ESCO Financing. State of Israel Ministry of National Infrastructure. Pierre Baillargeon. March 2007 ECONOLER INTERNATIONAL

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1 ESCO Financing State of Israel Ministry of National Infrastructure Pierre Baillargeon March 2007

2 Agenda Evaluation of the EE market Introduction to the ESCO concept Introduction to performance contracts Financing Mechanism for ESCO projects Role of local commercial banks Innovative financing mechanisms

3 Energy efficiency market Potential investment in EE projects? 450 Million Shekels of investment were identified for the government and public sector buildings Larger potential if we include the institutional, commercial and industrial sectors Those projects will need financing Opportunity for innovative banks to develop relationships with ESCOs

4 What is an Energy Service Company, an ESCO? An Energy Service Company provides: The identification of project The feasibility study The design (engineering) The financing (sometimes) The implementation (management or direct) The measurement and verification of savings A form of guarantee of savings By way of a contract between the ESCO and the client, therefore it is a performance contract

5 Important characteristics of an ESCO The ESCO organize the projects financing It does not use its own funds for financing (normally) An ESCO is not a financial institution

6 Role of ESCO in energy efficiency projects Traditional approach Customers implement some EE measures Several smaller energy efficiency projects It take time to achieve the full potential ESCO approach Energy performance contract Integrated solution Only one project

7 The traditional approach Contractors Professional consulting engineer Equipment manufacturers Client Energy Suppliers Governments Financial institutions

8 The ESCO approach Client Contractors Equipment manufacturers Governments Guarantee Analysis Concept Installation Financing Monitoring Training ESCO Financial institutions Energy Suppliers Professional consulting engineer

9 Why deal with an ESCO? Sole source for project realisation Less management time. One bidding process Experience ESCO is specialized in the design and the implementation of energy efficiency projects Risk mitigation Payment to ESCO is based on performance of project

10 Why deal with an ESCO? Project financing Project financing organized by a third party Potential access to off-balance sheet financing Money is available for other priorities Financial impact Potential immediate positive cash flow to client (shared saving agreement) Employee skill improvement Training activities included in the comprehensive approach Savings monitoring Evidence that the project is profitable

11 ESCO ressources Engineers and technicians Project managers Energy experts Accountants and economists Supporting staff Legal advisers

12 The skills of an ESCO Development Sales Marketing Technical IGA Engineering M&V Financial Direct Financing Or Arrangements Project Management Construction Management Or Execution Legal Contracts Local regulations Risk Management For guarantee of savings And for cost and delay control Training and Management Support Operation & Maintenance (Sometimes)

13 Stage in ESCO Stage in ESCO project Screening by the ESCO Preliminary audit (Walk Through) Signature of energy audit contract Energy audit (investment grade) Select measures Prepare financial plan Detailed design (engineering) Sub-Contract negotiation Implantation supervision Measurement & Verification process Training and energy management

14 Investment Grade Audit Low cost measure : Lighting upgrade Set point adjustment (temperature, humidity) Motion detector or control for lighting and equipments Steam leakages Peak demand shaving

15 Investment Grade Audit High cost measure : DDC systems Efficient lighting Variable speed drive for motors/pumps/fans High efficiency motors Ice storage systems High efficiency chiller High efficiency boilers (condensing)

16 Project cost items Equipments and construction cost Engineers fees for the energy audit, design and specifications, construction supervision Project management by ESCO Temporary financing Performance Guarantee ESCO administration and profit = Project implantation cost Long term financing + Energy management, M&V and staff training = Project total cost

17 Typical Project COST ITEMS Investment Grade Audit Construction costs Design and Specifications Construction management Project management ESCO Adm. & Profits Performance guarantee Temporary financing M&V Total Implementation Cost (TIC) Interests Total costs $ 60, ,000 85,000 30,000 40, ,000 80,000 45,000 30,000 1,320, ,000 1,663,000 % 3,6% 45,1% 5,1% 1,8% 2,4% 12,0% 4,8% 2,7% 1,8% 79,4% 20,6% 100.0% Savings = 350,000 Reimbursement: 4,6 Years

18 Savings generated cash flow All investments made are reimbursed by energy savings How to determine the savings? We can only measure the actual consumption after measure implementation Or the history consumption But we cannot measure the savings directly

19 Savings generated cash flow Measurement and Verification protocol (M&V) Integral component in the success of the implantation of an energy efficiency project Determine the energy savings by comparing energy consumption before (baseline) and after (post-retrofit) the installation Allows for variations in energy usage Temperature, occupancies The formulas to be used are defined in the contract No ambiguity

20 Savings generated cash flow International Performance Measurement and Verification Protocol (IPMVP) Supported by an independent international organization (EVO) Federal Energy Management Program (FEMP) - USA ASHRAE 14P : Measurement of energy saving and demand

21 Savings generated cash flow Issues associated with savings cash flow Is the budget rules allow to apply ESCOs invoices to the energy budget lines? What is the budget adjustment process? Is it sure that the budget to pay the ESCO will be sufficient for the duration of the contract? Is it sure that the customer can pay to the ESCO the savings timely? Is it sure that the savings received by the ESCO will be transferred to the financial institution?

22 What is an energy performance contract? A project implementation contract With a guarantee that it will be reimbursed (in part or in totality) from energy savings The guarantee takes multiple form Complete guarantee that all project cost and financing will be reimbursed from savings Partial guarantee on the quantity of savings (ex; 80% of expected results) Guarantee that the customer will not pay more than a certain amount over the cost of equipment financing Not all contracts are similar

23 Why use an energy performance contract? It help the realisation of projects for which $$$ may not otherwise be available for customers Depend of financing scheme and guarantee asked by ESCO It mobilises private capital It insures that savings will be realised in a certain time frame Customer may not be confident about the quantity of savings

24 Do ESCOs always finance? The ESCO may provide the financing or arrange financing. Provide = Internal funds or from his own financial institution Arrange = It helps the customer to obtain a suitable financing agreement with lenders Most ESCOs do not have large internal financing resource. They are not banks.

25 Performance contracts There are various approaches to energy performance contract (EPC) We first present the 3 most popular contracts Then the possible variations for key elements in the contracts Each ESCO can develop its own contract If there is an association of ESCOs, a typical contract can be proposed as a standard If its government projects, the government can impose a typical contract

26 Main families of performance contracts Shared savings Option: Fast-out contract Guaranteed savings Guaranteed rebate

27 Shared Savings Contract. The ESCO is paid from a share of the savings The ESCO provides the financing It usually retains a large portion of the savings 80%-95% is common 100% for a Fast-out option (more on that later)

28 Shared Savings Contract Hybrid contracts Some contracts combine elements from 2 families of contracts: Shared savings and Guaranteed savings (or just a traditional loan for equipment and installation) the shared saving only applies to the fees charged by the ESCOs to realize the project ESCO get a smaller share of the savings (above debt service for the equipment and installation cost)

29 Shared Savings Contract Cost can be open or closed book Open book: The breakdown of costs is presented to the customer and is adjusted according to the real cost Close book: The total cost is fixed and includes the project implantation (turn key) Guarantee: Annual savings (savings not demonstrated are not invoiced) Total savings or Maximum terms (adjustment at the end of the contract) Term: usually fixed term contract

30 Shared Savings Contract The ESCO s share is negotiated with the customer The percentage may change for each year The percentage can change before and after reimbursement of project balance If ESCO share is smaller More immediate cash flow for the client Interest will be higher Or the term of the contract will extend

31 Shared Savings Contract ESCO Energy Services, equipment, Installation, M&V of savings 2 Debt payment Loan Shared savings based on performance Client Financial Institution

32 Actual energy budget Shared savings Fixed contract duration Savings to the client ESCO's portion of the savings Future energy cost Year 1 Year 2 Year 3 Year 4

33 Fast-out contract 100% of the savings goes to the ESCO until project is reimbursed An option for shared savings contracts Usually found in market where there is a lot of competition Often proposed by associations of ESCOs Contract preferred for work within government agency for their transparencies Cost: Open book with client. Guarantee: Same as shared savings

34 Fast-out contract Term: Contract end as soon as reimbursement is completed Contract duration is shorter than other type of contract Interest on project financing is minimum

35 Actual energy budget Fast-out contract Contract duration = 3 yrs ESCO's portion of the savings 100 % Future energy cost Year 1 Year 2 Year 3

36 Guaranteed Savings Contract The ESCO is paid upfront for the project implementation (like a contractor) The ESCO provides a guarantee to the customer that a certain level of savings will be realized The project is financed by the customer The ESCO helps to arrange the financing.

37 Guaranteed Savings Contract This type of contract has lower risks for the ESCO No customer credit risk Upfront payment The client must be sure that the ESCO is well established and has credibility as well as experience It should be there to pay the guarantee of savings

38 Guaranteed Savings Contract If the savings are lower than the guaranteed amount, the ESCO must pay the customer the difference Guarantee is usually expressed as a percentage of the expected savings (ex; 100%, 80% etc )

39 Guaranteed Savings Contract Open of Close book Open book: The breakdown of costs is presented to the customer and is adjusted according to the real cost Close book: The total cost is fixed and includes the project implantation (turn key) Term: Generally fixed

40 Performance Guarantee (For Guaranteed Savings Contract) ESCO guarantees that Energy Savings will Cover Debt Service 4 ESCO pays savings shortfall Energy Savings Debt Service Customer pays debt service to the bank 3 BANK ESCO 2 Customer pays during implementation Customer Loan to Customer 1 Lender

41 Guaranteed Savings Contract Actual energy budget Fixed duration contract Fixed payments to the bank Savings to ESCO Saving to Customer Energy cost after the project Year 1 Year 2 Year 3 Year 4

42 Guaranteed Rebate The ESCO takes charge of a facility including payment of energy to suppliers It guarantees to customer a reduction in payment to energy utilities

43 Guaranteed Rebate Also called Chauffage contract Chauffage is a French term for heat supply contracts (often for buildings) Was used by extension for contracts in which the ESCO operate the facility and provide services to the customer Power plant operation combining an energy efficiency program

44 Chauffage Contract Chauffage contracting is a medium-term energy supply contract similar to one that might be negotiated between an independent power producer (IPP) and a utility The ESCO must carry out all aspects of project development and implementation

45 Chauffage contract The ESCO supplies energy (heating and cooling) for a specified price for an agreed period The assets remains the property of the customer Cost : fixed rebate over previous cost paid by the customer Guarantee : given through a predetermined reduction in energy cost. ESCO takes charge of the energy bill and gives a rebate on the projected budget Immediate positive cash flow for the client Interest rates are higher as customer rebate increases

46 Typical Chauffage Structure ESCO supplies energy from facility ESCO implements project for the facility. Customer Customer pays ESCO for energy Energy Facility Bank lends 70-90% of project costs to ESCO. ESCO is the borrower. ESCO BANK ESCO may assign receivables from Customer directly to bank. Loan is usually secured with facility assets. Lending Institution

47 Actual energy budget Chauffage Contract duration vary Owner's portion of the savings 1-15 % Increasing ESCO keeps the budget Year 1 Year 2 Year 3 Year 4

48 Case Study Increasing the Energy Efficiency of an office building

49 Scenario Small ESCO with strong technical expertise Low capital Cannot offer complete guarantee for loan Customer with good creditworthiness - Public

50 Investment Plan Selected options represent investment of 115,000 ILS Audit cost value of 23,000 ILS paid-in project cost Engineering cost: 16,500 ILS Project construction management cost of 16,500 ILS Profit margin of ESCO: 11,500 ILS M&V process fees: 19,700 ILS Economy of 125,000 ILS per year

51 Project Financed by ESCO ILS Investment Grade Audit % 2.4% Construction costs % 54.0% Design and Specifications % 4.3% Construction management % 2.2% Project management % 2.7% ESCO Adm. & Profits % 8.6% Performance guarantee % 2.7% Temporary financing % 1.6% M&V % 1.1% Implementation cost % 79.7% Interests % 20.3% Total costs % 100.0% Annual savings: Term 6 years

52 Discussion What would be: Your reaction as a financial institution Term Percentage rate Guarantee requested Rules for disbursement of the funds Verification

53 Management of savings generated cash-flow

54 Management of savings Shared savings The savings are generated in the facility An evaluation is done using the M&V protocol agreed in the contract An invoice is prepared by the ESCO at regular interval (usually monthly) The invoices are paid by the customer to the ESCO The ESCO use the savings to repay the loan to the bank

55 Management of savings From a bank perspective How do you see the flow of savings from its generation until it reach the bank? What mechanisms would you recommend to make it more secure?

56 Customer Project Financing (Guaranteed saving)

57 Financing Options for the Client For the guaranteed savings type of contracts Conventional financing options client internal financing (operating or immobilisation budget) conventional operating loan conventional capital loan capital lease

58 Conventional Loan Client prefers to borrow money from its own source at better conditions Ownership of equipment to the client Asset of the project must be identified in the balance sheet Debt must be identified as a liability in balance sheet

59 Conventional Lease Client prefers to lease equipment directly at better conditions Ownership of equipment remains with the leasing company until the end of contract (buy-back) No debt on customer balance sheet (usually) No asset

60 Other Financing Options for the Client Non conventional financing options (linked to ESCO guarantee) Modified conventional loan with the following conditions: Neutral cash flow; monthly savings must be sufficient to repay debt An ESCO offers a guarantee of savings performance The lender may consider energy cost savings as collateral for the loan

61 Other Financing Options for the Client Non conventional financing options (linked to ESCO guarantee) Modified conventional financing options, with the following conditions: the characterisation of the transaction is important to the owner, lender or third party for sales tax, revenue recognition, income tax or other reasons.

62 ESCOs Financing Mechanisms

63 ESCOs Financing Mechanisms ESCO s own internal capital Loan obtained by ESCO Loan obtained by ESCO but guaranteed by customer Risk capital by ESCO Capital lease by ESCO

64 ESCOs Financing Mechanisms ESCO s own internal capital Simple solution Limited financing capacity when the number of projects increases ESCO supports the financing risk of the client

65 ESCOs Financing Mechanisms Loan obtained by ESCO On-balance sheet for ESCO Limited financing capacity for several projects Client pays ESCO from energy savings ESCO supports the financing risk of the client

66 ESCOs Financing Mechanisms Loan obtained by ESCO, guarantee by customer On-balance sheet for ESCO Increased financing capacity to undertake several projects Client pays ESCO from energy savings ESCO supports the financing risk of the client

67 ESCOs Financing Mechanisms Risk capital raised by ESCO ESCO obtains risk capital from private or specialised financiers CV are looking for high returns may create pressure in selling cost structure Collateral is reduced against the higher expected profits

68 ESCOs Financing Mechanisms Capital lease by ESCO Mechanism is similar to a conventional capital lease, but lender recourses are made directly to ESCO. Important guarantee demanded to ESCO

69 Other Financing Mechanisms Shared Saving with automatic buy-back after one year Shared Saving with a loan raised by ESCO and transferred to a guaranteed saving scheme after one year Off-balance sheet Escrow account

70 Other Financing Mechanisms Shared saving with automatic buy back The customer have an obligation to buy back the project after one year of demonstration There is usually an agreement of the bank included in the financing agreement After one year, the customer and the financing institution knows the final cost of project and the amount of savings Reduce the contractual link between the customer and ESCO ESCO has a reduced debt ratio and can handle more projects

71 Other Financing Mechanisms Shared saving with conversion to guaranteed savings Usually when the saving demonstration is limited in time After one year, the saving level is known and the payment becomes fixed The ESCO add a provision in the contract that it can transfer the payment of the contract to a financial institution The financial institution prefer to deal directly with the final end-user (reduce the risk of default by the ESCO)

72 Other Financing Mechanisms Off-balance sheet The ESCO or the customer obtain the financing for the project Collateral is exclusively the energy saving $ stream Does not increase the debt ratio of the client or ESCO Does not affect borrowing capacity of the client or ESCO

73 Other Financing Mechanisms Escrow account Funds are held into this account to ensure timely savings payment Usually cover 4 to 6 months of savings value Can have an automatic replenishment mechanism

74 Role of local banks in EE projects financing

75 Role of local banks in EE projects financing Provide financing to: ESCOs End users Analyze creditworthiness of ESCO and End Users Design streamlined procedures to work with ESCOs

76 Role of local banks in EE projects financing Ideal scenario for financing ESCOs The financier agrees to consider the loan for an EE project as a single file for customer and the ESCO The bank agrees on working with ESCO which are lowly capitalized and cannot offer large guarantees The bank recognizes the value of monetary flow generated from energy saving by the project

77 Role of local banks in EE projects financing Ideal scenario for financing of ESCOs The financier requires reasonable guarantees from ESE and their customers

78 Role of local banks in EE projects financing Bank implication is : A success factor for the EE project A business opportunity for the banks themselves The EE project improves the customer organization efficiency and its creditworthiness in the medium and long term

79 Financial support tools

80 Financial support tools Specialized investment funds for Energy Efficiency Fund targeting energy efficiency project exclusively Adequate when there is a lack of financing in the country for such type of projects Application rules can be adapted for easier review of the projects

81 Financial support tools Revolving funds Funds where the initial funding is returned to the fund to realize multiple projects in sequence Provides a mechanism that allows leveraging several projects from the same initial fund investment

82 Financial support tools Guarantee funds Funds that can provide a partial guarantee to lenders Reduce their exposure to risk Vary from 25% to 80% of the principal usually Project cost can include different elements (material and work only, soft cost, ESCO profit) Default initiate the payment from the funds There could be a delay between default and payment The bank may be required to perform some recovery activities

83 Financial support tools Public Private partnership Implementing a financial scheme where public and private funds are blended Allows the public to benefit from the skills from the private sector The operation is run like a commercial venture Allows a larger size of project transaction Attract private capital by showing public sector strong support Distribute the profits from the operation to the partners Applied to ESCO concept; Internal ESCO

84 Financial support tools Clean development mechanism Carbon credit on CO2 emissions Can be sold on the international market (Prototype carbon fund, Community carbon fund, various institutional carbon fund, brookers etc..) The agreement for purchasing carbon credit is often developed in parallel with the project design First Kyoto period end 2012 Contract usually are for 7 years period (renewable up to 3 times) or for a fixed 10 year period

85 Where are we Where are the barriers and opportunity? From the discussion today and considering the potential support mechanisms, What is the most important issues to consider for the development of ESCOs in Israel?

86 Project Finance by ESCO ILS Investment Grade Audit % 2.4% Construction costs % 54.0% Design and Specifications % 4.3% Construction management % 2.2% Project management % 2.7% ESCO Adm. & Profits % 8.6% Performance guarantee % 2.7% Temporary financing % 1.6% M&V % 1.1% Implementation cost % 79.7% Interests % 20.3% Total costs % 100.0% Annual savings: Term 6 years

87 Discussion