Energy Service Company (ESCO) is not a protected term. Neither is it well-defined. In principle, therefore, any company providing components or services related to energy generation and consumption could, and oftentimes do, call themselves an ‘ESCO’ (Global ESCO Network, 2023). Setting a standard for what can be expected from an ESCO as the current market understand it is necessary to underpin the credibility of the sector. It may also help educating the client on what to expect as a minimum when considering the involvement of ESCOs for the delivery of energy efficiency and potentially demand side renewable energy services.
The following generic definition of ESCOs is endorsed by the Global ESCO Network:
An Energy Service Company (ESCO) is a legal entity that delivers energy services, energy efficiency improvement measures and/or demand side renewable services in a user’s facility, premises and operations and accepts some degree of financial risk directly linked to the project performance in so doing. The implemented services and improvement measures are based upon a holistic analysis of the users’ energy and resource demand, against financially and technically viable alternative energy source and/or resource efficient low-carbon technologies, and/or energy management systems. The remuneration scheme of the ESCO for the services delivered is based (either wholly or in part) on the measured and verified achievement of energy efficiency improvements and of any other agreed performance criteria. (Global ESCO Network, 2023)
It is the view of the Global ESCO Network that companies that do not operate in accordance with this definition should not be referred to as ESCOs.
What fundamentally differentiates an ESCO from another service provider is related to the way that its remuneration is link to the sharing of the performance risk. Any service provider might install a new heat pump and be paid for this service (including the cost of the equipment, but the client bears the risk that it achieves a reasonable reduction in energy consumption. An ESCO, on the other hand, bears the risk that it performs as calculated, as it is remunerated based in part or in whole on that basis (Global ESCO Network, 2023). While there are many ways in which the performance risks can be distributed, the Global ESCO Network recommends that in principle the performance risk of an installation should fall in part or in whole on the ESCO. The ESCO definition is based on this principle.
In order to assume this risk, the ESCO typically takes the responsibility of the designs and installs the systems as a main contractor or indirectly through a subcontractor. It may or may not engage in maintenance or operational optimization and it may or may not engage in the direct or indirect financing of the installation. But ESCOs should be able to assist clients in identifying financially viable options leading to the targeted technical and/or financial savings related to energy and resources demand, considering the whole spectrum of the user’s facility, premises and/or operations. (Global ESCO Network, 2023)
ESCOs are professionals in their field, more likely to apply systems approaches and less prone to ‘cherry-picking’. Energy systems, either demand side or supply side or a combination of the two, are complex and consist of a multitude of components. Optimization commonly require several interventions and components, each of which have different financial returns. The Global ESCO Network encourages ESCOs to apply systems approaches to the greatest possible extent.
Energy Performance Contracting (EPC) can be complex, and because such contracts may last for many years, it is an infrequent activity for most buyers who are often executing a performance contract for the first time. In this context, accreditation is a valuable instrument which can facilitate the interaction between the ESCO and the buyer. A registry of accredited ESCOs provides a basis for contractor selection, with those on the registry having demonstrated the capacity to operate as an ESCO and thus increasing the assurance of future success.
The Global ESCO Network recommends that a national ESCO registry is established and that it contains at least the following information:
- A list of accredited ESCOs with any accreditation classification they have earned
- Performance feedback on ESCOs from users
- Information about the process to become accredited
- The Ethical Statement that accredited ESCOs have agreed to follow
- ESCO primary contact information
- A dispute resolution window
The accreditation body for the development of the registry can be either a public sector entity or a private one, for example operated by a national ESCO association. A registry maintained by a public body may provide more confidence to public sector buyers.
Several countries use accreditation as a quality assurance instrument, where being an accredited ESCO is a precondition for proposing and winning the right to perform a contract mainly in the public sector.
When accreditation is required by government oversight, it must be available to any company working as an ESCO. Further, it should be considered best practice that in order to maintain the accreditation integrity, all ESCOs must periodically re-submit for accreditation, effectively updating their ability to perform.
A registry can also help enforcing the definition of ESCO and thus the differentiation in the market between ESCOs in the registry and other service providers that do not meet the ESCO definition criteria.
Along with an accredited ESCO registry, there must be a pathway for feedback on ESCO concerns. This type of service is often termed an Ombudsman, or a person or entity that will receive concerns, evaluate the issue and provide recommendations to the registry manager.
Concerns raised against registries are that they may serve as an entry barrier to new ESCOs with no prior experience, and that any fee charged for registration serves as a tax on contracting with a public sector entity. These concerns must be balanced against the desire of the ESCO to keep and maintain accreditation as a powerful influence on market development and project dispute resolution. The first concern can be addressed either by allowing a grace-period for new entrants (with limited evaluation), by providing a gradual system of accreditation or by initially using non-ESCO projects to validate the new potential ESCO expertise and capacities. Some registries operate with a 3-tier approach. Despite the significant benefits of a registry to the EPC sector as a whole (ESCOs, clients, financing partners, etc), the second concern, fees, should be used only to cover the costs of maintaining the registry and should not be perceived as a barrier to enter the market and to maintain one position in it.
The central document that governs the relation between the ESCO and its customer is the Energy Performance Contract (EPC). For several reasons, the ESCO contracts tend to be more complex than in many other business relationships, as it involves long term agreements and a payment scheme based on performance of the project. Their complexity is consistently one of the most prominent barriers in all ESCO markets for their development and growth. Therefore, the Global ESCO Network recommends that contracts are standardized to the extent possible, such standardization being established by authority rather than by general consent.
The Global ESCO Network recommends that standard based contracts are developed and authorized for use by a recognised entity, public or private (ESCO association as an example in the latter case), with the goals to:
- Ensure quality, transparency and effectiveness in Energy Performance Improvement Actions
- Provide a clear and transparent performance risk allocation as well as any other agreed energy performance criteria and associated payment schemes
- Provide a reference based contractual framework between user and ESCOs that clearly specifies value generation (including multiple benefits or co-benefits of the implemented improvements) and responsibilities of all stakeholders
- Agree on an acceptable dispute resolution scheme
The EPC is the core of the ESCO model. It is exclusive to the ESCO business model, but the term represents several possible alternatives, that effectively result in different contracts, notably “Guaranteed savings” “Shared savings” and “Chauffage” contracts
Standard based contracts must contain both a mandatory structure and a set of mandatory clauses. This oftentimes means that either they are too generic to be of use without heavy modifications, or that they are unable to fit across different legal frameworks. A main feature of a standard based contract, therefore, must be its adaptability and ability to be transposed to different legal frameworks depending on where it is to be applied.
A standard contract can also help in meeting new legal challenges or taxation issues – such as the IFRS 161, which has been in effect since the beginning of 2019 (see guidance on taxation) – ensuring that the sector responds cohesively and that companies are not left to compete on their understanding of legal frameworks.
While there can be many variations of such contracts used by different ESCOs, they should all have some basic common elements that qualify them as an EPCs. The standardization will not only reduce operational costs in general. It also provides familiarity with and thus higher confidence in contract terms by all stakeholders, reduces room for deviation and hence eliminates confusion and guesswork in the contracting process. In time, it will equally establish a body of case law for future reference. These are all trust enhancing characteristics that reach beyond the contracting parties to third parties such as financial entities.
1 16th policy recommendation from the IFRS Foundation. IFRS 16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value.
One of the most important barriers to the growth of ESCO operations is the limited access to affordable, adapted or dedicated, sustainable and low-risk financing. The availability of financing for ESCO projects is often hampered by commercial banks’ and financial institutions’ limited knowledge and experience with typical ESCO business models. Their perception of high risks in ESCO projects and reluctance to accept the project cash flows as collateral result in high-interest costs and short debt repayment periods, relatively large equity requirements, and, in the case of public sector projects, budgetary or other limitations on the ability of the client to pay for the ESCO services from energy cost savings. However, there is ample experience with financing mechanisms that overcome the financing barriers. Some of the approaches that have been successfully deployed are summarized below.
While financing mechanisms are not policies per se, the Global ESCO Network recommends that all stakeholders including governments and financing institutions together explore the feasibility and benefits of the various financing mechanisms that can facilitate the availability of affordable and sustainable financing, including government policies or initiatives that can underpin it, and implement the most suitable mechanism in their countries to help the scaling up of ESCO projects (Global ESCO Network, 2023). These include:
- Energy efficiency revolving funds (EERF)
- Dedicated credit lines
- Credit or risk guarantees to commercial financing institutions
- Super ESCOs
- Forfaiting through a fund for the securitization and purchase of ESCO cash flows
EERF established by national, state or local governments, in cooperation with financial institutions, can provide long-term, affordable financing for ESCO projects under favourable interest rates and repayment periods relative to commercial financing. This approach is particularly useful in the public sector, where the EERF provides loans to public agencies to cover the initial investment costs of energy efficiency projects, while the resulting energy savings are used to repay the EERF’s original investment, plus interest (World Bank, 2014). Examples include the Bulgarian Energy Efficiency and Renewable Sources Fund, the Armenia R2E2 Fund, and Salix Finance in the U.K.
An energy efficiency credit line established by governments, multilateral or bilateral financial institutions or international donor agencies can make funds available to FIs to provide debt financing of energy efficiency projects. An energy efficiency credit line increases the funding available from financing institutions for debt financing of energy efficiency project investments. Examples include EBRDs sustainable Energy Financing Facilities or AFD Sunref mechanism in many countries with emerging economies.
The provision of credit or risk guarantees to FIs is a mechanism that addresses the FIs’ common ‘high risk’ perception of ESCO projects. Such risk-sharing programs are designed to leverage commercial financing for energy efficiency projects including performance contracting projects by ESCOs (Global ESCO Network, 2023). They may also allow ESCOs to provide services to marginally creditworthy clients by partial coverage of the risk involved in extending loans. Examples include the World Bank’s Partial Risk Sharing Facility in India and the IFC Commercializing Energy Efficiency Finance facility in central and eastern Europe.
Super ESCO, capitalized by the government and/or IFIs, can help provide financing for ESCO projects in both public and private sectors. Such an entity contracts for energy efficiency projects with energy end uses, reduce transaction costs associated with complex procurements, finance the projects on an aggregated scheme, and engage ESCOs as subcontractors for the implementation process, without requiring financing from either the project’s beneficiary nor the ESCO. Successful examples include Etihad ESCO in the UAE, the SOFIAC in Canada and Tarshid in Saudi Arabia.
Finally, forfaiting through a dedicated Fund for the securitization and purchase of the cash flows from an ESCO project can be very useful in situations where an ESCO is investing substantial equity for its project financing. The Fund can purchase the future cash flow stream from the ESCO, thereby releasing the ESCO equity funds to finance additional projects. It transfers future receivables from the ESCO to the Fund. An example of forfaiting is the Bulgarian ESCO Fund established by the company Enemona, based on loan financing from EBRD, to buy receivables under the energy saving contracts signed by Enemona.
The interaction between an ESCO and its client has accounting, fiscal and taxation implications on both sides of the contract. Oftentimes, the specific wording of the contract determines particularly how the contract is going to be perceived not only by the contract parties, but by third party authorities determining how accounting and fiscal treatments will be applied and how and when taxes will be applied. This can often be linked to the way assets transfers are treated. A central issue in that regard is whether the assets are on- or off-balance sheet for the client – and vice-versa for the ESCO, and what are the implication associated with each.
As this particular issue at times is a driving force behind EPC, a straightforward clarification must be established with the national tax authorities. It must follow specific national guidance preventing a case-by-case determination with uncertain outcomes.
The Global ESCO Network recommends that accounting, fiscal and tax experts with particular knowledge of EPC and ESCOs and in a targeted country are consulted for the clarification and that their advice be incorporated into the recommended standard-based contract models in each jurisdiction for the benefits of all stakeholders.
In this regard, the standard-based contract to be used in a specific legislation is of essence (see the Standard Based Contract recommendation), designed to specifically clarify such accounting, fiscal and tax issues. The model contract must specifically indicate which clauses are critical for optimizing its treatment.
In most jurisdictions, such clarification and national guidance must also take into consideration the IFRS16 guidance (International Financial Reporting Standard promulgated by the International Accounting Standards Board (IASB)). IFRS16 ‘establishes principles for the recognition, measurement, presentation and disclosure of leases, with the objective of ensuring that lessees and lessors provide relevant information that faithfully represents those transactions.’ As it stands, it is now near impossible to structure an EPC transaction as off-balance sheet for the client, which is not a positive development for the industry. For this reason alone, the engagement of accounting, fiscal and tax experts with particular knowledge of EPC and ESCOs to (re-)establish this benefit of energy performance contracting is paramount. (Global ESCO Network, 2023)
It is essential that the clarification on accounting, fiscal and tax treatment issues is both dynamic, accommodating new market and contract trends, as well as non-retroactive, i.e. that it does not reclassify already existing contracts (Global ESCO Network, 2023).
The Global ESCO Network believes that governments play a huge role, not only in removing barriers which are impeding ESCO market growth, but also by becoming itself a large buyer of ESCO services to generate energy savings in public facilities and infrastructure. But policy barriers persist in many markets, despite some shining examples such as the thriving US ESCO market driven by a dominant and sustained demand for ESCO services by federal, municipal and military agencies.
The Global ESCO Network recommends that governments and policymakers review the existing procurement and budgeting frameworks and ensure that:
- Public agencies are able to directly procure ESCO services within the confines of government procurement regulations.
- ESCO contract durations are not capped by rigid multi[1]year contracting limitations.
- Energy (and maintenance) savings can be deployed to pay for ESCO services.
- Innovative procurement modalities such as Public Private Partnerships - PPP and Joint Ventures - JV transactions are enabled to optimize the mobilization of private sector capital and knowledge resources for public sector energy efficiency projects.
One of the most prominent barriers for successful market development is that government procurement regulations disallow public sector procurement of ESCO services because such performance contracts cannot, from the accounting and asset management standpoints, be classified as either “pure goods” or “pure services” contracts. ESCO performance contracts cannot be a “pure goods” procurement because the services associated with the guaranteed energy savings or shared savings agreement are not properly recognized and compensated for. Neither will ESCO contracts be classified as “pure services” procurements, because the government agency anticipates a transfer of assets at the natural expiration of the contracts.
A closely related barrier is the inability of public agencies to enter into multi-year contracts with durations or expiration dates that exceed time-bound limits defined usually by the end of the finite term of the elected officials or budgetary planning periods. Some projects will need performance contract terms of 10–15 years or longer for the full recoupment of upfront capital investments and O&M expenses, far beyond the typical 4–6-year elective cycles or public planning periods.
Many governments impose strict budgetary limitations on utilizing the monetary value of energy savings to pay for ESCO contracts. Public accounting policies in these markets dictate that all savings will have to be automatically returned to the national or local treasury. To circumvent this restriction, public agencies have proposed a new incremental budget to pay for ESCO services over-and-above the same annual energy budget, or on-bill charging of the ESCO services through energy utilities. While this remedy may work, it delays ESCO procurements and misaligns budgets with actual costs (Global ESCO Network, 2023).
Public-private partnership (PPP) contract procurement is well suited when many public buildings are bundled or when street lighting systems across several neighbouring municipalities are packaged as a singular tender. The larger scale of the project package allows full recovery of the PPP transaction costs and the budgetary overheads associated with the creation of corporate vehicles to implement the project. A joint venture (JV) arrangement between an ESCO and a state-owned enterprise or government corporation, where both the ESCO and the public company co-invest in the preparation and implementation of the activity, may be considered for smaller projects.
Policy frameworks should allow mobilization of private sector capital through such modalities.