The energy efficiency landscape
Although UK energy prices are low relative to a year ago, there remain regulatory drivers in place that may cause large commercial energy users to consider the need for energy efficiency projects.
A number of these drivers have emerged from the Energy Efficiency Directive 2009/125/EC and 2010/30/EU. The effects of that Directive’s transposition into national law (generally mandated to be implemented by summer 2014) are now filtering through to commercial and industrial organisations. For example, in addition to existing potential exposure to CCL or binding commitments under Climate Change Agreements, the CRC Scheme and EU ETS, the Directive prompted The Energy Savings Opportunity Scheme Regulations 2014.
Under those Regulations, private sector “large undertakings”* or “small or medium undertakings” which are part of a larger group undertaking, must carry out comprehensive assessments of energy use and energy efficiency opportunities at least once every four years.
The deadline for the first compliance period is looming - 5 December 2015.
Some organisations may simply wish to tick the box. Others may see this as an opportunity to understand more about how and when energy is used in their organisations and then take the next step – assessing how energy efficiency projects can reduce their energy use and carbon footprint.
In this context, the Directive has not only focused on mandatory requirements for business but helpfully has sought to encourage the implementation of practical measures to increase energy efficiency. Under Article 18, national governments are required to:
- Promote the energy services market;
- Promote access to SMEs to that market;
- Disseminate easily accessible information on:
- available energy service contracts and clauses that should be included in such contracts to guarantee energy savings;
- financial instruments, incentives, grants and loans to support energy efficiency service projects.
In January of this year, DECC issued a model Energy Performance Contract and guidance as part of its compliance with the Directive. The energy efficiency industry itself is rolling out contract models that seek to dismantle barriers that inhibit growth of the sector. Whether the combined weight of government measures and industry initiatives will boost the energy efficiency contracting sector remains to be seen - but greater government engagement is a positive step forward.
MESAs and ESAs
Two industry contract models (originating in the USA) that seek to dismantle barriers to growth are the Managed Energy Service Agreement (MESA) and the Energy Service Agreement (ESA).
How they work
Under both a MESA and an ESA the customer does not bear significant upfront costs. The energy efficient equipment is procured by the provider who funds and owns the equipment.
Under an ESA, the customer pays a service charge to the provider. This is a percentage of actual energy savings achieved - the “negawatt”. The detailed drafting will specify a baseline energy figure against which actual usage can be compared. The service charge is used by the provider to service debt and meet other outgoings as well as providing a return on its investment.
Under the MESA, the financing arrangements remain the same as for the ESA but additionally the provider pays the customer’s actual utility bills. It then charges the customer a service charge for all of the customer’s utility costs (commonly based on historical usage). The service charge is broadly fixed but, depending on the deal, can be subject to adjustment to reflect occupancy, usage and tariff changes. The differential between that service charge and actual energy costs is used by the provider to service debt, pay other costs, provide a return on its investment and pay the utility bills.
Unlocking structural barriers
The balance sheet issue
Both MESA and ESA arrangements are designed to be off-balance sheet solutions for the customer on the basis that the customer is buying a service not equipment. Simply characterising the output as a service though does mean that the arrangement is off-balance sheet. The key is the substance of the arrangement.
Under current UK accounting rules, if the service is dependent on a specific asset and the customer has control over that asset, it is likely that the arrangement would be treated as a finance lease and sit on the customer’s balance sheet. To minimise that possibility requires careful accounting/financial structuring and the inclusion of drafting to reflect those arrangements. Typically this might include (mirroring accounting guidance):
- The provider is only required contractually to deliver a service output not an asset input and is free to choose and substitute the assets required to deliver the outputs without the customer’s consent. If that is not achievable the control issue has to be tackled.
- To demonstrate that the customer does not have control, the contract drafting would need to reflect the following:
- The provider must be clearly stated to be the owner, operator and maintainer of any assets installed;
- Robust property rights must be granted to the provider to reinforce that it has physical control over on-site assets.
- Contractual controls to be drafted to protect against interference by the customer of asset operation.
- Payments to the provider are either fixed per unit of output or equal to the current market price at the time of delivery. This demonstrates service payments as opposed to payments linked to asset value.
But the contract drafting must follow accounting advice taken by a client on a case by case basis.
Mortgage lender limitations
Provided structured appropriately, the MESA/ESA model should avoid any suggestion that project debt has to be accounted for by the customer and should not therefore affect any borrowing covenants already given in respect of the customer’s building/estate.
Commercial landlord and tenant arrangements can create a specific misalignment of incentives. Where a tenant pays utility bills and a landlord pays for energy efficiency related capital expenditure on its building/estate, the tenant benefits from lower utility costs as the energy efficiency measures gain traction. The landlord is therefore not incentivised to invest in those measures (unless perhaps there is a rental premium) if the benefit accrues to others.
Under the MESA model, the provider (not the tenant) captures and utilises the energy savings to meet its capital and operational costs and deliver its returns. The landlord passes through to the tenant the fixed provider service charge as a landlord operating cost.
In turn, the provider may require the fixed service charge to be subject to adjustment to reflect increased energy usage by the tenant. In this way the tenant is incentivised to manage its energy usage. This safeguards the provider against utility bill reductions due to energy efficiencies being offset by bill increases caused by increasing tenant energy usage.
To solve the split incentive problem under an ESA would require pass through to the tenant all or some of the provider’s service charge as a landlord operating cost. This would ensure that the tenant did not receive benefit of the decrease in utilities bills with the landlord fully exposed to the provider’s service charge.
If MESAs, ESAs and similar models, coupled with government initiatives, assist in unlocking the issues above that have hindered uptake to date, this in turn may create:
- A more viable project pipeline;
- A demonstrable track record of success that could increase investor confidence; and
- Opportunities to capitalise on integrating these products with other demand side initiatives e.g. energy storage and demand response contracting.
*A large undertaking is one that employs at least 250 people or has an annual turnover in excess of fifty million EURO and a balance sheet in excess of 43 million EURO. Public sector bodies are not caught by the Regulations.