Contracting for Energy Management Outsourcing | Article

energy management outsourcingEnergy management outsourcing (“EMO”) means turning over responsibility for some or all of a company’s energy management function to a supplier. In a complete EMO transaction, the supplier might:

  • Conduct energy audits and identify cost-saving opportunities.
  • Design, finance and install high-efficiency equipment, control systems and lighting retrofits.
  • Take over management and operation of major energy systems (such as boilers or hot and chilled water distribution) or electrical distribution systems (such as generators and switch-gear equipment).
  • Generate power onsite, for example, using co-generation, fuel cells and micro-turbines, possibly including “green power” generation renewable, environmentally-preferable resources.

Three Key Elements

The customer’s goal is generally to minimize its total energy cost. Total energy cost consists of three key elements:

  1. Gas, electricity and other energy charges (net of revenues from selling energy back to the grid)
  2. Plant and equipment costs, and
  3. Energy management services fees.

EMO is intended to use the supplier’s expertise to balance the three elements for maximum efficiency. By making effective investments in a plant and equipment and improving operations and maintenance, the parties expect the supplier to significantly reduce gas and electricity charges.

The three elements of energy management are very different:

  1. Gas and electricity are commodities. Their prices are volatile, can depend on time of day and season and are easy to benchmark against market prices.
  2. Plant and equipment are major capital investments. Boilers, chillers, building control systems and similar equipment typically have a 25- to 30-year useful life. Prices change slowly, though deregulation has spurred an increasing rate of technological innovation.
  3. Energy management services are custom services provided by people. They are difficult to benchmark and specify.

Scope

Energy management, as described above, is a set of well-bounded business processes. The customer and the supplier have the opportunity to define a clear scope based on clear process boundaries. By defining a clear scope, the parties avoid the cost and conflict that come from patrolling the boundary between the supplier’s scope and the retained responsibility.

The scope should, of course, take advantage of the supplier’s expertise, scale or access to markets. However, an EMO supplier that produces or takes title to energy or equipment may have a conflict of interest if the scope involves investing in equipment to reduce energy use. In that case, the contract should include control provisions and pricing provisions to mitigate the conflict of interest.

Service Levels

There are three main types of service levels for EMO. The first type is operational minimums. For example, a service level for an office building might include air temperatures consistently between 69 and 73 degrees Fahrenheit and high-quality, uninterrupted power in the computer room. These are very similar to service levels in most outsourcing arrangements.

The second type of service level is based on reducing total energy cost. In guaranteed savings agreements, the supplier reimburses the customer for cost over a required savings level. In shared savings agreements, the customer pays the supplier a portion of the customer’s energy cost savings. The “savings” are based on models that estimate what the customer’s energy costs would have been without the supplier’s energy-saving and cost-saving initiatives.

Examine and negotiate those models carefully. Avoid models that assume without verification that the supplier’s changes produce the intended savings or that the customer would have done nothing to increase energy efficiency. The supplier should avoid models that ignore the customer’s energy-consuming or energy-inefficient activities. Both parties need the model to reflect changes in business or changes in energy costs.

The third type of service level measures intrusiveness. Energy management involves tearing open walls and shutting down production lines. These are necessary evils, and service levels (with appropriate service level credits) align the supplier’s incentives with the customer’s desire to continue its business.

Pricing

For a full energy outsourcing, the pricing structure may be for the supplier to charge the customer based on the customer’s use of steam, compressed air, chilled water, lumens or other resources. This structure allows the supplier to have full control over the process of producing these resources and allows the customer to pay (on a variable cost basis) for what it needs to run its business.

Different pricing structures are appropriate if there is a partial outsourcing, if the customer wants control of how these resources are produced or if the supplier has a cost-focused pricing model. In those cases, the parties may move to the natural pricing structures for the three primary elements.

Energy charges can be fixed or calculated based on market prices. There are a plethora of market prices available from regional or national energy spot markets, energy futures and options exchanges, and utility tariffs. Electric suppliers offer time-of-use (TOU) pricing based on peak vs. non-peak times and seasonal variations. For example, a company could define its purchasing and hedging strategy for the contract term; then the supplier could agree to price energy at a discount from the price that the customer would have paid. Alternatively, if the customer’s primary concern is energy cost volatility, the contract could provide a fixed price.

Investments in plant and equipment expenditures are costly and are typically justified by their potential to reduce energy costs over many years. The EMO suppliers may offer off-balance-sheet financing for these investments and bear the risk of success or failure through shared savings, guaranteed savings or other performance-based contracts.

Energy management services, of course, are traditional services. They can be priced as consulting services on a fixed-price or time-and-materials basis. However, it may be difficult to estimate the value of these services and to distinguish between services and selling efforts, particularly with suppliers who also supply energy or equipment. In that case, the shared savings model might be the appropriate way to both compensate for the services and to align the supplier’s incentives with the customer’s interest in minimizing its total energy cost.

Control Provisions

EMO raises the traditional outsourcing issues around personnel. The customer, for example, wants the right to:

  • Require the supplier to retain transferred personnel and various key personnel for minimum periods.
  • Approve the supplier’s personnel before they work on the account.
  • Require the supplier to replace personnel for good reason.
  • Prevent the supplier from churning people through the customer’s account or using the customer’s accounts as a training ground.
  • Require background checks and drug screening.

In addition to these traditional issues, EMO raises large issues around “projects.” A “project” is generally the replacement or significant improvement of an energy system. Replacing a 25-year-old boiler might mean shutting down a factory, taking out a wall, cutting the old boiler into pieces (possibly with the aid of an asbestos abatement team), bringing in a new boiler, rebuilding the wall, then bringing the factory back on-line. This is not your long-weekend IT cutover.

Thus, even where the customer is in the EMO transaction to have projects done, the customer will want control over the projects that the supplier undertakes and when the work is done. Similarly, the customer may need the right to veto or delay projects because of union rules, environmental issues, architectural standards, utility and energy regulations and provisions in its leases, and loan agreements.

Exit Rights

The three elements of an EMO transaction have different natural lives. The energy purchase element’s natural life is the natural life of the energy purchase and hedging strategy that it reflects. The equipment and capital investment component’s natural life is the time it takes to complete the project or, if the project is financed, the natural life of the financing. The natural life of an energy management component is similar to that of most other outsourcing transactions. As a result, an EMO agreement may have several expiration dates.

The customer will want the right to terminate for convenience, for cause, for failure to create savings, for significant service level breaches, for change of control of the supplier and perhaps for other exceptional events. Because the supplier may be amortizing a substantial investment, the supplier may require appropriate compensation for these terminations. The related calculation needs to reflect future shared savings payments from projects that the supplier may have completed before the termination.

The supplier might also want the ability to terminate for these same reasons. However, the customer will likely resist early termination options because the customer depends on the supplier for energy management and cannot continue its business without time to replace the services.

Upon an exit, the customer will want termination assistance services to assure a smooth transition to internal energy management or to a successor provider. These services might include the rights to purchase energy management assets used by the provider, hire dedicated personnel, and obtain all energy management data in a useful format and training and other knowledge transfer.

Other Issues

EMO is 20 percent energy and 80 percent outsourcing. The contracting issues described in Outsourcing Journal and BPO Outsourcing Journal also apply here, though often with an EMO twist.

Lessons from the Outsourcing Primer:

  • EMO transactions involve three key elements: energy, facilities and equipment, and services.
  • Unless the customer turns over the entire EMO function, the EMO agreement must deal with these elements differently on key issues such as service levels, pricing, control and exit rights.
  • EMO differs from IT outsourcing in the long useful lives of the assets, the physical intrusiveness of the activities and likelihood that the workers are unionized.
  • EMO transactions may include shared savings, guaranteed savings and other performance clauses that require careful scrutiny by both parties.

Attorney Brad Peterson is a partner in the Outsourcing Practice at Mayer, Brown & Platt in Chicago. His email address is [email protected].


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