Financing Energy Projects

Energy Performance Contracts and Data Centers

EPCs can be a particularly attractive means of financing energy-related projects

By Peter V.K. Funk, Jr.
Mission Critical magazine
August 13, 2013

Energy performance contracts (EPCs), also called energy savings performance contracts (ESPCs),1 have long been employed by energy services companies (ESCOs) to perform projects that involve the installation of energy efficiency and conservation measures (ECMs) and other measures in federal, state, and municipal facilities. In the current financial environment, particularly in the governmental sector, EPCs can be a particularly attractive means of financing energy-related projects and should be considered. Data centers have not been a primary focus of EPC projects, but this appears to be a good time to give serious consideration to expanding the use of EPCs for data centers.

In an October, 2012, column titled, Anatomy of an Energy Savings Guarantee, I discussed the legal implications of energy savings guarantees. In an EPC, the energy savings guarantee is the heart of the agreement and the basis upon which the governmental owner of the facility is able to obtain financing.

Energy performance contracts have a common characteristic — these projects should pay for themselves. The savings generated by a project are intended to amortize the capital cost of the ECMs and pay other project-related expenses during the term of the contract. The ESCO provides a projection of the savings to be achieved during the contract term and also guarantees that the savings it projects will be achieved. Both the governmental facility and the financier of the project rely upon these ESCO projections and guarantees.

The ESCO wears a number of hats in connection with energy performance projects: auditing the facility; recommending a project (and specifying ECMs); designing the project; and acting as a general contractor to procure, construct, implement, and commission the project. The ESCO’s role can also include providing maintenance and long-term monitoring of the project during its operational phase.

Measures implemented by the ESCO are customized to address the requirements of each facility and may include energy efficiency and conservation, cogeneration, renewable energy generation, water conservation, and sustainable materials and operations. In addition, the services provided by the ESCO typically include arranging for construction and long-term financing provided by a third-party financier although the ESCO, at times, provides the financing.

Federal Energy Performance Contracting

In recognition of the opportunities presented by the ESPC form of contracting for projects that reduce energy usage and costs, the Energy Policy Act of 1992 permitted federal agencies to enter into energy performance projects with ESCOs financed with private sector funds. This substantially reduced the need for appropriated funds raised from taxation or the sale of bonds, and permitted federal agencies to pursue projects that paid for themselves through realized energy savings.

Typically, the ESCO will begin the process by conducting a comprehensive energy audit of the federal facility in order to develop a baseline of energy usage and identify potential methods for improving energy efficiency and other appropriate measures. An essential requirement of the financing component for the project is that the ESCO must guarantee that the energy improvements will produce sufficient energy cost savings to amortize the cost of the project and provide a positive cash flow during its term. Following the ESPC term (which may not exceed 25 years for federal projects), all further cost savings accrue to the agency.

Federal data centers — there are over 3,000 of them — are possible candidates for ESPC financing. Three years ago, the Federal Chief Information Officers Counsel (CIO Counsel) formed the Federal Data Center Consolidation Initiative (FDCCI) to address the ongoing, unsustainable growth of federal data centers. Among other approaches pursued by FDCCI, such as consolidation, the FDCCI also sought to reduce energy use by enhancing the efficiency of data center equipment. It’s not a moment too soon. According to Michael Biddick, CEO, Fusion PPT, and contributing editor of InformationWeek Hardware, June 10, 2013, “Besides the cost to support and maintain these data centers, they consume an eye-popping amount of energy, initially estimated at 100 billion kilowatt-hours, or 2.5% of total U.S. electricity consumption.”2

In a blog posted on April 18, 2013, Miles Auvil, a national account manager for the Federal Energy Solutions team at Schneider Electric, discussed the fact that, in light of the current reduced budgets and sequestration initiative/law, it would be appropriate for ESCOs to use ESPCs to advance the FDCCI initiative. In his blog, Mr. Auvil expressed concern regarding a lack of awareness within the Federal IT community of energy performance conservation opportunities available to federal agencies. He notes that while ESCOs and the Department of Energy (DOE) have advocated the use of ESPCs for data centers, few EPC projects have been undertaken. He asserts, and I agree, that these significant opportunities for IT should not be ignored.3

Examples of federal agency use of ESPCs include the 2011 “partnership” between the DOE and Lockheed Martin under which Lockheed undertook to design and construct projects financed by ESPCs involving consolidating and providing energy upgrades in DOE data centers that meet the respective sites’ IT needs. These projects are required to generate sufficient savings to cover the annual financing costs together with providing a positive cash flow to the government after covering financing costs.

One such project, begun in 2011, focused on the Hanford Site in Richland, WA. According to the Lockheed website, the project involved the conversion of antiquated IT architecture into up-to-date architecture using a combination of “data center consolidation, virtualization, and cloud computing” to achieve sustainable goals and save money in a way that Lockheed describes as being “smart, green, flexible, scalable, and able to deliver information anywhere on the Hanford Site at any time.” 4

Until now, energy performance contracting has been used by federal agenciesfor energy upgrades, such as lighting retrofits and HVAC improvements and retrofits, but has not generally been used in connection with data centers. Hopefully, federal agency use of ESPCs will expand as projects uniquely suited towards data centers are developed that provide significant cost-savings benefits.

State Energy Performance Contracting

State agencies, public authorities, municipalities, and school districts generally require legislation in order to be able to enter into energy performance contracts. For example, Section 9-103 “Energy performance contracts” of the New York Energy Law passed in 1976 permits any New York agency, municipality, school district, or public authority to enter into an energy performance contract having a term of up to 35 years. This was a significant step for New York to have taken at that time since, prior to 1976, capital projects were required to be financed from appropriations or the proceeds of bond offerings approved by voters. EPCs entered into under the NY Energy Law do not require the state to make any monies available or to appropriate any funds since they are to be financed out of expense savings.

In fact, EPCs between ESCOs and municipalities and school districts in New York State and other states are generally required to include what is commonly called a “non-appropriation clause” since the concept of such energy laws is that the cost of the projects are met by reductions in energy costs and do not require appropriations. Under such clauses, it should be noted that a municipality or school board during any fiscal year can discontinue funding payments to the ESCO for the EPC. Municipalities and school districts, however, rarely discontinue EPCs.

When permitted by state law, public authorities (including public housing authorities), municipalities, and school districts have access to an alternative financing method called “municipal lease” financing for EPC projects that is not available to federal agencies. A municipal lease is a hybrid financing vehicle, which combines elements of a lease and time purchase agreement in which the facility lessee takes ownership of the installed measures upon installation (or acceptance) and the lessor retains a security interest. Since it is tax exempt financing, a municipal lease can provide a lower rate of interest than non-exempt financing. Like other energy performance contracting, when municipal lease financing is used, the ESCO must provide a savings guarantee.

EPC financing took hold following the OPEC oil price shocks during the 1970s and 1980s, economic periods that share some similarities with our present financial circumstances. As oil (and other energy commodity) prices rose substantially, the costs of paying for more expensive energy reduced the funds available to facility owners for capital projects such as retrofitting facilities with energy-efficient equipment.

On the other hand, higher energy costs reduced the payback time relating to such investments increasing the attractiveness of energy-efficiencient capital improvements. In that financial environment, the EPC form of financing projects became increasingly attractive. Of course, as energy prices inevitably rise and fall, such contracts may be viewed more or less favorably, which has hindered the development of the full potential of EPC financing. Inasmuch as EPCs are long term agreements, I believe that the longer perspective should prevail based upon the recognition that, in addition to the fact that EPC financing may be the only type of financing realistically available for certain projects, energy conservation measures provide a very long-term hedge against high energy prices.

As with the federal government, a great many EPC projects have been undertaken by state agencies, municipalities, and school districts that address building infrastructure, such as HVAC upgrades, lighting retrofits, and similar projects; and I do not believe many have specifically involved data centers. In light of the power requirements of data centers, state agencies, public authorities, municipalities, and school districts should take a close look at using EPCs for the purpose of implementing energy improvements in data centers.


Works Cited

1. The term ESPC is with federal contracting (in the event that multiple projects are performed by the same contractor, the term “Super” ESPC may be used).

2. InformationWeek: 3 Lessons From 5 Years Of Federal Data Center Consolidation Delays

3. Schneider Electric Blog: Funding the Unfunded: Energy Savings Performance Contracts for Federal Data Center Consolidation

4. Lockheed Martin to Implement Energy Efficient Data Center Consolidation for U.S. Department of Energy.

Peter Funk is a partner at Funk & Zeifer LLP where he practices in the area of energy law with a focus on energy generation and energy management/conservation projects. Funk's column Legal Perspectives discusses legal issues pertaining to energy generation and conservation.