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.