Energy service agreements: Potential big kid in town?

Blog Post | February 12, 2019 - 10:00 am

This is the first of a four-part series of blog posts on recent developments and trends in energy efficiency finance. Subsequent posts will discuss PACE financing and on-bill financing and financing deep retrofits.

Energy service agreements (ESAs), a type of financing, are growing in popularity. Under an ESA, a service provider delivers energy-saving services using equipment it owns and operates. Recent projects include multimillion dollar investments by financial institutions (Citi and Generate Capital) and a large utility (National Grid). While most ESAs target large businesses and institutions such as hospitals and universities, at least one vendor now provides these services to homeowners.

ESAs, available for many years, have gained notable support in the past year because they provide services guaranteed to save energy in a way that is designed to be off company balance sheets at a cost that is less than or equal to existing utility charges. Many companies want to minimize the liabilities shown on their balance sheets and therefore often prefer off-balance-sheet financing. In contrast, some other financing strategies – such as power purchase agreements and operating leases (including many energy savings performance contracts and shared savings agreements) – that previously were off the balance sheet now need to be disclosed on company financial statements under new guidance from the Financial Accounting Standards Board (FASB).

Under a typical agreement, the ESA provider develops, finances, and operates projects, with the customer paying for these services through a services charge based on realized savings. The ESA provider often subcontracts engineering and installation to an energy service company that can implement complex projects and guarantee savings. In some cases, the ESA provider pays a facility’s energy bill and in turn bills the customer for the combination of energy and energy efficiency services (this variation is sometimes called a “managed energy services agreement” or MESA).

An ESA can also be used to finance and install distributed energy equipment (e.g., solar or combined heat and power) or water efficiency (commonly labeled “efficiency service agreements”). Sometimes the terms “efficiency as a service” or “energy as a service” (EaaS) are used instead, as highlighted in a recent ACEEE technology brief. A 2017 Navigant Consulting research report estimates the annual global market deployment potential of EaaS in large Fortune 500 commercial and industrial sector buildings will reach $221 billion by 2026.

ESAs are beginning to scale

In the past few years, a growing number of ESA projects have been implemented. For example, Metrus Energy, with financing from Citi, has signed six agreements, totaling $62 million, with a large technology company in the Fortune 100 (the company name is not public). The projects mostly involve installation of LED lighting at company sites around the country. Metrus is the sponsor and equity provider, with debt financing from Citi and design and installation by SmartWatt. This program includes some leased properties (where landlord consent is needed) and blending of site economics. It combines economically strong sites with economically weaker ones to provide an adequate return on the entire package.

Metrus also recently signed an agreement with National Grid to work together to identify $50 million of energy efficiency projects within National Grid’s New York State service territory, and it has other ESA projects involving a variety of energy and water efficiency measures. Its ESAs for large commercial entities have terms typically ranging from 5 to 15 years. Metrus has projects in 21 states that it estimates will cumulatively save more than a billion kWh.

Other companies are also offering ESAs. For example, Carbon Lighthouse focuses on large commercial buildings that are typically at least 200,000 square feet, particularly offices, hotels, and conference centers. It also sometimes works in buildings as small as 50,000 square feet. Through a process it calls “efficiency production,” Carbon Lighthouse sources original data via dozens of sensors placed throughout the building, supplemented by utility, weather, and other existing information to identify the scattered and hidden inefficiencies that add up to significant savings — typically 10-30% of building energy spending (15-20% savings are most common). Its retrofit packages are often built around a building management system but include lighting upgrades, equipment replacement, and when possible, solar systems.

Every Carbon Lighthouse project is underwritten by Hartford Steam Boiler, a global company offering equipment insurance, and can be financed through a Generate Capital project fund. Carbon Lighthouse guarantees the energy savings and cuts a check to the customer if savings fall short. For buildings where tenants pay for utilities, it works with the building owner to recoup costs through common area maintenance charges. The company has worked in more than 600 buildings across the United States to date and has been particularly active in California, Hawaii, and the Northeast.

Several other companies are offering ESAs to commercial customers, including Redaptive, Spark Fund, and Empower Equity.

ESAs are also going residential

One company, Sealed, is now offering ESAs for single-family homes under its HomeAdvance financing program. It offers energy efficiency retrofit packages as well as oil-to-gas heating system conversions, financed with an ESA. Sealed reaches customers through a variety of channels, but is increasingly focused on co-branded marketing partnerships with utility companies such as Con Edison in the New York City area. Customers are qualified via a virtual process, including the development of a non-binding proposal. After a customer is qualified and verbally commits to move forward, Sealed works with local contractor partners who conduct a home assessment, finalize a contract, and install the improvement packages. Common efficiency measures installed include air-sealing, insulation, and smart thermostats.

Sealed estimates that, on average, these packages reduce electricity use by about 5% and heating fuel use by about 20-25%. The typical energy efficiency package costs $6,000-7,000. The company finances the installation with a 20-year service agreement, pays the utility bill, and then collects monthly service fees from the homeowner based on actual energy reductions such that customers’ energy bills are similar to prior energy bills. As of the end of 2018, Sealed had signed agreements with about 300 customers, 200 of whom signed on last year.

So far Sealed’s service is offered in New York State, because initial financing comes from NY Green Bank. Sealed is exploring financing that can be used in other states.

Lessons to date

ESAs provide one route for customers to finance substantial efficiency retrofits and make it easy to implement energy-saving improvements; customers just need to say yes and pay service fees that are based on savings. However the sales cycle and contracts are complex and as a result, most ESAs to date are for either large owner-occupied buildings or multiple smaller buildings owned or rented by large companies.

The examples above involve standardized types of measures (lighting, commercial building “retrocommissioning,” and residential weatherization packages) that can be expected to result in a medium level of savings (roughly 10-25%). These standardized packages are offered to well-understood customer segments, helping to keep costs in check and making marketing easier. Thus far ESAs have not been used for deep retrofits that save 30% or more. However we talked to one company that aims to break this barrier by combining ESA financing with utility incentives, allowing the execution of larger projects and correspondingly larger savings.

With an ESA, the service provider incurs substantial upfront costs and takes both credit and performance risk; these costs are passed on to customers over the life of the contract. For example, the payments under a Sealed 20-year contract average roughly double the initial cost of the work, with the difference between upfront investment and lifetime payments primarily covering financing costs (including risk allowances), but also marketing and administrative costs .

Not all customers will want to commit to 10- or 20-year contracts and not all will meet program requirements. For example, Sealed requires a FICO credit score of at least 680 and residence in the home for at least six months to provide an energy-use history. And because of the risks involved, the cost of capital tends to be higher than municipal and other low-interest debt. As a result, ESAs are uncommon in the municipal market and other markets with a low cost of capital.

In the past year, ESAs have gained significant momentum. Time will tell whether they continue to grow and potentially become a big kid in town.