of 2-5 years using low-cost interventions – at least in developing countries. ESCOs, when asked to provide a performance guarantee, will add installation and commissioning services, project management, financing, technical manpower, M&V cost, and their margins to design and execute the project involving performance guarantees. The break-even point typically doubles from the simple payback calculation that many customers start out with.
- Return on Investments for ESCOs and Financial Institutions are not commensurate with the efforts and risks involved: A “full service ESCO” needs expertise in energy assessments, engineering design and solution development across many critical systems and processes, project management and execution, project commissioning, facilitation of 3rd-party financing, measurement & verification, and risk management. Professionals with excellent technical knowledge and experience are much more likely to be running a small consulting firm specializing in 1-2 skills outlined above than be part of an ESCO where risks are much higher. This, coupled with the critical role of measurement and verification (M&V) in “paid from savings” contracts and repayments linked to “proven energy savings” casts a lengthy shadow from the Finance and Risk Management team of ESCOs especially if returns are not in line with risks.
- Long project development cycle and high financing cost: ESCOs have faced continuous challenges because of the fact that typical project development time for an ESCO project is between 12-24 months depending on the maturity of the customer and the energy services market. Further, many projects are aborted for one reason or the other after significant investment of time and effort has been made by the ESCOs to educate the customer on the subtle nuances and details related to ESCO projects. This coupled with the fact that rate of borrowing in many developing countries has been quite high has led to a competition between “internal projects” where energy efficiency projects have to compete with other business proposals with a requirement of Net Present Value positive in 2-3 years. In many situations, where there are attractive energy efficiency projects with excellent ROI, the banks are not willing to extend a loan without burdensome collateral or other onerous terms and conditions that the customer is unwilling to accept.
- Extremely narrow margin of error in critical facilities: While critical facilities (e.g. manufacturing, data centers, laboratories or clean rooms, industrial facilities involving specialized processes, etc.), where energy cost is a significant cost of operation, are willing to pay the kind of professional fees that ESCOs would like to get, they typically expect a very high service standard and may include stringent liability clauses in case things don’t go as planned. The number of ESCOs who can be trusted to execute a critical project within the allocated shutdown time while satisfying all other performance parameters is quite small thereby limiting the potentially accessible market for a traditional ESCO. These projects are typically performed by highly specialized, sector or process focused companies where “the one shop window” business model is not considered feasible. Further, we have seen that many avant-garde customers with a very strong facility management team opt to get consulting and engineering design advice from an ESCO or an energy assessment firm and choose to execute the project themselves through their preferred vendors or sub-contractors.
- Key policy mechanisms necessary to make ESCOs successful missing in most countries: The governments of two countries where ESCOs have been reasonably successful – US over the last decade and a half and China over the last few years – have made it possible by promulgating ESCO-friendly regulations and rigorously enforcing them. The fact that US Federal buildings have large energy bills, have aging infrastructure, and are required to reduce their energy bill under Energy Policy Act and subsequent Executive Orders coupled with really low interest rates during the same period and consistent technical support and project facilitation from a very strong Federal Energy Management Program has led to a billion dollar energy services market. China has increasingly placed a strong emphasis on energy efficiency of its industries and its buildings and because of its relatively healthy economy has been able to provide sizable incentives to ESCOs operating in China to undertake energy efficiency projects on a large scale. While Europe’s policy makers have consistently talked about the need for deep retrofits to improve the energy efficiency of its building sector and did establish the Emissions Trading Scheme (EU ETS), these measures have led to, at best, mixed results for the ESCO industry. In many developing nations, ESCOs have largely been supported through pilot projects carried out under multi-lateral bank’s and development organisations’ projects and have largely failed to gain traction once the support has been withdrawn.
In part 2 of the blog, I’ll be talking about some of the approaches or solutions that are likely to mitigate, if not, overcome the challenges outlined above. We certainly need some new thinking that can facilitate in the large scale implementation of energy efficiency projects – something that is sorely lacking. That may strengthen the business case for energy efficiency and help develop it as a national resource since energy efficiency continues to be the cheapest, fastest, and cleanest form of energy but which continues to face significant challenges in scaling up and becoming the 5th fuel.