Performance Contracting: An ESCo Perspective

Greg Thomas is executive director of Syracuse Energy Services Co.

Residential performance contracting presents great opportunities and great risks for both the utility and the energy service company (ESCo). Uncertainty emanates from the utility's lack of knowledge of the ESCo's real cost of implementing a project and the level of savings the project will actually produce. These unknowns become complicated in residential projects, where the buildings treated are small and many, and actual savings are difficult and costly to measure.

For successful contract negotiation and program execution, each party must recognize the risks that the other will incur. This mutual recognition should not wait for the contract negotiation phase, but should start with the utility's request for proposal (RFP). The better defined the bidder's responsibilities are in the RFP and in the proposed contract, the better the quality of the bids received. Bid pricing will be driven by this process of risk assignment. The issues associated with the definition of responsibilities in residential sector bid contracts are significantly different than those in commercial sector bid contracts. Therefore, the residential sector bids should be considered separately from commercial sector bids. The utility can obtain conservation resources cost-effectively if it is willing to address the unique needs and limitations of the residential sector.

Guidelines

What follows are some guidelines utilities should keep in mind for the RFP and subsequent contracts.

Create the right atmosphere. It is important for a utility to be knowledgeable about the techniques that ESCos use to shift risk away from themselves. The utility and contract evaluators will need to protect themselves in the event they see these techniques. But it is equally important for the utility to understand and take responsibility for the requirements in the RFP that may encourage bids from ESCos who play these games.

Specifically, if the utility uses the RFP primarily as a defensive tool, designed to transfer as much risk as possible to the ESCos, the utility will attract those ESCos most willing to gamble and engage in gaming in order to cut costs and mitigate the risks they agreed to assume in order to win the bid. In other words, the bidding process used by the utilities may encourage the bidder to suggest cost reducing proposals that the utility may find objectionable in later phases of the process.

What makes a good project? The utility should recognize that putting adequate staff resources into the development of the RFP, the selection of a capable and responsible contractor, and the subsequent contract negotiation will lead to a better project. The better a utility communicates its needs in the RFP process, the easier the bidder selection and the smoother the contract negotiation will be. Interviewing the contract administrators for the ESCo's previous projects and inspecting some of the sites treated can be a valuable investment of utility staff time.

Standard contracts can grease the skids. The industry needs standard contracts between utilities and ESCos, similar to those available in the construction industry. The use of a highly evolved standard contract form for inclusion in bidding and in the subsequent negotiations would substantially reduce the bid development costs for both utilities and the ESCos.

Such a contract should cover the risks that the utility seeks to avoid (non-performance by the ESCo, failure to deliver measured savings), definition of the payment stream and front loading security requirements, minimum evaluation requirements, life and failure rates of the measures, constraints against cream skimming, custom relations requirements, and general liability (for insurance or bankruptcy). Avoid attempting to subject the ESCo to risks that are outside of its control, such as changes in long-term avoided costs and subsequent prudence reviews.

Good contracts make good friends. Just as a utility must not attempt to impose undo risks, the ESCo must use the contract to protect itself against the utility's ability to interfere, purposely or blindly, with the ESCo's project implementation, especially when the utility chooses to relate to the ESCo at an arm's length rather than as partner in energy conservation. The ESCo must ensure that is has access to:

• high quality account numbers and billing data,

   

• timely utility review of the ESCo's proposed marketing methods, job sites, and specifications,

   

• the flexibility to adjust measures in keeping with technological change and the diversity of housing stock, and

   

• timely payment for completed work.

Front-loading can thwart bidders. Front-loading requires full or partial security held by the ESCo for the value of the payments it has received that are greater than the value of the measured savings delivered to date, not including projections of future savings. If the savings are estimated to last 15 years, front-load security could be required for almost the entire life of the measure. This practice significantly increases the cost of contracts and can be a significant barrier to bidders. It may be more cost effective for the utility to use other methods, such as escrow accounts, to provide long-term incentives.

It is in the bidder's interest to make an evaluation as soon as possible. This will reduce the risk of measures failing and ensure quicker payment. A waiting period of a full year may be appropriate for residential contracts. The bidder must carry an appropriate level of financial risk at the time of the evaluation. Too high a level of financial risk will be a barrier to responsible bidders and will be reflected in the bid price.

Expect to pay more for quality work. Take the time to investigate a bidder's previous contracts so you have a basis for judging quality. Retain the right to say no to a bidder based on an evaluation of the quality of past work.

Selection techniques for baseline pre-retrofit consumption and control groups are best defined in the RFP. Criteria for setting baseline consumption should be easy to program to allow computerized batch processing of multiple sites. It is important to point out that control group selection can be difficult for conservation programs oriented toward high energy users, where a large percentage of the eligible population will be treated.

Evaluation is also tied to the payment stream. The parties should define in the RFP the extent to which they expect the evaluation to affect payment. Here too, be careful to address residential evaluation procedures separately from commercial evaluation procedures. If the utility intends to pay for persistence of measures, it should provide for or specify the long-term evaluation of savings. Be sure to employ expert review when confronted with the unknown.

Comprehensive programs can be more cost-effective when targeted at high users. It is the utility's responsibility, to its customers and regulators, to select and monitor ESCos that provide a truly comprehensive diagnostic approach for high users. The ESCo's risk in producing measured savings can be reduced by allowing it to treat additional units when there is a shortfall in measured savings. This type of contract clause can be mutually beneficial if limited to prevent cream skimming.

Site inspection, according to well defined project specifications, is best accomplished using a third party that both parties mutually agree upon. Limitations on when and where inspections take place are appropriate only to the extent that they protect the ESCo's good- faith relationship with the customer. Inspections can be used to trigger ESCo payment.

Sometimes it's in a utility's interest to help new players, especially local ones. Residential demand-side management projects lend themselves to employing local contractors. These contractors may not have explicit DSM experience but often have considerable experience in the delivery of residential conservation or construction services. These local contractors may not be familiar with or capable of addressing the formal documentation requirements of the RFP process, so additional bid preparation support for these groups may be warranted. Financing support for these groups should also be considered, to the extent that the bidder will be seriously penalized for failure to deliver on a contract.

Pilot projects are a good way to build and test the capabilities of local contractors prior to a major RFP. A local group may not immediately have the capability to get a large project up and running, but their long-term interests in serving their community will be similar to those of the utility, resulting in an excellent working relationship. Non-local ESCos can also be encouraged to utilize local resources through the bid scoring process.

The rules for a truly equitable relationship between utility and ESCo are still being defined, project by project. Making constructive use of lessons learned so far will help ensure that this relationship evolves in a way that benefits the utility, the ESCo, and the community.