Economics of a third-party financing model for energy efficiency projects

Energy Efficiency ("EE") projects have traditionally been bilateral transactions between the energy consumer("Host") and the implementing agency, usually an Energy Services Company ("ESCO""). Typically, these projects are financed by the Hosts through internal cash accruals or debt, although some alternative financing models have emerged in recent years. In many cases, a Host may decide to either defer or drop EE projects even when these are financially viable, due to a number of reasons. EE projects compete for limited capital with other projects that may have a higher Net Present Value ("NPV").

Even in situations where EE projects have high NPVs, they may not be sufficiently large or material enough to justify the Host management's attention as energy may not be the dominant component of the Host's expenditure. Vendor financing could also be difficult as many of the ESCOs lack the financial wherewithal to extend credit to the Hosts, resulting in a "financing gap" for the project.

Given this situation, there exists an opportunity for third-party providers of capital to finance EE projects in expectation of market competitive returns and help the two parties overcome the financing gap. Third-party financing for energy efficiency ("EE") projects, is becoming increasingly popular as a financing mechanism for EE projects in the US, Europe and some countries in Asia.

This model, commonly known as "Energy Performance Contracting ("EPC")", involves a tri-partite agreement among the Project Host, the ESCO and the Financier. The Financier covers the upfront costs of designing and implementing the project and, in return, takes a large share of the resultant energy savings to earn back the invested capital plus a competitive rate of return.

Such tri-partite agreements are inherently more complicated and expensive to execute than the traditional bilateral agreements between the Host and ESCO. Energy efficiency projects, particularly in the commercial sector, are typically retrofits and design changes to existing equipment in the Host facility. Financiers that provide capital upfront and require some project-related collateral to safeguard their investments, find it difficult to securitise such retrofits.

Also, given the relatively small size of EE projects and the associated energy savings, high transaction costs involved in third-party financing can render otherwise profitable projects unviable. These challenges notwithstanding, third-party financing represents an important mechanism for scalable, private-sector involvement in the financing of energy efficiency.

In this article, the potential returns for a third-party financing mechanism for a small portfolio of energy efficiency projects in Singapore are assessed. The focus is not so much on accurately estimating the rates of return, but on highlighting the analysis process and issues involved in such a financing model.

To begin with, a set of seven EE projects listed on the E2PO portal are considered for the analysis. These projects were chosen for government grants under the EASe scheme, a Singapore government grant scheme to finance EE audits, and have successfully been implemented with proven energy savings for the Hosts. Some high-level details about total project costs and annual energy savings are indicated on the same portal under each project.

Not all EE projects are suitable

It has to be noted that all EE projects, which are successful from a technical perspective (i.e. those that generate energy savings for hosts), are not necessarily suitable for third-party financing. This model requires projects that: yield high NPVs over relatively short durations; are reasonably large-sized so as to keep transaction costs to about 5-6 percent of total project cost; with energy savings that can be objectively measured.

Of the seven projects listed on the Web site, four projects (Singapore Airline House, Komoco Motors, Singapore Post Centre and Caribbean Keppel Bay) with the highest and fastest returns have been included in the model. Together, they represent investments of about S$2.5 million and generate annual energy savings of 7,000MWh over the lifetime of the project.

Each project is assumed to have its own tri-partite agreement, with the ESCO receiving 80 percent of the project cost upfront from the financier and the subsequent 20 percent in four equal instalments over the next four quarters. The duration of the contract is assumed to be three years (12 quarters), with the energy savings beginning in the quarter after the project has been implemented.

For the duration of the contract period, the financier receives 90 percent of the energy savings generated, with the remaining 10 percent going to the Project Host. After the contract ends, all energy savings go to the Host.

Energy savings and electricity tariffs (assumed at S$0.27/kWh) are assumed to be constant over the contract period, although in reality significant fluctuations can be expected, increasing the investment risk. One-time expenses for Legal, Contractual, Insurance and other Consulting are assumed at about 5 percent of the project cost and incurred upfront. Recurring Monitoring & Verification expenses are assumed to be about 2 percent of the project cost and incurred quarterly.

Based on the above simplifying assumptions, the gross annual returns over a period of four years to the Financier from these four projects are about 54 percent, which is an attractive rate of return compared with other asset classes such as equities and bonds.

While this analysis closely simulates how such a third-party financing mechanism would be structured, the actual returns would primarily depend upon the quality of projects chosen, the expertise of the implementing ESCO, the active involvement of the Project Host, and the volatility in energy savings and electricity prices.

This analysis handpicks four best projects in retrospect and makes a number of simplifying assumptions, a benefit that no Financier has in the real world. Real-world decision dilemmas while choosing projects include the tension between selecting a project that is too small--thus incurring high transaction costs (as a percentage of total project cost)--and a project that is larger but with returns over a longer duration.

Nonetheless, the third-party financing model has been successfully deployed in other countries and could represent an important mechanism to mobilise private-sector capital to fund EE projects. 

BY: Shiva Susarla & Su Liying, Energy Studies Institute