Performance contracting

Performance contracting is a means of raising money for investments in energy efficiency that is based on future savings. It enables money that will be saved as a result of the introduction of a new energy-efficient technology to be used to offset the cost of financing, installing, operating and operating that technology. By definition, the future savings must be greater than the costs.

(Two other forms of savings financing are 'vendor financing' and 'savings reinvestment'.)

Performance contracting, also known as 'third party financing' or 'contract energy management', can be used to pay for measures to reduce energy costs and waste disposal costs, or to recover materials.

A third-party contractor designs, installs, finances and, if required, operates a new technology. The contractor is then paid according to the savings achieved - i.e. the performance.

The benefits of a performance contract for a business include:

• Reduced risk - the contractor takes on the risk of not achieving savings;
• Turn-key services - the performance contractor provides all required services;
• The business or institution needs less internal expertise;
• Project financing can be 'off balance sheet' and not affect debt load;
• State-of-the-art products and services are used;
• Savings are normally much higher than if the business or institution carries the work itself;
• Additional improvements to environmental performance can be paid for out of the savings.

Companies that provide performance contracts and energy services are called energy service companies, or 'contract energy management companies' or 'energy management companies'.

Parties to a performance contract

There are normally two or three parties to a performance contract:

1. The business or institution requiring the services;
2. The performance contractor providing the services;
3. A financial institution providing financing for the services.

The contract arrangements between these parties will depend on the type of performance contract and the sources of financing used. Other important considerations include savings guarantees, project size, method of savings verification, and handling of risk and insurance.

Types of contract

There are a number of different ways of structuring a performance contract. The most common is 'first out' or 'guaranteed savings', in which all the contractor's costs (equipment, installation, mark-up, fees and so on) are repaid annually out of the savings as they accrue. The length of the contract (typically four to eight years) is usually chosen so that all costs are paid for out by the end of the contract period.

This method allows the addition of extra measures as the contract progresses, with the increased savings covering the higher costs.

The second type of contract is known as 'shared savings'. In this arrangement, the business and the contractor agree to share the savings over the contract period according to an agreed formula. The actual cost of the measures is not included in the contract, and the business has no obligation to pay off those costs. In return, the performance contractor does not guarantee the savings. Contract terms are usually longer - up to 10 years - because it takes longer for the investment to be recovered, and the risks to the contractor are higher.

The third type is the 'chauffage' or full energy/environmental services contract. Here, a performance contractor effectively takes over the operation of a customer's utility or production facilities as well as upgrading them, and often pays the customer's utility bills as well. The business pays the contractor a regular fee equal to the utility bills before the project or some other negotiated fee. This arrangement is generally found in Europe, where the complete management of a building or facility by a contracted third party is more common.

Project size

Projects carried out under a performance contract must be of sufficient size for the savings generated to cover both the equipment upgrade itself and the project costs. The latter can be minimized by aggregating smaller projects together into a single contract, and/or streamlining the bidding and assessment process by using standard practices and pre-qualified equipment and contractors.

For smaller projects, or those where changes are to be made over a number of years, a different approach is more appropriate.

Sources of financing

Energy efficiency and pollution prevention measures installed under performance contracts may be financed in one of three ways: by the business itself; as a loan from a financial institution or special fund; or by the performance contractor itself.

If the performance contractor provides the financing, it is termed 'off balance sheet' or 'non-recourse' financing. The contractor can use its own funds, borrow money, or sign a leasing arrangement. The business has no debt, and its only obligation is to pay the contractor all or a share of the savings during the contract period.

If the business finances the investment, it has a debt. However, the contractor guarantees that the savings will provide enough cash flow to repay the loan as well as to cover fees and costs.

Methods of savings verification

Verifying that savings actually occur is an important part of any performance contract. Three methods are normally used: (i) deemed or stipulated savings; (ii) savings based on utility bills; or (iii) measured savings.

In the case of deemed or stipulated savings, annual payments are made based on savings estimates made before contract signing. A concept study is used to provide these estimates, using measurements or other audit information taken before the project starts, and the performance characteristics of the equipment to be installed.

Savings based on utility bills provide the most common method used for savings verification. Here, energy and water savings provide the basis for repayments. Baseline consumption is determined using past energy bills. Savings are calculated using the actual energy bills received throughout the contract period.

The third method, measured savings, involves 'before' and 'after' measurement of utility use by the technologies installed in the project. This is the most exact method of determining savings, but also the most costly. Adjustments have to be made for weather and facility use changes, and because equipment loads can vary from day to day, elaborate protocols need to be established.

Risk sharing and insurance

In any performance contract, the contractor takes on the risk of the expected savings not being achieved. A contract can take account of factors that would affect the savings such as warmer winters or cooler summers, or changes in the use of the building. Other factors, such as insolvency of the energy user or non-payment of fees, are problems faced by any contractor.

Risk can be diminished in several ways, including the use of due diligence when assessing the project.

Is performance contracting right for your organization?

If performance contracting is to be used, a business or institution should:

• Be able to finance the project itself or have sufficient financial health to meet the payments required;
• Have the authority to sign an energy performance contract;
• Have reasonable knowledge of expected major capital expansions, and changes in ownership, facility use and occupancy that are likely to occur over the life of the contract;
• Have internal technical, legal and managerial capability to understand performance contracting and to work with an ESCO.

Types of energy service companies (ESCOs)

Companies offering performance contracting services include:

1. Equipment suppliers: performance contracting services are normally offered by an independent branch of companies such as industrial control manufacturers, both as a marketing strategy and as an additional revenue source; this is the best choice if these technologies are the main measure being considered.
2. Fee-based service companies: performance contracting is the only service offered by these companies, which grew out of energy management and other contractors. They are the best choice if a wider range of measures is being planned or if the contract is to cover building renovation and long-term facilities management
3. Utility-based ESCOs: some electric utilities have set up their own ESCOs to deliver demand side management programmes and to provide an additional source of revenue. These are a good choice if the project is focused on electricity or gas technologies.
4. International energy companies: some larger power utilities, independent power companies and consulting firms have established subsidiaries in several countries (often through joint ventures with local companies) to offer performance contracting services.

Choosing a contractor

An ESCO undertaking an energy performance contract must have the technical, business, financial and management skills necessary to carry out a turnkey project. In most countries, an industry association exists to provide accreditation of members to assist clients with ESCO selection. In the US, for example, this function is provided by the National Association of Energy Service Companies.

Two options are available for procuring the services of an ESCO on a performance contracting basis: first, a 'request for qualifications' (RFQ), and second a 'request for proposals' (RFP).

In the case of an RFQ, the range of measures required (energy and water efficiency, maintenance and so on) is specified, and ESCOs are asked to submit qualifications. The final contractor is selected on the basis of experience in the sector, financial stability and other factors. The chosen contractor then carries out a detailed concept study and makes a contract proposal under a letter of agreement that stipulates that if no contract is issued, the cost of the concept study will be paid for. The final scope of the project is then discussed, the basis of payment negotiated, and the performance contract drawn up and signed.

The RFQ method is preferred by most clients and ESCOs, because it is quicker and cheaper.

However, some public institutions are required to use competitive tendering for all contracts. In this case, a shortlist of qualified bidders is drawn up, and then these companies are asked to prepare proposals for carrying out the work. The contractor is selected based on the lowest bid or other criteria specified by the client.

Under this RFP method, contractors are required to undertake detailed assessments of the work without any that they will recover the cost. Experience has shown that the RFP approach does not necessarily lead to a lower project cost.