ESCOs and Utilities: Shaping the Future of the Energy Efficiency Business

ESCOs and Utilities: Shaping the Future of the Energy Efficiency Business

As oil hits $110 per barrel and climate change reaches the mainstream conversation in both our consumer culture (carbon neutral products, hybrid cars, etc.) and political conversations (green collar jobs, cap-and-auction schemes, etc.) the issue of energy efficiency has once again become prominent. There is virtual agreement, among policymakers and economists, that efficiency is the low-hanging fruit for reducing carbon emissions and essential to any comprehensive approach to halt global warming.

In fact, many efficiency gains come at a negative marginal cost, meaning that they are actually profitable (a recent McKinsey study estimated the market at $170 billion per year at a 17 percent annual rate of return). However, there are a variety of market barriers that prevent these opportunities from being realized. Prominent among these market barriers is the lack of well-developed energy efficiency business models.

The current landscape of energy efficiency business models can be divided into three groups. The first is composed of various product manufacturers and marketers selling energy efficient products (GE, Sylvania, etc.). This is the most traditional business model for energy efficiency. However, companies that sell products only care that the products are sold; they are not necessarily selling efficiency, but rather one specific means of becoming more energy efficient.

The second business model, more innovative than product manufacture/marketing, is generally referred to as the Energy Service Company (ESCO) industry. It describes companies that offer energy services, either on the supply or demand side, but are not directly connected to a utility (although utilities can create ESCOs). On the supply side, ESCOs in deregulated markets (markets that allow energy competition) can supply energy to customers that they create or buy from others. On the demand side (i.e. energy efficiency), ESCOs will install or redesign building and industrial systems to reduce energy use and finance their fees out of the energy cost savings. As will be clear later, some of these ESCOs have parent companies that focus on products manufacture/marketing.

The third business model, much more rare, involves utilities offering for-profit energy efficiency services. Unlike ESCOs, most utilities are regulated to some extent by commissions appointed by state or local governments. While this regulation can limit investment returns, it also allows for lower investment risk, as regulators virtually guarantee returns based on energy demand projections. In this context, there is a long history of utilities offering energy efficiency services for regulatory reasons, usually with prescribed spending limits. However, utilities are increasingly looking to energy efficiency services as a profit-center separate from their main business of supplying energy to customers, leveraging existing relationships and brand identification.

The future of the energy efficiency business will largely be determined by the role these business models play in the market. It is not an easy market; besides the diet industry, there are not too many companies that make money off of a lack of something. And there are also many "agency" issues, with one party paying the bills and another party receiving the benefits. But as the size of the opportunity becomes more apparent and the need to realize these opportunities becomes more urgent, the market dynamics of these business models will determine the nature of the energy efficiency industry in the years ahead.

History of Cooperation and Competition

ESCOs and utilities have a long history of both cooperation and competition. In a long cooperative tradition, ESCOs have provided energy efficiency services to utility customers in order to fulfill various regulatory requirements. Utilities in turn can provide the transmission services (wires, billing, etc.) to ESCOs looking to supply energy in deregulated markets.

But while cooperation may be the norm, there is also a history of competition between ESCOs and utilities. Back in the go-go mid-1990s, the energy services business experienced a rapid rise due to the growth of deregulation in US energy markets. Utilities, which for decades received guaranteed returns on its power plant investments, soon found themselves in a strange new world where energy customers (especially large industrial users) could choose their own energy providers. Energy services companies (ESCOs), which had started in the 1970s as efficiency providers in response to that decade's energy crisis, started to expand into the supply business, providing energy to large commercial, industrial, and residential users. Companies such as Enron began to see themselves as energy service providers, no longer concerned with whether those services were supply (providing energy) or demand (providing energy efficiency).

In this period for ESCOs, the biggest opportunity was on the supply side; energy prices were historically low (thus discouraging energy efficiency investments) and utility regulations were allowing for competition in energy delivery for the first time in recent history. In theory, ESCOs could buy or build power anywhere and sell it to anyone.

The utilities, realizing this competitive threat, started to respond in kind. While traditionally demand-side ESCOs added supply services, the utilities began to supplement their traditional supply services with for-profit demand-side energy efficiency services, although they severely cut down on not-for-profit demand-side management spending since their profits were no longer linked to the benevolence of state utility regulators. For a period, it looked as if these two groups would continue to converge: both ESCOs and utilities would offer energy services, competing against each other for customers.

This free-market utopia ended abruptly, however, in the wake of the California energy crisis. The deregulation dream quickly turned into a nightmare, as energy companies learned how to game the system and regulators failed to anticipate severe market failures implicit in the new energy market (in many cases the utilities were forced to buy energy at a higher price than they were allowed to sell at). The crisis also helped to expose the Enron accounting scandal, which sent shivers up the spine of every energy company. All of a sudden, it was not so cool to be an innovative "energy services" provider, and bread-and-butter supply or demand services did not seem so bad.

In the wake of the scandals, Congress passed new legislation that restricted some of the accounting practices that allowed many of the energy service companies to book large profits. And many regulators either reversed or halted deregulation. Partly as a consequence, the utilities shut down or sold many of their demand-side service arms. There was a parallel shift towards consolidation in the ESCO industry as many smaller ESCOs failed. The ones who survived were generally product suppliers who used the ESCO model as a sales and marketing vessel, allowing flexible financing options for their products and services.

At the turn of the new millennium, ESCOs and utilities had stopped competing with each other and returned to their respective areas of expertise. And that is how it would have remained, but for Al Gore and the rise of energy and climate change issues to the forefront of national debate. All of a sudden there is a renewed emphasis on energy efficiency. These market shifts have created a new dynamic in both the ESCO and utility industry.

ESCOs: Back to the Future

For ESCOs, this new market is similar to the original market of high energy prices in the 1970s that led to the creation of the industry, with the added twist that global warming is now also a paramount public policy concern. This dynamic has translated into tremendous growth opportunities; the ESCO industry has experienced over 20 percent annual growth since 2004, according to the latest study [PDF] by NAESCO, the U.S. ESCO trade group.

And this trend may only accelerate. Last May, the Clinton Climate Initiative announced a partnership with ESCOs, banks, and over 45 major cities across the world to create $5 billion in energy efficiency investments. As President Clinton pointed out at this year's Greenbuild conference, this $5 billion doubles the current ESCO market. But while obviously highlighting the significance of their achievement, Clinton was careful to point out that this was a small amount of money compared to the total potential value of profitable energy efficiency investments. The message was clear: we are only scratching the surface of what is possible, but new partnerships and models are needed to realize these opportunities.

An example of this new model is Ameresco, an ESCO founded by market veterans in 2000. While still smaller than many of the largest ESCOs (Siemens, Johnson Controls, etc.), they have been able to grow quickly by buying the remnants of many failed ESCOs from the 1990s such as Duke Energy spin-off DukeSolutions and by marketing themselves as the only major ESCO not owned by a technology-based parent company. Leveraging their perceived independence and technical expertise, (according to their website) Ameresco has grown 400 percent in the past year and is on the verge of overtaking the established players in the energy services business.

Utilities: Changing the Game

For utilities, an equally significant opportunity has presented itself, although in a very different manifestation. There are signs that the current model of utility energy efficiency spending may be radically changed in the coming years. Energy efficiency spending is currently viewed as a regulatory investment. There is an implicit understanding between utilities and regulators: if the utilities spend more money on energy efficiency programs, the regulators will allow rate increases for capital improvements, operating costs, inflation, or general profitability.

Over the years, this understanding has become much more explicit. Most states have some sort of rate recovery system whereby utilities raise rates or add a surcharge in order to cover their energy efficiency costs. More recently, some regulators have tied rate increases directly to energy efficiency spending or performance. California, the acknowledged state leader in efficiency regulations despite their ill-fated experiment with deregulation, has recently embraced these "performance incentives," joining many northeastern states that had previously instituted these regulatory incentives.

California will now penalize utilities that do not meet prescribed energy efficiency goals, but will also allow them to keep 12 percent of the energy cost savings realized if they exceed the goals. It is yet to be seen whether this incentive will create the intended energy savings. The profit-motive to California utilities, while stronger than simple rate recovery (the rate of return on energy sold is usually in the range of 10 percent), provides less of an incentive for energy efficiency than a similar regulatory proposal being pushed by Duke Energy in North Carolina and other states.

Under Save-a-Watt, as the program is called, Duke will be able to recover 85 percent of the avoided supply costs. According to a recent article in Forbes, Duke sells energy for about 8.5 cents per kWh, but can reduce demand for about 4 cents per kWh. 85 percent of this spread, or about 4 cents per kWh saved, is their profit. While there is more risk by investing in energy efficiency (unlike the traditional utility business model, there is no guaranteed cost recovery), there is the potential to realize a higher return than supply (mostly coal for Duke). Save-a-Watt offers the promise of a positive feedback between utility profits and energy efficiency.

If the promise of these regulatory regimes were fulfilled it would be a large step towards realizing the opportunities of energy efficiency. Not only would there be large investments in energy efficiency, but it could potentially ease the incentive for an increase in supply investments.

The New Competitive Dynamic

As the efficiency market evolves, different challenges confront each industry. For ESCOs, who rely on making sales to individual corporations and other entities (government, residential, etc.), the challenge is to develop tools and models that allow for low-touch, high volume energy efficiency solutions. ESCOs have to convince each energy consumer that they would benefit from their services.

Utilities are also challenged to effectively market energy efficiency as a product/service, but have the inherent advantage of strong pre-existing customer relationships. However, utilities must make a much tougher sale to regulators in order to create a sustainable business model.

As the ESCO and utility industries realize the opportunities unfolding due to energy prices and climate change concerns, there will also be a competitive dynamic somewhat similar to the convergence of the 1990s. As both ESCOs and utilities will be marketing energy demand reductions, they are bound to face each other in the marketplace.

The competition may take one of many forms. Utilities may offer incentives to businesses for efficiency retrofits at the same time that ESCOs are selling a turnkey financing/retrofit package. It will be the free rebates of the utilities versus the expertise and guarantees of the ESCOs. Similar to the 1990s, the utilities have the customer reach, but the ESCOs may have better technical expertise.

The utilities may also be able to finance improvement through on-bill financing, which places energy efficiency service charges on a customer's utility bill, which allows for streamlined billing and potentially lower credit risk (most Americans pay their utility bills on time).

Another, more subtle dynamic may also take place. In order to justify profits from efficiency, a third party must verify the energy savings. However, the protocols for additionality (proving that the utility spending made a marginal impact), is an imperfect science at best. Many utility energy efficiency programs actually buy down the interest rates on retrofit contractors, including ESCOs, claiming credit for the savings that occur. In the past, the credit for these savings have not been a major issue - they would be put into a regulatory filing and could be used by the state and utility for publicity purposes. With a profit motive attached, however, the politics become much trickier.

Consumers may not want to pay twice for their efficiency retrofits, first to the ESCOs and then to the utilities. Instead, they may demand significant rebates from the utilities that subsidize the upfront cost, forgoing the ESCO business model of long-term financing linked to energy savings. Under this scenario, the ESCOs may try and discredit the utility methodologies and the utilities will attack the ESCO business model as exploiting real estate owners who lack the capital or sophistication to implement efficiency retrofit solutions themselves.

Of course, there is no guarantee that either of these new competitive dynamics will occur. As noted, ESCOs are a key component of many utility energy efficiency programs and will probably remain so well into the future. It is certainly possible, that verification protocols will be accepted that benefit both ESCOs and utilities.

There are also many innovative partnerships that may be possible. For example, utilities could employ on-bill financing, but place charges from ESCOs (instead of the utility themselves) on customers' utility bills, taking a percentage of the charge as compensation for the billing channel.

Whatever the specifics, the simple fact that ESCOs and utilities are again in the same industry makes it much more likely that there will be a strong competitive dynamic in addition to expanding the current cooperative dynamic, both at the consumer and regulatory level. How these dynamics play out will be a significant determinant of how the energy efficiency marketplace develops in the near future.

Andy Frank is an analyst at GreenOrder, an environmental strategy consulting firm.