An overview of the ESCO industry

An overview of the ESCO industry

The following is the text of my presentation made in Cairo on the 18th December 2023 at a UNIDO organised event presenting the results of a project on ESCO contracts completed by a consortium consisting of Eenovators, ep Group, Sheeta Law and Eng. Mohamed Atef.

The problem

It is always important to start with defining the real problem that we are trying to solve. It is important to focus on that and not be distracted. The problem we are trying to solve, as energy efficiency and ESCO professionals, was defined perfectly in COP28, and that is to increase the average rate of reduction in global energy intensity to 4% per annum, compared to historical levels of 1% to 2%. At the COP more than 110 countries committed to double the rate of improvement in energy efficiency by 2030.

How do we increase the rate of improvement in energy efficiency? Although better energy management, i.e. better managing what we already have, can undoubtedly help, the real key is investment in projects that improve energy efficiency. The IEA’s surveys of energy efficiency investment show this is running at about $600 billion per annum. We need to triple this rate of investment and bring it more in line with the investment in energy supply.

How do we increase investment in energy efficiency? To answer that we need to consider a systems view of the process of investment in energy efficiency, which as in other areas, goes through generic five stages, starting with origination, (the idea), and goes through development, underwriting, financing, building and operating. We know from many, many studies in all sectors, in all countries that the potential for energy efficiency projects is huge. Any decent energy efficiency consultant can go into almost any building or industrial facility and find some potential energy efficiency projects. The problem is that there is a huge ‘development gap’ between the potential, and having practical, financeable projects. Energy efficiency is no different to other energy sources in this respect, there is a big gap between a geologist saying for example, ‘here is an oil field’, and having a functioning, producing oil well. The potential for energy efficiency is huge, the volume of projects being developed at any time is much, much smaller, and the volume of projects being financed at any time is much smaller again.

It is clear that we need to grow the volume of projects under development and the volume of projects being financed. So what drives those volumes? They are driven by four factors: the demand for energy efficiency projects; the capacity to develop projects; the capacity to finance projects; and the volume of finance available to fund the projects. The demand for energy efficiency is critical, decision makers, whether in industry and commerce or in the residential market, need to demand projects. This requires them to know what is possible and what the advantages are likely to be, and we all need to recognise that strategic benefits e.g. increased building value or improved health outcome, are more likely to make decision makers demand energy efficiency projects than just energy cost savings.

Developing projects requires technical and financial skills, as well as human skills – development is a process that can be taught. Even if projects are being developed there needs to be capacity to finance projects which requires building skills in the finance industry. When the wind industry started in the early 1990s there was very little capacity in the finance industry to finance wind projects, at one time the only bank in London that knew anything about wind power was Bank of America because they had financed wind projects in the USA.

The final lever is the volume of finance, this can of course be finance that is labelled as ‘energy efficiency’, which can be made available through various financing instruments, or it can be general finance such as regular commercial loans that is applied to energy efficiency projects. Ultimately the volume of capital is not a constraint because the capital markets are so large – it is more about the demand and the capacity to develop and finance projects.

What is an ESCO?

The Global ESCO Network has defined an ESCO and highlights three critical aspects that distinguish ESCOs from other types of companies. These are:

– ESCOs deliver energy services and energy efficiency improvement measures in a user’s facility

– The improvement measures are based upon a holistic analysis of the users energy and resource demands

– The payment for the services is based, (either wholly or in part), on the measured and verified achievement of energy efficiency improvements and of any other agreed performance criteria.

History of ESCOs

It is often said that ESCOs were invented in the USA in the 1970s. This is an ocean and 200 years away from the truth. ESCOs were invented by Matthew Boulton, who partnered with James Watt in the 1770s. Boulton and Watt sold Watt’s more efficient steam engine to mines, where they were typically used for pumping water, and took payments based on the savings in coal. These were the first ESCO shared savings contracts.

The modern ESCO of course did start in the 1970s with two models emerging – in the USA the Energy Performance Contract (EPC) developed and in Europe the ‘chauffage’ or heat service model was more common. In the 1980s the EPC model spread into Europe, in the UK both the oil majors BP and Shell created subsidiaries offering EPCs although the most common projects were replacing coal or oil fuelled boiler houses with new, automated gas fired boiler houses which reduced energy and labour costs.

In the 1990s the USAID spread the ESCO model around the world, although it has to be said that they promoted the concept but didn’t really talk about the finance aspects, which in the USA at least was usually based on cheap municipal or federal funds, funds that clearly not available outside the USA. In many markets utilities entered the ESCO market, proclaiming themselves as energy service companies and ESCOs as the future. This all went into reverse after the collapse of Enron, where Enron Energy Services was an innovative form of ESCO that provided both energy supply and energy efficiency projects on a service basis. The models pioneered by Enron Energy Services at least in the UK, went onto success under RWE Solutions. Following the collapse of Enron utilities came under pressure to focus on core business and retreated to that, selling off or closing their ESCO arms.

In the 2010s interest in energy efficiency started to grow again and we saw the emergence of the Super ESCO model, pioneered by Dubai in the form of the Etihad Super ESCO. We also saw some innovation in contract forms emerging but EPCs remained the dominant contract form.

According to the IEA the global ESCO market accounted for $40 billion of investment, so about 7% of the total investment in energy efficiency. Although the energy efficiency industry gets very excited about ESCOs, at $40 billion of investment, the whole industry remains very small. The oil majors Shell and BP have a combined annual capex of circa $38 billion and Aramco has a capex of circa $52 billion. If we are going to triple the investment into energy efficiency we need to (at least) triple the capital invested through ESCOs.

ESCO models

There are varieties of ESCO models. Every text book or paper on ESCOs presents the ‘shared savings model’ and the ‘guaranteed savings model’. Most contracts in practice are guaranteed savings – early shared savings contracts in the US often ended up in bankruptcy of the ESCO or expensive legal arguments about the actual level of savings. Shared savings are often presented as a magic bullet that helps finance energy efficiency but advocates of this model forget that the ESCO, any ESCO, has a limited balance sheet, (however big), and can’t take on more and more finance as they do more and more projects. Also the model requires them to effectively take on the credit risk of the client, something that banks and financial institutions are better qualified to do. ESCOs need to use their expertise to take and manage technical risks, banks need to take financial risks. ESCOs financing projects themselves can work if there is a way of recycling the cash flows through a forfaiting facility.

The other ‘traditional’ ESCO model is ‘chauffage’ or Outsourced Energy Management. In this model the ESCO builds a stand-alone plant, often a boiler house or a Combined Heat and Power (CHP) system, and supplies heat, (and power for a CHP project), to the client who pays on a per unit basis. This model can be applied to any utility including heat, chilling, industrial gases, treated water and compressed air. It has the advantage of having a clearly isolated plant and the ability to meter the output. The Enron Energy Services contract referred to above, and subsequently implemented by RWE, was primarily of this form and required investment in new utility supply infrastructure, and supplied all the utilities used in the Guinness breweries including: steam, chilled water, compressed air, nitrogen, treated water, effluent. By implementing these measures in the Guinness brewery in London energy use was reduced by circa 40%.

In recent years there has been a flowering of innovation in ESCO contracts and an alphabet soup has developed including: MESA – Managed Energy Services Agreement, ESA – Efficiency Services Agreement, and MEETS – Metered Energy Efficiency Transaction Structures. These contract forms address some of the problems with Energy Performance Contracts but have not yet scaled as much as ‘traditional’ EPCs.

We have also seen the growth of Lighting as a Service (LaaS), which has been enabled by the big energy savings that come from installing LED lighting to replace conventional fluorescent lamps. LaaS companies carry out surveys, design new lighting systems, maintain them and charge the client a fixed fee over an extended period. The fee is typically less than the savings achieved.

A promising new area that needs to grow is Cooling as a Service, CaaS, in which the ESCO installs more efficient cooling technology and charges on a service basis. CaaS is going to be critical, especially in hot countries where demand for cooling is growing fast such as in the Middle East, Africa and Asia. Although CaaS is often presented as being about air conditioning for buildings, it should not be forgotten that establishing and maintaining cold chains for the supply of food and other critical supplies such as vaccines, is critical for development – improving living conditions, health and avoiding waste, as well as reducing energy demand from cooling which are growing rapidly. CaaS has a vital role to play and will become a huge and critical part of the ESCO market.

We are seeing a general growth in ‘as a service’ business models in many aspects of life, including mobility as a service, and there is no reason they cannot be applied to other parts of the energy system eg more efficient motors – Motors as a Service(MaaS) is an untapped market for electric motor suppliers.

Risks

It used to be said that energy efficiency projects had high returns and little or no risks. As a 1980s energy efficiency text book said:

‘Energy efficiency has high returns and virtually no risk’.

This myth continues to be repeated and is not helpful for developing the market. If they really had high returns and no risk everyone would be investing in them. Now we have better understanding of the risks of energy efficiency projects which include: performance risk; equipment risks; Operations and Maintenance risks; weather risks; and changes in production volume or mix, or changes in the use of buildings. We saw the effect of the latter during the pandemic where many buildings were completely empty for long periods, and indeed even now many office buildings are operating at a fraction of the occupancy they enjoyed pre-pandemic. Any ESCO contracts covering such buildings have been severely disrupted and Measurement and Verification (M&V) techniques have been sorely tested.

ESCO contracts of course are a way of allocating and managing risk. Clients, and ESCOs need to understand the risks and be reasonable about where they are allocated and how they are mitigated.

Advantages and disadvantages of ESCO contracts

ESCOs are great at bringing capacity and skills in energy and utilities to organisations that are focused on their core activities, and not energy. They can bridge the development gap between concepts for projects and fully developed, bankable projects. They can also bring finance to projects.

However, ESCOs are not the answers to all the problems with energy efficiency. ESCO contracts have their limitations and these need to be recognised alongside their benefits. They can only be applied to large projects because of the high transaction costs, and they need long-term stability in the client base such as afforded by public sector estates, They need to be applied in the right circumstances but not considered as ‘the answer’ to increasing the investment into energy efficiency. They are an important tool but not the only tool.

Super ESCOs

The Super ESCO is a rapidly emerging model that helps address many of the problems of growing the ESCO market. Pioneered by the World Bank and other International Financial Institutions we now have Super ESCOs in Dubai, Etihad Super ESCO, and Saudi Arabia, TARSHID. It is great to see these state backed companies in the Arab region developing the market for ESCOs.

Super ESCOs can develop projects at scale, enforce standardised contracts and processes, arrange finance at scale, and develop capacity in the ESCO market. In the next few years we should see additional Super ESCOs being formed, including in Kenya.

ESCOs in different regions

In the USA there has been a long-established market for ESCOs in Federal and State government owned buildings. In the Federal market, the Federal Energy Management Programme, (FEMP), provides assistance, capacity building and template forms and contracts. It also provides a standardised procurement system. Federal agencies are required to assess all opportunities for energy efficiency every four years which helps drive demand for new projects. At the state level the main market is the ‘MUSH’ market, Municipalities, Universities, Schools and Hospitals. Often financing comes from municipal bonds which provide cheap finance.

China accounts for 60% of the global ESCO market. Development of the market started in 1998 with World Bank and Global Environment Facility support which came together in an ESCO Loan Guarantee Scheme with funding of USD 22 million. There are now a reported 6,500 ESCOs employing some 760,000 people but 80% of them are small or micro businesses so the number actually implementing significant projects is considerably smaller. Unlike the US, 90% of the market is in the private sector and 55% of projects are in industry where there has been a strong focus on industrial waste heat to power installations. The 2010 legislation is supportive of ESCOs, which have to be certified and get special tax treatment, and created a special ESCO fund. Interestingly the Beijing Environmental Exchange allows trading of future revenue streams of ESCO contracts which is a really useful way of allowing the ESCOs to recycle capital.

In the Middle East, as already mentioned, there are world leading Super ESCOs in the form of Etihad Super ESCO in Dubai and TARSHID in Saudi Arabia. The Etihad Super ESCO was created by DEWA, the Dubai Electricity and Water Authority, and is closely allied to the demand side management policy. The Super ESCO creates and develops projects at scale, secures finance at scale, and uses commercial ESCOs to undertake the work under Energy Performance Contracts. DEWA has also established standards and certification programmes for ESCOs, energy audits and Measurement and Verification (M&V). These have helped develop the market. In Saudi Arabia TARSHID is focused on government buildings which provides a large pipeline with much potential as many of the buildings were constructed in the oil boom years and are very inefficient.

Lessons learnt

In all of our work around the world on scaling energy efficiency, including ESCOs, we came to the conclusion that in order to be successful in scaling it is necessary to put in place four pieces of a jigsaw, what we call the jigsaw of energy efficiency financing. The four parts are:

– Develop pipelines – we need pipelines at scale, not just one building here and there

– Standardisation – of contracts, technical solutions, processes and under-writing

– Build capacity – in the demand side, the supply side and the finance sector

– Provide finance – both development finance as well as project finance.

ESCOs, and particularly Super ESCOs, can provide all these pieces. They can build pipelines at scale, but this can be greatly helped by the public sector taking bold procurement decisions and providing portfolios of buildings for improvement. ESCOs, and particularly Super ESCOs, can drive standardisation. They can also build capacity in the sector. ESCOs can provide development capital, which is their risk capital, but the public sector can provide additional development capital through Super ESCOs or mechanisms such as guarantee schemes.

The future for ESCOs

The future looks bright for the ESCO sector but in order to achieve the success we know is possible, and grow the industry at least in line with the target of tripling investment in energy efficiency, policy makers, ESCO professionals and the finance sector need to work together to ensure that the four pieces of the jigsaw ae in place, This requires co-ordinated policy and capacity building work along with dedicated financing instruments. It also requires a realistic assessment of the areas where ESCOs can help, and those areas where the conventional EPC offering cannot work. In those areas we need innovations in contract form and business model, as in ep Group’s ESCO-in-a-box which is designed as a simplified, and repeatable business model to address the energy services needs of the SME sector.