There are many major barriers to the realisation of energy management activities. They include the lack of sufficient technical and managerial expertise or time to focus on energy management; the lack of assurance that any resources that are devoted to energy management will actually yield financial benefits; and the difficulty of mobilising the necessary financing for implementing energy management projects.
This is especially true for countries in Central Europe, facing specific challenges and having the highest energy intensity in the world.
In the 1980s, particularly in North America and in Western Europe, a type of firm called an Energy Service Company (ESCO) emerged, specialising in working with clients to overcome barriers to the development and implementation of energy efficiency projects. ESCOs have become more commonplace in most of the western world, and were introduced to some Central European countries in the mid 1990s. Many of these countries, however, are still struggling to introduce the concept today.
THE ESCO CONCEPT
An ESCO can be defined as “A firm that provides integrated solutions for achieving energy cost reductions, whose payments are linked to the performance of the implemented solutions”. This definition contains two essential elements that distinguish it from a conventional approach – the provision of integrated solutions, and the linking of payments with performance.
One important role frequently played by ESCOs is participation in the development of a financing mechanism for the project implementation. Even if the ESCO plays no formal role in the financing of a specific agreement, the mere fact that it is willing to enter into a performance contract can serve to increase a bank’s confidence in the proposed project.
Finally, since the remuneration of the ESCO will be linked somehow to the performance of the project, monitoring and evaluation (M&E) of energy consumption is an essential concept that it needs to master in order to evaluate the savings generated by the projects and to bill its client (or reimburse the client, depending on the contractual approach selected) based on the actual results of the project. The need to develop an acceptable and recognised methodology and tools to realise M&E activities has become one of the fundamental issues for ESCO projects, not only related to the invoicing or guarantee issues but also to the capacity to follow the project performance on a regular basis.
Many organisations have tried to develop protocols that could be used by ESCOs to perform M&E activities. They include the US Department of Energy (DOE) with the Federal Energy Management Program (FEMP), ASHRAE, and the Efficiency Valuation Organization (EVO), with the International Performance Monitoring and Verification Protocol (IPMVP).
ESCO CONTRACTUAL MODELS
An ESCO performance contract can be defined as a service contract in which the ESCO provides a partial or complete service to achieve energy savings in a building or anc enterprise, with a guarantee that the energy savings resulting from the project will be sufficient to reimburse the ESCO in a given period of time. There are three big families of ESCO contracts that are used.
1. Guaranteed savings
The ESCO guarantees that the installed energy efficiency measures will yield energy savings greater than a certain amount. If the energy savings fail to reach the level specified in the guarantee, the ESCO is responsible for making up the difference by making a payment to the client equal to the shortfall in energy savings.
Figure 1 – Guaranteed savings performance contract
2. Shared Savings
A shared savings performance contract, as the name suggests, shares the energy savings between the ESCO and the client according to a pre-arranged formula.
Figure 2 – Shared savings performance contract
Here an ESCO takes over complete responsibility for the provision to the client of an agreed set of energy services (e.g. space heat, lighting, motive power). The ESCO takes on the responsibility for providing the agreed level of energy service – the more efficiently and cheaply it can do this, the greater its earnings.
Figure 3 – Chauffage contract
THE ENVIRONMENT FOR ESCO PROJECTS IN CENTRAL EUROPE
The extent to which ESCOs are established varies greatly across the different countries of Central Europe. For example, in the Czech Republic, Poland and Hungary, the concepts are well understood and ESCOs are relatively commonplace, although there is plenty of scope for further development. Conversely, in Estonia, Romania and Slovenia, the development of this market sector is just beginning. In order to understand such different levels of development, it is of interest to examine the legal, regulatory, fiscal and institutional factors that influence the environment for ESCO activities in Central European countries.
1. Obligations under international agreements
Most, if not all, of the countries in Central Europe have in common the fact that they are parties to the Energy Charter Treaty (including PEEREA – the Protocol on Energy Efficiency and Related Environmental Aspects), and all are linked one way or the other to EU regulations. These international commitments are likely to have some bearing on the environment for energy performance contracting and third-party financing of energy efficiency projects. Both PEEREA and the EU include obligations that explicitly address ESCO-type activities.
At a more general level, the actuality of future EU accession means that all countries have a strong imperative to liberalise their energy sectors and ensure that energy prices reflect true economic costs. The assurance that state interference in energy price-setting is a thing of the past should provide a stimulus to the development of the ESCO sector. The prospect of exposure to competition may also cause electricity distribution companies to seek to retain customers by offering additional services – for example, by forming partnerships with ESCOs to deliver energy efficiency services.
2. Promotional programmes of multilateral agencies
There have also been a number of multi-country programmes in operation in some Central European countries. The most significant is the EBRD multi-projectfacility (MPF) programme, which saw the establishment of ESCOs in Lithuania, Poland, Slovakia and Hungary in cooperation with a number of Western companies. In most cases, this programme was the first in each country to attempt to stimulate the development of an ESCO industry.
Several of the European Union programmes include the promotion of ESCO activities among their objectives. For example, the work programme for SAVE and Altener listed performance contracting and third party financing among the themes to be addressed by projects seeking support under these programmes. Since 2003, EU support for energy activities has been handled under a new, integrated programme known as Intelligent Energy for Europe. It is too early to comment on the level of support it will provide for ESCO activities.
The World Bank has also become involved in supporting the development of the ESCO market. The new development of HEP ESCO in Croatia, and the new Krakow energy efficiency projects, both partly GEF financed, are examples of this.
The International Finance Corporation (IFC) began its involvement in the introduction of the ESCO concept in 1997, through the Hungary Energy Efficiency Co-Finance Programme (HEECP). It ran for four years, and its success has led the IFC to continue to invest in it. The programme provides partial guarantees on loans to energy efficiency projects made by participating Hungarian financial institutions.
The IFC followed up on this success with the introduction of the Central European Energy Efficiency Fund, applying essentially the same mechanisms for many different Central European countries. This is now stimulating the development of the ESCO market in these targeted countries.
3. Local legal, regulatory, fiscal and institutional factors
While the multilateral agency programmes had a powerful impact on the development of ESCOs in the targeted countries, there are a specific number of local legal, regulatory, fiscal and institutional barriers that still prevent ESCOs from flourishing in Central Europe. In many cases, the pioneering efforts of the multilateral agency projects have highlighted the areas where there are weaknesses in local legislation, regulation or institutions.
Of course, it is clear that a favourable environment for ESCO activities depends on there being a favourable environment for energy efficiency investment in general. This implies at the very least an absence of significant energy price subsidies, and a generally high level of awareness of the potential for energy efficiency improvements. In addition to these general conditions, the following specific conditions are lacking in many Central European countries, which hampers the development of ESCOs.
It is important that there is a high level of awareness of the EPC concept among potential clients and financial institutions. The concept can be a difficult one to grasp, and it is common for there to be considerable scepticism among potential clients and financial institutions that there could possibly be a win-win situation. A sufficiently high level of awareness (and a low level of scepticism) can only be achieved through the implementation and wide dissemination of demonstration projects. Transparent and favourable regulation of tariffs The ideal situation in which ESCOs can flourish is a system within which tariffs are set according to economic costs. However, even in situations where this is not yet the case, transparency of tariff setting at least provides project partners with a high degree of certainty as to their future costs and obligations throughout the lifetime of a performance contract.
Clarity of responsibilities
Constructing an energy performance contract is usually a complex task. In situations where there are diverse players whose roles and responsibilities are not clear, or where there is a poor history of communication and cooperation, the task can become so difficult that the transaction costs of setting up the project become prohibitive.
Financial autonomy of the client
For ESCOs to be able to work effectively with public sector clients, the client must be in a position where it has full control over a real, tangible budget. Where a budget is allocated from central government according to actual expenditure, it will prove much more difficult to structure a project according to the EPC principle. Furthermore, unless the public sector body can actually benefit from the money saved through improved energy efficiency, it is unlikely to be motivated to enter into an agreement with an ESCO. This institutional framework is still not present in many Central European countries.
Appropriate procurement procedures
Public institutions may simply be forbidden from contracting out services to external private sector firms. In these cases, ESCOs would find it impossible to work with them. Even where contracting out is permitted, procurement regulations may require lowest first-cost to be the deciding criterion, which would effectively exclude ESCO-type arrangements. Another potential obstacle is where regulations impose a maximum permissible contract length that is too short for an ESCO project to yield savings.
Favourable fiscal treatment
Many particularities of the fiscal rules in Central European countries related to VAT, income taxes and amortisation processes present a special challenge that is limiting the development of the ESCO concept in these countries.
Clear and simple legal procedures for recovery of assets
In some cases it may be necessary or advantageous to structure a project such that the ownership of energy efficiency equipment remains with the ESCO for the duration of the contract, similar to a leasing arrangement. However, unless the ESCO is confident that it will be able to recover the assets reasonably rapidly in the event that the client defaults, the risk will be too great. Where a strong leasing market already exists, it can safely be assumed that the timely recovery of leased assets is not a serious issue.
Proven methodology for determining energy savings
In some circumstances, it can be difficult to determine accurately the actual level of energy savings achieved, particularly with clients whose energy use is not constant. The main difficulty here resides in the fact that ESCOs are trying to measure energy consumption that did not occur, in order to demonstrate the savings generated. The availability of cash flow to service a loan may depend crucially on this determination. Financial institutions are likely to be reluctant to lend money for a project while there is any uncertainty in this respect. This is why monitoring of energy consumption is so essential in the ESCO concept.
The ESCO development in Central European countries is currently quite different from one country to another. On the one hand it continues to be dynamic, with wide and varied institutional changes and market fluctuations. On the other hand, there are still many institutional barriers that will have to be addressed in the near future to enable the development of the ESCO market.
But otherwise, ESCOs still face the same challenges as anywhere else where the concept has been used. Monitoring and evaluation of energy savings play a fundamental role and are considered one of the most important skills an ESCO must master in order to succeed.
All in all, the future seems to be bright for enterprising and risk-taking firms which are now advancing into this new territory. As commercial banks and financial institutions are starting to view energy efficiency as a potentially attractive financing opportunity, and as multilateral and bilateral institutions are designing sharply focused technical and financial assistance packages that would bridge some of the missing links in the energy efficiency market, we can expect the emergence of ESCOs in most countries in the near future. The next few years should have vibrant stories to unfold.