The Financial Benefits of Energy Savings Performance Contracts
Energy Savings Performance Contracts (ESPCs) are an excellent way to procure facility modernization improvements within the confines of your existing Maintenance & Operations (M&O) budget. M&O costs associated with utility expenses and lower deferred maintenance expenses will decline such that savings can be reallocated to pay for the new equipment and systems via a Tax-Exempt Lease Purchase (TELP) or other financing agreement. As such, ESPCs can be an excellent alternative to traditional payment methods like bonds or cash.
Introduction to ESPCs
While cash flow neutral financing within an existing M&O budget is a major financial advantage of ESPCs, there are many other reasons to use this method regardless of your funding source. This resource article will dig in to five additional financial advantages of energy saving performance contracts vs. traditional funding and construction methods.
Reason #1: ESPCs provide better cash flow
Let’s suppose you plan to pay for upgrades gradually through allocated budget dollars in the coming years. While this may seem like a prudent strategy, the cost of waiting often offsets the benefits of avoiding interest expense. Let’s look at an example for an Advanced Metering Infrastructure (AMI) project, which municipalities can complete through an ESPC.
Suppose you plan to complete a $1.75M AMI project and are considering self-funding the work by budgeting $437,500/yr over 4 years. Let’s also assume the benefits of this project once completed will be $150k/yr between increased water revenue ($100k) and decreased operational cost ($50k). We’ll assume installed cost ($1.75M) will be the same in either method. This is a reasonable assumption since the gradual approach would lose economies of scale benefits and increase risks associated with price increases due to inflation, while the performance contracting approach would incur ESCO and financing expenses.
In the cashflow, we’ll assume a 3% annual water rate increase, 2% annual operational cost increase and 3% interest rate. To be conservative we won’t assume an internal cost of funds for cash.
Given all we have going on in this scenario, we need to discount back our 20-yr cashflow on net savings to today’s dollars to compare. For this we used the Net Present Value (NPV) calculation. When using NPV we must assign a discount factor or “hurdle rate”. We’ll use 6% here, but it could be any value for our comparison.
What we see is that using the ESPC method yields a NPV of $605k vs. $222k for a cash payment method (remember, with Net Present Value more value is better). This means that in today’s dollars, using an ESPC to implement saves an extra $383k! The avoided interest expense saved by paying cash is quickly offset by the cost of waiting to realize full benefits.
Note that in this example we didn’t assume any increase in cost over the 4 years due to inflation or the management and oversight of multiple construction projects. In reality, inflation has a very real impact on cost over time. This is especially true for construction costs in high growth areas like Texas. Assuming a 3% inflation cost neutralizes the cost of interest over those first 4 years. In fact, many ESPC financing options allow the first payment to be deferred 1-2 years, which means you can buy now at a current price and realize the benefits of a fixed payment long after inflation has increased cost for everyone else.
There are many additional benefits of having a single project all completed at once vs. multiple projects over time. Spreading out the work ties up employees longer, incurs multiple mobilization costs, and increases fixed costs. For example, suppose you’re replacing 40 rooftop units and choose to install 10/yr instead of all at once. This means you’ll need to have a crane rented 4x rather than 1x, increasing total fixed cost for the same job.
Reason #2: ESPCs offer reduced risk with integrated design and delivery
Energy Service Companies (ESCOs) provide both design and construction services when delivering an ESPC. This means you’ll get a fixed cost contract that guarantees the project will be delivered for the agreed upon price.
Integrated design and delivery also puts you, the owner, in control of the products and vendors used in your project. Rather than always getting the low bid product or vendor, you can work collaboratively with your ESCO to choose what is best for your situation. This avoids the common complaint of performing M&O services for different systems in different buildings and ensures you’re optimizing purchases for their lifecycle cost and not just first cost.
When selecting an ESCO, be sure to talk with them about their integrated design and delivery capabilities and ensure the contract provides these owner options.
Reason #3: ESPCs offer lower first costs
This may surprise you as being a benefit since an often-heard criticism of ESPCs is that they are more expensive than other construction methods. While this criticism can be true, it doesn’t have to be if you select the right ESCO.
Since ESPCs are primarily focused on cash strapped institutions, providers sometimes take advantage of the situation and charge higher margins (30%+). Performance Services has much lower overhead expenses than many of our publicly traded manufacturing competitors and passes along the savings. Our transparent, open book pricing ensures the margins we charge are often much lower than traditional construction pricing.
Traditional construction fee structures have overhead and profit spread across several entities including architects, engineers, general contractors, and construction managers. When comparing the net result of these compounding and additive margins vs. a single provider you’ll generally find our ESCO fees to be lower than a Design-Bid-Build or Construction Manager at Risk approach. The result is the owner can save 10-20% on constructed cost with an integrated design and delivery approach.
Reason #4: ESPCs offer performance guarantees
When you buy a piece of equipment outside of an energy savings performance contract, you’re acting on good faith that it will operate as efficiently as promised. If for some reason it doesn’t perform, you may never know it (are you leveraging Measurement & Verification of savings?) and are on your own to resolve the problem if you do.
For this reason, new buildings built with design-bid-build construction often must be re-commissioned 1-5 years after opening to align actual performance to design. Energy models may say a building will operate at a certain efficiency, but actual performance is often way off target.
Guaranteed savings contracts ensure your ESCO has a long-term vested interest in your success. Here at Performance Services, we stay closely involved with the building operators for the first year after construction as part of our 4 Season Optimization process. This ensures the systems are tuned to your climate and usage patterns. After Year 1, monthly, quarterly, and annual reporting ensure you get the savings you planned when you made your investment. If performance starts to slip, we’ll engage with the operators to solve the problem before it costs you big dollars.
Reason #5: ESPCs don't have to be funded through bonds, allowing you to keep them for where only bonds can be used
Depending on your situation you may prefer to use your M&O or I&S budget to fund your ESPC. In Texas, as many states, either is allowed. This is an advantage as you can achieve the many benefits an ESPC provides while matching up the best funding source for your situation and budget.
Traditionally, M&O funds were used for quick payback items (Lighting, controls, etc.) while I&S was used for more capital intensive upgrades with little energy savings (roofing, HVAC, etc.). An ESPC allows a shift between these where M&O can be used for more infrastructure projects or I&S for quick payback items. Let’s look at an example where you might use each.
If you don’t have existing bonding capacity and lack the ability to raise a bond, funding within M&O is preferred. The typical mechanism for this is a Tax Exempt Lease Purchase (TELP) and it is perhaps the most common funding source and reason for an ESPC. The cost of issuance on a TELP is usually less than a bond while borrowing cost are similar. This allows for a fast, cost effective way to address a mix of quick payback and long payback upgrades.
However, some situations lead to I&S funds being favored. In Texas, the passage of Senate Bill 2 during the 86th Legislative Session put a 3.5% cap on annual M&O tax revenue increase for cities. Since this puts more focus on managing M&O cost but doesn’t directly impact I&S a city with bonding capacity may choose to fund their ESPC through their bond, which allows all the savings to stay within M&O without requiring it to bear the cost as well. This is an effective strategy to “free up” room as M&O costs increase in other areas.
Guaranteed Energy Savings Performance Contracts offer a host of benefits beyond providing an alternative procurement option within your existing M&O budget. Whether you recently passed a bond or are fortunate enough to have cash in the bank, let’s sit down to discuss how an ESPC can be the best implementation method for your next infrastructure project. Learn more about how to get started implementing an Energy Savings Performance Contract.