State of Wisconsin Department of Administration Division ... · State of Wisconsin Department of...

State of WisconsinDepartment of AdministrationDivision of Energy

Focus on Energy II Pilot Study

Performance Contracting and EnergyEfficiency Services in the NonresidentialMarket – Market Status and Implicationsfor Public Purpose Interventions1

June 26, 2001

Evaluation Administrator: PA Consulting Group

Prepared by: Michael W. Rufo2, XENERGY Inc.

1 All sources cited are listed at the end of the paper (Section 8).2 Mr. Rufo is Vice President of Consulting, Western Region for XENERGY Inc. Mr. Rufo has conducted a number

of recent evaluation studies on California’s Standard Performance Contracting Programs (XENERGY 1999, 2000,

and 2001a). In addition, Mr. Rufo has led numerous other studies on nonresidential energy services markets (for

example, Rufo, 1998; Rufo and Train, 1999; XENERGY, 2001c).

State of WisconsinDepartment of Administration

Division of Energy.8/17/01

State of WisconsinDepartment of AdministrationDivision of Energy

Focus on Energy II Pilot Study

Performance Contracting and EnergyEfficiency Services in the NonresidentialMarket – Market Status and Implicationsfor Public Purpose Interventions

June 26, 2001© PA Consulting Group 2001

Contact: David SumiPA Consulting Group2711 Allen Boulevard, Suite 200Middleton, WI 53562Tel: +1 608 827 7820Fax: +1 608 827 7815E-mail: [email protected]

Prepared by: Michael W. RufoXENERGY Inc.492 Ninth Street, Suite 220Oakland, CA 94607Tel: +1 510 891 0446Fax: +1 510 891 0440E-mail: [email protected]

Acknowledgment: Ralph Prahl, Prahl & Associates, contributed critical review and analysis

i

PA Consulting Group/XENERGY Inc. 6/26/01

TABLE OF CONTENTS

I. Executive Summary I-1A. Introduction I-1B. Key Findings I-1C. Conclusions and Recommendations I-2

II. Introduction II-4

III. Overview of Performance Contracting (PC), ESCOs, and EESPs III-5A. ESCOs and EESPs III-5B. What are Energy Performance Contracts? III-6C. Basic Elements of the Energy-Efficiency Project Development

Cycle III-8D. ESCO Cost Structure III-9E. Brief History of ESCOs and Performance Contracting III-10

IV. The ESCO Industry through the Lens of Intermediation Theory andthe Theory of Trust IV-13A. Understanding ESCOs as Intermediaries IV-13B. The Importance of Reputation and Trust IV-14

V. Position of Performance Contracting in the Broader NonresidentialEnergy Efficiency Services Market V-16A. General Energy-Efficiency Market Characteristics V-16B. Penetration of Performance Contracting V-18C. Market Size of Performance Contract Versus Other Energy

Efficiency Services V-21

VI. Summary of Performance Contract-Promoting Programs VI-23

VII. Findings VII-31

VIII. Implications and Recommendations VIII-36

IX. Sources IX-39

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I. EXECUTIVE SUMMARY

A. INTRODUCTION

This paper summarizes concerns over the trend toward nonresidential energy efficiencyprogram portfolios that strongly promote performance contracting (PC) over other simpler andmore common methods of procuring energy-efficient equipment and services. We refer tothese programs as performance contracting-promoting programs (PC-promoting programs).This paper looks across several PC-promoting programs at the underlying markettransformation-related objectives of the programs and assesses whether the objectives areachievable based on the history, economics, and current status of the performancecontracting markets in the U.S.

Though often referred to as if it were a single contract model, performance contracting isactually an umbrella term for a fairly broad class of contract types that have developed withinthe energy services industry over the last 20 years. What all of the contract types under thisumbrella term share is the characteristic that a customer’s payment to an energy servicescompany (ESCO) is in some way tied to the amount of energy savings and cost reductionsobtained from an energy efficiency project. Performance contracting involves a number ofactivities that range from marketing and sales, to contract negotiation, project design andimplementation, financing, and measurement and verification of savings.

The “transaction-related” functions that ESCOs and some energy-efficiency service providers(EESPs) perform–prospecting, identifying, selling, funding, and M&V–are all essential togetting the “deal done.” For the ESCO, depending on the size and nature of the project, thesetransaction costs (including the ESCO’s profit margins) can range from 25% to 66% of thetotal cost of simply designing and implementing the project. What drives the economics ofperformance contracts is the fact that these relatively fixed transaction costs must be paid forout of project savings. This is generally not difficult to do with large projects that have largesavings streams, but it can be virtually impossible to achieve with small customers fromwhom only small savings can be found.

B. KEY FINDINGS

Performance contracting is a mature and niche contracting product. Performancecontracting has been available for approximately two decades. Performance contracting is aniche contracting product because of two factors: (1) the underlying economics require largeprojects (due to the associated sales, prospecting, M&V, and other transaction costs); and (2)the use of financing as its defining characteristic limits its appeal to only those largecustomers that lack easy access to private financing (namely, mostly institutional customers).

PC-promoting programs have been based on the notion that performance contract-based energy efficiency products and services should be favored over those procuredwith fee-for-service contracts. Recently, some of these PC-promoting programs havecontrolled most of the public purpose energy efficiency incentive dollars available for thenonresidential markets in which they have been implemented. In a market transformationpolicy context, PC-promoting programs can only be justified if it can be shown there aremarket barriers significantly inhibiting the societally optimal amount of performancecontracting occurring in the market – as compared to the more common fee-for-service basisfor procuring energy-efficient products and services.

I. Executive Summary

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However, the existence of supply-side market barriers to performance-based productsand services has not been well established. A key hypothesis of many PC-promotingprograms is that there are supply-side market barriers to providing performance contracting.Support for this hypothesis would require evidence that supply-side markets do not recognizewhere and when customers are demanding performance contracts, are limited in their abilityto stimulate demand for performance contracts, or are otherwise restricted in their ability toimplement performance contracts. Such supply-side barriers to performance contracting havenot been demonstrated by the research conducted to date.

What has been established is that there are significant barriers to delivering performancecontracting to small customers and non-institutional customers. However, performancecontract-promoting programs have not yet demonstrated that they can amelioratethese barriers in a sustainable way. PC-promoting programs have, to date, failed to showthey can make performance contracts work on a sustainable basis for smaller customers.

Evaluation results to date consistently show that PC-promoting programs are unlikely toproduce significant and sustainable changes in the majority of participant EESPbusiness practices. Programs may help some new or weak ESCOs/EESPs to develop newbusiness strategies or improve their M&V skills. In addition, some programs have caused afew new companies to successfully enter specific markets, but these have tended to beexceptions.

To date, no PC-promoting program has demonstrated how it can result in significantlyreduced transaction costs for performance contracts and EESP/ESCOs. Without asustainable reduction in transaction costs for the majority of EESP/ESCO participants in suchprograms, performance contracting will remain in its current market niche (eg outside of thesmall/medium customer and non-institutional markets). This conclusion is based both on thehistorical record and an assessment of the underlying economics of the performancecontracting business model.

M&V in PC-promoting programs has been rationalized both as part of promoting PCand as necessary to protect rate-payers and demonstrate program savings to policymakers/regulators. This latter argument ignores the fact that impact evaluation doesessentially the same thing but typically with less expense because it involves sampling acrossprogram participants.

C. CONCLUSIONS AND RECOMMENDATIONS

Customers and EESPs should have multiple programmatic choices on how theyprocure energy-efficient products and services. The majority of programs within anyportfolio should support increases in energy efficiency without preference to the type ofcontract executed between the customer and the EESP. EESPs that want to test their PC-related business models should only be supported with small incubation programs. PC-promoting programs also have a role in demonstrating savings from newer and more complexmeasures where performance uncertainty is genuinely high for many customers.Nonetheless, incentive funds for performance contracting should be a minority portionof total incentive funds available for nonresidential programs. PC-promoting programsshould complement rather than preclude the larger fee-for-service contract market forenergy-efficient products and services.

I. Executive Summary

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Some portion of resources in any program portfolio should be available to help EESPs toimprove their business skills; however, the evidence strongly suggests that focusing onpromoting a single business model such as performance contracting overly limits this.Less restrictive EESP business support efforts might include customer education, customerreferrals and lead generation, sales and marketing training, assistance in business plandevelopment, development and provision of marketing support materials, and training in theanalysis and delivery of cutting edge energy-efficiency measures. A trusted programadministrator also can create a “halo” effect that benefits EESPs. A halo effect can beachieved without requiring a performance contract between a customer and EESP. A haloeffect can be created through simple mechanisms such as a program administrator’s reviewand “blessing” of an EESP’s estimated savings calculations.

Most market transformation success stories to date have been based on increasing netsustainable penetration of specific efficiency measures, often using rebates to createan initial market stimulus. Examples include horizontal-axis clothes washers, electronicballasts, and high-efficiency furnaces. Targeted rebates, when designed and implementedappropriately, remain a simple and effective means of stimulating demand for new high-efficiency products.

End users are ultimately the demand engine upon which sustainable changes inenergy efficiency markets must be based. Efforts to improve supply-side EESP capabilitiesare extremely important, especially for EESPs serving small customers; however, they mustbe balanced by strong efforts to reduce the many market barriers faced by end users, ofwhich performance uncertainty is but one of many. Where performance uncertainty doesexist, there are a number of programmatic ways to reduce it in addition to performancecontracting. Examples include dissemination of case studies, demonstration projects, use ofa trusted independent third-party to approve savings calculations, and providing measure-specific incentives. A balance between these other approaches and performance contractingis needed.

Finally, recent energy service industry trends illustrate the inherent difficulty in pickingbusiness models to promote. The market shift from shared savings to guaranteed savingscontracts, the emergence of energy asset outsourcing, and the increase in EESP/ESCOmergers and acquisition are a few examples of how quickly the supply-side of theEESP/ESCO market can change. This underscores the problem faced by policy makers whenan attempt is made to pick selected business models for the private sector to achieve a publicpolicy goal. Doing so in a productive way that stays ahead of naturally occurring markettrends is extremely difficult. As a result, public policy objectives should stay focused onthe desired end game: creating sustainable net increases in the amount of cost-effective energy efficient products and services implemented in customer facilities.

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II. INTRODUCTION

This paper summarizes concerns over the trend toward nonresidential energy efficiencyprogram portfolios that strongly promote performance contracting (PC) and associated energyservice company business (ESCO) models. We refer in the paper to these programs asperformance contracting-promoting programs (PC-promoting programs). Examples of thetypes of programs that we consider under this rubric include the California NonresidentialStandard Performance Contract (SPC) programs, the Public Service of Colorado Demand-Side Bidding Programs, the New Jersey Standard Offer programs, the New York EnergyServices Industry Program (also an SPC program), the TXU Electric Standard OfferPrograms, and the Wisconsin Energy Efficiency Performance (Pilot) Program.

This paper does not attempt to provide an assessment of all of the advantages anddisadvantages of these programs. There are a number of reports and papers written aboutthe programs by both program designers and evaluators (see bibliography in Section 9).Instead, our goal in this paper is to look across performance contract-promoting programs attheir key underlying market transformation-related objectives3 and assess whether theseobjectives are achievable given the history, underlying economics, and current status of theESCO and performance contracting markets in the United States.

This paper is comprised of the following sections:

• Section 2 – Overview of Performance Contracting, ESCOs, and EESPs

• Section 3 – The ESCO Industry through the Lens of Intermediation Theory and theTheory of Trust

• Section 4 – Position of Performance Contracting in the Broader Nonresidential EnergyServices Market

• Section 5 – Review of Public Purpose Performance Contract-Promoting Programs

• Section 6 – Findings

• Section 7 – Implications and Recommendations

• Section 8 – List of Sources.

3 We recognize that not all of the programs listed have explicit market transformation goals, some of the programs

are or were primarily resource-acquisition oriented in their expressed purpose. However, all of the programs listed

either explicitly or implicitly seek to promote performance contracting and the ESCO business model in ways that

are desired to be lasting.

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III. OVERVIEW OF PERFORMANCE CONTRACTING (PC), ESCOS, AND EESPS

In this section we present a brief overview and history of the energy services industry and thecreation and use of performance contracting as a risk mitigation tool.

A. ESCOS AND EESPS

We begin our discussion by describing the two categories of firms that provide energyefficiency-related products and services: “ESCOs” and “EESPs”. The term “Energy ServiceCompany” (ESCO) has been around for about 20 years. The term is sometimes loosely usedto refer to any company that specializes in delivering energy efficiency products and services.However, the term originally referred to companies whose sales model was based onfinancing energy efficiency projects and taking on the associated performance risks.According to Easton 1999, “The ESCO genus is limited to companies that absorb specifictypes of risk associated with energy efficiency projects. These risks—tied to projectengineering and design, project performance, energy price uncertainty, and (in some cases)customer solvency—are ones customers and their financing sources would face were they toundertake energy efficiency projects themselves. Some correspond to the ‘market barriers’4

observers of energy efficiency markets have long viewed as inhibiting customer-initiatedenergy efficiency projects.”

As further elaborated in Easton 1999, the ESCO category definition “is broad enough toaccommodate companies traditionally labeled as ESCOs, newer entities created asunregulated subsidiaries of utilities, service companies of large property owners (eg Rouse),and relevant activities of both large market actors (eg Honeywell) and small firms (eg risk-absorbing local architectural engineering firms).” The number of ESCOs nationally or in anyregion is difficult to estimate precisely because many firms do not fall completely inside oroutside the definitions quoted above, and because there is a great deal of churn in the ESCOindustry. New ESCOs are formed often and older ESCOs have been bought and merged withothers at a rapid rate over the past five years. In California, there are probably 30 to 70ESCOs depending on how narrowly or broadly one defines them (XENERGY, 1998; CEC,1997). This range is probably reasonable for states that have a high density of energy users,average to above-average energy prices, and a history of DSM programs. Because more andmore utilities have created and bought ESCO businesses over the past five years, thenumber of ESCOs nationally could be as many as 200; however, only about 100 are activeacross the different regions of the country. In contrast, over 100,000 contractors, distributors,and manufacturers are delivering the bulk of energy-efficient products and services in theU.S.5

ESCOs probably deliver about 25 percent of all energy-efficient products and services in theUnited States (XENERGY, 1999; Frost & Sullivan, 1999). Obviously, this is a large share ofthe energy services market given how few ESCOs there are compared to all energy-relatedservice providers in the country (most of whom are small, local contractors as noted above).However, this is still a minority of the total activity and, as discussed later, tends to beconcentrated among large and institutional customers.

4 See, for example, Eto, et al., 1997.5 Although most of these firms do not focus on the energy-efficient dimension of the products they sell and install.

III. Overview of Performance Contracting (PC), ESCOs, and EESPs

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Whereas the term “ESCO” has long been used to refer to specific types of energy efficiencyservice providers (namely, those who seek to mitigate risks associated with energy efficiencyprojects), the term “EESP” (Energy-Efficiency Service Providers) is newer and moreintentionally broad. EESP refers to the broad class of companies engaged in providing energyefficiency products and services, regardless of whether the energy efficiency dimension oftheir products and services is the primary characteristic of their business and regardless ofwhether they absorb risks associated with energy efficiency projects. The EESP umbrellaincludes ESCOs, but it also includes contractors, architectural and engineering firms,equipment distributors, product manufacturers, and other entities that provide energy-efficientproducts and services directly to end users. As noted above, there are perhaps as many as100,000 EESPs in the U.S. (mostly contractors and distributors), as opposed to only about100 major ESCOs. We estimate that three-quarters of the energy-efficient products andservices in the U.S. are delivered by non-ESCO EESPs.6

Distinguishing between these terms is particularly important in the context of public purposeprograms that seek to promote performance contracting. It is particularly important within thecontext of programs like the Energy Efficiency Performance (EEP) pilot program inWisconsin, which seeks to cause non-ESCO EESPs to adopt performance contracting as oneof the services offered by their business (PA Consulting Group, 2001). In our opinion, whenEESPs adopt performance contracting as part of their services and business strategy, bydefinition, they become ESCOs. The reason the energy industry continues to differentiate theterm “ESCO” from that of other service providers is because the history of the industry showsthat firms cannot casually engage in performance contracting as a business sideline –performance contracting is a specialty that differentiates ESCOs from other EESPs. The skillsrequired to sell and manage the risks associated with performance contracting are significant.These difficulties are well known throughout the industry. We hypothesize that those whohave succeeded in developing successful ESCO companies have done so because of theirability to achieve economies of scale and risk mitigation across projects, obtain access to low-cost financing, build a brand reputation for trust, and minimize sales and transaction costs.7

In our opinion, any EESP that can deliver performance contracts as efficiently as an ESCO,essentially becomes an ESCO.8

B. WHAT ARE ENERGY PERFORMANCE CONTRACTS?

Although often referred to as if it were a single contract model, performance contracting isactually an umbrella term for a fairly broad class of contract types that have developed alongwith the ESCO industry over the last 20 years. What all of the contract types under thisumbrella term share is the characteristic that a customer’s payment to an ESCO is in someway tied to the amount of energy savings and cost reductions obtained from an energyefficiency project. To understand our view on performance contracting’s place in public-purpose energy efficiency program portfolios, it is important to first establish a common

6 Frost & Sullivan, 1999; XENERGY, 2001c.7 Easton, 1999; Frost & Sullivan, 1999; XENERGY, 2001c.8 Therefore, the Wisconsin EEP program in seeking to encourage performance contracting among local EESPs is

also encouraging the formation of new ESCOs, albeit small, local ones.


III-7


understanding of the characteristics of the various types of performance contracts. The twoprimary types of performance contracting are:

• Shared savings contracts

• Guaranteed savings contracts.

Each of these contract types is described briefly below.9

Shared Savings Contracts. Shared savings contracts are considered by many to be theoriginal performance contract. Under a shared savings contract, the ESCO provides theresources, including financing, to implement an energy cost reduction project after securingthe owner’s agreement to “host” the new equipment on the company’s premises. In return,the ESCO receives a percentage of the savings generated by the project for a fixed, specifiedterm. The customer benefits from the new equipment and receives a share of the savingsgenerated by the project. In this type of agreement, the ESCO finances the purchase of theequipment and then receives a percentage of the annual savings. Shared shavings havediminished in popularity because most ESCOs and customers prefer the guaranteed savingsapproach (see below). A related reason is that, until recently, few investors would repurchaseshared savings contracts on a non-recourse basis from ESCOs. This meant that ESCOsoffering shared savings contracts had to use their own capital for investments or developspecialized, special-purpose funds for that investment.

Guaranteed Savings Contracts. By most accounts, guaranteed savings contracts nowcomprise the majority of energy service agreements being written between ESCOs andcustomers. Under this mechanism, an ESCO guarantees to the customer that the savingsgenerated by the project will be adequate for the customer to cover the cost of the project.Guaranteed savings contracts are different from shared savings contracts in a critical way:the ESCO does not invest equity dollars in the project. Instead, the customer provides thecapital for the project, usually with funds borrowed from a third-party financer. In short, thecustomer’s balance sheet, not the ESCO’s, is used to secure the funds.

9 Based on the definitions provided in Bulluck and Caraghiaur, 2000.


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C. BASIC ELEMENTS OF THE ENERGY-EFFICIENCY PROJECT DEVELOPMENTCYCLE

A number of steps are involved in a typical energy efficiency project cycle (Figure 1).

Figure 1. Energy Efficiency Project Value Chain

ProspectingConstruction/Implementation

DesignEngineering &Specification

FundingPackaging &Closing

Project Identification

Measurement &Verification

Source: Easton 1999.10

The various elements or functions in the chain are the same, regardless of whether theproject is an ESCO- or EESP-initiated energy services performance contract or has beenidentified, implemented, and financed internally by the energy user. In addition, the steps fornon-PC projects are essentially the same, with the exception that packing and closing andmeasurement and verification costs are usually significantly lower for non-performancecontracts, and financing costs do not exist. Energy efficiency projects require EESPs,ESCOs, or customers’ internal personnel to perform the following activities:11

• Marketing and Prospecting. Positioning for, searching for, identifying, and makingcontact with prospective energy services customers.

• Project identification. Evaluating the prospective customers’ facilities and processes— usually through a combination of energy audits and analysis of energy consumptionhistory — to identify energy efficiency investments that will yield attractive returns.

• Packaging and Closing. Under performance contracts , putting together andnegotiating an agreement that attracts capital to the project; apportions risks betweenthe ESCO, the customer, and the financing source; and allocates the savings betweenthe customer and the ESCO so as to make completion of the project worthwhile forboth parties. Under fee-for-service contracts, packaging and closing is generally morestraightforward because the EESP is typically paid by the customer for the cost ofequipment plus installation.

• Funding. Under performance contracts , identifying and securing commitments fromsources of capital. Sources can be external third parties, the customer’s ownfinance/treasury departments, or the ESCO’s financing affiliate. Under fee-for-servicecontracts, the EESP is not directly involved in funding the project.

10 Bulluck and Caraghiaur, 2000, identify a similar set of required activities, namely, project identification and

development, engineering design, construction, and monitoring and maintenance.11 Descriptions adapted from Easton, 1999.


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• Design, engineering, and specification. Creating the plans and finalizing costs,equipment specifications, etc., for the energy efficiency measures involved in theproject.

• Construction/implementation. Obtaining and managing contractors to install/implementthe energy efficiency measures, then supervising, inspecting, and commissioning theirwork. In most cases, ESCOs act as general contractors, managing some combinationof their own internal resources and third-party subcontractors. As discussed later inthis paper, this is one aspect in which ESCOs act as market intermediaries – theycompete with direct exchange of energy-efficient products and services by trying toadd value to customers through turnkey sources such as construction managementand risk mitigation through performance contracts.

• Monitoring and Verification (M&V). Tracking energy consumption and costs to assurethat savings targets have been met and that the energy efficiency measures areperforming as planned. How extensive this function is depends considerably on thecomplexity of the transaction and the structure of guarantees. In a fee-for-servicecontract, there is often no M&V at all.

The ability to provide funding has historically been critical to an ESCO’s success. As noted byBulluck and Caraghiaur, 2000, the type of financing offered depends on (1) whether thecustomer wants an obligation off the balance sheet, (2) who is at risk for performance, and (3)whether payment obligation is tied to a specific project. According to Easton, 1999, ESCOsusually leave funding activities to other specialized providers. In contrast, all perform somedegree (but not all) of the design engineering and project management services. The amountof contracting activity conducted by ESCOs varies widely. As discussed previously, virtuallyby definition, most ESCOs perform the selling, financial packaging and project identificationthemselves.

D. ESCO COST STRUCTURE

It is well known that the activities ESCOs and, to a lesser extent, non-ESCO EESPs, take onto add value to customers also add costs to the service provider. As discussed in Section 3, asuccessful ESCO project is one in which the ESCO can add more value than they incur indirect costs (equipment and installation) plus transaction costs. A range of the costs that areassociated with each of these activities, estimated in Easton, 1999, is shown in Figure 2.


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Figure 2. Relative Costs Associated with Elements of ESCO Projects

Transaction Costs 20 to 40%

Project Costs 60 to 80%

Source: Easton, 1999.

The ranges were developed by Easton through in-depth interviews with many ESCOs. It isimportant to note that the “transaction-related” functions that ESCOs perform—prospecting,identifying, selling, funding, and M&V—are all essential to getting the “deal done.” It is alsoimportant to recognize that non-ESCO EESPs must cover a portion but not all of thesetransaction costs, i.e., they usually do not incur costs for funding and M&V. For the ESCO,depending on the size and nature of the project, these transaction costs (including theESCO’s profit margins) can run as much as 25% to 66% of the total cost of simply designingand implementing the project. Note that there can also be a significant fixed cost componentto performance contracting (for example, for sales, contract negotiations, and legal fees). Forthe non-ESCO EESP, transaction costs are likely to be half as high. The performancecontract provided by the ESCO must thus add at least as much incremental value to the enduser as it adds in incremental transaction costs to the ESCO. The additional transaction costsassociated with performance contracts must be paid for out of project savings. Thus, whatreally drives the economics of performance contracts is the fact that the relatively fixedtransaction costs associated with delivering the contract (including sales) must be paid for outof project savings. This is generally not difficult to do with large projects that have largesavings streams, but it becomes virtually impossible to achieve with small customers fromwhom only small savings can be found.

E. BRIEF HISTORY OF ESCOS AND PERFORMANCE CONTRACTING

To understand the position of performance contracting and ESCOs in the energy efficiencyservices market today, it is important to appreciate the historical situation from which theyemerged. This section draws on several sources to briefly present this context.12

The first ESCOs emerged with their first products in response to the twin oil crises in the1970s. Early companies included Time Energy, Inc., Scallop Thermal, NORESCO, and HEC.Time Energy, a small company in Texas, was perhaps the first to discover that it could sell itsprincipal product – time clocks – through a shared savings contract and that this approachmight be more profitable than selling the equipment directly. However, several factors,including an SEC investigation of Time Energy’s principal owners, failure of several early

12 See, in particular, Bulluck and Caraghiaur, 2000, and Easton, 1999.

Funding Premium (third party)g Fees (legal

Prospecting / Proposal GenerationProject Identification

Design

Capital Equipment andInstallation

Measurement and Verification


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shared shavings firms, and belief that many firms inappropriately manipulated savingsestimates and other contract terms, quickly combined to create a strongly negative perceptionof the nascent ESCO industry. One response to these early troubles was the formation of theNational Association of Energy Service Companies (NAESCO) in 1981. NAESCO worked tostandardize some aspects of the business such as monitoring and verification (M&V) andworked to improve relations with utilities and end users. Another reason the first ESCOs didnot fare well, despite the rapid increase in oil prices in the 1970s, was that few energyefficiency options at that time were available other than operations and maintenancemeasures such as time clocks and pneumatic controls.

Undeterred by the lack of success of pioneer ESCOs in the 1970s, many in the energyindustry saw promise in the concept of shared savings and other ESCO-oriented energyefficiency services. As a result, many new ESCOs were formed in the 1980s, such asEconoler/USA, CES Way, EUA Cogenex, and Sycom Enterprises. In addition, many of thesefirms were electric utility affiliates. The industry had a few things going for it in the 1980s:investment of electric utility financial resources into the industry, development of new energysaving technologies (eg energy management systems and first-generation energy savinglamps and ballasts), establishment of utility audit and rebate programs, and the perceptionthat oil and gas prices might stay high (at least in the early 1980s). Nonetheless, the 1980sproved to be a difficult decade for ESCOs. Factors making business difficult for ESCOsincluded: complex contracts that made customer negotiations long and difficult, lack ofbanking community acceptance of ESCO contract mechanisms, residual end user skepticismand distrust of the industry, and at times competition from local utilities (who viewed thenewcomers as threats to their monopoly position in the market). ESCOs in the 1980s weregenerally small and unprofitable. To most of the utility industry, they were consideredstumbling industry stepchildren with an inconsequential future. To others, however, the ESCOindustry was worth sticking with during the 1980s, because they foresaw what would be oneof the key ESCO-growth factors of the 1990s: electric industry restructuring.

With the advent of electric industry restructuring in the 1990s came a surge in demand forESCO services, not so much on the part of end users, but rather from utilities wanting to buildor buy ESCO capabilities. In utility boardrooms throughout the country, industry executivesrealized that energy services focusing on understanding and managing customers’ energyconsumption would be critical to success in a competitive retail environment. By the mid-1990s, ESCOs that once had trouble finding new owners and investors were findingthemselves entertaining multiple, top-dollar offers for their firms. Utilities and others wantingto get into the competitive energy services market were willing to pay high prices for ESCOs(even though most continued to be unprofitable or marginally profitable at best) because theywanted to develop ESCO capabilities quickly. The alternative to buying an existing ESCOwas to build one from scratch. Although many companies went this route (and continue to doso), building an ESCO in the late 1990s was difficult because of the specialized skillsrequired, the value of having existing regional or national clients, and a scarcity ofengineering and account management labor.13

Although industry restructuring fueled ESCO development in the latter half of the 1990s, DSMwas a critical growth engine throughout the decade, but especially, in the early and mid-

13 Some readers may recall this in the form of a run-up on salaries for senior energy engineers and account reps

that occurred in several markets as they opened to competition in the late-1990s.


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1990s. ESCO growth in the 1990s was significantly affected by the several billion dollarsworth of DSM expenditures in the 1990s. Although DSM-bidding and performance-contractpromoting programs were developed in the 1990s (especially the late 1990s) specifically tosupport ESCOs, ESCOs had no trouble taking advantage of the utility rebate programs thatdominated many regional markets for the years preceding these programs. In fact, the declineof DSM dollars in the late 1990s was considered a major risk factor for the ESCO industry asit moved into the era of utility restructuring.14

Another potential source of funding that fueled ESCO prospects in the late 1990s was the riseof the Federal government as the country’s largest performance-contract seeking customer.The Federal Energy Management Program (FEMP) and related federal programs andExecutive Orders created the largest contract vehicles ever for many ESCOs. Many analystsconsider these Federal contracts to be the key engines of ESCO growth in the near term.15

Two other related key trends that emerged in the late 1990s and continue today include thefollowing:

• Rise (and Fall) of so-called “Super ESCO”. Vine, 1998 defined the “Super ESCO” asfirms distinguished by the following characteristics: (1) a corporate culture orientedtoward customer service; (2) the ability to rapidly ‘metabolize’ information on newtechnologies; (3) expertise in technological integration; (4) ownership of proprietarytools for energy analysis; (5) diverse, but internally standardized, financial tools; (6)clearly defined market identity; and (7) the ability to leverage these skills acrossgeographic areas and sectors. However, as quickly as many of the “Super ESCOs”rose, several of them left the retail energy commodity business or went out ofbusiness entirely, notable among many: PG&E Energy Services, Columbia EnergyServices, Edison Source, PSEG Energy Technologies, EnergyOne, QST Energy.16

• Birth of Energy Asset Outsourcing (EAS). EAS refers to outsourcing contracts in whichan energy supplier owns, operates and maintains the energy infrastructure inside thecustomer’s facility, such as central HVAC, compressed air, lighting, or other majorenergy using systems. In exchange for outsourced ownership of the energy bill andinfrastructure, the customer is provided with energy services at a price thatguarantees a reduction in the total cost of such services over a specified contractperiod, typically, 10 years or more.17 Although the concept had been around for manyyears, Enron Energy Services broke open this market with a series of majoroutsourcing contracts in 2000 and 2001. Duke Solutions, Sempra Energy Solutions,TXU Energy Services, and FirstEnergy Services are a few of the other companies thathave begun to make headway in this burgeoning area.18

14 Frost & Sullivan, 1999.15 Easton, 1999; Frost & Sullivan, 1999.16 XENERGY, 2001b.17 XENERGY, 2001c.18 XENERGY, 2001b.

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IV. THE ESCO INDUSTRY THROUGH THE LENS OF INTERMEDIATION THEORYAND THE THEORY OF TRUST19

Advances in the economic theory of intermediation (Spulber 1999) and the related theory oftrust (Lazaric and Lorenz 1998) have been found useful to understanding the history, marketpenetration, and current market position of ESCOs (Rufo, et al., 2000; Goldstone, et al.,2000).

A. UNDERSTANDING ESCOS AS INTERMEDIARIES

To understand the position of many EESPs and ESCOs in the larger energy efficiencyproducts and services markets in which they operate, it is important to understand that, inmany cases, the position of these firms is that of an intermediary. Understanding this helps toclarify why many EESPs and ESCOs historically have served mostly larger customers, theimportance of reputation and trust to their business models, and the ways in which publicpurpose programs are likely or unlikely to affect these companies in a sustainable way.

By way of contrast to fundamental neoclassical economic theory, the economic theory ofintermediation explicitly incorporates the costs of carrying out transactions that are reflectedin the customer barriers to implementation of energy efficiency. According to intermediationtheory, the total economic costs of any product or service include both the cost of supplyingthe good and the costs associated with carrying out exchange transactions in the market. Foran economically advantageous exchange to occur, the value of the good to the customermust exceed the sum of these two costs.20

Spulber (1999) defines an intermediary as an economic agent who purchases from suppliersfor resale to buyers, or who helps buyers and sellers meet and transact. Many kinds of firmscarry out intermediary functions, including financial, wholesale, and retail intermediaries. Mostimportantly for our purposes, the intermediation theory of the firm rests on the idea thatintermediaries can do much to reduce the costs or otherwise improve on how marketexchange transactions are carried out. Under this theory, firms form if they can lowertransaction costs (or improve transaction quality) relative to direct exchange. As Spulber putsit, “Firms are formed when gains from intermediated exchange exceed the gains from directexchange.” Under this theory, intermediated exchange will occur if and only if intermediationlowers the transaction costs to the customers.

19 Sy Goldstone of the California Energy Commission originally wrote much of this section. Mr. Goldstone provided

this analysis in response to a request for comments on the program theory developed as part of an evaluation of

the 1999 Nonresidential Standard Performance Contract Program in California (XENERGY, 2000).20 The net economic value of any good is, thus, equal to the value it delivers to the final customer (V) less the cost

of production (C) less the total transaction costs (T). As a consequence net gains associated with supplying and

trading (exchanging) any economic good equals: V – C – T. It follows that for economically advantageous

exchange to occur V must exceed C + T.

IV. The ESCO Industry through the Lens of Intermediation Theory and the Theory of Trust

IV-14


From this perspective, many EESPs and ESCOs are intermediaries who not only competeagainst each other but also against direct exchange.21 To compete against direct exchange,an EESP must reduce total transaction costs. This includes reducing the critical customerbarriers associated with energy efficiency goods (Eto, Prahl, Schlegel, 1997; XENERGY,1999).

For example, if customers do not have the expertise to readily ascertain energy efficiencyquality, they will be less well-informed than direct sellers of these goods. This creates thepossibility that such sellers will behave opportunistically (i.e., what Eto, et al., 1997, refer to asthe “asymmetric information and opportunism” barrier). Under these conditions, in accordancewith Ackerloff’s, 1970, well-known market for lemons, the market will select adversely againstcost-effective energy efficiency.

Intermediation theory clarifies how information asymmetries about product quality create arole for intermediaries. Because of unobservable product quality, intermediaries can earnreturns by investing in technology and expertise needed to test, evaluate, assure, and certifyproduct quality. In so doing, they can address and mitigate the problem of opportunism andresulting adverse selection (the market for lemons condition). They are able to earn returnsby performing this function partly because they can realize economies of scale by dealingwith a greater number of buyers and sellers. Also because they have a long-term time horizon(oriented to future customers), intermediaries have greater incentive to learn from experience,invest in expertise, innovate in transactions (eg the kinds of contracts used), and earn returnsfrom building a reputation for truthfulness.

B. THE IMPORTANCE OF REPUTATION AND TRUST

Most businesses, and intermediaries in particular, need to build a trusted reputation in orderto succeed. Once established, a good reputation is a valuable asset that an intermediary canuse to reduce marketing and other transaction costs to a broad range of prospectivecustomers.

Further clarification of the causal mechanisms involved in economic exchanges betweencustomers and suppliers comes from recent advances in the economic theory of trust. AsLazaric and Lorenz,,1998, define it, economic trust “refers to beliefs about the likely behaviorof another, or others, which matter for a trustor’s decision making and which pertain tosituations where the complexity of the relationship…is marked by unanticipated contingenciesso that it is not possible to reduce all uncertainty about outcomes.”

Thus, as Coriat and Guennif (1998) point out, “Trust is, above all, a consequence ofuncertainty…In a state of uncertainty, and with opportunistic agents, economic transactionscannot develop without there being extremely high transaction and contracting costs, since

21 Note that some ESCOs and many EESPs are direct providers of specific brands of equipment (for example,

many of the energy management controls companies and lighting and HVAC contractors and distributors). In this

section, we focus on those EESPs and ESCOs that are not tied to specific brands or types of equipment. These

EESPs and ESCOs form an important part of the market for energy efficient products and services and, as we

note throughout this paper, have been successful in bundling such services to mostly large and institutional

customers.

IV. The ESCO Industry through the Lens of Intermediation Theory and the Theory of Trust

IV-15


each agent seeks by way of even more sophisticated contracting specifications to protecthimself from the opportunism of the other.22 Thus, if something like trust is possible betweeneconomic agents, it should reduce the need for, and the cost of, contracts. Consequently,trust becomes an efficient mode of economic coordination.

Briefly, five findings from the theory of trust literature that are specifically germane to EESPs,performance contracts, and the public purpose programs that promote them. First, contractsbetween business organizations are typically incomplete and allow a wide range ofopportunistic to trusting behavior. Second, trust-based behavior depends on repeatedinteraction and reciprocated experience between the parties involved. Third, reputation mustbe differentiated from trust. A good reputation can be built by a single agent and is valuablebecause it encourages customers to initiate trust requiring trading relationships. But it doesnot guarantee that a trust relationship will develop, and its development and maintenancedepends on compliance being easily observed by the entire community concerned. Fourth,institutions can encourage agents to risk renouncing opportunistic behavior and therebypromote, but not guarantee, trust-based behavior. Fifth, contractual strategies vary with thecircumstances, including modification of circumstances by factors identified above. Differentstrategies and contract forms have different effects on performance (Williamson 1996, Coriatand Guennif 1998).

In sum, intermediation theory highlights the crucial importance of EESPs adding value,reducing transaction costs, and building good reputations. Trust theory reminds us that agood reputation does not guarantee trust. Trust is built between EESPs and their customersby repeated interactions and reciprocated experiences; its continuance is dependent upon thebehavior being easily observed by all.

Public purpose programs may thus help EESPs by increasing end user trust (or temporarilyreducing end users’ perceived risks of working with EESPs) or by otherwise stimulatingincreased EESP-end user contracts, which provide EESPs with increased opportunities todemonstrate their trustworthiness directly.

Consistent with this theory about the importance of reputation, previous research has foundthat a good reputation is one of the most important factors in selecting a supplier of energyefficiency services (XENERGY, 1999; Rufo and Train, 1999).

22 Note that this is, in fact, exactly what happened in the ESCO industry. After a rocky start in which some ESCO’s

reputations were sullied, the next wave of industry activity was characterized by highly complex shared savings

contracts and measurement and verification (M&V) requirements. The industry has recently moved away from

these types of contracts toward simpler guaranteed savings contracts. This has likely been made possible by a

combination of improved ESCO reputations and reduced customer uncertainty in the range of savings that are

likely for certain types of measures, especially, lighting.

V-16


V. POSITION OF PERFORMANCE CONTRACTING IN THE BROADERNONRESIDENTIAL ENERGY EFFICIENCY SERVICES MARKET

As discussed in the previous sections, performance contracting is a fairly mature product thathas been extensively marketed for approximately two decades. We also discussed how boththe product and the market receptiveness to it have changed over this same period. Despitethese changes, recent research indicates that performance contracting continues to be aniche product within a much larger market for a wide range of energy efficiency services.

A. GENERAL ENERGY-EFFICIENCY MARKET CHARACTERISTICS

This section presents summary information on energy efficiency market characteristicsgathered from a national survey conducted in late 1998 (XENERGY 1999). The surveyincluded 499 respondents divided equally among major market segments and customer sizegroups.23 Note that the results presented in this section are weighted by the size of eachcustomer’s energy use. Thus the results reflect the percentage of total nonresidential energyaffected, rather than the percentage of customers. As shown in Table 1, two-thirds of the U.S.nonresidential market took some action to reduce energy usage in a two-year period (andalmost a third participated in some type of efficiency-related program). The most popularactions taken were installation of efficient lighting (49%), efficient motors and HVAC (35%),energy management and other control systems (28%), and re-engineering of industrialprocesses (19%). Customers’ primary reasons for taking these actions were to (1) lowerenergy costs (81%), (2) enhance productivity (15%), and (3) reduce environmental impact(10%).

Nonresidential customers were also asked whether, in the prior two years, there were anyefficiency-related actions that were identified but not undertaken. On an energy-weightedbasis, approximately one-fourth of the respondents indicated there were such actions. Thoserespondents who reported they had identified opportunities for savings that had not beenacted upon were asked to describe the most important reasons for lack of action. The primaryreason was described as “other priorities for capital spending.” Other key reasons were thatthe savings did not justify the added investment costs, and that there was a lack of fundsavailable for investment. Other reasons cited by fewer respondents were uncertainty overenergy savings, inadequate information with respect to convincing management, and a lackof management time to oversee project development.

The national surveys also probed respondents with respect to their energy-related decision-making practices. On an energy-weighted basis, about a quarter of the market had formalpolicies in place that required the selection of energy efficiency equipment. With respect towhether formal financial analysis was used in the process, roughly half reported using sometype of long-term investment criteria when making energy-related decisions. Large and VeryLarge customers were more than twice as likely, in most cases, to have taken energyefficiency actions or have a policy to do so.

As shown in Figure 3, energy efficiency services are widely marketed to large customers. Onan energy-weighted basis, 35% of the market reported being approached in the prior two

23 The survey included 499 respondents from the lower 48 states, minus California, plus 515 respondents in

California. The results reported in this section are for only the non-California sample.

V. Position of Performance Contracting in the Broader Nonresidential Energy Efficiency Services

Market

V-17


years by companies offering to provide services to improve energy efficiency. In the largestcustomer group, the figure was 64% nationally. In contrast, only 13% of the small customermarket reported receiving offers for energy-efficient products or services.

Table 1. Summary of Energy Efficiency Proclivity, National Nonresidential Market,1998 (XENERGY, 1999)

Customer Size

IndicatorSmall Medium Large

VeryLarge Total

Participated in EnergyEfficiency

Programs in Last 2 Years 21% 19% 39% 62% 32%

Taken Some Action toReduce

Energy Use in Last 2 Years 47% 57% 69% 95% 66%

Have Policy for Selecting

Energy Efficient Equipment 23% 15% 22% 38% 23%

Long-Term InvestmentAnalysis

Applied to EE Investments 30% 41% 62% 75% 52%


Market

V-18


Figure 3. Portion of National Nonresidential Market Offered Energy Efficiency Servicesin Previous 2 Years (XENERGY 1999)

35%

13%

20%

45%

64%

0% 10% 20% 30% 40% 50% 60% 70% 80%

OVERALL

Small

Medium

Large

Very Large

B. PENETRATION OF PERFORMANCE CONTRACTING

In late 1998, end user awareness of performance contracting was moderate across allcustomer groups (Figure 4). When weighted by energy use, approximately 34% of thenational market was aware of performance contracting. As expected, awareness levels variedgreatly by market sector and size strata. Differences were even more striking betweencustomers of different sizes. The largest customers were almost seven times more likely to beaware of performance contracting than were the smallest customers. Customers were alsoqueried in this study on whether they could define performance contracting (as opposed tosimply stating they had heard of it). As shown in Figure 5, a much smaller number ofestablishments were able to demonstrate an understanding of the characteristics ofperformance contracting than were their large counterparts. Only 20% of the market overallcould identify the defining characteristics of performance contracting; however, 58% of thevery largest customers could do so.

About one-fourth of the nonresidential market reported receiving energy performancecontracting offers every two years (Figure 6). The energy-weighted percentage of customersreceiving at least one performance contract offer in the last two years was 22%. Strongdifferences were found by sector and customer size. Note that approximately half of thelargest customers reported receiving performance contract offers in the prior two years.


Market

V-19


Figure 4. Portion of National Nonresidential Market that is Aware of EnergyPerformance Contracting (XENERGY 1999)

17%

22%

55%

19%

47%

28%

34%

0% 10% 20% 30% 40% 50% 60%

Office

Retail

Institutional

Other

High Industrial

Low Industrial

OVERALL

Figure 5. Portion of National Nonresidential Market that Understands Characteristicsof Performance Contracting (XENERGY 1999)

20%

10%

8%

18%

58%

0% 10% 20% 30% 40% 50% 60% 70%

OVERALL

Small

Medium

Large

Very Large


Market

V-20


Figure 6. Portion of National Nonresidential Market Approached by Firms OfferingPerformance Contracting in Previous 2 Years (XENERGY 1999)

22%

1%

12%

24%

43%

0% 10% 20% 30% 40% 50% 60% 70%

OVERALL

Small

Medium

Large

Very Large

As shown in Figure 7, among those customers that receive a performance contract offer, onlya small percentage, roughly 13%, typically result in signed agreements. In most cases, offersgo no further then an informal “presentation” stage, or they result in a formal bid but nocontract award. Institutional customers are twice as likely, on average, to sign finalperformance contracts (XENERGY, 1999 and 2001c). The net two-year penetration rate ofaccepted performance contract offers is thus about 2 to 3 percent for all nonresidentialcustomers (i.e., 13% of the 43% of customers that received offers ended up signing acontract). A more recent survey assessing nonresidential energy service offer andacceptance rates for customers over 500 kW found a 5% performance contract penetrationrate, again over a two-year period (XENERGY, 2001c).

Figure 7. Disposition of Performance Contracting Offers Among NationalNonresidential Customers (XENERGY, 1999)

0% 10% 20% 30% 40% 50%

Do not know/refused

Tried to negotiate/no agreement

Negotiated and signed contract

Got proposal/no contract

Heard presentation/no proposal


Market

V-21


C. MARKET SIZE OF PERFORMANCE CONTRACT VERSUS OTHER ENERGYEFFICIENCY SERVICES

Unfortunately, few studies have attempted to empirically measure the size, in terms ofrevenue, of the general market for energy efficiency services or the specific market forperformance contracting in the U.S. Of the studies that even discuss the question of totalmarket size, few use statistically based methods. Even fewer studies exist that estimatemarket size and activity indicators for specific states.24 As noted in Easton, 1999, there areseveral reasons for the lack of reliable estimates of the size of the competitive energyefficiency markets nationally, including the following definitional problems:

• “Should a measure of the market include equipment, engineering, or contractingservices used in the construction of high-efficiency buildings and factories?

• Should it include investments in energy efficiency measures identified, installed, andfinanced by owners themselves?

• Should it include additions to operations and maintenance routines that are institutedas a result of energy audits?

• Should it include investments in energy-using equipment or controls that yield‘operational’ as opposed to energy savings?”

To Easton’s stumbling blocks, we add the following:

• Should performance contracting be characterized in terms of the total value ofcontracts sold in any year or by the annual revenue equivalent of such contracts?Because most performance contracts have payout terms that can go as long as 20years, the actual annual revenue equivalent of such contracts is much less thanESCOs often report as the value of the contract.

• Performance contract values depend on a wide range of highly variable factors,including the percent of the customer’s energy use reduced, the costs of achieving thereductions, the percent of the savings allocated to the ESCO, and, as noted above,the length of contract. This makes estimation of revenues difficult when usingcustomer-based product penetration rates like those presented in the previoussubsection.

• Estimating the size of the total market for energy efficiency products and services interms of revenues to service providers also requires estimates of the percent ofcustomer energy use reduced and the costs of achieving the reductions. Again, thismakes estimation of revenues difficult when using customer-based productpenetration rates.

24 California is an exception worth noting. As part of the State’s policy shift toward market transformation and the

privatization of energy services (roughly 1996 to 2000), several statewide studies of market activity were

conducted as part of efforts to characterize baseline conditions (XENERGY, 1999; XENERGY, 2000; XENERGY,

2001a).


Market

V-22


Frost & Sullivan, 1999, estimate the size of the North American energy management servicesmarket at $23 billion per year.25 They further estimate that “The traditional ESCO industry,often referred to as the ‘performance contracting’ industry, accounts for less than a quarter ofthe revenues presented here, or about $5.5 billion.” XENERGY estimates the size of thenational performance contracting market at $1 to $2 billion of new contract value per year,26

which is consistent with the Frost & Sullivan figure because most ESCOs draw a significantshare of their revenues from non-performance contracts.27 XENERGY further estimates thesize of the total market associated with nonresidential energy efficiency energy savings to be$5 to $10 billion , or about 5 times the value of the performance contracting market. Theprimary reason for the difference between the $5 to $10 billion XENERGY estimate and the$23 billion Frost & Sullivan figure is probably that Frost & Sullivan include the total equipmentcost of purchases associated with energy efficiency and on-site generation. In contrast, theXENERGY estimate is generally based on the incremental cost of the portion of theinvestment associated with generating energy savings above what would occur throughnatural replacement of equipment and excludes on-site generation. In addition, theXENERGY method is based on customer self-reports from a statistically representativesample. The Frost & Sullivan estimates appear to be based on service provider self-reports ofrevenues and review of secondary sources.

25 “Energy management services are defined as…services performed by an organization for the purposes ofreducing energy expenditures of their client...The services and consulting work covered include: energy audits;conservation project design, project management, project engineering, project financing, load research andprofiling, and operation and maintenance contracts. In addition, [this estimate] covers the sales and installation ofequipment for energy management purposes, specifically: HVAC; lighting systems; building control systems;onsite power generation; energy storage systems; energy efficient motors and drives; and uninterruptible powersupplies.”26 This estimate was developed by the author for this paper using data from XENERGY, 2001c.27 For example, California ESCOs reported that typically only one-third to one-half of their revenues were from

performance contracts (XENERGY, 1999).

VI-23


VI. SUMMARY OF PERFORMANCE CONTRACT-PROMOTING PROGRAMS

This section presents a brief summary of PC-promoting programs around the country. Moredetailed findings from evaluations conducted of these programs are incorporated intoSections 6 and 7 of this paper.

Current PC-promoting programs are descended from the demand-side management (DSM)bidding programs that were popular from 1987-1997. However they differ from theseforerunners in a number of significant ways. First, PC-promoting programs attempt to reducesome of the administrative costs and responsibilities that the bidding process imposed onboth the ESCOs and the utilities. PC-promoting programs encourage EESPs to market anddevelop projects and rely less on utility staff as middlemen.28

Many PC-promoting programs also make a more conscious effort to transform the energyservices market than did the older bidding programs. For example, Wisconsin’s EnergyEfficiency Performance (EEP) pilot is trying to introduce performance contracting to EESPswho have not done this contracting in the past. California’s Standard Performance Contract(SPC) programs have tried to stimulate the market for EESP services and M&V. Currently,seven states – California, Colorado, Massachusetts, New Jersey, New York, Texas, andWisconsin – have significant PC-promoting programs. While these programs share somecharacteristics, they have varying policy objectives. A summary of these objectives ispresented in Table 2. The California, New York, and Wisconsin programs have had thestrongest focus on market transformation (although California has recently shifted back to aresource acquisition focus for most programs including SPC). The New Jersey and Coloradoprograms have been focused primarily on resource acquisition.

Because most of the PC-promoting programs are fairly new, information on theiraccomplishments is necessarily somewhat preliminary. However, in a few cases, suchCalifornia and New Jersey, the programs have been in full-scale operation for several years.Table 3 summarizes the program’s accomplishments reported to date. Across programs, onecan conclude that they generally deliver energy and demand savings at levels sometimescomparable to traditional utility rebate programs. However, important limitations have beenidentified for those programs that have undergone comprehensive evaluation. Some of theselimitations are summarized in Table 4.

The evidence consistently indicates that PC-promoting programs have not been successful todate at engendering significant, sustainable changes in EESP business practices (Table 5). InCalifornia, an already-established EESP and ESCO industry consistently reports that the SPCprograms have not affected their business strategies and have had only marginal effects onthe volume of business they would otherwise be doing. In New Jersey, an opposite problemoccurred: the high standard-offer prices in the first phase of the program engendered a waveof program-induced resource acquisition that was then followed by an ESCO exodus from thestate after prices declined. Both the California SPC and Wisconsin EEP programs have highlevels of estimated free-ridership, whereas the New Jersey program was estimated to havelow free-ridership levels.

28 Schiller, et al., 2001.

VI. Summary of Performance Contract-Promoting Programs

VI-24


Finally, many of the currently available evaluation results point to implementation barrierssuch as the cost and complexity of required M & V procedures, lengthy application and salesprocesses arising from performance contracting provisions, and lack of general customerawareness and understanding of performance contracting. However, programs in California,New York, and Wisconsin (the EEP pilot) have been making changes in applicationprocessing and M&V requirements in response to these evaluation findings.29

29 For example, for 2001, the California Large SPC Program now has two paths: one for measured savings and

one for calculated savings. End use prices are 10% higher under the measured savings option and only certain

measures are allowed under the calculated savings approach.


VI-25


Table 2. Comparisons of Objectives Across Programs

StateProgram Name

(dates of initial programimplementation) Program Objectives

California Non-Residential SPC Program

(1998-1999)

• Creating a self-sustaining market for energyefficiency products and services that capturesthe cost-effective opportunities in end-userfacilities.

Ø Changing the market practices andbusiness characteristics of participatingEESPs.

• Reducing customer-related market barriers

Ø Improving customer confidence in EESPsas credible providers of EE services.

Ø Improving customer confidence in savingsfrom EE measures.

Ø Increasing customer knowledge andawareness of performance contracting.

• Achieving cost-effective energy and demandsavings.

Colorado Public Service of Colorado’sDSM Bidding Programs (mid-1990s to present)

Achieving cost-effective, peak period demandsavings.

Massachusetts

Boston Edison IntegratedResource Management (IRM)program (1996)

Achieving energy savings, peak reduction, andmarket transformation.

New Jersey Standard Offer 1, 2, 3 (1993) Achieving energy savings, peak reduction, andmarket transformation.

New York Energy Services IndustryProgram

(early 1999)

• Facilitating the development of a strong energyservices industry.

Ø Encouraging ESCOs to offer EE tocustomers along with electric commoditysales.

Ø Reducing market barriers such as lack of EEawareness in institutional sector, customerrisk averseness, and limited access tofinancial resources for EE implementation.


VI-26


Table 2. Comparisons of Objectives Across Programs (continued)

StateProgram Name

(dates of initial programimplementation) Program Objectives

Texas TXU Electric TEEM StandardOffer Pilot Programs

(2000)

• Having energy efficiency incentive programsavailable to all customer classes.

• Encouraging private sector delivery of energyefficiency products and services.

• Stimulating investment in energy efficienttechnologies most likely to reduce TXU’s peakcapacity requirements during 2000 and 2001.

• Creating a simple and streamlined programprocess to stimulate strong programparticipation.

Wisconsin Energy Efficiency Performance(EEP) Program

(1999)

• Encouraging both national and local EESPs toexpand their service offerings and marketshare by pursuing performance-basedrelationships with C & I customers.

Ø Delivering new performance-based EEproducts/services

Ø Delivering performance-based EEproducts/services to new customers ormarket segments.

Ø Delivering performance-based EEproducts/services through the use of newdistribution strategies, marketing channels,or teaming alliances.


VI-27


Table 3. Comparisons of Accomplishments Across Programs

State Program Budget Program Accomplishments

California 1998 program: $42million.

• High participation levels and strong demand forprogram incentives.

• Approximately 40-45 GWh of net performancecontracting business may have been generatedby the program.

• Estimated 231 GWh of energy savings from theprogram.

• 26 EESPs participating, nine of which alsoparticipated in the 1999 SPC program.

• 92 unique customers at 605 sites.

California • 1999 Large C/Iprogram: $68.3million.

• 1999 SmallBusiness C/IProgram: $10.6million.

• Only 65% of the incentive funds for the large C/Imarket were used.

• Large C/I program had 32 EESPs participating, 9of which had participated in the 1998 program.

• Small C/I program had 37 EESP participants,most of which were not active in the large C/Iprogram. Small SPC only 20% subscribed.

• 347 projects committed.

• 122 unique customers for large C/I program withanother 133 unique customers for the small C/Iprogram.

Colorado $15 million over 2 years(2000-2001)

• 23 winning bidders.

• 15 EESPs and 8 customers participating.

• 120 GWH of estimated energy savings andestimated peak demand savings of 37 MW.

Massachusetts $50 million over 2 yearsplus administrativecosts..

• 5 winning ESCO bidders.

New Jersey Standard Offer 1, 2, 3 -$230 million budget over1993-97 period.

• Lighting accounted for 60% of the eligiblemeasures, with fuel switching measuresaccounting for 27% and the remainder beingHVAC and motor measures.

• Standard Offer 1 had very successful participationlevels, Standard Offer 2 had lower participationlevels due to reduced incentives, SO 3 wasoversubscribed.

• Through March 1998 it had 860 projects and $230million in incentives.

• 162 ESCOs and customers participated.

• 1,100 GWh estimated savings


VI-28


State Program Budget Program Accomplishments

New York • StandardPerformanceContract (SPC)Program: $47.7million originallyallocated. As of4/26/01 $14 millionin funding was stillavailable.

• FinancialPackagingServices: $2.25million.

• In 2001 NYSERDAhas allocated anadditional $90million to the SPCprogram over thenext 5 years.

• Through early June 2001, a total of 190 projectsare in various stages from development throughsaving verification.

• Through early June 2001 Incentives of more than$40 million have been awarded to 50 differentESCOs.

• When fully implemented these projects will savean estimated 258 GWh of electricity. 180 GWhestimated saved in first years of program.Summer peak demand reductions are estimatedat more than 60 megawatts.

• 67% of the estimated SPC program savings willcome in non-lighting uses.

• 133 institutions are participating in the FinancialPackaging Services.

Wisconsin • $5 million budgetfor two-year EEPpilot program.

• As of end of first phase of program (Focus 1) on6/30/00 the program had executed 4 programcontacts, approved 33 Qualifying Applicationsfrom 8 different sponsors, and was reviewing 4final applications.

• Committed incentives for Focus 1 were $2.5million.

• These participation levels are expected to yieldover 9,000 equivalent MWh of savings whichshould yield $360,000 in annual cost savings.

• For seven of the eight Sponsors in the programso far, this is the first time that they will bedelivering performance-based energy services.

• Based on projections submitted Sponsorssubscribed in the program, there is a potential tostimulate over $2 million in sales revenue in theyear 2000.


VI-29


Table 4. Comparisons of Limitations Across Programs

State - Program Initial Evaluation Findings

California• Relatively little evidence of market effects from program.

• High level of free-ridership (net-to-gross ratio of 0.53 for the1998 program).

• About half of the SPC sponsors were end-users submittingprojects on their own behalf, which indicated that theprogram was not promoting the EESP industry as much asit could be.

• Many EESPs viewed the M & V requirements of theprogram to be too onerous, complex, and expensive.

Massachusetts • The time between RFP release and contract award wasquite long (i.e., nearly two years in some cases).

• Contract negotiations and review/acceptance of M&Vprotocols were a significant time drain.

• Delays in measure installation and the harvesting ofcontracted energy savings due to industry restructuringactivities, the introduction of new utility markettransformation-type energy efficiency programs, anddifficulties experienced by the winning ESCOs in marketingto customers.

New Jersey • Standard Offer 2 had a dramatic fall-off in ESCOparticipation and was widely criticized due mainly to a largereduction in the price paid for savings.

• Standard Offer 2 was almost exclusively focused on largelighting projects.

• Evaluators found that although the Standard Offerprograms had helped establish the ESCO industry in NewJersey, if the subsidies were to end, the industry wouldlikely be limited to certain niche markets.

• Evaluators concluded that an SPC-type program shouldcontinue for large C/I but that different program approacheswere needed for other markets.


VI-30


Table 4. Comparisons of Limitations Across Programs (continued)

State - Program Initial Evaluation Findings

New York• Factors identified by surveys of ESCO as barriers to

program success included: (1) hassle associated withunderstanding performance contracting requirements, (2)getting such arrangements approved, and (3) savingsuncertainty, both from the customer and ESCOperspectives.

• Other barriers identified by evaluators through interviewswith ESCOs included:

Ø need for additional marketing and insufficient marketresearch information;

Ø confusion surrounding electric utility industryderegulation;

Ø the positive state of the New York economy made EEprojects less appealing;

Ø need for M & V assistance;

Ø need for reduced paperwork and streamlined applicationprocesses;

Ø need for improved certification programs; and

Ø need for better linkage with other energy efficiencyprogram offerings.

Wisconsin (EEP I)• Findings to date are based on limited number of case

studies:

Ø the program has had very little impact to-date onSponsor’s business practices

Ø The program appears to be resulting in limitedexpansion of the energy efficiency market

Ø The program has had difficulty reaching the appropriatelevel of M&V that protects the customer while notdeterring market effects for measures other thanlighting and HVAC

Ø The program seems to not have been particularlyeffective as a resource acquisition program

Ø There is some evidence that program support functionsto vendors should continue

VII-31


VII. FINDINGS

Performance contracting is a fairly mature product that has been extensively marketed forapproximately two decades. Recent research indicates that performance contractingcontinues to be a niche product within a much larger market for a wide range of energyefficiency services. Once having established this, however, why should one care? The reasonis that by understanding the extent to which performance contracting has both succeeded andfailed to succeed in penetrating specific market segments and energy efficiency opportunities,we can better understand how program interventions might be designed to improve not onlyperformance contracting, but also (and more importantly) energy efficiency services in thebroad sense. In addition, this understanding should help to establish at least a qualitativeestimate of the near- and mid-term upward market penetration potential of performancecontracting relative to other energy efficiency products and services. This, in turn, can helppolicy makers allocate program resources most effectively among energy efficiency productand service options to maximize the return of societal resources invested.

This section presents a number of findings from our review of EESPs, ESCOs, performancecontracting, and public-purpose programs to promote these firms and contract methods.

Performance contracting is a mature contracting product. The empirical evidencesuggests that performance contracting is a mature product that has been available for manyyears. Performance contracting is widely offered to large and institutional customers. There isa large population of ESCOs throughout the United States available to provide performancecontracting to those customers who demand it and can be served profitably.

Performance contracting is a niche product. Even among ESCOs themselves,performance contracts typically represent only one-third to one-half of their revenues, withfee-for-service contracts making up the remainder.30 In addition, performance contracting hassignificantly penetrated only the Institutional segments of the nonresidential market. Inaddition, it has only been cost-effective for large-customer projects. Performance contractingis a niche contracting product for two reasons: (1) the underlying economics require largeprojects because of the associated sales, prospecting, and other transaction costs; and (2)the use of financing as its defining characteristic limits the appeal of performance contracts tolarge customers that lack easy access to private financing (namely, mostly institutionalcustomers). This finding is supported by a number of independent sources and evaluations,including the ongoing evaluation of the EEP program in Wisconsin.31 The traditional sharedsavings performance contract, which typically requires significant M&V, is a product that hasshown an ability to significantly penetrate only the Institutional sector. Guaranteed savingscontracts have broader appeal but are often found to be unnecessary by many customers.

30 XENERGY, 1999 and 2001a.

31 EEP evaluation findings (PA Consulting Group 2001) indicate that the program’s difficulty is not due togeographic constraints (being limited to the pilot territory in Northeast Wisconsin), but because performancecontracting is only an effective option for some customer segments and some types of energy efficient measures.Evidence for this included the fact that many projects dropped out of the program for the reported reason thatperformance contracting was too complicated and costly for measures where energy and demand savings weremore difficult to estimate, measure and verify.

VII. Findings

VII-32


Performance contracting in the institutional sector has not been driven by the fact thatthese customers have greater performance uncertainty about savings than do othercustomers, but rather by the fact that institutional customers lack the ability to pay forefficiency upgrades directly because of limited capital budgets and restrictions on self-financing.

The ESCO industry is relatively mature. ESCOs have been in existence for over 20 years.They fall into several classes–independent ESCOs, product-affiliated ESCOs, utility-affiliatedESCOs, etc. ESCOs were the target of significant capital investment throughout the secondhalf of the 1990s as many ESCOs were built, purchased, or merged. There are 100 or moreESCOs currently doing business in the U.S.

Performance contracting is a defining product for ESCOs. What makes ESCOs differentfrom other EESPs is their use of performance contracting and, more recently, their use ofenergy outsourcing to finance and absorb risks associated with investments aimed atreducing customers’ energy costs. Performance contracting is a very specialized product thatrequires specialized financing and legal expertise and a large enough portfolio of projects tomanage project-specific risks. These factors underlie why most ESCOs are national orregional firms. Although most ESCOs engage in a significant amount of fee-for-servicebusiness, few EESPs can long engage in performance contracting without becoming, bydefinition, ESCOs.

Over the past 5 years, strategy and investment changes in the ESCO industry have beendriven much more by the industry’s reaction to utility restructuring than by energyefficiency programs. In response to utility restructuring, dozens of utilities either started orpurchased ESCOs in the later half of the 1990s, and many continue to do so today. Inaddition, the principal product innovation in the ESCO industry–energy asset outsourcing–finally took off not because of any public purpose program, but because of the increasedattention large end users began to pay to their energy bills in response to restructuring.

Energy-efficient products and services are widely marketed to large customers. Theyare not widely marketed to small customers. Similarly, large customers routinely take energyefficiency actions, while small customers do not (XENERGY, 1998; 1999, 2000).

PC-promoting programs are often implemented in a way that presumes thatperformance contract-based energy efficiency products and services should begenerally favored over those procured with fee-for-service/product contracts. Recently,PC-promoting programs have captured most (in several cases all) of the energy efficiencyincentive dollars available for the nonresidential markets in which they have beenimplemented.

Performance contract-promoting programs are unique from other energy efficiencyprograms in their focus on the contracting vehicle between a customer and an EESP.Although this may seem like a tautological or otherwise uninteresting observation, we believeit is important to consider in light of the other findings presented. Virtually all other energyefficiency programs, besides the PC-promoting programs discussed in this paper, arefocused on increasing the provision of specific types of energy-efficient products (eg high-efficiency air conditioners) or services (eg compressed air leak reduction). In addition, manymarket transformation programs also focus on skills development or encourage existingenergy-related vendors to focus on and promote the high-efficiency versions of their products

VII. Findings

VII-33


and services. Performance contract-promoting programs are unique, however, in their focuson the contract mechanism by which high-efficiency goods and services are procured. In amarket transformation policy context, such promotion can only logically be defended ifthere can be shown to be market barriers that are inhibiting the societally optimalamount of performance contracting occurring in the market.

However, the existence of supply-side market barriers to performance-based productsand services has not been well established. A key implication of many PC-promotingprograms is that there are supply-side market barriers to the provision of performancecontracting. However, such supply-side barriers to performance contracting have not beendemonstrated by any research to date. Support for this hypothesis would require evidencethat supply-side markets do not recognize where and when customers are demandingperformance contracts, are limited in their ability to stimulate demand for performancecontracts, or are otherwise restricted in their ability to implement performance contracts. Thenumber of ESCOs and their distribution throughout the U.S., the amount of investment inESCOs over the past five years, and the fact that the majority of the largest customers areaware of performance contracting and are offered a performance contract every few years, allargue against the notion there are significant supply-side constraints on deliveringperformance contracts to that part of the market that has been shown to be profitable toESCOs historically.

What has been established is that there are significant barriers to delivering performancecontracts to small customers and non-institutional customers. However, performancecontract-promoting programs have not yet demonstrated that they can amelioratethese barriers in a sustainable way. For example, PC-promoting programs have, to date,failed to show they can make performance contracts work for smaller customers even whengenerous incentives are provided. This should not be surprising, however. The costsassociated with delivering performance contracts are significant, and the amount of energysavings available to cover these costs vary in proportion to the size of the customer.32

PC-promoting program theories tend to focus on performance uncertainty and lack offinancing as key end user market barriers. However, the relative importance ofperformance uncertainty varies widely by customer and project type. (For example, mostcustomers are likely to be confident about savings from installing an electronic ballast butunsure of savings from a perimeter dimming system.) The research on the relativeimportance of performance uncertainty as compared to other barriers is mixed. Whencustomers are asked generically about performance uncertainty it tends to be reported as asignificant barrier (XENERGY, 1998), however, when queried about performance uncertaintyof specific projects prior to implementing them in California’s NSPC program, customerstended to report low levels of uncertainty (XENERGY 2001a). Similarly, low levels ofcustomer-reported performance uncertainty have been found in the initial case studyevaluations of Wisconsin’s EEP (PA Consulting Group, 2001). In addition, the evidence isstrong that many large, non-institutional customers do not lack financing or capital and oftenhave policies explicitly against third-party financing.

32 These findings are consistent with results from evaluation to date of the Wisconsin EEP program, which finds

that most participants are large end users (PA Consulting Group 2001).

VII. Findings

VII-34


PC-promoting programs favor performance contracting between EESPs andcustomers as the optimal means of reducing performance uncertainty. The hypothesisunderlying this aspect of several PC-promoting programs is that customers must be shownmeasured savings at their individual site to convince them to proceed with projects. PC-promoting programs tend, however, to ignore other means of reducing performanceuncertainty. Other methods of reducing performance uncertainty include the use oftestimonials/case studies/demonstrations, independent review of energy savingsestimates/conservatively calculated savings (i.e., without necessarily requiring M&V), andmeasure-specific incentives. These methods may prove to be more cost-effective at reducingperformance uncertainty.

Most PC-promoting programs were developed to support policy goals that seekprivatization of energy services. Underlying some of these programs and policies is thehypothesis that ESCOs were inhibited by regulated utility energy efficiency programs and theposition of regulated utilities in local energy services markets. There is some evidence thatthis was the case in service territories where utilities funded large numbers of customerservice representatives through DSM dollars and used their monopolist position to carry out arate-payer-funded, ESCO-like function (i.e., the utility acted as a value-adding marketintermediary but, rather than being paid for the service by the customer, it paid itself throughDSM funds).33 Despite qualitative evidence that some utilities sought to inhibit ESCOs, thereis little empirical research that shows ESCOs were any more successful (in a sustainableway) in areas that lacked utility programs or where utility programs were converted to PC-promoting programs. In New Jersey, there is evidence that ESCOs were able to achievetemporary, program-induced increases in business activity from the Standard Offer programbut that these increases were not sustainable in the absence of significant incentives.34

California ESCOs did not report any significant sustainable effects on their businesses of the1998 and 1999 Nonresidential Standard Performance Contract programs.35 To date, fewmajor changes in business practices appear to be resulting from the Wisconsin EEPprogram.36

It appears that utility restructuring was a much stronger factor in spurring EESPbusiness and investment activity than were public purpose programs. For example, inresponse to utility restructuring, dozens of utilities either started or purchased ESCOs in thelater half of the 1990s and many continue to do so today. In addition, the principal productinnovation in the ESCO industry, energy asset outsourcing, finally took off not because of anypublic purpose program, but because of the increased attention large end users began to payto their energy bills in response to restructuring.

M&V in PC-promoting programs has been rationalized both as part of promoting PCand as necessary to protect rate-payers and demonstrate program savings to policymakers/regulators. This latter argument ignores the fact that impact evaluation doesessentially the same thing but can do so less expensively because of its use of sampling.

33 This should not necessarily be viewed negatively. The success of many utilities in this role was a purposefully

intended outcome of DSM-era resource acquisition policies that led to significant amounts of energy savings.34 Kushler, 1999.35 XENERGY, 2001a.36 PA Consulting Group, 2001.

VII. Findings

VII-35


M&V for regulatory proof of savings would be equivalent to census-based impact evaluation,which is not cost-effective. For example, in California, SPC M&V for 1998 and 1998 may beon the order of $3 to $6 million whereas statewide impact evaluation study could have beencompleted for $1 to $2 million by using statistical sampling.

PC programs have found that it is difficult to control the EESP’s application ofincentive dollars. Many PC-promoting programs have functioned similar to traditional rebateprograms in how they are used by EESPs in the market. That is, incentive dollars, rather thanbeing used to improve business strategies, sales and marketing techniques, etc., are used tobuydown the first cost of efficiency upgrades for customers. Evidence of this exists for theEEP in Wisconsin (PA Consulting Group, 2001)37 and California.38

PC-promoting programs have shown the potential to produce significant resourceacquisition effects, but results have been mixed. Several programs, such as NewJersey’s, have shown that performance-contract promoting programs can produce levels ofresource acquisition similar to traditional utility DSM customized rebate programs. However,both the Wisconsin and California PC-promoting programs have had high-levels of freeridership, which has eroded the level of net savings achieved. In addition, the Wisconsinapproach of favoring performance contracts between customers and EESPs will likelysignificantly limit the resource acquisition potential of the program.

37 EEP evaluation findings (PA Consulting Group, 2001) indicate that in some respects, the EEP program may be

functioning similarly to a rebate program. The program incentive, as originally designed, was intended to motivate

Sponsors to participate in the program, compensate Sponsors for the administrative costs of participating in the

program and reward Sponsors for taking on performance risk by guaranteeing savings. Several Sponsors

expressed dissatisfaction with the program because there is now open sharing of the incentives and resulting

pressure to share the incentive with customers. The most common percentage reported being shared with

customers is 50 percent.38 In the California SPC programs, EESPs reported that 90 percent of the incentives were passed back to the

customer through sharing arrangements of price discounts.

VIII-36


VIII. IMPLICATIONS AND RECOMMENDATIONS

In reviewing the underlying factors that drive PC and the ESCO industry, the markettransformation-related goals of the PC-promoting programs developed to date, and theevaluation results associated with these programs, we find that there is a lack of evidencefor the hypothesis that performance contracting can be sustainably increased throughPC-promoting interventions. More importantly, we find a lack of theoretical basis for howthis would occur and for whether supply-side market barriers to performance contractingactually exist.

Evaluation results to date consistently show that PC-promoting programs are unlikely toproduce significant and sustainable changes in the majority of participant EESPbusiness practices (Kushler, 1999; XENERGY, 2001a; PA Consulting Group, 2001).39 Thebulk of EESP participants in the California programs reported that their business practiceswere unaffected by participation in the SPC programs. The first phase of the New Jerseyprogram did induce significant increases in EESP and ESCO business, however, thosechanges proved to be short-lived as service providers significantly reduced their efforts and inmany cases left the state after incentive levels for the program were reduced. Modestchanges in business practices, particularly M&V capabilities appear to be more achievable.40

In addition, some programs have caused a few new companies to successfully enter specificmarkets or test new sales and delivery approaches, but these have been exceptions ratherthan the rule.

No PC-promoting program yet has demonstrated how it can result in significantlyreduced transaction costs for performance contracts and EESP/ESCOs. Without asustainable reduction in transaction costs for the majority of EESP/ESCO participants in suchprograms, performance contracting will remain in its current market niche (eg outside of thesmall/medium customer and non-institutional markets). This conclusion is based both on the

39 One of the main findings from the EEP evaluation effort to date (PA Consulting Group, 2001) is that the program

has had very little impact to date on Sponsors’ business practices. Of the four EEP I Sponsors that completed

projects, three did not have prior performance contracting experience. However, these three Sponsors only expect

to use performance contracting sparingly in the future. The main reported reasons for limited use of performance

contracting is that it is only appropriate for certain types of customers and certain types of measures. In fact, it is

questionable how effectively Sponsors could use performance contracting as a sales tool since customer

interviews indicate that the Sponsors’ sharing of program incentives with them was more of an impetus for going

forward with projects than guaranteed savings. For three of the four EEP I Sponsors, there was no reported

change in customer base, service offerings , or marketing strategies. Perhaps the most significant change is one of

the Sponsors is now expanding their customer base to include smaller commercial customers, although a few

large customers still account for the majority of this Sponsor’s energy and demand savings.40 There is moderate evidence for improved EESP M&V skills from both the California and Wisconsin evaluations

(XENERGY, 2001a; PA Consulting Group, 2001).

VIII. Implications and Recommendations

VIII-37


historical record and assessment of the underlying economics of the performance contractingbusiness model.41

The Wisconsin EEP is somewhat unique in its attempt to stimulate local EESPs todeliver performance contracts. However, this approach may expose providers tosignificant financial risk. Firms that have been successful at performance contracting havehad to specialize in this contracting approach. Performance contracting is seldom successfulas a business sideline. In addition, to manage the risks associated with performancecontracting, successful ESCOs typically must build up a diversified portfolio of projects so thatrisk on any one project is balanced by potential gain on another. Whether local firmsencouraged to enter into performance contracts will be adequately diversified remains to beseen.

Recent EESP/ESCO industry trends illustrate the inherent difficulty in picking businessmodels to promote. The shift from shared savings to guaranteed savings, the emergence ofenergy asset outsourcing, and the increase in EESP/ESCO mergers and acquisition, are afew examples of how quickly the supply-side of the EESP/ESCO market can change. Thisunderscores the problem faced by policy makers when an attempt is made to promoteselected business models for the private sector. Doing so in a productive way that staysahead of naturally occurring market trends is extremely difficult.

A trusted program administrator can create a “Halo” effect. An underlying but too oftenunstated goal of performance contract-promoting programs is to increase the credibility ofEESPs and ESCOs in the eyes of customers. We refer to third-party induced increases inEESP and ESCO credibility as a “halo” effect. The halo effect can reduce both performanceuncertainty and customer concerns over asymmetric information. Once again, however, ahalo effect can be achieved without requiring a performance contract between a customerand EESP. A halo effect likely can be created through program administrator review andapproval of EESP’s estimated savings calculations and the confidence engendered by thewillingness of an administrator to pay something for savings (regardless of whether thesavings are measured with M&V). Even simple rebates have been shown to increasecustomer confidence in energy savings by virtue of the fact that a trusted third-party hasdemonstrated its confidence in a measure through its willingness to share the cost(XENERGY, 1998).

Where performance uncertainty does exist, there are a number of programmatic waysto reduce it besides performance contracting. These other approaches includedissemination of case studies, demonstration projects, use of a trusted independent third-party to approve savings calculations, and provision of measure-specific incentives. Thesemethods are likely to be less costly to society than extensive, census-based M&V. To often,performance contract-promoting programs do not include or emphasize these otherapproaches.

41 One of the few new products in the industry that was developed to provide performance contracting-like benefits

outside the institutional sector is energy asset outsourcing. However, this product is targeted to the very largest of

nonresidential customers (eg national firms with energy bills over $10 million) and was developed completely

independently of any public purpose program.

VIII. Implications and Recommendations

VIII-38


As noted previously, PC-promoting programs are unique from other energy efficiencyprograms in their focus on the contracting vehicle between the customer and EESP.Where performance contracting already has a self-sustaining place in the market, anappropriate role of public policy may be to accelerate the naturally occurring process byproviding M&V training and standards, M&V samples and case studies, independent reviewof savings estimates, etc. - for those customers and EESPs who voluntarily choose to pursueperformance contracting. However, incentive dollars should not be restricted to only thoseprojects that use a performance-contracting vehicle.

Most market transformation success stories to date have been based on increasing netsustainable penetration of specific energy-efficiency measures (Souzzo, 1999). PC-promoting programs tend not to address measure-specific market barriers. Most successfulmarket transformation programs have focused on specific energy-efficiency measures.Examples include horizontal-axis clothes washers, residential windows, electronic ballasts,and high-efficiency furnaces. We believe that some portion of program resources should beavailable to help EESPs to improve their business skills, however, the evidence stronglysuggests that focusing on promoting a specific procurement mechanism such as performancecontracting is an overly limiting means of doing so. Less restricting EESP business supportefforts could include customer referrals, sales and marketing training, assistance in businessplan development, development and provision of marketing support materials, and training inthe analysis and delivery of cutting edge energy-efficiency measures.

Customers are ultimately the demand engine upon which sustainable changes inenergy efficiency markets must be based. Efforts to improve supply-side EESP capabilitiesare extremely important, especially, for EESPs serving small customers; however, they mustbe balanced by strong efforts to reduce the market barriers faced by end users. PC-promotingprograms have not generally been complemented by equally strong efforts to reduce enduser barriers such as organizational practices that lead customers to demand extremely shortpayback periods for efficiency investments.

Customers and EESPs should have multiple programmatic choices on how theyprocure energy efficient products and services. The majority of programs within anyportfolio should support increases in energy efficiency without preference to the type ofcontract executed between the customer and the EESP. EESPs that have PC-relatedbusiness models that they want to test should be supported with small, well-targetedincubation programs, rather than large performance contracting programs that attract a widearray of already established EESPs.

In sum, based on the evidence from experience with performance contract-promotingprograms to date, we strongly recommend that public purpose incentive funds used topromote performance contracting should be, at most, a minority portion of totalincentive funds available for nonresidential programs. PC-promoting programs shouldcomplement, rather than preclude, the larger fee-for-service market for energy efficientproducts and services. A variety of other market intervention mechanisms are needed innonresidential markets to achieve energy savings associated with both market transformationand resource acquisition policy goals.

IX-39


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