CONTRACTING (EPC) GUIDEBOOK

ENERGY PERFORMANCE Energy Performance Contracting (EPC) Guide CONTRACTING (EPC) GUIDEBOOK Prepared by The CarbonSmart Secretariat Hong Kong Productivity Council June 2014

Table of Content 1 INTRODUCTION 4 2 WHAT IS ENERGY PERFORMANCE CONTRACTING? 6 3 HOW DOES ENERGY PERFORMANCE CONTRACTING WORK? 9 GUARANTEED SAVINGS APPROACH 10 SHARED SAVINGS APPROACH 11 4 TIPS FOR CUSTOMERS 13 5 FREQUENTLY ASKED QUESTIONS 15 Page 2

Disclaimer Any opinions, findings, conclusions or recommendations expressed in this material/event do not necessarily reflect the views of the Government of the Hong Kong Special Administrative Region and the Environment and Conservation Fund. This provided material / event is for information purpose only. Whilst every effort has been made to ensure the accuracy of the information supplied herein, the publisher of this material and the associated organizations in this Programme cannot be held responsible for any damage or claim resulting from use of the information. About this Guide With the funding support by the Environment and Conservation Fund, the Hong Kong Productivity Council (HKPC) in collaboration with the Federation of Hong Kong Industries (FHKI), Hong Kong General Chamber of Commerce (HKGCC) and Business Environment Council (BEC) has implemented the CarbonSmart Programme (the Programme), which is a 2.5-year programme to encourage and sustain concerted industry effort on carbon audit and reduction, as well as facilitate the development of related environmental industries. Under the campaign banner of CarbonSmart, the campaign aims to rally the business sector of Hong Kong to capture the opportunities in carbon reduction through enhancing energy efficiency. The campaign aims to encourage the adoption of market-based means such as Energy Performance Contracting (EPC), which is important for corporate end-users to finance their energy efficiency improvement works. This guide gives an introduction of EPC and discusses how to incorporate EPC models in businesses, with an aim to assisting business sector in Hong Kong to achieve energy efficiency improvement. Page 3

1 Introduction Background In 2011, the annual energy consumption in Hong Kong increased by 3.1 percent when compared with 2001 1. This increase can be partially attributed to a steady growth in population and general improvement in living standards over the period. At the same time, energy consumption accounts for more than 90 percent of the carbon emissions produced in Hong Kong 2. Enhancing energy efficiency is thus an important step in the journey towards a low carbon economy and eventual climate change mitigation. As a member of the Asia-Pacific Economic Co-operation (APEC), Hong Kong adopted the APEC Leaders Declaration on Climate Change, Energy Security and Clean Development in 2007. The Declaration calls upon APEC economies to achieve a reduction in energy intensity of at least 25 percent by 2030 (taking 2005 as the base year) 3. Energy saving has clearly become an important issue and as a result, over the years, many programs have been launched by the Hong Kong SAR Government to enhance energy efficiency, as illustrated by the figure below: 1995 1998 2009 2011 2012 Voluntary Energy Hong Kong Energy Building Energy Mandatory Energy Building Energy Efficiency Labelling Efficiency Registration Efficiency Fund Efficiency Labelling Efficiency Scheme Scheme for Buildings Schemes Scheme Ordinance (CAP 610) Fig. 1: Examples of Government Initiatives to Improve Energy Efficiency [Source: EMSD] 1 Electrical and Mechanical Services Department (2013), Hong Kong Energy End-use Data 2013. Hong Kong 2 Environmental Protection Department. (2013) Greenhouse Gas Emissions in Hong Kong by Sector [Online] Available from: http://www.epd.gov.hk/epd/english/climate_change/files/hkghg_sectors_201304.pdf [Accessed: 10 th February 2014] 3 Environmental Protection Department. (2005) Climate Change Actions in Hong Kong [Online] Available from: http://www.epd.gov.hk/epd/english/climate_change/hkactions.html [Accessed: 10 th February 2014] Page 4

In 2012, the Government enacted the Buildings Energy Efficiency Ordinance. Under the Ordinance, developers or owners of newly-constructed buildings must ensure that four key types of building installations 4 comply with the design standards of the Building Energy Code (BEC). Also, in commercial buildings, an energy audit should be carried out on these four installation types every 10 years, in accordance with the Energy Audit Code (EAC). Investing in Energy Efficiency Improvement Project It is clear that energy management has become a trend it is no longer seen only as an environmental protection strategy. By investing in energy efficiency improvement projects, energy users i.e. customers will usually be paid back through the energy savings achieved. However, the common approach of such investment currently involves the customer paying a sum of money to upgrade their existing facilities and cover consultancy fees. There is also a risk that the customer s investment in energy saving retrofits may not pay back at the expected rate. Energy Performance Contracting The above issues may be addressed though adopting an alternative approach to energy management Energy Performance Contracting (EPC), which incorporates energy performance guarantees into the contract. Also, in the EPC model, the source of capital for the energy project is not necessarily the customer, it can also be an Energy Service Company (ESCO) or even a third-party financier. 4 These installations are: air-conditioning installation, lighting installation, electrical installation, and lift and escalator installation Page 5

2 What is Energy Performance Contracting? Energy Performance Contracting is a turnkey service which provides energy users with a comprehensive set of energy efficiency measures. Usually, the contract also guarantees that the energy savings produced by the project will finance the full project cost. The customer is usually the owner or representative of a utility, premises or building which has significant energy saving potential. At the beginning of an EPC project, the ESCO will identify and evaluate energy saving methods and recommend a package of improvements to the customer. The ESCO can provide energy services such as design, installation, maintenance and financing to retrofit and upgrade a project to improve its energy efficiency. These services can be provided all the way from an initial energy audit through to long-term monitoring and verification (M&V) of the project s savings. In many cases, an EPC project will include the maintenance costs of energy efficient equipment over the contract period 5. In contrast to the common approach to energy management, in an EPC arrangement, the customer may not be the sole source of capital for the project: i.e. the customer may not have to pay for the energy efficiency improvement work, but can still enjoy the energy savings the work brings. Details of EPC models and financing mechanisms are discussed in the following chapters. 5 Electrical and Mechanical Services Department, HK EE Net, website accessed 17 th March 2014, [http://ee.emsd.gov.hk/english/general/gen_other/gen_other_esco.html] Page 6

Table 1: Summary of the Major Differences between the Common Approach of Energy Efficiency Investment and Energy Performance Contracting Common Approach of Energy Energy Performance Efficiency Investment Contracting Capital Customers provide the capital Energy efficiency improvement Source required for energy efficiency works may be financed by the improvement works ESCO and/or a third-party financier Parties involved The customer and the ESCO The customer, the ESCO and/or a third-party financier Risks Customers bear the sole risk of the The risk that the energy efficiency energy efficiency improvement improvement works may not pay works not paying back at the expected rate back at the expected rate may be shared between the customer, the ESCO and/or a third-party financier Ownership of installed energy facilities Belongs to the customer The facilities may/may not have to be returned to the ESCO upon project completion As a turnkey service, an Energy Performance Contract may include services such as*: Energy audit Design engineering Construction management Arrangement of long-term project financing Commissioning Operation and maintenance Savings monitoring & verification Page 7

An EPC enables the energy user to: Reduce the financial risks associated with energy consumption Conduct a detailed energy audit to identify where and by how much energy demand can be reduced Utilize ESCO s design, implementation and financial resources to improve energy efficiency Enjoy guaranteed cost savings Constraints of EPC: An EPC may not be effective when the savings generated by an energy retrofit are insignificant or are unable to cover the project costs within a reasonable timeframe Compared to the common approach to investing in energy efficiency improvement projects, an EPC involves more complex terms and conditions that may lead to a customer s unwillingness to adopt the contract An EPC usually involves a long-term contractual relationship between the involved parties, which may mean less flexibility because the customer is prohibited from changing the ESCO over the contract period Page 8

3 How does Energy Performance Contracting work? Customer ESCOs Energy Performance Contracting (EPC) Thirdparty Financier There are various models of EPC in the world and the mechanisms of models may vary from country to country. According to Electrical and Mechanical Services Department (EMSD), there are two common models usually known as the Guaranteed Savings Approach and the Shared Savings Approach in Hong Kong 6. In the following section, these two models will be introduced. 6 Electrical and Mechanical Services Department (2008), Overview of Energy Performance Contracting. Hong Kong Page 9

Guaranteed Savings Approach Fig. 2: Guaranteed Savings Approach Financier (Bank or Other Financial Institution) ESCO (Project Developer) Loan Repayment Loan Project Fees Customer Project Design and Implementation; Savings Guarantee to Customer (Project Owner) In a typical Guaranteed Savings contract, the customer obtains capital directly from a third-party financier to finance the project. The customer then partners with an ESCO with a guaranteed savings contract, which typically lasts for several years. The ESCO guarantees the customer a minimum level of savings that will be achieved through the design and implementation of the energy saving project. The customer then pays a deposit or first installment for the energy work (such as the installation of equipment) to the ESCO during the project implementation, while withholding the rest until the project has been completed and energy savings have been verified. The customer may also need to pay an ongoing fee to verify savings (usually annually) or to maintain the equipment that has been installed. The savings realized is agreed in the initial stages of the contract. If the actual savings are less than what the ESCO guarantees, the ESCO will reimburse the customer; whereas if the savings exceed the amount guaranteed, the customer typically keeps the excess. Essentially, this means that the ESCO takes the performance and design risk, the project owner takes the energy price risk and the financier takes the financial risk. Two key advantages for the customer of adopting the Guaranteed Savings approach are that a minimum level of savings is guaranteed by the ESCO, and that upon project completion, the customer has ownership of the equipment installed. However, extra costs may arise from monitoring and verification of the savings after completion of the project. Page 10

Shared Savings Approach Fig. 3: Shared Savings Approach Financier (Bank or Other Financial Institution) Loan Payment ESCO (Project Developer) Energy Saving Split Project Design & Implementation Financing Project Customer (Project Owner) Energy Saving Split The Shared Savings approach utilizes the potential savings as the project capital. In a typical Shared Savings contract, the ESCO instead of the customer first obtains capital from a third-party financier. The ESCO then designs, implements and finances the energy saving project. The customer usually does not have any contractual obligations with the financier; instead they have a shared savings contract with the ESCO, which specifies that a share of savings gained by implementing the energy project will be paid to the ESCO this figure is usually more than 50 percent 7. Once the energy project is completed, the customer then pays the ESCO a share of the energy savings, and the ESCO uses these savings to repay the loan from the financier. The ESCO makes a profit if its share of energy savings exceeds the loan repayment. In view of this, the ESCO takes all financial risks associated with the project. Sometimes, energy savings may be valued based on prevailing energy prices, meaning that the ESCO may also take energy price risks. 7 Electrical and Mechanical Services Department (2008), Overview of Energy Performance Contracting. Hong Kong Page 11

One of the key advantages of the Shared Savings approach for the customer is that minimal financial risks are borne by the customer, since the ESCO takes on both the financial and energy price risks. However, one disadvantage is that the ESCO typically retains ownership of the equipment that was installed during the project. Table 2: Summary of the Differences between the Guaranteed Savings Approach and the Shared Savings Approach Guaranteed Savings Approach Shared Savings Approach Possible Risks Borne by the Customer/Project Owner The customer/project owner takes the credit risks as they need to repay the debt to the financiers. The customer/project owner takes the performance risks, as the performance of the project will affect the savings shared between the customer and the ESCO. Level of Savings The level of savings is agreed between the customer and the ESCO at the start of the project, and may be fixed throughout the duration of the project. The savings are guaranteed by the ESCO to meet the customer s debt obligations. The level of savings depends on the actual amount of electricity saved, which in turn depends on the prevailing market price of electricity/energy. The fluctuation of market electricity prices will affect the level of savings. Ownership of Equipment Installed during the Project Extra Cost Paid by Customers The equipment belongs to the project owner. Extra costs may arise from extensive monitoring and verification of savings. The equipment may belong to the ESCO, as the equipment may be leased. Usually nil during the project period, but the ownership of the equipment may/may not revert to the ESCO after the project period. Page 12

4 Tips for Customers Energy Performance Contracting is still a relatively new service in Hong Kong, and as such customers generally do not have an in-depth understanding of how the process works. Additionally, there is currently no widely-recognized EPC standard, meaning that the process may vary greatly between service providers. As up to three parties (the customer, the ESCO and the financier) are involved in an EPC project, customers may find the contractual obligations of energy performance contracts too complex. To help address the above issues, here are some tips for customers: Understand the concept of EPC Apart from the information provided by the ESCO, there are many other EPC-related guidelines available on the Internet to help you understand the EPC models. Understand the operation of different EPC models and their pros and cons. Understand your needs and capability Consider the desired project scope. This is likely to depend on the customer s resources, which include but are not limited to: capital, time, personnel and policy support. Compare the service packages provided by different ESCOs. Compare different EPC models and financing modes, and choose the one that best suits your needs. Understand the contract Ensure that there is a comprehensive measurement and verification plan which has been mutually agreed by both the customer and the ESCO. This plan should clearly state how the baseline measurements, energy consumption and savings are to be determined. The International Performance Measurement and Verification Protocol (IPMVP) has been widely adopted in different countries to verify the savings claimed by ESCOs, and can may as a valuable reference for customers. Understand your obligations. Delivering the expected energy savings is not only the obligation of the ESCO but also the customer. Customers should cooperate as much as possible with the ESCO in such areas as: Page 13

Providing accurate information to the ESCO in order to calculate baseline measurements and energy savings; and Ensuring staff operate facilities according to the procedures stipulated in the contract or agreed with the ESCO. This is to ensure that energy savings are not undermined by the improper operation of facilities. Other considerations Consider the ESCO s track record and reputation in delivering energy savings. This is especially important when the Guaranteed Savings approach is adopted, when the customer is responsible for repaying loans to the financier through energy savings achieved. Interested parties may also wish to consult the CarbonSmart Programme website (http://www.carbonsmart.hk/) for useful information related to EPC, including a list of energy-related organizations registered under the programme and EPC success stories. Page 14

5 Frequently Asked Questions Q1: What are the basic steps involved in implementing an EPC? A1: Typically, a customer should first decide which approach is more suitable for their energy efficiency enhancement needs: EPC or the common energy management approach. Chapter 2 of this guide explains the differences between the two. If EPC is considered more suitable, customers should select an appropriate ESCO to implement the EPC process, define the scope of the project and negotiate the contract. After the EPC has been implemented, longer-term steps include facility maintenance, savings verification and the eventual closing of the project. Q2: What factors should customers take into consideration when negotiating a contract with an ESCO? A2: The energy performance contract factors to which customers should pay close attention are funding, maintenance, performance guarantees, baseline adjustments, and measurement and verification 8. Q3: What does measurement and verification refer to? A3: M&V refers to the measurement and verification of energy savings. Before implementing any energy efficiency measures, energy use is tracked and recorded. This measurement becomes the baseline energy use. After implementing energy efficiency measures, the new level of energy use is compared with the baseline levels; with adjustments being made for factors affecting energy use, including variations in weather, occupancy, operation hours and production 9. Q4: What are the major differences between the Shared Savings approach and the Guaranteed Savings approach? A4: These are two EPC models, each of which uses a different form of agreement between a customer and an ESCO. In the shared savings approach, no funds are required from the customer at the beginning of the project, but at the close of the 8 The Australian Energy Performance Contracting Association for the Energy Efficiency Best Practice Program in the Australian Department of Industry Science and Resources (2000) A Best Practice Guide to Energy Performance Contracts, Commonwealth of Australia, Australia 9 Sustainable Energy Authority of Ireland (2012) A guide to Energy Performance Contracts and Guarantees, Ireland Page 15

project, the customer has to pay the ESCO a portion of the energy savings realized. Costs may also arise from the long-term maintenance of energy facilities. Conversely, in the guaranteed savings approach, the customer has to pay the ESCO to provide energy efficiency improvement works at the start of a project. The ESCO guarantees a level of energy savings that will be achieved over the contract period; usually greater than the initial investment by the customer. If the energy savings is less than what is guaranteed, the ESCO pays for the shortfall. Q5: How long is the contract period? A5: The contract period may vary greatly from three to 20 years, depending on a number of factors, for example the payback period of the initial investment. Q6: What are the risks commonly associated with an EPC? A6: There are risks associated with an EPC but it is too broad to cover in this guide. However, according to the Joint Research Centre Institute for Energy and Transport of European Commission, there are three major types of risks that customer will need to pay attention to 10 : Technical risks the energy facilities may not perform as expected, or the underlying assumptions made when predicting savings may not be correct. These may eventually lead to discrepancies between actual and expected energy savings. Credit risks the customer may not be able to pay for the project as agreed in the contract. Energy risks energy prices may change, which will directly affect the value of any energy savings gained. 10 Joint Research Centre - Institute Energy and Transport Energy Performance Contracting (2014), Energy Performance Contracting, website accessed 11 st June 2014, [http://ee.emsd.gov.hk/english/general/gen_other/gen_other_esco.html] Page 16

Q7: What assistance can the CarbonSmart Programme provide? A7: The CarbonSmart Programme provides information on energy efficiency support services, aiming to encourage and sustain concerted industry effort in the areas of carbon audit and reduction. Eligible parties can register with the Directory of Energy-related Organizations (http://www.carbonsmart.hk/en_energy1.asp), while energy users i.e. potential customers may utilize the Directory as a source of information on companies which can provide services to enhance energy efficiency. Page 17