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ESCOs: Risks & Rewards

Aug. 31, 2010
Energy Service Contracts represent a dynamic and constantly evolving business model, driven by facility modernization and mandatory savings initiatives.

What exactly is an ESCO? The answer you’ll get depends on whom you ask. Even the name itself can stand for Energy Service Contractor or Energy Service Contract (ESCO). So, yes, an ESCO could provide a customer with an ESCO. Let's just say that ESCOs represent a dynamic and constantly evolving business model.

ESCOs were conceived in the 1970s to reduce U.S. dependence on foreign oil. In the mid 1980s to early '90s they came to the forefront, driven by the realization that thousands of megawatts of electricity could be saved at as electric generation was becoming expensive.

Most ESCOs are focused on institutional and industrial users of electricity. Their core purpose remains to improve building energy efficiency, although the door is wide open for expansion into renewable energy and other technologies.

Why should you be involved in the energy services market? Because there's a huge stock of existing buildings that need these services, and many newly-constructed buildings are mandated to meet verifiable performance standards. Your competitors in the HVAC business will be offering ECSO services, and new, ESCO-specific competitors are going to appear. Your choices are to lead, follow, or get out of the way. Unfortunately, following or getting out of the way puts your customer relationships in jeopardy and your margins at risk.

To know what you're getting into as an ESCO, it's useful to know what your customers will expect. Here are some definitions that point out the broad range of expectations of an ESCO.:

"A business that develops, installs, and arranges financing for projects designed to improve the energy efficiency and maintenance costs for facilities over a seven to twenty year time period." — National Association of Energy Service Contractors (NAESC).

  • "A self-financing mechanism to pay for energy efficiency retrofits and capital improvements." — Building Owners and Managers Association International (BOMA).
  • "A means of raising money for investments in energy efficiency based on future savings. It enables money saved as a result of new energy-efficient technology to be used to offset the cost of financing, installing, operating, and maintaining that technology." — Business and Sustainable Development
  • "A turnkey service, sometimes compared to Design/Build contracting, which provides customers with a comprehensive set of energy efficiency, renewable energy, and distributed generation measures, and is often accompanied with guarantees that the savings produced by the project will be sufficient to finance the full cost of the project." — U.S. Environmental Protection Agency (EPA).

Add to these far-ranging definitions (and the accompanying customer expectations) the real kicker about being an ESCO: you're "in it" with your customers. According to the EPA, excluded from its definition of ESCOs are "companies such as engineering and contractors . . . that may offer energy-efficiency services, but do not assume performance risk for their projects. We only consider [companies] an ESCO if they offer performance contracting — projects in which the ESCO assumes some performance risk during the project's economic lifetime — as a core business line."

In other words, while traditional contracting activities focus on managing the scope of the project, ESCO activities focus on managing the outcome of the project.

This brings us to the key themes of ESCO work: the projects must be turnkey to the customer, and they must offer guaranteed energy efficiency.

ESCOs are basically self-financed: they don't get paid unless their customers save money. In fact, the sole source of payment to many ESCOs comes from the savings their customers achieve. This makes ESCOs partners in their customers' risk, and points out the importance of creating a comprehensive energy plan that will ensure savings well into the future. If your company doesn't deliver on the promised energy savings, the financial consequences can be severe and long-lasting. If you're not willing to assume that risk, being an ESCO isn’t for you.

Why Are ESCOs Growing?
Why is now the time to look closely at offering ESCO services? The ESCO industry has had its ups and downs since the 1970s, but it has seen tremendous growth since 2004. Reasons for this growth include: an increasing interest in green and sustainable technology, concern over the role that greenhouse gases such as carbon dioxide (CO2) may play in global warming, and volatile energy prices.

Add to this the growing emphasis of federal, state, and local government on ESCO activities, a continued lack of capital and maintenance funding at many commercial properties, and the impetus provided by the American Reinvestment and Recovery Act, and you have a "perfect storm" (in a good sense) for the ESCO market.

Market Drivers & Constraints
As with any business, there are market drivers and market constraints for ESCOs. The drivers include facility modernizations undertaken by building owners, and federal and MUSH (municipality, university, school and hospital) mandatory energy savings initiatives that often come without capital funding.

Market constraints include the need for ongoing measurement and verification of building performance, a shortage of skilled personnel, dealing with government bureaucracies, and dealing with the vagaries of the commercial real estate market and the sometimes difficult financial lending practices of the private sector.

If you're interested in broadening the scope of your business, providing much-needed (and even mandated) services to a huge market, and positioning your company as the leader in energy services in your area, the ESCO market beckons. Just know the risks and rewards going in. You're going to be partnering with customers for years to come, with your profits totally dependent on your performance. This means that the focus is on the people, at a higher level than is found in traditional service and installation contracting. You must put together a talented, qualified team to ensure that your company can deliver what it promises. And, you must select customers carefully, too, as you will have long-term obligations to them.

A few tips to remember: first of all, being an energy services company is not the same as being in the construction or service business. Solutions and savings are often achieved through equipment and building optimization, not necessarily equipment sales. Focus on a specific market to start, such as school or hospitals. Build your expertise and portfolio in one area, and then branch out.

It's OK to think big, but there's nothing wrong with starting small.

Bob Swanger, LEED AP, is vice president of Harris Service Companies, St. Paul, MN. Swanger can be reached at 651/602-6500, or by e-mail at http://[email protected]. This article is based on the presentation, "ESCOs and Performance Contracting," which Bob Swanger delivered during the Commercial HVACR Symposium, Sept. 23-24, Baltimore MD. The Symposium was part of Contracting Business's original show concept, HVACR WEEK. Watch for more articles from the Symposium in future editions of Contracting Business.