Most ESCOs provide financing for projects from their own funds (working capital); however, they generally are only able to finance the initial stages of a project. Even though the ESCO eventually has no equity investment in the project, the ESCO does provide its equity to fund the initial risk equity by investing its working capital to develop and finance a paid-from – savings project for the customer. Thus, ESCOs seeking to use performance contracting must develop or arrange sources of debt and equity to finance their projects. More often, the ESCO’s role is to arrange financing for its customers with leasing companies, institutional investors, and commercial banks.
The customer usually enters into separate agreements for energy services and for financing. Typically, the ESCO may arrange financing but is not a party to the finance agreement. The end-user credit risk is assumed by the financier, not the ESCO. The ESCO and the end user enter into a turnkey contract or energy services agreement whereby the ESCO provides engineering, equipment installation, and other services such as operations, maintenance, and savings verification. If the savings do not materialize as projected, the end user has recourse against the ESCO.
Many ESCO projects are financed using nonrecourse or limited-recourse financing. Since no capital is required up front and financiers are repaid through energy savings, ESCOs and customers are allowed to develop projects that are much larger than their net worth. Although nonrecourse financing has important advantages (e. g., a positive cash flow immediately for the customer), it also introduces significant business risks into the financing and higher project costs.
The two types of project financing commonly used by ESCOs in the United States are guaranteed savings and shared savings. In a guaranteed savings agreement, the ESCO guarantees to the customer that the project’s realized savings will equal (or exceed) the payments made (or financing costs absorbed) by the customer over the term of financing. In guaranteed savings contracts, ESCOs typically guarantee approximately 80-85% of the savings they expect to get out of a project. In these projects, the customer assumes the obligation to repay the project costs to a third – party financier (usually introduced by the ESCO), which is very often a commercial bank or leasing company. If the customer finances the project itself, the customer repays itself by saving energy costs.
If the savings realized fall short of the payments made by the customer due to a failure of the project to perform as guaranteed, the ESCO pays the customer the difference. If, however, actual savings exceed the payments, excess savings are normally returned to the customer. In some cases, the customer and ESCO negotiate the sharing of savings in excess of the amount guaranteed.
In shared savings projects, the ESCO’s payments are typically structured as a percentage of the energy savings actually realized by the end user over the length of the contract. The percentage is predetermined, but the percentage of savings allocated to each party can vary over the period of the contract. The ESCO must ensure that the proceeds it receives will cover the costs it has incurred in implementing the project.
In exchange for the ESCO providing project financing and for the ESCO’s assumption of performance and credit risk, the customer agrees for a fixed term to pay the ESCO the value of a set percentage of those savings. The portion of savings paid to the ESCO that is attributed to debt service is always higher for shared savings than for guaranteed savings projects, reflecting the ESCO’s significantly greater risk and expense. The ESCO uses its payments from the customer to repay debt associated with the project, conduct equipment maintenance, measure and monitor savings, and earn a return. As with guaranteed savings projects, the ESCO measures energy savings throughout the term of the project agreement.