The Pennsylvania Guaranteed Energy Savings Act, like many analogous state statutes, authorizes governmental entities to enter into long-term energy service company (ESCO) contracts, often utilizing third-party financing and requiring a 15-year payback. The operating theory is that capital upgrades, equipment procurement and operational modifications are funded through recognized energy savings resulting from the implementation of facility improvement measures (FIMs). Typically, the ESCO procures financing, balancing short-term returns on investment, such as upgraded lighting and insulation, with longer-term aspects of the build-out, such as co-generation facilities. But with the ESCO performing so many integrated services, can the commonwealth be assured it has maximized its savings and in the most cost-effective manner?
To start the GESA process, the commonwealth, generally through the Department of General Services (DGS), issues an expression of interest to approximately 17 qualified ESCOs. Based on past performance and other due diligence, typically, three ESCOs are invited to respond to an RFP, with the contract awarded to the perceived best value approach, not necessarily the lowest bid. As discussed further below, the ESCO then performs an investment-grade audit (IGA) leading to a form of energy performance contract (EPC).
Presuming the IGA proves reliable and the various FIMs perform as billed, the ESCO derives its profit from a share of the savings recognized by the government agency. The government benefits from the implementation of projects that may hedge against the variability of energy costs, facility upgrades that decrease energy demand, manipulate equipment and systems use to maximize off-peak energy rates, and generate on-site energy to reduce dependence on the grid. However, a careful review of many of these projects, as well as the contract terms, leaves open the question as to whether the commonwealth, or indeed many states at all, have the internal resources available to evaluate the ESCO proposals in a way to maximize savings and benefits to the government. The same issue is present with IGAs and EPCs for private enterprise and MUSH institutions (municipalities, universities, schools, hospitals).
While many agencies, businesses or schools have facilities managers on staff, these individuals are typically well versed in the operation of the equipment, maintenance requirements and overall costs. However, they do not necessarily understand the world of energy procurement, co-generation performance, load management or even how the entire EPC is implemented. For these facilities, the CFO is in a good position to determine that deploying the company or college’s limited resources to energy upgrades that have speculative or relatively small returns on investment is probably less favorable than other investment choices. The director of sustainability can provide guidance on overall environmental and conservation goals, as well as desired LEED or Energy Star certifications. So how can these individuals, or their government counterparts, critically review the holistic energy savings approaches urged by the ESCO? How can they be certain the savings are not only achievable but maximized?
At a large city’s recent public hearing on executing a multimillion-dollar ESCO contract, part of which utilizes my client’s private energy network, I noted the difficulties the government representatives had in explaining many of the intricacies of the FIMs the ESCO was proposing. Frankly, it was the ESCO that answered most of the questions, which is not surprising given the depth of their expertise. Some in the audience, and certain political opponents, voiced concerns that the ESCO selection process was a no-bid scenario, though they skirted the fact that there was a valid RFP process. Nonetheless, what was clear was that the government representatives could not clearly articulate specific reasons as to why the chosen ESCO was the best proposal. They indicated it was largely because that ESCO was the only one to propose a specific desired process.
That highlighted the knowledge gap in a very public way. A similar discussion of the government’s lack of expertise can be found on the DGS’s website, in a candid and well-drafted memo by Deputy Secretary Liz O’Reilly (http://bit.ly/LSrDTm). The recurrent theme of that memo, as well as my experiences with negotiating EPCs and other energy agreements, is that the ESCO customer is often bargaining at a distinct disadvantage. The same ESCO that performs the IGA to determine energy use at the facility, then implements its own findings, funds its own projects and recommends the equipment as well as all other aspects of a turn-key, design-build contract. Thus, who is truly in a position to objectively determine the best energy package on the best terms? Some would argue these decisions are being made based upon the slickest Powerpoints with the most impressive presentations of theoretical returns on investment and shiny state-of-the-art equipment.
Ultimately, the DGS urges a reboot of the GESA contracting process to provide that the commonwealth hire staff or third-party energy engineering consultants (EECs) to oversee the evaluation of the process and to perform the upfront IGA. Similar to the method I urge to clients, this allows for the audit to form the basis for everything else that follows under GESA or a private arrangement. The company or government can then craft the RFP to require certain improvements, environmental certifications and verification methodologies. Together with counsel, the consultant can assist in negotiating key terms of the EPC, some of which have contractual terms (in the private and institutional sectors) that are generational in length.
What DGS and financial auditors want to see is how savings assumptions are structured, measured and verified. Moreover, they are likely to require more user-friendly means by which to determine that critical benchmarks in energy conservation and savings are met, and how construction and other costs are calculated. By turning to a brief discussion of what issues the EPC addresses, and a few of its critical terms, it should become apparent that a government agency or facility owner would be well advised to have both technical and legal support of their own in moving forward with projects often valued in the tens of millions.
The archetypal process starts with the selected ESCO providing a letter of intent that sets out certain general goals of the anticipated EPC, but focuses on performance of the IGA. The ESCO will insert a provision that contains a walk-away fee should the customer terminate after review of the audit. The DGS approach, and one that I urge, would not yet involve the ESCO, but rather has the EEC perform the IGA. That process then leads to the RFP.
However, more frequently, the ESCO performs the IGA, which calculates the total available energy savings as measured against the current utility tariffs. The ESCO specifies certain FIMs, breaking down the costs of each and evaluating its impact on cash flow. It also attempts to analyze some of the softer costs that it incorporates into its financial model, such as avoided or less frequent maintenance expenses or the predicted long-term increase in the cost of electricity as measured against a load management strategy designed by the ESCO. If important to the customer, the IGA can also evaluate emissions credits, renewable energy credits, carbon offsets and sustainability goals. Lastly, the IGA presents a variety of financing options
The EPC itself provides a turn-key project guarantee that the customer will obtain savings, a guaranteed maximum price for the capital upgrades, procurements and construction, some form of gain sharing, a verification protocol and the key to the entire deal: The ESCO assumes all of the performance risk associated with its proposal. The standard upgrades include a mix of lighting improvements, HVAC modifications, shell improvements (e.g., insulation, windows), energy load management systems and generating facilities. The concept is for the ESCO to undertake a holistic evaluation of the facility’s entire energy use and create a long-term vision for bringing that burdensome and variable cost to a more stable, cost-effective and reliable management system that saves the customer energy costs over time.
My view is that any agreement designed to last 15 to 25 years will contain provisions that seem attractive at first glance but after years of implementation may become crippling. Long after the glow of entering into an agreement that guarantees millions in savings over that period, new management may question whether it was the best deal and how success is benchmarked over the years. Creating a separation of function between the IGA and the EPC may be a good method of generating reliable metrics, or at least providing the customer with its own representative during the audit and the system design and build process to maximize the odds of success.
The EPC itself contains many pitfalls, often starting with the definition of the “project.” Because the performance guarantee is intimately tied to the project, one can be sure the ESCO will carefully define and limit its scope. Financing, especially if tax credits are available, is also extensively discussed in the EPC, and the overall deal needs to be carefully structured to ensure the availability of these credits.
The EEC can be especially helpful in evaluating the terms of the excess savings provisions. This term typically provides that once the ESCO provides the project cost, any savings it achieves inure to the customer, whether private, MUSH or government. Since the typical EPC provides that the ESCO controls the entire process of design and build, it is in the best position to negotiate the most advantageous price. But if it does not share in the excess savings, the EEC can assist the customer in evaluating whether the ESCO maximized value engineering opportunities. In one recent project discussion, the ESCO bragged that it returned $200,000 to the customer on a $15 million project. I could not help but think a third-party evaluator could have urged the ESCO to do better than a 1 to 2 percent savings.
The EEC can also be useful in setting the baseline of the facility’s energy use, a key metric in evaluating the effectiveness of the FIMs. Moreover, helping to craft the verification method, or at least assuring the customer that the process is standardized, is another role for the EEC. Lastly, the professional can provide guidance on the schedule for the FIM implementation, operation and maintenance requirements and the feasibility of recommended building modifications (in the hope of minimizing the dreaded change orders).
Ultimately, energy efficiency projects can be a boon for facilities that drive down the bottom-line impact of energy costs. Because the EPC agreements with ESCOs are so complex and are implemented over many years, facilities should consider, as the DGS is with respect to its GESA program, whether the use of independent EECs as an owner’s representative through the ESCO project can provide the customer with both the knowledge and leverage to negotiate the greatest savings on the best financial terms. •
Andrew Levine co-chairs Stradley Ronon Stevens & Young’s energy practice group. He has been working on renewable and natural gas energy production facilities for more than 20 years, and his practice emphasizes the development of downstream energy generation plans, especially co-generation, that take advantage of abundant natural and landfill gas supplies in the region.