What do ESCOs actually do?

 

One of the persistent questions we hear when discussing energy efficiency is “What about ESCOs?  Why can’t they just do all of this stuff?”

 

It seems that there is a disconnect between what Energy Services Companies (”ESCOs”) actually provide to building owners and what many in the market think they provide.  Understanding the nature of what ESCOs do will help the market to better understand the requirements for future solutions.

 

What do ESCOs actually do?

ESCOs sell, design, and manage energy efficiency projects.  They often provide a long-term performance guarantee to a building owner, which gives the building owner comfort that the forecasted savings will be achieved from a technical perspective.  Other important variables that drive potential savings, such as operations of the building or the mix of tenants, are not covered. Basically, the ESCO just provides a guarantee that the equipment will work as expected.  In some cases, the ESCO will actually operate the project over the long term, too, which helps to minimize the operational risk of a project. 

 

It’s worth noting that many of the largest ESCOs also own equipment manufacturing companies.  As we mentioned in our last post on the ESCO industry, many ESCOs are viewed by their corporate parents almost purely as another channel to sell equipment.  Case in point: the acquisition of YORK by Johnson Controls in late 2005 helps to highlight the degree to which ESCOs are focused on selling equipment as a primary concern.

 

One thing ESCOs generally do not do, however, is provide financing for projects they are involved in.

 

The ESCO generally expects to be paid for its work at the completion of the project.  This means that the building owner / project host needs to have the full amount of capital on hand at completion to pay the ESCO.  Some owners – the very small minority – will just pay outright for the project.  However, the vast majority of owners involved in projects with ESCOs will have to source third party capital for the projects.

Financing considerations

 

In almost all cases, this capital will take the form of traditional corporate / parent entity level debt. To be more explicit, third party financing virtually never lends directly against the energy savings produced by a retrofit project.

 

Because so many ESCO deals are in the MUSH (municipal, university, school and hospital) sector, this financing is often sourced from the municipal finance desks of banks. Issuing debt to fund a retrofit is no different from issuing debt to fund anything else a municipality might want to invest in. The key variable that a lender would evaluate is the municipality’s overall credit quality, not the guarantee from the ESCO.

 

The key question of whether capital is available for the “ESCO model” is not whether a performance guarantee is in place but rather whether the host is willing to assume additional debt at the parent entity level.  Virtually all energy efficiency deals that are financed by a third-party rather than paid for by the host owner require a credit worthy recipient of debt.

 

If a building owner is sufficiently creditworthy and is willing to guarantee that payments will be made regardless of project performance, then there is little reason for a financial institution not to provide financing.

 

Without an ESCO guarantee, the bank is likely still comfortable that the debt will be repaid due to the host’s credit quality and the nature of the debt which has recourse to the host’s assets. All the ESCO’s performance guarantee does is to help the host get comfortable that it will have funds available to service the debt.  Banks may prefer to lend to projects that are managed by leading ESCOs, but this is likely due to avoiding scenarios where litigation or other complications occur.  The bank only sees a creditworthy entity taking on more debt.

 

Building owners can also use an ESCO for project management of energy efficiency retrofits and to provide a guarantee. The financing would then be sourced elsewhere.  This is how the Empire State Building retrofit worked, for example – Johnson Controls managed the project and provided a guarantee, but the building’s owner Tony Malkin put down the money for the project. In that structure, Malkin was basically just buying insurance from the ESCO that the project will perform as expected.

ESCOs are great, but can’t solve everything

 

ESCOs provide a valuable function in the market.  They offer expert engineering services, performance guarantees for projects, and integrated project management services.  However, they are not a one-size-fits-all solution to the barriers preventing private building owners from pursuing energy efficiency.  Understanding exactly what an ESCO does – designing, selling, and managing project, possibly with a performance guarantee – is useful.  They do not guarantee to provide payments to lenders, and they do not offer financing directly to building owners themselves. 

 

So while ESCOs play a large and beneficial role in energy efficiency today, new financing mechanisms and business models beyond the ESCO will need to emerge in order to scale retrofit investment in private real estate.

Advertisements

2 Responses to What do ESCOs actually do?

  1. Brenden says:

    Hey guys, great post. I think one reason there’s so much confusion in the market about what ESCOs actually do is because of their historical role as companies. Traditionally (decades ago), ESCOs simply aggregated their customer’s load together and shopped directly for energy supply — gas, oil, and electricity — on whole sale markets so their customers could pay wholesale prices instead of purchasing energy directly from utilities. ESCOs were traditionally a way for large companies and industrials to find 3rd party supply.

    I think this historical remnant is important for understanding how ESCOs think about projects, and why they often are most interested in equipment sales. A company like Trane, for example, is going to be very different from a company like Constellation New Energy that is a much more traditional, 3rd party supply, ESCO.

    Anyway, informative post as always, keep ’em coming!

    • Ben says:

      If there is a service problem, for instance — cut wires as a result of a storm, will the ESCO or ConEd come to the rescue. At present, we call ConEd, which responds promptly and doesn’t charge.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: