Comparing Cost Elements in ESPCs and UESCs

November 1, 2002

Many Federal agencies are finding alternative financing vehicles useful tools for meeting their energy goals. Federal investments in energy efficiency improvements through energy savings performance contracts (ESPCs) and utility energy service contracts (UESCs) have grown to nearly $2 billion since agencies began using them in the late 1980s.

Many Federal energy managers who have considered implementing alternatively financed energy projects have wondered which financing mechanism they should use. Examining the cost elements of ESPCs and UESCs reveals that they are actually more similar than different, but also highlights distinctions that can help agencies determine which financing vehicle will best address their needs.

Similarities—Cost Elements in All Energy Projects

ESPCs and UESCs are more similar than different. With either financing vehicle, your energy project will involve expenses for project development (i.e., energy surveys, feasibility studies), engineering design, labor and materials for construction, and finance costs. Under both types of contracts, the service provider (energy service company (ESCO) or utility) may have an in-house engineering team or may subcontract engineering tasks. Both ESCOs and utilities generally subcontract construction/installation of energy conservation measures (ECMs) and have access to the same sources of equipment, supplies, and financing.

The most significant distinctions between ESPCs and UESCs are a function of which goods and services are provided, and what payment methods you choose. There is no indication that one group charges more than the other for equivalent goods and services. As a representative of the Federal government, you have the tools and the ability to perform due diligence determinations of fair and reasonable pricing. Even though formal competitions for delivery order awards are not required in ESPCs and UESCs, there is real competition among the businesses that are trying to attract Federal customers for their energy services.

The majority of costs in energy projects fall into these categories:

Implementation costs account for most expenses—for energy surveys, feasibility studies, engineering design, and construction including labor and materials.

"Other" costs generally incurred in energy projects are for project management and administration, taxes, insurance, permits, and licenses.

Mark-ups are applied to energy or construction projects procured by the Federal government. The mark-up, usually a set percentage of the project implementation cost, is added to the project price to cover non-project-specific overheads such as general administration and marketing. The mark-up is readily apparent in Super ESPC delivery orders because the contracts require that it be shown as a separate item on project financial schedules. Maximum mark-ups were negotiated between DOE and the ESCOs who were awarded the prime ESPC contracts. The mark-up on any particular Super ESPC project is negotiable between the agency customer and the ESCO, and mark-ups have been well below the maximums in most delivery orders.

ESCOs, utilities, and other companies that provide energy services generally incur the same kinds of expenses in providing these services, and must recoup those expenses to stay in business. Mark-ups may not always be listed in UESC task orders (or non-financed construction contracts), but they are always included in the price. The mark-up can and should be requested as a line item in the UESC cost proposal if the Federal agency chooses to have it specified.

Differences in Project Development Practices

Although the same types of expenses are generally incurred in all energy projects, there are notable differences in the ways project development activities and costs are handled. The price of Super ESPC delivery orders includes all project development expenses (for marketing, energy surveys, feasibility studies, development of initial and final proposals, etc.), either as line items or in the mark-up.

UESCs provide agencies with a little more flexibility regarding the payment of project development costs. Agencies may either finance project development costs with the delivery/task order for complete design and construction/installation of ECMs or proceed step by step and pay as they go. Under the pay-as-you-go strategy, the utility may, at the agency's request, complete an energy audit (often free) and feasibility study, and the agency would agree to an established fee for those services. Next the agency may issue a task order to the utility for advancing project design to 30 percent completion and developing specifications to put out for bids. The agency would again pay for each task separately, or proceed with the project and roll all the costs into the financed amount. The important aspect to remember is that this process is subject to negotiation and provides flexibility based on the needs of the agency and the utility.

These different project development practices give agency customers several choices. Those who prefer to proceed step by step and pay for project development costs up front rather than finance those costs will pay less interest overall. Those who can't or don't choose to pay development cost up front can finance all costs in one package. The fact that project development costs generally are included (and financed) in ESPCs but may not be included in UESCs helps to explain why direct comparison of similar projects sometimes makes ESPCs seem more expensive than UESCs. When doing such comparisons make sure you are comparing projects with similar cost structures.

Savings Guarantees and Measurement & Verification.

Savings guarantees and measurement and verification (M&V) of savings, which are required in Federal agencies (ESPC agreements and are included in some UESCs, affect project costs directly and indirectly. M&V requires effort and expense)to develop an M&V plan, install meters or other instrumentation, gather data, and document and report results. Annual M&V costs in Super ESPC projects have averaged about 3.5 percent of guaranteed annual savings.

While needs and priorities vary among agency sites, M&V is regarded by many as a wise investment and an essential element of an overall energy strategy. Federal project experience is providing evidence that potential energy and cost savings are unlikely to be realized even initially, and especially in the long term, without planned and executed follow-up such as with maintenance and M&V.

A potential indirect cost of guarantees and M&V is slightly higher interest rates. If the lender sees these requirements as representing any risk that the ESCO might fail to fulfill the contract (i.e., risk that the lender might not be paid), that risk may be priced into the interest rate. To mitigate the risk, most ESCOs guarantee less than 100 percent of estimated savings, and agencies can use M&V plans that are practical and simple, but sufficiently rigorous to reliably verify that the equipment is operating as intended.

Performance Period Services—M&V, O&M, and R&R

Services (including M&V) that are provided to the agency during the term of the ESPC or UESC are handled in a variety of ways by agency customers. In both ESPCs and UESCs, performance period services such as operations and maintenance (O&M) and equipment repair and replacement (R&R) are negotiable and can be assigned to the ESCO/utility, agency staff, or subcontractors. In Super ESPC projects, performance period expenses always include M&V, and the ESCO is always responsible for defining the maintenance program and verifying execution. Generally the ESCO is responsible for R&R through extended equipment warranties.

Because ESCOs guarantee savings in Super ESPC projects and must also ensure that specific standards of service are achieved (i.e., temperatures, lighting levels, etc.), they usually wish to exert some control to ensure that the equipment is properly maintained and operated. These O&M services increase the expenses incurred by the ESCO, which, in turn, increase the ESCO's cost to the agency. Commonly the agency operates and maintains the equipment with ESCO oversight, which recognizes both parties' positions, but Super ESPCs allow agencies to negotiate whatever arrangement best addresses their needs. Performance period services are included much less frequently in UESCs than in ESPCs, which contributes to the longer terms typical of ESPCs. Performance period services can be included in UESCs through negotiations with the local utility if the agency desires them.

Interest and Finance Costs

Financiers indicate that interest rates for energy projects are more dependent on project size, length of contract term, and perceived risk than on whether financing is through an ESPC or UESC. The experience and credit rating of the ESCO or utility are very important factors as well. Overall, interest rates on UESCs have been slightly lower than interest rates on ESPCs, primarily because savings guarantees and M&V procedures, which increase investor's perceived risk (depending on the contract language) are less common in utility projects, and contract terms are generally longer for ESPCs than UESCs.

Qualitative Considerations

FEMP endorses both ESPCs and UESCs and encourages agencies to use the financing mechanism that delivers the best value for their facilities, based on their own needs and priorities. There are benefits and considerations in either alternative. UESCs often provide more flexibility to proceed with projects that are of smaller scope and size and the UESC contracting process is generally more flexible, with more elements subject to negotiations between the parties. EPSCs provide a more prescriptive contracting process and a longer contract term, which may be required for the viability of some projects. Additionally, ESPCs are available nation-wide while UESCs require a local utility that is willing and able to complete the project. A best-value project will provide precisely the services and goods that you need at a fair price, and will not require you to pay for services you don't need.

Most acquisition teams choose a financing vehicle and service provider based on qualitative concerns. Their choices often turn on questions such as: Among the available options, where will we find the expertise and approach we're looking for? Which has the best record of success relative to our needs? Perhaps the most important question is: With which service provider can we develop the best possible partnership and most productive working relationship? Remember, whichever financing option agencies choose, FEMP offers a wide variety of financing workshops and can provide experienced project facilitators to guide you through the entire process of developing and implementing a project.

For more information, please contact Tatiana Straijnic, FEMP Project Financing Team Lead, at 202-586-9230 or tatiana.strajnic@ee.doe.gov, or David McAndrew, FEMP Utility Team Lead, at 202-586-7722 or david.mcandrew@ee.doe.gov.