Current state of the ESCO industry

A Survey of the U.S. Energy Services Company (ESCO) Industry: Market Growth and Development from 2008 to 2011 (link to PDF is here) is the latest installment of the hugely valuable Lawrence Berkeley National Laboratory report on the current state of the ESCO industry. As with the last report in 2007, this report provides strong facts and figures to supplement anecdotes and support the trends that we see in the industry day to day. 

Just as a refresher, ESCOs are companies that help develop energy efficiency solutions in buildings.   ESCOs also generally provide a guarantee that the package of technologies component will perform as specified.  Most also help to create a situation where lenders can provide finance but do not necessarily provide the financing themselves.

 Many, but not all, ESCOs are also technology providers, the eponymous controls of Johnson Controls are one of their key products.  These types of ESCOs sell their own technology (often with a huge margin mark-up) to a building owner.

 Takeaways

The first and foremost takeaway from the report is that ESCOs continue to grow.  ESCO industry revenues in 2008 were $4.1 billion, amounting to growth of 7% per year between 2006 and 2008. Most survey respondents are estimating much quicker growth through the next couple of years as stimulus funding continues to flow into building energy efficiency retrofits.

 Second, most ESCOs are big businesses, with 88% of the industry controlled by 12 ESCOs, each with over $100 million in annual revenue. The report also suggests that consolidation in the industry will continue and accelerate over the coming years. This is driven by the structural advantages bigger ESCOs have, like investment grade balance sheets and the ability to offer broad performance guarantees.

 ESCOs are all MUSH

 84% of ESCO revenues are derived from MUSH (Municipal and state governments, Universities and colleges, K-12 Schools, and Hospitals) and federal government retrofit markets. This proportion is actually up from the 2007 report figure of 80%.

As is well documented, MUSH buildings are generally perfect candidates for ESCOs – owner occupied, single tenant, long-term ownership time horizon, and occasionally limited access to capital – making the match between MUSH and ESCOs made in heaven.  Real estate ownership is not usually the core function of the building owner; they inhabit the building to do something, rather than own the building to purely make a profit.

 Additionally, the report notes that market analysis suggests that untapped energy savings in the MUSH market could easily sustain an additional $35 billion in additional ESCO investment, which means that ESCOs can maintain consistent revenue growth by simply keeping their efforts focused on the core MUSH market.

Privately Owned Real Estate

 ESCOs are generally perceived by the private real estate market to be good project engineers.  For example, the coalition that pursued the retrofit of the Empire State Building hired Johnson Controls to coordinate and run the engineering on the full project and provide a performance guarantee.  However, JCI did not provide financing and probably would not have done this type of deal if not for the high profile of the Empire State Building.  Why is there this disconnect between ESCOs role in public and private buildings?

 For one thing, the combination of the high-credit long-term offtake of, say, a US Government tenant, and the ESCO’s performance guarantee give a project lender enough security to lend into the structure.  This doesn’t yet work at scale in the private real estate market, leaving the market on its own to develop new financing sources.

 The LBNL report offers up this additional reason for the lack of ESCO penetration in commercial buildings:

 “In the private commercial building sector, most building owners are looking for a short-term increase in net operating income (NOI), which leads them to emphasize low-cost/ no-cost operating improvements or short payback retrofits (e.g., retrocommissioning or common area lighting) rather than the comprehensive retrofit projects that ESCOs deliver. Also, during the period covered by the survey, the commercial building market has been in a severe downturn, making it difficult for building owners to finance comprehensive energy efficiency retrofits at attractive interest rates.”

 No doubt. But there is also the broader question of how ESCOs would prefer to grow. Let me explain.

 As described above, most ESCOs are big businesses, and many of them are just one smallish subsidiary of a much larger corporation. For example, Johnson Controls is a massive corporation with three major business lines and consolidated total revenues of $35 billion, but the ESCO unit is a relatively small unit for such an organization. After all, selling controls and equipment is really Johnson’s core business. The same thing is true at Honeywell.

 Growing these ESCO units at a much faster rate would require additional capital allocation from the corporate parent. However, because most of these ESCOs are not the core business, I find it somewhat unlikely that they will get more allocation of capital from a corporate board being pushed by investors. I suspect these boards view their ESCO units more as sales channels than independent business units that should be grown for their own sake. After all, one benefit of Johnson Controls being the ESCO at theEmpireStateBuildingis that they get to sell more of their own controls. The same is true for Honeywell and the other equipment manufacturers.

 This is not meant to disparage ESCOs at all. They have driven significant investment in energy efficiency over the past several decades, and will continue to do over the next several. Like many market participants, they publicly admit that the privately-owned real estate sector is still difficult to access.

The bottom line is there is a lot of opportunity out there for new financing sources to emerge alongside ESCOs to push the building energy efficiency market toward its potential.

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One Response to Current state of the ESCO industry

  1. Pingback: What do ESCOs actually do? « Financing Efficiency

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