The UK market for energy service contracts in 2014–2015

As illustrated in Fig. 1, it is useful to distinguish between

Both types of contract deliver energy savings through improving the efficiency of primary or secondary conversion equipment such as boilers and lights, preserving heat, momentum or materials in the associated passive systems such as buildings, or reducing demand for final energy services such as illumination (Cullen and Allwood 2010). EPCs generally provide greater incentives to reduce energy demand than ESCs,¹ but the boundaries between the two are blurred and contracts vary in the number of energy-related technologies and services that they cover and the degree to which they cede control of those technologies and services to the contractor. A more common term for ESCs in the UK is contract energy management which typically involves the delivery of steam or hot water to a medium-sized site (‘taking over the boiler house’) often in association with CHP investment. EPCs are more commonly used for public sector buildings and usually involve the guarantee of energy cost savings, the finance of investment from those savings and the inclusion of detailed provisions for monitoring and verification. The EU Energy Efficiency Directive (Council of the European Union 2012) has sought to standardise the definition of EPCs as follows:

…Energy performance contracting means a contractual arrangement between the beneficiary and the provider of an energy efficiency improvement measure, verified and monitored during the whole term of the contract, where investments…in that measure are paid for in relation to a contractually agreed level of energy efficiency improvement or other agreed energy performance criterion, such as financial savings… (Council of the European Union 2012)

Sorrell (2005; 2007) argues that both ESCs and EPCs can be classified by the following:

Scope relates to what technologies and systems are included in the contract (e.g. boilers, CHP, lighting, building and controls) while depth relates to how they are included (e.g. who has responsibility for design and engineering, financing, equipment specification, purchasing, installation, commissioning, operation, maintenance, monitoring, verification, and energy purchasing). Taken together, these influence the potential for cost savings, the distribution of risks and rewards and the associated transaction costs (Sorrell 2005). Comprehensive energy service contracts are broad and deep, providing the contractor with extensive control of the majority of useful energy streams and final energy services on one or a group of sites. However, it is possible to have contracts that are broad and shallow, as well as those that are narrow and deep.

The source of finance may include working capital provided by the client or by the ESCO, loans from financial institutions and equity from risk investors. Of particular importance is whether the investment is primarily financed through debt taken on by the client and hence appears on the client’s balance sheet, or whether the investment is financed by the ESCO (DECC 2014b; Fawkes 2007). The latter may be unsuitable for small ESCOs since additional projects increase leverage—unless subcontractors can take on the debt. With larger projects, the ESCO may join with providers of risk capital and possibly the client to form a ‘special purpose vehicle’ (SPV)—where lender security is confined to the assets of the project, rather than those of the client or contractor.

The terms of an energy service contract can be complex (Table 1), and until recently, there has been little standardisation. On the one hand, bespoke contracts provide diversity and adaptability and can form a core part of an ESCO’s ‘value proposition’. On the other hand, such contracts can be time-consuming to negotiate and establish (e.g. 12 months), require the client to engage significant legal expertise (‘…lawyers are making a fortune on non-standardised contracts…’²) and increase transaction costs for both parties (typically 5–10 % of total project cost). This in turn can make contracting unsuitable for smaller sites that have only limited scope for energy cost savings. Standardised contracts offer the potential to reduce transaction costs, while standardised methods for monitoring and verification (notably the International Performance Measurement and Verification Protocol—IPMVP) can reassure clients and reduce risk to lenders.

The bidding process for contracts also varies. Clients may specify targets in terms of energy savings or other metrics and solicit bids against those targets (target bidding), or they may enter into a partnership with one or more ESCO to develop projects before agreeing targets (partner bidding). The former approach encourages competition and hence value for money, but may also entail higher costs for the ESCOs and miss more ambitious opportunities. The latter approach can foster innovation and trust as well as helping clients to identify potential savings, but it can also limit competition at an early stage of the procurement process. This is where dedicated intermediaries can be useful in helping clients to identify projects and estimate target savings prior to going to tender.

Some of the biggest market players are subsidiaries of international equipment suppliers, such as Honeywell and Johnson Controls, and have sufficient scale to provide their own financing. Suppliers of primary conversion equipment (e.g. Veolia) offer energy supply contracts focused upon CHP, suppliers of secondary conversion equipment (e.g. Philips) offer specialised ‘pay as you ‘save contracts for technologies such as lighting (Philips 2014) and suppliers of building energy management systems (e.g. Johnson Controls) offer bespoke performance contracts using a range of technologies. But diversification is the norm and companies are increasingly combining these approaches. For example, it is common for building control providers to install more efficient boilers and CHP while companies specialising in CHP are moving into building controls.

Subsidiaries of energy utilities see the energy service market as a way of diversifying their business and adding value to their core markets. Their level of involvement varies widely, with British Gas being one of the most successful and with several utilities actively participating in the public procurement frameworks (Table 4). But the provision of energy services presents a different business challenge to energy supply and requires new competencies and skills, so entering this market can be challenging. One response is to buy up specialised energy efficiency companies, but several interviewees questioned whether utilities fully understood the complexity involved:

…My view is that [utilities] know they have to do something but they don’t know what to do and they don’t really understand it because, at the end of the day, […] they are run by people who understand energy supply but don’t understand energy efficiency. I think they understand [the need to change], but it’s like steering a super-tanker.⁹

Facilities management companies such as Cofely (GDF Suez) and MITIE are increasingly active in the energy services area, building upon their extensive experience with outsourcing more generally—particularly in the USA (Goldman et al. 2005; Larsen et al. 2012a, b). Such companies have the capacity to cover a wide range of contracts and may have different divisions targeting different markets.

Independent ESCOs are typically smaller and newer and tend to intermediate between technology providers, maintenance contractors, legal firms, financiers and other organisations (DECC 2014b; Garnier 2013a). Much of the engineering work is subcontracted to specialist companies who guarantee equipment performance and sometimes also provide financing. The ‘risk boundary’ differs between contracts and some ESCOs may outsource nearly every step of the process to other companies—thereby minimising their risk exposure. Their business model relies upon cooperation with established technology providers with a proven track record and a solid credit rating since ‘…they are the only ones that can give a guarantee that’s worth it…’¹⁰

Local authorities are increasingly engaged in energy projects, with a proportion of these involving the provision of district heating through energy supply contracts (Hannon et al. 2015; Nolden and Sorrell 2015). The two main business models for local authorities are: first, to establish an arm’s-length, not-for-profit ESCO that is owned and operated by the local authority; and second, to collaborate with an existing ESCO to establish a special purpose vehicle. Notable examples of the former include Aberdeen Heat and Power (Aberdeen City Council) and Thameswey Energy (Woking Borough Council), while notable examples of the latter include Birmingham District Energy Company Ltd (Cofely GDF Suez) (Hannon et al. 2015; Hawkey et al. 2013).

Local authorities may also act as sponsors for various types of community ESCO, but the majority of these are primarily engaged in small-scale renewable energy supply rather than energy efficiency.

Overall, this review demonstrates that there is no single market for energy service contracts in the UK and no unified set of market actors. Instead, it is more useful to subdivide the market into particular segments, such as the market for energy performance contracts in public sector buildings. Each market segment appears relatively competitive, with no single dominant players.

Industrial contracts primarily focus upon heat supply and on-site electricity generation through CHP. As well as delivering useful energy at a specified unit cost, these contracts must meet high standards of reliability, since interruptions in energy supply can damage or stall industrial processes and have a major impact on profitability. Contracts that ‘take over the energy centre’ may also provide industrial gases, cooling and water but rarely extend to industrial processes—both because the contractor has less expertise than the clients with these technologies and because the clients usually wish to retain control over their core activities. Performance contracts are less common in industry, although some ESCOs provide guaranteed savings for specific services such as compressed air, warehouse lighting or voltage optimisation. The continuing decline in UK industrial capacity constrains market growth in this sector, and the potential for energy savings is typically less than in public and commercial buildings:

…What we’re seeing within the manufacturing sector is that a lot of the low-hanging fruit, the things you would typically look for when you step on-site for the first time have already been done. They’re looking for more innovative technologies such as waste-to-energy, on-site generation, modern control systems, anything like that that would give them an additional 5–10 % saving on top of what they have already achieved…¹¹

Many of the industrial sites targeted by ESCOs are of intermediate size with moderate energy intensity. This is because large, energy-intensive sites tend to have sufficient in-house expertise to exploit cost saving opportunities, while smaller, less energy-intensive sites may miss those opportunities but the potential savings are too small to make contracting viable (Sorrell 2005). As a consequence, SMEs remain largely untapped to date, although some ESCOs are beginning to enter this market through energy purchasing. By procuring energy for several similar SMEs, it is possible to guarantee lower energy bills through bulk purchasing. Once a trusted relationship has been established, further demand reduction services may be included in the energy service package.

While there are numerous examples of ESCs in the UK commercial sector, the take-up of EPCs is much lower than in the public sector. This parallels the situation in the USA, where industry and commerce account for only 15 % of the US EPC market and commercial offices only 6 % (Larsen et al. 2012a, b). The UK market includes small-scale CHP contracts in hotels and leisure facilities, larger supply contracts in airports and data centres that also extend to lighting, ventilation and other services, and an increasing number of contracts in private schools that encompass both energy supply and energy demand. The combination of ageing infrastructure, access to finance and a desire to appear ‘green’ has made private schools a growth market. Contracts in all areas increasingly include solar PV and biomass, and use the revenue derived from feed-in tariffs and the renewable heat incentive to cross-subsidise investments in energy efficiency.

Despite the size of the relevant estate, there are relatively few contracts in the retail sector—largely because retailers have large and sophisticated energy management teams that manage multiple sites, and because they are reluctant to cede control over critical equipment such as refrigeration. The largest potential market is commercial office space, but here, the barriers to energy service contracts appear particularly large. Commercial companies have a higher credit risk than the public sector and shorter time horizons, which make them reluctant to sign contracts of more than 5 years duration. But a greater problem is that the majority of office space is leased, creating the well-known problem of split incentives (Sorrell et al. 2004). Landlords are reluctant to invest since tenants will reap the benefits in terms of lower energy bills, energy-efficient buildings do not attract a significant rental premium (despite the use of Energy Performance Certificates) and tenants lack the ability and/or incentive to invest since their tenure may be relatively short. This leads to widespread scepticism of the potential for EPCs in this sector:

…You can’t do any EPC in commercial office space. It doesn’t work… EPC works in a certain market segment and that is primarily the public sector. It doesn’t work in any other market segment. In the US when they tried to take into another segment it failed miserably…¹²

Several interviewees highlighted the potential of alternative policy initiatives and business models to overcome these barriers—as summarised in box 3. These ideas draw upon recent experience in the USA and Australia (Dixon et al. 2008; Fawkes 2013; Kim et al. 2012; Sayce et al. 2009; Supple 2010) and were considered by one interviewee to represent: ‘…a huge flowering of innovation and change that will completely eclipse the EPC market in time….’¹³ However, the UK has yet to develop an equivalent of PACE or MEETS; green leases have attracted only limited interest (Dixon et al. 2014), and a policy initiative based upon on-bill financing (the ‘Green Deal’) was not a success (Rosenow and Eyre 2015; Rosenow and Sagar 2015). More generally, energy efficiency improvements in the commercial and other sectors are hindered by the difficulty financiers have in recognising energy cost savings as security for loans:

…Energy efficiency projects do not yet meet the requirements of capital markets. The industry is too disaggregated. No two projects or contracts are alike. Securitisation is not practical or possible under these circumstances. Say you have 1000 energy efficiency projects. Standard and Poor would have to read 1000 documents to assess the risk. Fees won’t pay for that level of review…¹⁴

Box 3: Emerging models for energy efficiency investment in the commercial office sector

Source: Dixon et al. (2008); Fawkes (2013); Kim et al. (2012); Sayce et al. (2009); Supple (2010); Stakeholder interviews 2014–2015

In most countries, the public sector provides the largest market for energy service contracts, owing to its large and diverse estate (e.g. hospitals, offices, schools, libraries, leisure centres), low credit risk, long time horizons, security of tenure, targets to improve energy performance and, in some cases, access to low-cost financing. The UK public sector market has taken longer to develop than in the USA and many European countries (Bertoldi et al. 2014; Garnier 2013b; Goldman et al. 2005; Larsen et al. 2012a, b), but the recent introduction of public procurement frameworks (PPF) for energy service contracts has significantly increased activity. These frameworks are the most important development in the UK market in the last ten years.

Framework agreements are a common feature of UK public sector procurement and set out the terms and conditions under which purchases or contracts (‘call-offs’) can be made throughout the period of the agreement (typically 4 years). The agreement is advertised in the Official Journal of the European Union (OJEU), but the individual call-offs are not—thereby avoiding the associated time delays and costs. The new PPF involve a standardised process for developing energy service contracts that comply with EU regulations and allows a number of pre-qualified ESCOs to bid. The PPF also establish intermediary organisations to facilitate the contracting process and use standardised templates and contracts. There are five frameworks currently in operation: two developed by local authorities (RE:FIT and P-EPC) and three developed for the National Health Service (NHS) (CEF, Essentia and Ecovate)—although each are being extended beyond their core sectors. Table 3 summarises these frameworks while Table 4 indicates the companies participating within each. Their importance is reflected by the number of contracts that they have established in a short space of time, the growing interest in their approach by a range of public sector organisations the development of model contracts and guidance notes by the UK government that are based upon those used by RE:FIT (DECC 2015a, b).

Procurement of an energy service contract typically requires significant time, resources, know-how and expertise on behalf of the client. These may not be readily available, or may be expensive to acquire, with the procurement process being further complicated by the need to coordinate departments with competing interests. The intermediaries established by the PPF can reduce these problems by assisting clients in feasibility studies, structuring finance, preparing tender documents, evaluating proposals, providing monitoring and verification and so on. At the same time, the intermediaries can help contractors to better understand client needs and assist in mediating conflicts (Bleyl et al. 2013; Mourik et al. 2014).

As an illustration, the Programme Delivery Unit (PDU) set up by the RE:FIT framework helps clients to benchmark their energy consumption, identify investment options, estimate potential energy and carbon savings, develop project briefs and conduct competitions to select their preferred contractor. It significantly lowers transaction costs for the client by providing expert assistance along with templates for each project stage, and encourages learning by providing case studies and facilitating access to previous RE:FIT participants to share knowledge.¹⁵ Such a process allows clients to benefit from the experience of previous projects, as well as streamlining the procurement process and minimising conflicts (Bleyl et al. 2013; Mourik et al. 2014). And since the intermediary is independent of the contractors, cost-effectiveness is increased. The CEF operates in a similar way:

…Traditionally public sector bodies would complete stand-alone procurement so contracts had to be purchased, consultants employed and contractors procured, and once it was complete all the knowledge was lost. Then, after construction, the schemes typically started to underperform due to a lack of finance, contractual awareness and knowledge if things didn’t go as well as expected. The CEF was created as a place to capture knowledge and to simplify the process so could be repeated time and time again…¹⁶

Up to 2015, RE:FIT clients paid no cost for this facilitation process, thanks to subsidies from the local authority and the EU ELENA scheme,¹⁷ while clients of other PFEPCs pay around 4 % of the capital value of the projects. All of the PPF appear increasingly successful, but they differ in their focus, scale and method of approach (Table 3). To illustrate, we summarise the two largest—CEF and RE:FIT.

The Carbon and Energy Fund (CEF) is the oldest and largest framework in the UK and primarily operates in the health service—which has an annual energy bill of more than £750 million across 12,000 sites (2300 hospitals), ageing infrastructure and significant backlog maintenance (GIB 2014). The CEF funds, facilitates, manages and monitors complex energy infrastructure upgrades for large sites, including hospitals and, more recently, universities. The CEF combines the roles of framework agreement, intermediary and financier, since it is also an SPV with funding from the Green Investment Bank and other sources. Most CEF projects involve large scale CHP, boiler replacement, building management systems and some demand side investment, with a minimum project size of £1 million and typical size £6 million. On average, 4–6 of its 16 pre-approved suppliers bid for individual projects, guaranteeing either unit price or energy cost savings of 20 % or more over periods of 15–25 years. The framework has completed or is processing more than 40 projects amounting to over £200 million in capital value and expects to double that figure over the next few years.

RE:FIT was launched by the Greater London Authority (GLA) in 2008 and is now being extended throughout the UK public sector. The scheme was partly modelled on US experience, including the retrofit of the Empire State Building (GLA 2012). The framework uses EPCs with guaranteed savings and has a target of retrofitting 40 % of London’s public sector floor space by 2025 (GLA 2015). There are 12 approved contractors, of which 4–6 typically bid for a project. The average project involves capital investment of £1 million and delivers 15–20 % energy savings with a payback period of 5–7 years—primarily using established, low-risk technologies. In contrast to CEF, most RE:FIT projects are financed by clients taking on low-cost loans. The use of standardised contracts and involvement of the PDU can shorten the contracting process to as little as 8 weeks. Over 50 contracts had been signed up to summer 2015, involving 200 public sector bodies (e.g. local and central government, NHS, museums, schools) and over 400 buildings, and these are expected to reduce carbon emissions by 30 kt CO₂/year from an investment of £63 million (GLA 2012, 2015). A notable feature of RE:FIT is the extension of the approach to schools via bundled, multisite contracts with a target of retrofitting over 200 schools in 3 years.

Overall, the procurement frameworks have catalysed the UK market for energy performance contracts and are expected to drive energy savings in the UK public sector for a number of years. The frameworks are similar to those emerging in other EU countries (e.g. Austria, Germany, Sweden) and demonstrate the importance of such intermediaries for enabling clients to access energy service contracts (Bleyl et al. 2013).