Capital contributions, the payments made by ESCOs to developers in exchange for long-term concession agreements, are a hangover from the days when everyone thought onsite generation would be highly profitable.
We’ve since discovered that it isn’t as lucrative as expected. Nevertheless developers continue to demand these upfront payments, leading to higher standing charges, longer contracts and unhappy residents. Isn’t it time for the practice to stop?
Back in the heady days of 2007, home construction was reaching fever pitch even as building regs and planning requirements tightened up. The new Part L had just come into force, planners were demanding higher ratings under the Code for Sustainable Homes and, despite furious resistance from house builders, government was plotting a course to reach Zero Carbon Homes by 2016.
To meet these stringent requirements, developers had to make extensive use of onsite generation of low carbon heating and power. But no one expected the developers (or home buyers) to shoulder all this new cost.
Instead, the prevailing view at the time was that onsite generation was best delivered through ESCOs. We all expected these onsite energy companies to take the hassle out of meeting the new regs by designing, building, owning and operating the systems. And all this at little or no extra cost to developers since ESCOs would bear the brunt.
Actually, organisations like OFGEM and the Oxford ECI thought developers might have to make some payment towards the cost of new onsite energy systems, but any contribution would be small.
Over the following decade, the market evolved. Developers lost their terror of the new regulatory regime and they even made their peace with the expected requirement for Zero Carbon Homes. Energy strategies that had once been unthinkable gradually became business as usual. And, crucially, the housing market largely absorbed the cost of these new systems.
Also during this period, we woke up to the fact that there isn’t (and shouldn’t be) a pot of gold at the end of the ESCO rainbow – only the possibility of a modest return and only if you get everything right.
But despite this evolution, some developers still expect ESCOs to cough up. If the project is big enough, developers expect to auction off the energy concession to the highest bidder. The resulting payment, from ESCO to developer, is called the capital contribution.
When forced to compete for projects on the basis of capital contributions, ESCOs looked to their financial models for sources of additional value. For example, maybe some additional revenue could be wrung from electricity generated on site or perhaps heat network efficiency could be tweaked to reduce wastage. But of course there was a limit.
One variable in the model was inherently flexible: the standing charge to residents.
Unlike system optimisation, increasing the standing charge to fund the capital contribution is not a value add, it’s a value transfer. The ESCO makes a bigger capital contribution to the developer in order to win the project and the residents pay this additional cost to the ESCO over time as part of the standing charge.* The value moves from the residents to the developer, with the ESCO acting as the bank in the middle.
At this point you might say, hang on, the developer built the scheme and made a profit on the sale of the houses – why should residents pay for their energy system twice (once in the house price and once in the form of a higher standing charge)? And I’d say you’ve got a point – the value should stay with residents in the form of lower energy bills, not transfer to the developer. Nevertheless, it’s what some developers continue to demand.
When developers procure an ESCO based on the size of their capital contribution (instead of on heat price, customer satisfaction, system performance or carbon emissions) it creates a number of perverse outcomes:
- It pushes all parties toward long term contracts. All things being equal, the more years of standing charge revenue that the ESCO can count on, the bigger the potential capital contribution. So when it comes to contracts, the longer the better.
- The Winner’s Curse strikes the residents. The ESCO keenest to win the concession may make the highest offer, perhaps even exceeding the concession’s intrinsic value, but much of the cost of fulfilling this offer falls to the residents.
- It puts pressure on ESCOs to accept poor systems. Contractors and subcontractors are highly incentivised to get schemes over the line and move on to the next job. If an ESCO starts poking its nose into a heat network before practical completion, pointing out things that need putting right, the contractors are likely to shout and bluster about programme delays. With primary focus on the capital contribution rather than performance, if the ESCO presses the point the developer may simply swap that ESCO for one willing to make the capital contribution and accept the heat network without a fuss.
Capital contributions are not intrinsic to the ESCO model. If the practice stopped tomorrow, at the very least it would allow ESCOs to set lower standing charges in their models.
Moreover, removing them from the picture frees up ESCOs to create value in ways that may not require a monolithic offering or long term contracts. Just for starters these might include:
- Offering standalone design and build services
- Providing performance guarantees as part of operation and maintenance
- Offering customer service capability
- Owning and operating just the distribution pipes (aka Pipeco)
- Obtaining best value for onsite generation or demand side response (DSR) and sharing the benefit
These services could be offered in a bundled contract or as an a la carte menu with contract duration adjusted to suit the offering. More choice for sites, better value for customers, and not a capital contribution in sight.
* Standing charge to service a historic capital contribution shouldn’t be confused with standing charge for a reserve fund used to periodically replace onsite assets. The latter is necessary in order to ensure the energy system remains viable in the long term.
Much more interesting post than the techie ones. 🙂
Banishing capital contribution isn’t quite that simple in my eyes mind.
My mortgage rate is 2% and change. Public funding is similarly cheap. Commercial weighed average cost of capital is nearer 10%.
Moving money from a house-buyer to a resident using an ESCO funded at commercial rates adds cost: the extra cost of the commercial loan over and above the mortgage loan or public funding.
This is arguably value destruction from the consumer’s perspective: you’re transferring the value to the debt provider. (why should I pay a premium when I could have bought this loan out using cheaper capital myself when purchasing the property etc – see also the PFI balance-sheet-engineering to screw over the taxpayer from the Blair/Brown era)
On the flipside if there’s no secure asset to invest in that makes a commercial rate of return you’ve not got an industry that’s stand on its own two legs without subsidy either.
A morally legitimate and commercially viable model is where the overall cost to the consumer and landlord remains below that of the gas/electric equivalent (including applicable carbon taxes/offsetting); yet there’s still room for commercial finance (pension funds etc) and capital contributions for the primary infrastructure within this.
If the Heat Trust had the nerve to finally deliver on a cost comparator – to agree what that cap on overall cost to the consumer and landlord ought to be then stick to it – we might get some movement that retains both fairness to the consumer and the opportunity to develop a sustainable industry. (retains the opportunity for institutional investors to back infrastructure)
Failing this…you’re back to the ye-olde-school Landlord and Tenant Act. All kit within the freehold is owned outright. Service fees are paid al a carte. Costs are passed through with the addition of a reasonable administration fee. DH companies stick to negotiating bulk supplies to blocks rather than offering to finance the kit within them etc.
Nothing wrong with it until the accountants and their lawyer buddies decided to engage in financial engineering/book cooking/artificial special vehicles at the behest of their clients.
Where those clients were Local Government and Housing Associations I find this particularly shameful. They have duties to consider and the individuals involved ought to answer for the decision to agree to any ESCo that has a detrimental effect on either the resident or the landlord (as a public or charitable entity).
Other thoughts:
Should there be a reserve fund?
Should this be financed at 10% or at 2%?
If 2% is better are you not better off having the Local Authority or mortgageable consumer manage their own reserve fund and pay for infrastructure renewal as one-off events?