This article was incorporated as a chapter within a report compiled by Swiss Sustainable Finance titled “Financing the Low Carbon Economy”. The complete study can be accessed here.
Energy efficiency investments face unique barriers, such as high up-front costs, long pay-back periods and small scale of individual investments, all of which contribute to the investment gap needed to reach the climate goals set in the Paris Agreement.
Energy Performance Contracting (EPC) carries the potential to address some of these financing barriers by aggregating investments into portfolios to achieve the required scale.
Receivables from EPCs are sometimes sold to institutional investors who appreciate their alignment with their long-term liabilities.
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Energy efficiency is an integral part of global energy policy as it is widely recognised as a cost-efficient means of reducing energy demand, thereby curbing greenhouse gas emissions. The Interna- tional Energy Agency (IEA) estimates that energy efficiency could provide more than 40% of the abatement required by 2040 under the Paris Agreement.1 However, despite the clear environmental and economic case for energy efficiency, current annual investment volumes are significantly below policy targets. This chapter provides an overview of the trends in energy efficiency investments and presents Energy Performance Contracting (EPC) as a tested and mature model for channelling investments into energy efficiency.
Energy efficiency investment trends
Energy efficiency has the potential to play an important role in achieving global climate targets. However, global investments in energy efficiency in 2018 only equalled USD 240 billion, a marginal 3% growth on the year before.2 The current level of capital deployment is well below the required level to deliver on climate commitments. According to IEA's estimates, annual investments should run at USD 584 billion per year between 2017 and 2025, more than double today's level, and will further increase to USD 1.3 trillion per year up to 2040. This investment gap is depicted in Figure 26 on the following page.
The sluggish progress is mostly due to investment barriers that are unique to energy efficiency, such as the diverse nature of invest- ment measures both in terms of technology as well as sector (building, transportation, industry), high up-front costs, long payback periods and small scale of individual investments, among others. Such barriers result in low demand for developing projects and consequently weak supply of financing, with the former being the key driver of the process. Delivering the necessary scale of investments requires a favourable policy that incentivises efforts to develop projects and generates the necessary pipeline, as well as innovative business models that address specific financing challenges particular to energy efficiency.
Delivering scale through Energy Performance Contracting
One business model that is relatively mature and has proven to be successful in addressing such challenges is Energy Performance Contracting (EPC), which is essentially a contractual agreement between an Energy Service Company (ESCO), a third party that is specialised in delivering energy savings solutions, and the end user. This model allows a third party such as an ESCO to undertake the implementation of energy efficiency measures on behalf of the end user through an EPC, which often provides a guaranteed level of energy savings to the end user and furthermore allows for the sharing of additional savings between both parties. As such, the remuneration of the ESCO is tied to the energy savings achieved.
Figure 27 depicts an example of how an EPC structure delivers value to the consumer through the savings generated during the duration of the project after the implementation of concrete energy efficiency measures, such as a public lighting project or the retrofitting of commercial real estate assets. The end user enjoys full benefits of savings after the project is completed. ESCOS may or may not provide for the financing of the upfront costs. A distinction is often made between two types of EPC contracts with ESCOS: “financing Energy Performance Contracts" and "operational Energy Performance Contracts".4 A schematic overview of the two options is presented in Figure 28. The key difference between the two lies in the arrangement of financing.
In operational EPCs, the end user is the borrower and the financing agreement is established between the user and the lend- ing institution, on the basis of the EPC between the user and the ESCO, which guarantees a sufficient level of energy savings to ser- vice the debt. In this case, the ESCO's role is more operational, which mitigates technical risks, and acts as a savings guarantor.
In financing EPCS, ESCOS initiate the project, arrange third party financing, implement the efficiency measures and monitor the project. For large projects, such a centralised role is extremely beneficial as the ESCO serves as the main counterparty for the financiers as well as the beneficiaries. In such cases, ESCOS enter into debt agreements with a lending institution, again based upon the EPC signed between the end user and the ESCO. However, debt servicing obligations fall to the ESCO and not the end user."
The EPC model addresses some of the challenges associated with energy efficiency investments. Firstly, one EPC contract typically aggregates a portfolio of projects which are ideally structured jointly and ready to be financed. Financiers (debt or equity) are accustomed to financing large projects. High transaction costs do not always make it worthwhile for investors to focus on individual small-scale projects. In most cases, aggregation is therefore necessary to reach critical mass for the projects to become attractive from a financing point of view.
Furthermore, ESCOs are equipped with the technical know-how needed to assess and implement energy efficiency measures. This is particularly important for energy efficiency investments, as due to their cost-saving nature (as opposed to cash-flow generation), each project needs to establish baseline measurements on current consumption levels on which basis future savings are calculated. As such, measurement, reporting and verification (MRV) as well as quality assurance processes are required continually throughout the investment period to document the savings generated and essentially create associated investment returns.
In addition, implementation of energy efficiency measures requires significant up-front capital, which may not always be available to end users. EPC structures can address this challenge, since an ESCO can attract third-party financing, which allows end users to participate in such programmes without the need to deploy significant up-front capital. To date most efficiency projects are delivered through means of self-financing. However, delivering the ambitious climate targets requires mobilisation of third-party capital at scale, which can be achieved through use of financing models such as EPCs.
ESCOS typically finance energy efficiency projects with their own capital and on-balance-sheet debt. This often limits their ability to undertake more projects due to debt ratio restrictions. In order for ESCOS to implement more projects, they often sell receivables from EPCS to secondary buyers and thereby free up their balance sheets. EPC portfolios are typically sold to institutional investors or thematic funds who find such investments to be in line with their investment criteria. Receivables from implemented energy efficiency projects are de-risked in terms of technical implementation and also have an established operational track record that demon- strates concrete achieved savings. Furthermore, EPCs are considered to be low-risk, long-term assets with stable returns, thereby matching institutional investors' long-term liabilities. SUSI Partners, for example, a Zurich-based infrastructure fund manager, has a dedicated energy efficiency fund which collaborates with ESCOS on such off-balance sheet investment structures.
ESCO market in Europe and Switzerland
According to an IEA report, the European ESCO market was estimated to be EUR 3 billion in 2017 representing about 10% of the global ESCO market with China and the United States leading the way." The level of market development is influenced by opportunities in energy savings from energy efficiency in various geographies, as well as enabling policies that support such investments. Within the EU, Germany is considered to be the most mature market, along with France, Austria, the UK and the Czech Republic.10 In Switzerland, the ESCO market is relatively new compared to its neighbouring countries. The development of the market in Switzerland is championed by swissesco, an association founded in 2015 by industry leaders with the aim of promoting the application of EPC contracting within Switzerland.
To date, there have been about 20 EPC projects implemented in Switzerland, most of which are based in the French-speaking region of the country. One example worth mentioning is the energy efficiency investment at the Hôpital Universitaire de Genève (HUG) for which an EPC contract was signed between HUG and Services Industriels de Genève (SIG). The latter is acting as the ESCO and invests over CHF 1.2 million in efficient lighting. Energy savings during the duration of the contract are shared between the two parties. According to swissesco, one of the biggest challenges in Switzerland with regards to the further development of the EPC market is lack of awareness about the business model and the benefits it delivers to stakeholders. As such, it is imperative that more efforts are made to raise awareness in the country and communicate the contribution it makes towards achieving Swiss policy targets.
Conclusion
EPCS carry the potential to address some of the existing financing barriers in energy efficiency by aggregating investments into port- folios to achieve the required scale. EPCs also enable third-party financing, which can act as a catalyst to drive investment levels in energy efficiency closer to the climate targets set by the Paris Agreement. Institutional investors can get involved by purchasing receivables, which would allow ESCOS to undertake more energy efficiency projects. Policymakers, in conjunction with other stakeholders such as the financing community and project developers, should ensure that favourable policies are put in place to enable the development and financing of energy efficiency projects.
International Energy Agency. (2018). Energy Efficiency 2018, Analysis and outlooks to 2040. IEA: Paris
International Energy Agency. (2019). World Energy Investment, 2019. IEA: Paris
Laffont-Eloire, Karine. (2 October 2019). Energy Performance Contracting (EPC). Renovation Hub EU. Available at: https://renovation-hub.eu/business-models/ energy-performance-contracting-epc/
Energy Efficiency Financial Institutions Group (EEFIG). (2014). How to drive new finance for energy efficiency investments – Part 1: Buildings (Interim Report). Available at: www.unepfi.org/fileadmin/documents/EnergyEfficiencyInvest- ment.pdf
European Energy Efficiency Platform (E3P). (n.d.). Energy Performance Contract- ing. Available at: https://e3p.jrc.ec.europa.eu/articles/energy-performance-con- tracting
Wilson Sonsini Goodrich & Rosati. (May 2012). Innovations and Opportunities in Energy Efficiency Finance. Available at: www.wsgr.com/publications/PDFSearch/ WSGR-EE-Finance-White-Paper-14.pdf
European Energy Efficiency Platform (E3P). (n.d.). ESCo Financing Options. Available at: https://e3p.jrc.ec.europa.eu/articles/esco-financing-options
International Energy Agency. (2014). World Energy Investment Outlook 2014. IEA: Paris.
Energy Performance Contracting
International Energy Agency. (2018). Energy Service Companies (ESCOs). At the heart of innovative financing models for efficiency. Available at: www.iea.org/ reports/energy-service-companies-escos-2
Boza-Kiss, B., Bertoldi, P. & Economido, M.. (2017). Energy Service Companies in the EU. Status review and recommendations for further market development with a focus on Energy Performance Contracting. Available at: https://publications.jrc. ec.europa.eu/repository/bitstream/JRC106624/kjna28716enn.pdf
See www.swissesco.ch for more information on the association