Friday, November 12, 2010

A Bright Idea: Energy Services Agreement

Versions of this entry can also be seen at Tyler Hamilton's Clean Break blog (http://www.cleanbreak.ca) and here at Energy Management (http://www.energymanagementcanada.com).

Introduction

Energy retrofits of industrial and commercial buildings have recently proven to be one of the more popular initiatives for Canadian landlords and tenants (“project proponents”) seeking to brandish their green credentials or, simply enough, to save money. However, comprehensive retrofits can be quite costly with high initial capital costs and long payback periods. Incentives such as the federal government’s ecoENERGY Retrofit, BOMA Toronto’s Conservation and Demand Management (CDM) $60 million fund and Toronto Hydro’s Business Incentive Program have been attempts to make some of these investments more palatable to building owners and operators.

Unfortunately, for energy efficiency enthusiasts, these programs are generally limited-time offers and may not coincide with building maintenance or budget cycles. (In fact, both the ecoENERGY Retrofit and the BOMA Toronto CDM programs will be shut down by March 31, 2011.) What other options does a cash-strapped business have to conduct electricity conservation projects on their properties? One solution that is currently overlooked, but may prove more appealing as incentive programs are phased out, is employing an Energy Services Agreement (“ESA”).



The Case for Energy Retrofits: Lighting Improvements

Energy retrofits in general, and lighting retrofits in particular, have proven remarkably reliable in offering predictable paybacks to project proponents. One such cornucopia of successful projects can be found in the Greater Toronto Area’s Pearson Eco-Business Zone. The Zone’s 12,500 businesses along with the Toronto and Region Conservation Authority and the Greater Toronto Airports Authority recently embarked upon a partnership called Partners in Project Green with the mutual understanding and drive to restore, protect and enhance the area’s natural resources.

Businesses within the Zone have already demonstrated the success of retrofit projects including:
  • Velcro Canada’s lighting retrofit, which resulted in a 50% reduction in energy use, better lighting and will save the facility more than $42,461 annually. The company did, in fact, offset part of the cost with a $28,000 incentive from the ecoENERGY Retrofit Incentive program but regardless would have enjoyed a net payback estimated at slightly more than two years.
  • Nahanni Steel Products Inc.’s $58,000 lighting retrofit is expected to yield a net simple payback period under one year after taking advantage of incentives.
  • The International Centre commitment to becoming a sustainable environment and leading venue of choice for socially-minded businesses and individuals involved a reduction in energy consumption of 335,000 kWh by retrofitting their light fixtures, increasing operational efficiencies and monitoring energy usage.
  • IPEX Inc.’s $102,000 lighting retrofit project in 2009 has yielded electricity savings of about $56,000 per year. Incentives substantially reduced the payback period to 1.7 years, but it’s clear there was a relatively short payback regardless.
  • Jervis B Webb launched an Energy Management Program in the summer of 2009 but started with lighting. A lighting retrofit saved them $67,000 with a payback period of less than 6 months.
Although, each of the above projects took advantage of government incentive programs, the figures demonstrate that these programs only accelerated what would have otherwise been a predictable and relatively short payback. However, it is understandable that a lack of incentives may make the business case slightly harder for potential project proponents. One other complication facing a potential building retrofit project is how to divide the costs and savings between property owners and their tenants. Many existing leases make a landlord responsible for capital expenditures and the tenant responsible for rising operating costs. An ESA may be one way to address both of these concerns.

The Energy Savings Agreement

An ESA outlines and addresses the design, construction, guarantee, and follow-up monitoring of energy-saving projects. Generally speaking, an ESA establishes a building’s baseline energy use, adjusted for weather and occupancy, for a fixed period of time pre-retrofit. A party other than the property owner (e.g. contractor, third party financing company) will pay for the retrofit and earn its revenue when the project proponent remits energy savings realized against the baseline to the financing entity.

Arguably, the most popularized form of ESA is the Energy Savings Performance Contract (“ESPC”) employed between a US federal agency and an energy service performance company (“ESCO”). Under an ESPC, the ESCO finances, installs and maintains new energy efficient equipment in the facilities at no up-front cost to the government. The ESCO is paid back from the energy savings of the contract, which are contractually guaranteed to exceed payments. According to the US Department of Energy, more than 550 ESPC projects worth $3.6 billion have been awarded as of March 2010. These projects have shaved an estimated 30.2 trillion Btu annually resulting in savings of $11 billion in energy costs.

Natural Resources Canada has also developed an approach to carry out energy efficiency projects using ESAs (referring to them as energy performance contracts). According to NRCan, over 86 retrofit projects have been implemented using ESAs, attracting $320 million in private sector investments and generating over $43 million in annual energy cost savings. The projects have been responsible for 15-20 percent in energy savings and helped to cut greenhouse gas (“GHG”) emissions by 285 kilotonnes.

Broadly speaking, contracting parties have the choice of two different contract options: the first-out performance contract or the shared savings performance contract.

First-Out Performance Contract

Under this version of an ESA, the ESCO finances the project and retains all the energy savings until the project is paid for or until the end of the contract, whichever occurs first. A contract may stipulate a maximum return on investment in this case, thus triggering contract termination if the ESCO realizes this return prior to the contract’s expiration. Should the ESCO fail to realize its return before contract expiration, the contract terminates as originally intended, and payments to the ESCO stop.

In the public sector context, the ESCO is required to declare its investment up front, including all costs and mark-ups. Any percentage margin allowed to the ESCO is fixed. As noted above, at the end of the contract or when the contract has been paid for, the building retains all subsequent energy savings. This may not always be the case in the private sector where an ESCO and its client are more likely to enter into negotiations over the payment duration. The contract will ultimately be concluded if both sides perceive they can extract sufficient benefits from the project.

Shared Savings Performance Contract

With this contract, the ESCO and project proponent each receive an agreed-upon percentage of energy savings over the life of the contract. The catch here is that even though a project proponent may start to realize a financial benefit earlier that a first-out performance contract, this type of contract will run for a significantly longer period of time. Otherwise, the two contracts are substantially similar.

The ESA’s Key Elements

Some of things that may be considered when drafting an ESA include:
  • Type of Contract: As the above discussion noted, there the parties have contract options when drafting the form of payback to the ESCO.
  • Scope: ESAs can be drafted to be limited in scope and only address a simple lighting retrofit or may prove to be more ambitious and include a package of improvements.
  • Energy Usage Records and Data: The ESCO requires access to the historical energy consumption, building operations and occupancy data in order to develop a baseline utility consumption. Some industry participants recommend a minimum of 24 months of data. Existing facility conditions, operations and equipment needs to be carefully recorded in order to establish an accurate baseline.
  • Energy Savings Calculation: Careful drafting is required to ensure that an agreed-upon baseline energy usage is clearly described and how future energy usage is calculated in order to derive the difference from which the energy savings will originate.
  • Partial Savings: For more comprehensive projects, a project proponent may start to realize energy savings before the full completion of the retrofit. An ESCO will probably want to ensure it captures these early savings.
  • Incentive Ownership: Parties will have to agree on who will apply, monitor and benefit from any government incentive programs for a retrofit. Typically, a project proponent will have to make the application, which means if the funds are being reimbursed to the ESCO, a mechanism to deliver those funds must be created.
  • Post-Installation Relationship: The ESCO and project proponent may revert to a simple financial arrangement post-installation or the relationship could deepen as the ESCO provides staff training and long-term maintenance services. This will depend on the scope of the improvements.
  • Ownership of Environmental Attributes: Given the potentially significant reductions of GHG emissions from a retrofit, or portfolio of retrofits, it is possible there may be some value attached to those reductions. It is important to understand which party will take ownership of these  attributes in the event they can eventually be sold on a voluntary or mandatory carbon market.
Benefits of Employing ESAs
  • Better Buildings: Updating or replacing old and/or obsolete equipment with newer, more efficient technologies, will result in higher-quality systems, fewer breakdowns and reduced maintenance. Improved lighting, better air quality and more comfortable room temperatures, could reduce absenteeism and increase employee productivity.
  • Cost Savings: Once the ESCO is compensated for its services, the project proponent will benefit from significant energy savings a reduction of long-term maintenance costs.
  • Established Technology and Expertise: With the proliferation of energy retrofit incentives over the past decade, ESCOs have developed considerable experience with improving technologies and savings calculations. Moreover, ESCOs have a financial incentive under an ESA to ensure the most suitable equipment is used to achieve and maintain the promised savings.
  • Limited Sacrifice: An ESA enables a project proponent to undertake an energy efficiency project now without the necessary funds. Improvements are affordable even when facing budget cuts or competing priorities.
  • Prudent Investment: Utilizing an ESA allows a project proponent to divert funds that would otherwise be spent on energy bills into other investments. For governments, this means limited budgets can stretch further, putting taxpayers’ money where it really counts. For private sector property owners, more modern, efficient energy systems can increase property value and improve marketability of the property.
  • Reduced GHG Emissions: North American buildings contribute more than 1/3 of the continent's GHG emissions and energy retrofits could prove to be the cheapest, quickest and most significant way to reduce them.
  • Stakeholder Relationship-Building: An energy retrofit is a demonstrable contribution to sustainable development and may not only generate excitement in a building’s community, but also enhance its goodwill in the marketplace as a progressive green business.
Conclusion

As government intervention in the building retrofit market recedes, it is clear that the commercial real estate market and its approach to energy efficiency will be dramatically different in the coming years. ESAs can help property managers deal with these changes by providing reliable benefits with minimized financial risk. At the end of these contracts, property owners will own modernized energy-efficiency equipment and inherit substantially reduced energy bills.

Epilogue

Once a building has undergone a successful energy retrofit, it may then consider using a Green Lease to arrange the energy consumption and maintenance rights and responsibilities of the landlord and tenant. That's a topic for another day. 

Sunny days,
~Rob

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