FINANCING OPTIONS FOR ENERGY MANAGEMENT SERVICES · guarantees energy-cost reductions for building and facility owners. Projects are self- financed from energy and operating cost

FINANCINGOPTIONSFOR ENERGYMANAGEMENTSERVICES

Part of the Efficiency andAlternative Energy Program

Un élément du Programme del'efficacité énergétique et desénergies de remplacement

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Q Minister of Supply and Services Canada 1995

Catalogue No. h427-Ol-547E

Copies of this publication may be obtained free of charge from: Natural Resources Canada c/o Canada Communication Group otmva, ontalio KlA OS9 Phone: (819) 997-l 107 Fax: (819) 994-1498

Cette publication eat kgalement disponible en fraqais sous le titre de : ik financement des options dam les sewices de gestion de l’hergie

a9 Printed on recycled paper

CONTENTS

1 .O INTRODUCTION ................................................... .l

2.0 FINANCING METHODS ............................................. .4

2.1 Routine Financing ............................................ .4

2.1 .l Owne*t internal financing ... :. .............................. .4

2.1.2Directloanorkase ........................................ .5

2.1.3 Capital lease ............................................. .5

2.1.4 Operating lease ........................................... .S

2.1.5 Ownership and title ........................................ .5

2.2 Non-routine Financing ......................................... .

2.2.1 Owner’s internal financing - modified ....................... .6

2.2.2Directlaanorkase-modified.. .......................... .7

2.2.3 ESCO arranged financing ............................... .7

2.2.3.1 Assignment by the owner .......................... .7

3.0 SELECTION CRITERIA .............................................. .lO

3.1 Rirktotheowner.. ......................................... .10

3.2Cortofcapital ............................................. ..12

3.3 Owner’s cash flow position ................................. .12

3.4 Accounting considerations ................................... .13

3.5 Tax considerations .......................................... .14

4.0 CHECKUST AND SUMMARY ....................................... .16

4.1 ESCO’s rele in proiect financing .............................. .16

4.2 Gfbbalance sheet financing ................................. .16

4.3Contractualagreements.. .................................. ..16

4.4Gwner’srirks ............................................. ..17

APPENDIK A

Gverview of most common financing options .................... .17

APPENDIK B

Nu~ricalexample..............................................l B

Energy Management Project - Typical Costs ...................... .19

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1 .O INTRODU~ION

The purpose of this guide is to provide decision makers in industrial, commercial and institutional facilities with practical advice on how to finance energy-efficiency improvement projects.

Experience has shdwn that there can be several individuals within an organization who share the decision-making responsibility for an energy-efficiency project. Typically, they are drawn from facilities, financial, administrative and legal groups. For simplicity, we refer to any one or all decision makers as the “owner” or the “client”.

Financing an energy-efficiency project need not involve any circumstances different from the routine financing of equipment, services or projects that any organization processes as part of its normal operations.

An owner has several routine financing options:

l internal capital or operating funds

l bankloan

l capital lease

l operating lease

Performance contracting is a turnkey engineering and general contracting service that guarantees energy-cost reductions for building and facility owners. Projects are self- financed from energy and operating cost savings. The companies that provide this service are called ESCOs (energy service companies).

Financing can also be non-routine, if a performance contract is used or one or more of the following conditions apply:

l Payment to a lender must maintain a neutral cash-flow,

l A third party offers a guarantee of savings performance;

l A lender uses energy-cost savings as collateral for its loan; and

l The characterization of the transaction is important to the owner, lender, or a third party for tax, revenue recognition or other reasons (i.e., the project, equipment or service being financed).

Non-routine financing requires some modifications to traditional loans and leases. Performance contracts with energy service companies, or ESCOs, contractually deal with all these modifications, since a performance contract can be financed by internal funds, loans or leases. In addition, an ESCO can offer off-balance sheet financing by making suitable contractual relationships with both the owner and lender.

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It is important not to confuse the different financing options with the different implementation options. As described above, financing can be achieved using internal funds, loans, leases, or off-balance sheet financing, whereas, implementation options can be divided in two broad categories (see FIGURE 1):

l Construction project. Procure the services of a consulting engineer, project manager, general contractor or trades. It is assumed that no performance guarantee is offered and the transaction is conventional to any typical construction project; or

l Performance-based project. Procure the services of an ESCO or enter into an ESCO-type arrangement. It is assumed that some form of performance guarantee is involved.

It is important to note that there are contractual consequences to the non-routine financing options that in many cases can assist in tax and ownership interpretations. An owner must consider both the best way to get the project implemented and the optimum mechanism to get the project financed.

This guide briefly describes each of the financing options and summarizes the cost, cash flow, accounting, tax, and structural implications of each option. It is convenient to dis- cuss each financing option in the context of a performance contract because the ESCO transaction deals with all combinations of financing alternatives, ownership, and tax issues. It is important to emphasize that the use of ESCOs is not being promoted. Owners can purchase engineering and construction services in their traditional manner, if they wish to do so.

It has been assumed that the reader is less interested in the routine financing methods, for which, presumably, there is a large degree of familiarity, and is more interested in information and awareness surrounding the non-routine mechanisms. Furthermore, it is assumed that the owner has reached a conclusion, albeit not necessarily cast in stone, as to which implementation route to go, either conventional or performance-based. This guide does not compare the cost benefits of the alternative implementation choices.

This guide is not meant to be a substitute for professional, legal, tax, or accounting advice. Owners should consult with their in-house or external professional advisors, with respect to the impact of any proposed contractual or financing option on their particular circumstances. The guide identifies the main issues that need to be addressed.

Published material that may assist the user of this guide includes

“Performance Contracting for Energy and Environmental Systems”, Shirley J. Hansen, Ph.D., the Fairmont Press Inc., 1992.

“Energy Performance Contract Guidelines” September 1992, J. T. Brett, LL.B., published by the Canadian Association of Energy Service Companies, CAESCO.

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1

ROUTINE FINANCING

F7

Dn-balance ShOOt

financing with an

ESCO

r NON-ROUTINE

FINANCING I

Modii ban Ylf!z?

loo off-balance ShOd r financing

with an ESCO

Figure 1: Project Financing Decision Tree

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2.0 FINANCING METHODS

Different financing methods involve different risks for the owner, in terms of:

l costs of capital;

l accounting and tax treatment;

l cash flow consequences; and

l implications for the ownership of the equipment.

2.1 ROUTINE FINANCIN~B Owners have at least four methods of financing an energy-efficiency improvement project, using conventional or routine financing tools. These methods are as follows:

l owner’s internal financing, from capital or operating funds;

l a direct loan with a lender;

l a capital lease; or

l an operating lease.

More credit-worthy owners have a wider range of options than less credit-worthy owners. This section of the guide deals with each financing option. Section 3 presents some of the factors that would lead the owner, ESCO, or contractor to choose one option over another.

2.1.1 OWNER’S INTERNAL FINANCING

Some owners have elected to pay cash for the improvements rather than have a third party finance them.

Owners may decide to self-finance because they have excess cash, or they conclude they can borrow the funds more inexpensively than from commercial lenders and that they have no more profitable alternative for the use of such funds. Private-sector owners will want to consider the opportunity cost of any of their own capital they decide to invest in projects. In light of reduced public sector operating budgets, it is unlikely that a majority of public institutions will have the excess funds to invest in such projects, given the number of competing claims on capital.

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FINANCING OPTIONS FOR

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Moreover, owners may have covenants in existing loan agreements that preclude them from taking on further debt or subject them to laws or policy guidelines which govern the manner in which they may borrow funds. For example, the federal government cannot borrow, except in the manner set out in the Financial Administration Act. The federal government does not permit its’ departments to borrow to finance energy-efficiency projects.

2.1.2 DIRECT LOAN OR LEASE

Project financing by the owner can be arranged with lenders or lessors (lenders) of record. The owner then enters into a direct construction loan or equipment lease agreement with that financial institution.

While the owner can enter into a loan, a capital lease, or an operating lease with the financial institution, these legal instruments accomplish the same business objective. The accounting and tax implication of each option will differ, for the owner.

2.1.3 CAPITAL LEASE

A capital lease is essentially a loan by the lender to the owner to finance design and construction work under contract (typically a standard construction document) and the risks and benefits of ownership are deemed to have passed to the owner. Most lease arrangements entered into between the owner and lessors are, for accounting purposes, at least, capital leases. Like loans, they must be shown as a debt on the owner’s balance sheet.

2.1.4 OPERATING LEASE

On the other hand, an operating lease, or true lease, is one under which benefits and risks of ownership remain with the lessor (or lender) and is, typically, for a term, much shorter than the economic value of the assets. At the end of the lease term, the assets revert to the lessor (lender), or the lessee (owner) has the option to purchase them at market value. It is unlikely that a lease to finance energy-efficiency improvement work would be classified as an operating lease. It is difficult to characterize the building improvement retrofit as a rental-type arrangement.

2.1 .S OWNERSHIP AND TITLE

Title to equipment installed is usually held by the lender. The lender may wish to register its security interest in the equipment, under the relevant provincial Personal Property Security legislation.

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2.2 NON-ROUIINB FINANCINO Owners have at least six methods of financing an energy-efficiency improvement project, using special or non-routine financing tools. These are modified versions of the four methods described in Section 2.1, with the addition of on-balance and off-balance sheet financing via an ESCO:

l owner’s internal financing, from capital or operating funds;

l a modified owner’s direct loan with a lender;

l a modified owner’s capital lease;

l a modified owner’s operating lease;

l off-balance sheet financing with an ESCO; or

l on-balance sheet financing with an ESCO.

For financing to be characterized as non-routine or special, any one or more of the following conditions must apply:

l Payment to a lender, ESCO, or contractor must maintain a neutral cash flow, that is, the monthly energy savings must be sufficient to fund the payment;

l A third party offers a guarantee of savings performance;

l A lender uses energy-cost savings as collateral for its loan; and

l The characterization of the transaction is important to the owner, lender, or a third party for tax, revenue recognition or other reasons (i.e., the project, equipment or service being financed).

2.2.1 OWNER’S INTERNAL FINANCING - MODlFIED

An owner may elect to pay cash for the improvements rather than have a lender or ESCO finance them. The owner can still benefit from the ESCO’s technical expertise, project management, and the performance guarantee under the performance contract. The ESCO would still guarantee, for example, that the savings will repay the total project costs within a fixed number of years.

ESCOs can also offer performance guarantees that insure that the owner’s invested funds will be returned in pre-defined amounts on a pre-determined schedule. The most common example would be when an annual cost-savings stream is guaranteed by an ESCO. Often, the cost savings must not only retire the capital invested by the owner, but it must also retire an imputed interest cost to recognize that the capital could have earned interest in other investments.

A second reason for involving an ESCO or contractor in a special arrangement, could be to describe the project as one of providing services versus the acquisition of equipment. Such a characterization may be necessary to insure that the appropriate budget is used to

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finance the project, for example, an operating budget rather than capital budget. While the ESCO is paid when construction is complete, the owner has recourse to be compensated from the ESCO if savings targets are not met over a pre-determined period.

2.2.2 DIRECT LOAN OR LEASE - MODIFIED

ESCOs, in some cases, attempt to arrange the financing for the project by introducing the owner to a pre-selected lender or lessor. Mature ESCOs have established relationships with lenders who are familiar with lending against energy-efficiency projects. The owner then enters into a direct loan or lease agreement with that financial institution, usually upon completion of the construction phase of the contract and once savings are demonstrated, in an amount sufficient to retire the loan the lender has provided to the ESCO. The performance contract will sometimes oblige the owner to enter into such an arrangement at the completion of construction, require the owner to cooperate with the lender, and provide the necessary information to establish a credit rating. The ESCO will pre-clear the credit rating of the owner with its lender. In such an arrangement, the ESCO is responsible for obtaining its own financing for the construction phase.

A capital lease is, essentially, a loan by the lender to the owner to finance the work under the performance contract, with the risks and benefits of ownership deemed to have been passed to the owner. Most lease arrangements entered into between the owner and lessors are, for accounting purposes, at least, capital leases. Like loans, they must be shown as a debt on the owner’s balance sheet.

On the other hand, an operating lease, or true lease, is one under which benefits and risks of ownership remain with the lessor, and for a term is, typically, much shorter than the economic value of the assets. At the end of the lease term, the assets revert to the lessor or the lessee has the option to purchase them at market value. It is unlikely that a lease to finance the ESCO’s work under a performance contract would be classified as an operating lease. It is difficult to characterize the ESCO retrofit as a rental-type arrangement.

The advantage of the arrangement to the ESCO is that it has no loan or lease itself. It will have an obligation under the performance contract to reimburse the owner for any shortfall in the savings, relative to the owner’s loan or lease payment obligations, and often on an annual basis. The owner incurs the risk that it will be “out-of-pocket” for a period of a few months. This risk can be mitigated by setting the monthly payment on the loan or lease at a level less than the projected monthly savings, by the owner not executing the loan agreement until construction has been completed and savings demonstrated, and by making those events condition to its obligation to enter into financing arrangements in the performance contract.

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2.2.3 EXO-ARRANGED FINANCING

Owners have several additional options, when working with an ESCO under a performance agreement.

The ESCO can assign the owner’s promise to pay under the performance contract, with or without the owner’s commitment, to make a stream of fixed payments to the lender.

Alternatively, the owner may be offered the ESCO’s internal financing on the strength of its general credit. Here, the ESCO enters into a loan or lease agreement with its lender, with the owner agreeing to pay the ESCO, and not the lender, from cost savings achieved.

Finally, in selected cases, the ESCO may be willing to finance the project from its internal capital funds. However, there is a trend in the energy performance contracting industry for ESCOs to arrange third-party financing of projects with minimum recourse to the ESCO itself. That is, many ESCOs wish to avoid carrying the debt associated with project financing on their books.

This trend is understandable, given that ESCOs are specialized contractors, and not financial institutions. Those ESCOs with the financial capacity to relieve building owners of any onerous financial recourse obligations, all other things being equal, may be more attractive to clients who require external project financing and cannot, or prefer not to, take any additional debt.

2.2.3.1 Assignment of the Owner’s Promise to Pay

In this arrangement, the ESCO enters into a loan or lease agreement or “Sale of Receivables” with the financial institution, either on execution of the performance contract or at the completion of construction. As security for the loan, the ESCO assigns (contractually transfers) the owner’s promise to pay the savings generated under the performance contract to the lender, together with title to any equipment that the ESCO installs in the owner’s facilities.

The lender insists that the ESCO retain the obligation to perform under the performance contract and accepts assignment of the benefits only. The lender wishes to enforce the contract between the ESCO and owner to insure that a savings stream will result and be reli- able. In addition, the lender will register a security interest in the assignment or in the equipment or both.

The lender will also want an “acknowledgement” (a letter signed by an officer of the organization) from the owner that they have entered into a performance contract with the ESCO, which is not in default an agreement to make the savings payments directly to the lender “without set-off or recourse”. In other words, whether or not the owner has a dis- pute with the ESCO under the performance contract, the owner agrees to continue to pay the lender with regular payments.

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The lender will also want the owner to agree to make a fixed stream of payments to the lender, and recover any shortfall from the ESCO, if the monthly savings do not equal the agreed payment to the lender. As an alternative, the lender may require the ESCO to undertake to pay a deficiency payment equal to the shortfall, between the owner’s monthly savings payment and the monthly loan payment.

In other cases, the lender will take a greater degree of project risk and be content to receive only monthly interest payments from the ESCO, with the capital of the loan paid only from the savings stream. In the latter case, the owner’s sole obligation would be to pay the EsCO’s lender the savings real&d under the performance contract for the term of the contract. The lender may charge a higher interest rate for the latter arrangement, which is clos- er to a pure “project financing”, that is, a financing based on the estimated cash flow from the project, supported by the longevity of the owner, rather than on the financial strength of the ESCO itself.

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3.0 SELECTION CRITERIA

Having chosen an implementation approach, selecting the most appropriate and beneficial financing mechanism involves a careful analysis of:

l risk

l cost of capital

- cash flow

l accounting considerations

l tax considerations

With the exception of risk and cost of capital, the aforementioned criteria are more relevant to a performance contracting approach or one that uses non-routine financing.

The very reason the performance contracting has grown in Canada and the United States is that ESCOs transfer some of the risks associated with financing and implementing an energy-efficiency project from the owner to the ESCO.

Section 3.1 deals with the risks associated with a performance contracting approach.

3.1 RISK TO OWNER

The owner has two primary risks in the performance contract transaction.

The first is that the projected monthly and annual savings will not be realized. The second is that the ESCO will become insolvent during the ongoing energy management phase, either during the construction period or after construction is finished.

Both these risks are affected by the financing method the ESCO and the owner select. The risk of savings not being realized falls mainly on the ESCO, under the performance contract, as the ESCO guarantees that the savings generated over the contract term will pay out the total project cost. The owner’s obligation is to pay only the savings as realized. As long as the owner’s sole obligation is to pay the ESCO as savings are realized, the owner has maximum leverage on the ESCO and is able to insist on the ESCO’s continued performance with respect to warranties, energy management and monitoring, maintenance obligations, and the like.

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If the owner undertakes a fixed monthly payment obligation to a lender, either under a separate and parallel agreement, or pursuant to an assignment of their promise to pay the savings in the performance contract, owners have lost some operational leverage, as they are then committed to make a monthly payment and must depend on the ESCO to make an annual reconciliation payment. The owner can be protected further, by including a clause in the contract stating that if the annual reconciliation shows that the savings have not been realized, the owner can discontinue payments until savings are restored.

The owner’s more secure position is where it is obliged to pay only such savings as are realized under the performance contract. To the extent that the ESCO wishes to have the owner agree to make a stream of fixed payments not linked to actual savings, the owner will want to assess the financial strength and track record of the ESCO. The owner’s obligation would remain, if the ESCO failed to perform under the performance contract due to incompetence or due to its insolvency. If the ESCO were to fail after completion of construction, the owner would lose their performance guarantee but still be obliged to make the loan payment.

In the event the ESCO were to become insolvent during construction, the owner would be left with a partially finished project, but with an obligation to make payments. For that reason, owners generally should not enter into financial arrangements that oblige them to pay a fixed stream of monthly fixed payments unconditional upon there being savings at least until after the completion of the construction phase, or insist that the ESCO provide a performance bond to ensure completion of the project. The bond should be structured in such a way that the surety is obliged to complete the project in a manner that results in a minimum level of savings which can be sustained for a reasonable period of time.

An additional risk to the owner in the case of ESCO insolvency is that the lender will seek to seize (as security for its loan) the equipment the ESCO has installed in the owner’s facilities. Virtually every performance contract provides that the title to the equipment installed in the owner’s premises remains with the ESCO, as security against payment of savings by the owner for the term of the Agreement. Typically, the ESCO assigns the title to the equipment to the lender. In the event the ESCO were to default on its loan, the lender would have the right to realize upon its security.

The performance agreement usually gives the owner the right to pay off the ESCO’s loan, in respect of the project and equipment at the owner’s facilities, and receive title to the equipment. Some owners have insisted on terms in the performance contract and the loan agreement that preclude the lender from even seeking to remove the equipment, regardless of the circumstances, or except where the owner is in default. (Lenders will resist the inclusion of such a provision.) A more practical approach is for the lender to have the right to appoint another ESCO to carry on the project, continue the energy management activ- ities, and collect the savings. As a practical matter, most of the equipment installed is very difficult to remove and would have limited resale value. It may, even in some circumstances, legally become part of the building (a fixture) and subject to the claim of parties holding interests in the real estate, for example, a mortgagee. Traditionally, however, lenders like to take security for their loans and will try to negotiate these rights.

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3.2 COSTS OF CAPITAL

The owner may prefer to use its own capital to pay for the work.

Before making the decision to commit its own scarce resources, the owner should consider the alternative return available if they used their capital for other projects. There is an opportunity cost associated with the use of its own money to finance energy-efficiency improvements. There is also a cost of delay if the owner contemplates waiting for several years until they have sufficient funds to do the entire job. Sometimes the owner will fall into the trap of only implementing items with very short paybacks, with the objective of using the cumulative savings from these measures to finance other projects. Such an approach needlessly delays the implementation of the full retrofit project and may make the longer payback items difficult to finance.

An owner with a strong credit rating can assist the ESCO to obtain lower cost financing for the project, if they agree to take on the loan/lease obligation themselves (a separate and parallel agreement), or they agree to make a fixed stream of payments to the ESCO’s lender. In particular, if such payments are unconditional and the owner has to look to the ESCO to be made whole, financing costs will be reduced.

In making these choices, the owner is trading off increased risk against a lower cost of capital. If the owner wants a pure project-financing arrangement, or arrangements, where their only obligation is to pay the ESCO the savings under the performance contract (the ESCO will finance the arrangement without the assistance of the owner) the result may be higher financing costs. The degree to which the costs are higher will depend in part on the creditworthiness of the ESCO. There are also more financial institutions entering the energy performance contract market. Some of these companies may make non-traditional arrangements at a cost comparable to the cost of the more traditional banking and leasing arrangements.

3.3 OWNER’S CASH FLOW POSlTlON

The standard FIRST-OUT performance contract does not provide a guaranteed annual energy savings to the owner.

If the owner agrees to make a stream of fixed monthly payments to the lender, either pursuant to an Assignment of its promise to pay the ESCO or in a separate and parallel loan or lease, it may face a cash flow deficiency in months where the realized savings do not equal the monthly loan payment. In principle, at least, a shortfall could carry on for several months. In order to mitigate this risk, the owner can insist that the agreed monthly payment be less than the anticipated monthly savings, that the commitment to pay not commence until savings are demonstrated, and that the ESCO’s obligation to hold the owner harmless is on a quarterly rather than on an annual basis.

If the issue is important to the owner, they would seek a guarantee of monthly savings or a monthly reconciliation from the ESCO.

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3.4 ACCOUNTING CONSIDERATIONS

Some owners do not want to show a debt on their balance sheet for a variety of policy, practical, and legal reasons.

If the owner’s only agreement is the performance contract with the ESCO, the owner would not have to show a debt on their balance sheet, since their obligation to make payments to the ESCO under the performance contract is contingent on savings being realized.

The fact that the ESCO may assign the contract to a financial institution in return for funding of the project, either at the outset or on completion of the construction phase, does not change the nature of the owner’s obligation. As noted earlier, the ESCO would typically guarantee the financial institution, as part of the assignment and funding agreement, to keep the lender whole. That is, if the owner fails to make a monthly payment under the performance contract because of a savings shortfall in that month, the ESCO will make up the balance to the level of the monthly payment in the assignment and funding agreement.

However, if the owner agrees to make fixed monthly payments to the ESCO’s lender, pursuant to an Assignment of the performance contract to the lender, then the owner may have incurred a debt, unless the obligation is contingent on the cumulative savings being sufficient to fluid it over the life of the project. The owner should consult with its accoun- tants, if the treatment of such an obligation is an important issue.

On the other hand, if the owner enters into a separate loan agreement with a financial institution with fixed repayment obligations, they have incurred a debt which must be shown as a liability on their balance sheet, notwithstanding the fact that the ESCO has undertak- en to reimburse them on a regular basis for any shortfall between savings generated and the loan payments. The owner has a firm obligation to pay the bank, regardless of whether the project generates the predicted savings or whether the ESCO remains in business.

The same rules apply if an owner enters into a capital lease with a financial institution. The capital lease must be reflected on the balance sheet of the lessee (owner) as the acquisition of an asset and an equal liability.

Certain companies will not find a direct loan or the capital lease to be an attractive option. For example, a company which has borrowed heavily to achieve rapid growth may have a number of restrictive financial covenants in its loan agreements that are to be measured by using its annual audited financial statements, prepared in accordance with generally accepted accounting principles. There may be restrictions on the annual amount of capital expenditures, the working capital ratio (the ratio of liquid assets to short-term liabili- ties), the debt/equity ratio (the ratio of the corporation’s total debt capital to its equity, a measure of financial leverage) and interest coverage (the ratio of operating income to interest payments on the debt).

The introduction of a sizeable capital lease cost onto such a company’s financial statement would likely offend most of the restrictive covenants in its borrowing agreements. The contract would result in the acquisition of an asset, thereby affecting the capital expenditure

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test. The principal portion of the rents due within a year would be included in current lia- bilities, reducing working capital. The debt/equity ratio would also increase because the lease obligation is reflected as debt. Finally, the interest element of the rent payments results in higher interest and consequent deterioration in the interest coverage test (a check on the extent to which a company is obliged to make interest payments).

If the owner enters into an operating lease with a financial institution, the lease obligation does not have to be capitalized for accounting purposes. The lease payments are recorded as expenses on the income statement in the years in which they are incurred. It is difficult, however, to see how an agreement under which a financial institution finances the assets that are installed and the services provided in the course of implementation of a performance contract can be characterized as an operating lease. The present value (using the concept of the time value of money) of the minimum lease payments under such an agreement would typically be equal to substantially all of the fair market value of the leased property at the commencement of the lease. This fact would normally mean the lease would be capitalized for accounting purposes.

Some parties in the industry will set up the financial transaction as an operating lease, with a side agreement that allows the owner to purchase the assets for a nominal amount at the end of the lease term, but this arrangement seems transparent. Most of the assets, installed as part of a performance contract, become part of the realty and are under the possession and control of the owner for a long term, and they have very little salvage value. The benefits and risks of ownership would seem to have been transferred to the owner.

3.5 TAX CONSIDERATIONS

Owners will want to assess the tax consequences of any financing arrangements for the project. They should seek advice from their professional advisors in this regard, as this booklet does not purport to offer definitive legal, accounting, or tax advice.

There are two tax issues to consider:

l the right to take capital-cost allowance on the equipment installed as part of the performance contract;

l and the tax treatment of the payments made by the owner to the ESCO or the lender.

Some firms in the private sector have treated the savings payments to an ESCO, under a performance contract, as payments for professional services or operating costs. Similar to utility costs, they can be deduced from taxable income in the year in which they are made.

Under a performance contract, an ESCO provides a full range of professional services, from energy audit to design, construction management, and ongoing energy management and monitoring of savings. As such, performance contracts are service contracts rather than contracts for the sale of related energy conservation equipment. The equipment is

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used by the ES20 to achieve its obligation to reduce energy consumption. There may be retrofit projects, (for example, simple lighting retrofits where little or no professional service is involved, and that would not meet this characterization) but a typical comprehen- sive retrofit is a contract for professional services. It seems reasonable, therefore, to treat the savings payment to the ESCO as fees for services rendered and a legitimate business expense.

If the owner enters into a separate financing arrangement with a financial institution, it can deduct only the interest component of the loan, but it can claim capital cost allowance on the equipment. The repayment of capital is not deductible from taxable income since the loan itself is a capital transaction. The same treatment applies to the payments under a capital lease. Only the interest component can be deducted.

On the other hand, under an operating lease, the monthly lease payment is viewed as an operating expense and is therefore deductible to the extent of 100%. The lessee cannot claim capital-cost allowance, and the ownership is deemed to remain with the lessor. In order for a lease to be an operating lease and not a sale for tax purposes, the lessee must not acquire title to the property automatically after paying a specific amount in rentals; the lessee must not be required to purchase the goods at the end of the lease; and, they may not have an option to purchase the assets at the termination for a nominal amount or for less than the then fair market value.

The preferred financing arrangement from a tax perspective would appear to be an arrangement where the owner has a contingent obligation to make payments to the ESCO under the performance contract but not a separate firm obligation to make a loan or lease payment to a financial institution. Alternatively, if the owner has a separate arrangement with a financial institution, it must be characterized as an operating lease, at least for tax purposes.

The issue of capital-cost allowance on equipment installed in facilities under performance contracts is not a major issue in the case of the typical building retrofit, since most heat- ing, air conditioning and related equipment falls into Class 3, which is depreciated on a declining balance at a five per cent annual rate. However, in certain types of projects in the industrial sector, where heat-recovery equipment may be installed, Class 43 rates apply, resulting in a 30 per cent declining balance treatment.

As noted earlier, most performance contracts provide for the equipment to that title to remain with the ESCO or its assignee during the contract term. This is so, at least in cases where the owner has not paid for the project at the outset.

Generally speaking, owners will prefer to have the ability to deduct their savings payments in the year in which they are made, rather than take the capital cost allowance on the equipment. In certain industrial projects, however, the ESCO and the owner should care- fully review the relative attractiveness of the two options.

. FfNANClNG OPTfONS FOR - q


4.0 CHECKLIST AND SUMMARY

4.1 ESCOQ ROLE IN PROJE~ FINANCING While ESCOs do have the ability to arrange for the financing of energy-efficiency projects, their primary %alue added” is creating economic, sustainable cost-saving projects and implementing building renewal programs on a least-cost basis to the building owner.

ESCOs have a number of important roles to perform in the financing of projects, namely:

l where the owner does not have access to project financing, the ESCO can offer several alternative routes and explain the different risk, tax, and accounting issues;

l work with the owner to customize financial arrangements to meet the owner’s internal criteria and policies with respect to tax, cash flow, ownership etc., and introduce the owner to lenders familiar with performance contracting transactions; and

l arrange payment schedules and offer performance guarantees that respect the owner’s cash flow requirements.

4.2 OM=BALANCE SHEET FINANCING Financing is available where the owner is not required to show any debt on its balance sheet. To create such a mechanism requires the co-operation of the lender, legal counsel, auditors and the ESCO.

4.3 ~NTRACFUAL Aou~mwrs The type of contractual arrangement has no direct impact on the financing vehicle chosen. Contractual language, however, must accommodate the accounting and tax considerations the parties wish to achieve.

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4.4 OWNER’S RISKS

Performance contracts range in investment size, from a few hundred thousand dollars to tens of millions of dollars. Prudent owners should retain independent legal and financial advice to clearly understand what risks, if any, they are exposed to. This is not to imply that the ESCO is seeking a win-lose relationship. On the contrary, a qualified ESCO has many incentives to establish a true working partnership with the owner for a contract term lasting many years.

Performance contracts are reasonably complex from a legal and financial perspective, and owners should not feel uneasy in prudently and deliberately requesting the ESCO explain its program, more than once, to several colleagues and to external advisors. A confident owner results in a smoother project and excellent customer relations. A clear understanding of ESCO and owner-individual responsibilities reduces the risk of transaction disputes and any potential financial hardship.

Appendix A

OWNER MANAGED ESCO MANAGED

htemol Rormw baring lntomal Rormw basing ESCO capital (1) Capital (1) Financed

Initial Cash Outlay 100% O-3096 0% 100% O-3096 0% 0%

Fixed Payments (2) NO YES YES NO YES YES NO

Payment Source Capital Capital Operation Capital Capital Operation Operation

Risk Assumed by Owner Owner Owner ESCO ESCO ESCO ESCO

Ownership of Equipment Owner Owner Owner Owner Owner Owner ESCO

Tax Deduction (3) deprec depreclint depredint deprec deprec/int depredint savings

Cost of Capital (e) Prime Prime+ Prime++ Prime Prime+ Prime++ Prime+++

Debt on Balance Sheet NO YES YES NO YES YES NO

(I) Capital lease, rather than operating lease, is assumed. It is unlikely that building retrofits could be considered as a rental-type arrangement.

(2) Under ESCO managed, payments are corrected after each reconciliation. (3)Depreciation (deprec), Interest (int)

FlNANClNG OPTIONS FOR : q ENERGY MANAGEMENT SERVICES

Appendix B

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NUMERICAL EXAMPLE

The attached table illustrates typical costs associated with an energy-efficiency project, managed either by the owner or an ESCO. It should be noted that under each of the two scenarios, aside from interest charges, no other components are affected.

Although most of the cost components are incurred at the beginning of the project, some components are incurred over the life of the project. Consequently, most items listed under “other charges” would be subject to marginal changes depending on the payback period.

The interest charges shown on the table are for illustration purposes only. Rates may vary from owner to owner and from ESCOs to ESCOs. As rates influence the payback periods, given expected annual energy savings, the reader should substitute available and represen- tative interest rates.

Another main assumption introduced on the table relates to the expected energy savings to be derived under each scenario. An ESCO should provide as much as 20% more savings than if an owner managed the project. Given that the total project costs with an ESCO, including the performance guarantee, may be about 20% more expensive, the payback periods tend to be relatively unchanged at similar interest rates.

. q FINANCING OPTIONS FOR


ENERGY MANAGEMENT PROJECT - TYPICAL COSTS

Comparison of Implementation Approaches and Financing Rates (Thousands of Dollars)

OWNER MANAGED EXO MANAGED

Conventional Project Budget

EngiW?Ykg:

Concepts 60 60

Plans & Specifications 85 85

Supervision 10 10

Commissioning 10 10

Training 10 10

Subtrades:

Materials & Labour 650 650

Overhead & Profit 100 100

TOTAL Project Budget 925 925

Other charges (1)

Project Management 25 60

Utility Bill Tracking and Analysis 11 20

Operations Inspection and Review 0 50

Occupant Awareness Campaign 5 3

Commissioning 10 5

Training 20 10

Performance Guarantee 0 100

TOTAL Other Charges 71 248

TOTAL Project Costs 996 1,173

Interest Rates (2) 7% 10% 13% 7% 10% 13%

Interest or Opportunity Costs 232 388 616 267 444 700

GRAND TOTAL Project Costs 1,228 1,384 1,612 1,440 1,617 1,873

Expected Annual Savings (3) 200 200 200 240 240 240

Months to Amortize all Costs 74 83 97 72 81 94

Note (1): About $28,000 of the other charges total, under the ESCO managed scenario, are paid directly by the owner, as its share for training, awareness campaign and management costs.

Note (2): Assuming prime rate to be at 7%, the different financing options may be at the following interest rates: owner’s money - 7%; owner borrowing - 8% to 10%; leasing - 9% to 11%; ESCO finarlcirlg 10% to 15%.

Note (3): Experienced ESCOs provide 20% more savings than if managed by owner.

Note (4): At similar interest rates, the payback period is shorter under the ESCO managed scenario, due to the higher expected energy savings.

Documents

FINANCING OPTIONS FOR ENERGY MANAGEMENT SERVICES · guarantees energy-cost reductions for building and facility owners. Projects are self- financed from energy and operating cost