Energy Policy 61 (2013) 783–787

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Energy Policy

0301-42http://d

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Lasse.Ok1 Te

journal homepage: www.elsevier.com/locate/enpol

Communication

The Energy Services Company (ESCo) as business model for heatentrepreneurship-A case study of North Karelia, Finland

Niko Suhonen a,1, Lasse Okkonen b,n

a University of Eastern Finland, Faculty of Social Sciences and Business Studies, Department of Business, PO Box 111, FI-80101 Joensuu, Finlandb Karelia University of Applied Sciences, Centre for Natural Resources, Sirkkalantie 12 A2, FI-80100 Joensuu, Finland

H I G H L I G H T S

� We simulate the ESCo business model in a challenging sector of residential heating services.

� We provide a detailed and replicable method for ESCo business modelling.� Simulation and conclusions stimulate further ESCo business model development.

a r t i c l e i n f o

Article history:Received 29 November 2012Accepted 12 June 2013Available online 9 July 2013

Keywords:ESCoHeat entrepreneurshipBusiness model

15/$ - see front matter & 2013 Elsevier Ltd. Ax.doi.org/10.1016/j.enpol.2013.06.047

esponding author. Tel.: +358503423582.ail addresses: niko.suhonen@uef.fi (N. Suhonekonen@karelia.fi (L. Okkonen).l.: +358405916080.

a b s t r a c t

Energy Services Companies are widely implemented for improving energy efficiency both in the publicsector and industry. The model has also been introduced as a business model for biomass-based heatentrepreneurship. However, the residential sector has been problematic with regard to ESCo adoptionand constitutes a minor share of ESCo operations. The barriers, both social and economic, are many. Thispaper focuses on the application of ESCo as a business model for heat entrepreneurship in Finland. First,we present the ESCo model and a review of the main barriers. Second, we present the modelling withaspects of profitability and risk sharing. Third, we demonstrate the operation in the residential sector byusing 26 housing associations as a case study. We simulate the energy investment, profitability ofoperation, and the sharing of risks between the customer and the ESCo. The results indicate that the ESComodel is challenging in our case area. Low profit levels and the assumed customer's preference forachieving cost savings from the beginning of energy renovation can result in long contract periods tyingup the capital. The ESCo model is unattractive in the current business climate, requiring modifications orintegration with other maintenance services of housing associations.

& 2013 Elsevier Ltd. All rights reserved.

1. Introduction

The reduced energy end-use and improved energy efficiency areboth needed for the reduction of primary energy consumption inEurope by 20% by 2020. Several priority actions and policy measures ofthe Energy Efficiency Plan, as well as member-state policies, aim at theintroduction of innovative financing instruments and facilitation of theEnergy Services Companies or ESCos (European Commission, 2011).However, barriers for ESCo adoption such as hindering public procure-ment rules, lack and mismatch of financing, low client confidence andunclear contracts still exist (World Energy Council, 2008).

The major problem for ESCos is the residential sector, includingprivate houses and housing associations (World Energy Council,2008). The barriers that have been identified include the high relative

ll rights reserved.

n),

transaction costs, the low level of information, lack of interest in theESCo models and mistrust. The existence of these barriers is oftendue to the complexity of the ESCo projects, the eventual possibility ofsmall savings, and lack of confidence (Ibid). However, ESCo drivers inthe residential sector include models of external financing, provisionof service, and technical and business expertise, which are oftenlacking in housing associations Fig. 1.

The statistics reveal the ESCo market potential in the residentialsector of Finland: 24% of private houses, 22.8% of row houses and16.9% of block-of-flats were still heated by oil in 2011 (StatisticsFinland, 2012). The use of fuel oil is especially high in housingassociations located on the outskirts or outside the municipal centresand district heating networks. Our case study includes 26 housingassociations in North Karelia2 . The housing associations used

2 The North Karelia region is a resource-dependent NUTS (Nomenclature ofterritorial units for statistics) 3-level region in the north of Europe and increasinglyboosted by state-led innovation policy and various regional policy projects. Theregion is single-nodal and development is currently concentrated mainly in theJoensuu and its surroundings.

Fig. 1. The customer's annual ESCo fee as a function of the payback period. Theannual ESCo fee decreases with the payback duration. In this study, we estimate theESCo fee when a fixed time period is 7 (k1), 10 (k2) or 15 (k3) years, and the pre-determined percentage for sharing the profits between the ESCo and the customeris 50%.

N. Suhonen, L. Okkonen / Energy Policy 61 (2013) 783–787784

500,000 l of fuel oil annually. In most of the cases, the heating systemsare to be renovated in coming years. (Väkeväinen, 2010). Because noestablished ESCos are operating in the area, we use the housingassociations here as an illustrative example of the ESCo clients in theresidential sector of North Karelia.

The main objectives of this article are to investigate the ESCo asa business model for local heat entrepreneurship, to identifyinvestment dynamics, profitability and risk sharing, and to inter-pret the applicability of the model.

2. ESCo—Business model for biomass-based energy

2.1. Concept and contracting

ESCo is not only a concept to improve energy efficiency but alsoapplicable to heat entrepreneurship (Okkonen and Suhonen,2010). The ESCo concept is here defined according to Bertoldiet al. (2006, 2007) as a legal entity delivering energy services orenergy efficiency measures to various types of customers such asindustries, housing associations and the public sector. In doing so,the ESCo gives the guarantee of savings and thus takes theinvestments and financial risks (World Energy Council, 2008).The payment for the services delivered is based on the energyefficiency improvements achieved, reduced energy costs or otheragreed performance criteria.

ESCos usually offer design and development services for energyprojects, installation and maintenance services, and measurement,monitoring and verification of energy savings (World EnergyCouncil, 2008). Bleyl-Androschin and Ungerböck (2009) presenttwo main options for energy contracting: (1) energy supplycontracting, and (2) energy performance contracting:

�

In Energy Supply Contracting (ESC), the efficient supply ofenergy is contracted and measured in megawatt-hours (MW h)delivered. This supply of energy usually includes purchasing offuels and is thus comparable to supply contracts for districtheating or cogeneration. The energy end-use efficiency mea-sures are usually limited to the energy supply side.

�

3 Moreover, if ESCo charges a constant fee, the price fluctuation does not affectthe customer and, thus, the customer's risk is also decreased.

4 The traditional present value method has been criticised because it does nottake account of irreversibility and flexibility of investment and thus undervaluesinvestment opportunities (see more, for instance, in Dixit and Pindyck, 1994).

In Energy Performance Contracting (EPC), the focus is onreducing final energy consumption through demand sideenergy efficiency measures. The scope is wider than in ESC,extending to the entire building or enterprise. Measures caninclude technical building equipment, user behaviour orimprovements in insulation. The model is based on deliveringsavings compared to a predefined baseline. The EPC applies acontract between the beneficiary and the provider, typically

ESCo, of an energy operation where the investment is paidaccording to a contractually agreed level of improvement inenergy efficiency (Bertoldi et al., 2007).

The energy supply/performance contracting can be organisedvia shared energy cost savings or via guaranteed energy costsavings (World Energy Council, 2008). Under the shared energycost savings model, the ESCo and the client share energy costsavings according to a predetermined percentage for a fixed timeperiod. In the model of guaranteed energy cost savings, ESCoguarantees the client a certain level of energy cost savings andthus assumes the performance and the credit risk (Ibid).

In this paper, we focus on the Energy Supply Contracting (ESC)based on a renewable wood energy supply. We will apply theshared savings option in contracting because we want to simulatea risk-sharing between the client and the company. Our simulationis based on the expected cash flows, not realised cash flows.

2.2. Customer's and ESCo's perspectives

The investments costs for a heating oil system are lower thanfor the wood heating energy system, and the investments there-fore involve higher risks. The decision maker's attitude towardrisks affects the investment decision. In economic theory, riskychoices are often considered with the help of the so-calledexpected utility theory by von Neumann and Morgenstern(1944) (see also, e.g., Schoemaker, 1982; Anand, 1993). In general,people are thought to be averse to risks, and as a consequence,risky although possibly profitable choices in an economic senseare avoided. This risk aversion means that the investor wants toavoid risk and would not invest in the production of heat fromwood even if it is more profitable than the system based on fueloil. One solution is that the investment can be provided by theESCo, with the ESCo carrying the main risk of the investment andtaking out a fixed share from the total profit for the expenses andprofit of the cover company3. Thus, the risk aversion of thecustomer provides the opportunity to do business in such a waythat both the customer and the company are beneficiaries. Thecash flows are dynamic, i.e., dependent on time, so we mustsomehow estimate the expected profitability of the investmentover time.

In economic theory, investments over time are investigatedwith the help of the present value method (see Levy and Sarnat,1994, for instance). This method provides the opportunity toconsider long-run profitability by using cash flow and discountrate4 . In the profitability sense, the discount factor can be seen asa constant risk-free interest rate. However, the discount rate canalso include the risk premium of investment, the so-called risk-adjusted discount rate. In behavioural economic theory, the “sub-jective” discount rate is not a constant but bullish in the short termand downward over time, the so-called hyperbolic discounting (forreview, see Frederick et al., 2002). Investors are therefore moreinterested in short term revenues than long term ones. Analternative method for application of the risk-adjusted discountrate is to make the adjustment for risk to cash flows and theresulting certainty-equivalent cash flows at the risk-freeinterest rate.

Risk aversion and hyperbolic discounting are both conceptsthat may help us to understand why people sometimes rejectparticipating in projects that are expected to be economically

N. Suhonen, L. Okkonen / Energy Policy 61 (2013) 783–787 785

profitable in the long run. These concepts also provide opportu-nities to provide different kinds of business models in line withcustomer preferences. In this paper, we introduce a simple versionof risk sharing between the client and the ESCo by using themethod in which the adjustment for risk is made to cash flows andthe resulting certainty-equivalent cash flows are at the risk-freeinterest rate.

First, we must know that the investment is profitable andcompare the current and the new heating systems5. If the invest-ment in the new system is profitable, the customer will proceed toproject planning, otherwise not. Second, if the customer does notwant to make the investment but still wants to retain the own-ership of the investment, the ESCo contract might be the solution.Knowledge and estimation of the feasible payback period and theESCo fee, which makes the investment profitable for both thecustomer and the ESCo, is therefore important. Estimation of theexpected total payment that would be paid to ESCo for avoidingthe investment risk and receiving a reasonable profit from theinvestment is also important. The expected total payment cantherefore be called a risk premium.

In heat production, the ESCo could invest in heat productionwhile the customer would pay the same price for the heat asbefore the investment. After the ESCo recoups its investmentincluding the profit of the company, the customer gets ownershipof the system and also lower heating costs.

ESCo operations are often difficult to apply successfully on asmall scale because of small profits, long payback periods, andtying up the capital in investments. However, the ESCo often hasready-made concepts, experience in feasibility assessments, andskills to run the operations. For the customer, the strengths of thismodel are external financing (small investment risk), steady heatprice for an agreed period and ownership of the heat production.

3. The ESCo modelling

3.1. Variables

The total costs of the current heating system per annum can berepresented as

TCc ¼ PcEc þ Cc; ð1Þwhere Pc is price of energy (euros), Ec is the amount of energyused per annum (MW h), Cc is the operating costs per annum(euros), and the lower index c denotes the current heating system.

The total cost of the new system per annum is

TCn ¼ PnEn þ Cn; ð2Þwhere the lower index n denotes the new heating system. A newsystem needs investment I (euros) and its residual value isassumed to be RVI (euros). We assume that it is possible to receivea subsidy g (rate) for the investment. Other factors are duration ofinvestment T (years) and discount rate r.

The variables of the simulation are as follows. The price is anestimation of the energy price per MW h that includes all costs ofenergy (e.g., the price of heating oil per MW h produced). Amountof energy is the expected amount of energy consumption (e.g., thetotal MW h/a). Operating cost is an expected amount of other costsper annum that includes employment costs, administration costs,service costs, etc. Investment is the expected value of the invest-ment costs. Subsidy or grant rate is the estimated public subsidy

5 In theory, the ESCo cannot itself make the investment profitable if it is notprofitable by itself. However, in practice, the ESCo may have knowledge andreliability that can decrease the investment costs to the customer and thus makeinvestment more profitable.

for the investment (e.g., the state gives a 10% subsidy for invest-ment in renewable energy). Time period is the expected durationof the investment. The residual value of the investment isestimated value received past the duration (e.g., we can sell orre-use part of the heating system after the time period). Discountrate is the expected risk-free rate level for a loan.

3.2. The profitability of investment

Measurements of profitability of investment include, forinstance, payback time, net present value, and internal rate ofreturn. We use the net present value because (1) it measuresprofitability in monetary value, and (2) it also gives us theopportunity to adjust the risk of the customer in the cash flows(the risk-premiums).

To simplify calculations, we write the net investment asIn ¼ ð1−gnÞI and the net revenues per annum as Rn ¼ TCc−TCn.The net present value of investment is then

∑T

t ¼ 1

Rn

ð1þ rÞt þRVIn

ð1þ rÞt� �

−In ¼Π; ð3Þ

where Rn is the net revenues per annum, RVIn is the residual value,In is the net investment, r is the discount rate, and T is the durationof investment. If the net present value is positive, the investmentis profitable, and there is opportunity to produce an ESCo contractthat is profitable to the customer as well as to the company.

3.3. Risk sharing between the customer and ESCo

The net present value of investment Π can be divided betweenthe customer and ESCo, that is

Π ¼ΠESCo þ Πcus; ð4Þwhere ΠESCo is ESCo's share of the profit and Πcus is the customer'sshare of the profit. In particular, ESCo's share of the profit is thecustomer's total payment to the company and can be interpretedas a customer's risk-premium in the present value form.

Typically, in an ESCo partnership or contract, the ESCo and theclient agree upon the ESCo's fee and payback period. We canestimate the ESCo's profit – customer's risk-premium – if weassume a constant ESCo fee per annum and payback period, thus,

ΠESCo ¼ ∑K

k ¼ 1

Fk−TCnk

ð1þ rÞk−In; ð5Þ

where k is the payback period, Fk is the ESCo's fee per annum, TCnk

is the total cost of the new system per annum, and ΠESCo is thetotal profit of the ESCo. Further, by fixing the risk-premium, wecan calculate the exact fee per annum assuming some paybackperiod. The ESCo fee can be written as

Fk ¼Πn

ESCo−InAk

þ TCnk; ð6Þ

where Πn

ESCo is the fixed risk-premium (0≤Πn

ESCo ≤Π), and

Ak ¼ ð1þrÞk−1rð1þrÞk . The fixed risk-premium is the negotiable parameter

between the client and the ESCo. The main purpose of this exerciseis that we can simulate different payback periods and see howthey affect the ESCo's fee by using the real data from the HousingAssociations.

4. The case simulation of the housing associations in NorthKarelia, Finland

The data for the energy consumption of housing associationswas collected by Väkeväinen (2010). A survey of the local housingassociations in the municipalities of Lieksa and Kontiolahti

Table 1The results of the ESCo simulation in the housing associations of Lieksa.

Housingassociations

Consumption(MW h/a)

Investment(euros)

NPV(euros)

Break-even(years)

Risk-premium(euro)

Cost currentsystem (euros)

Cost newsystem (euros)

Operationalcosts (euros)

Fee(k¼7)

Fee(k¼10)

Fee(k¼15)

A 189 46,000 58,320 5 29,160 20,598 11,013 920 23,207 20,150 17,811B 226 58,000 66,421 6 33,210 24,657 13,228 1160 27,989 24,289 21,457C 141 46,000 30,569 8 15,285 15,383 8,449 920 18,246 15,790 13,911D 201 46,000 65,258 5 32,629 21,929 11,653 920 24,447 21,241 18,786E 179 46,000 52,539 6 26,270 19,529 10,479 920 22,173 19,242 16,998F 153 46,000 37,507 7 18,754 16,692 9,090 920 19,486 16,880 14,886G 312 87,000 84,021 6 42,011 34,039 18,401 1740 39,193 33,982 29,992H 153 46,000 47,062 6 23,531 16,693 9,090 920 19,486 16,880 14,886I 136 46,000 27,679 8 13,839 14,838 8,182 920 17,729 15,336 13,504J 178 46,000 51,961 6 25980 19,420 10,425 920 22,070 19,151 16,917K 252 70,000 68,162 6 34,081 27,493 14,857 1400 31,634 27,429 24,210L 320 87,000 88,646 6 44,323 34,912 18,828 1740 40,020 34,708 30,642M 192 46,000 60,055 5 30,027 20,947 11,173 920 23,517 20,423 18,054N 150 46,000 35,773 7 17,886 16,365 8,930 920 19,176 16,608 14,642O 279 70,000 83,771 6 41,886 30,439 16,299 1400 34,425 29,882 26,404P 131 46000 24,788 9 12,394 14,292 7,915 920 17,212 14,882 13,098Q 196 46,000 62,368 5 31,184 21,384 11,386 920 23,930 20,786 18,379

Table 2The results of the ESCo simulation in the housing associations of Kontiolahti.

Housingassociations

Consumption(MW h/a)

Investment(euros)

NPV(euros)

Break-even(years)

Risk-premium(euros)

Cost currentsystem (euros)

Cost NnewSsystem (euros)

Operationalcost (euros)

Fee(k¼7)

Fee(k¼10)

Fee(k¼15)

A 159 46,000 40,976 7 20,488 17,347 9,411 920 20,106 17,425 15,373B 180 46,000 53,117 6 26,559 19,638 10,532 920 22,277 19,333 17,079C 243 70,000 62,958 7 31,479 26,511 14,376 1400 30,704 26,612 23,479D 150 46,000 35,773 7 17,886 16,365 8,930 920 19,176 16,608 14,642E 198 46,000 63,524 5 31,762 21,602 11,493 920 24,137 20,968 18,542F 198 46,000 63,524 5 31,762 21,602 11,493 920 24,137 20,968 18,542G 125 46,000 21,319 9 10,660 13,638 7,595 920 16,592 14,337 12,611H 135 46,000 27,101 8 13,550 14,729 8,129 920 17,625 15,245 13,423I 214 58,000 59,483 6 29,742 23,347 12,588 1160 26,749 23,199 20,482

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identified 26 oil-heated housing associations (Ibid). The energyconsumption is based on their energy certificates. In most of thehousing associations, the current oil-based systems are at the endof their life cycle6, and it is thus realistic to assume systemrenovations (Ibid).

We must make several assumptions for the parameters beforeour analysis. First, we assume that duration of pellet investmentsis 15 years (T), and there is no residual value. Second, we alsoassume that the current heating system does not need investmentor include any operational costs (Cc). The subsidy for pelletinvestment is 10% (g). The operational cost for the pellet heatingsystem is estimated to be 2% of the total investment cost perannum (Cn). The price of pellet energy is assumed to be 53.4 euros/MW h (Pn), and the price of heating oil energy is assumed to be109.1 euros/MW h (Pc).7 The interest rate is 5% (r). Finally, weassume that the net profit is shared equally between the customerand the ESCo. The pre-determined percentage is 50%. Using theseassumptions, we can estimate what the fee (risk-premium) wouldbe per annumwith a fixed time period, i.e., the payback period (k).

Tables 1 and 2 describe the basic information for each studyunit (housing association) and the results of the simulation. Thesecond column presents the energy consumption of the housingassociation, and the third column is the investment cost of the

6 Building years vary in Lieksa from 1964 to 1984 and in Kontiolahti from 1971to 1985, meaning actual need for energy renovations also varies.

7 The fuel prices applied are based on energy price statistics (Statistics Finland,2011), and investment costs are based on the budget offers received from localre-sellers.

new pellet heating system. The NPV (net present value) presentsthe profitability of investments in euros. The break-even is thetime period when the investment is compensated back. The risk-premium is the total amount of risk-premium (50% of the NPV).Cost of the current system is the per annum cost of the old heatingsystem based on oil, and the cost of the new system is the perannum cost of the new pellet heating system. Operational costincludes the service and maintenance costs. The fee is thepayment of the customer per annum, if the payback period is 7,10 or 15 years.

The simulations prove that all cases are profitable, with thelowest profits being 22 788 € and the highest profits being 88 646€. The break even point varied from 5 to 9 years, and the riskpremiums varied from 12 394 € to 44 323 €. For a payback periodof approximately 10 years, the ESCo fee was approximately thesame as the cost of the current oil-based heating system. The ESCofee decreases as the payback period increases. From the customer'sperspective, a very attractive option is the 15-year payback period,with lower costs from the beginning of the energy renovation,stable energy costs, and assurance of service.

For the ESCo, the shorter payback period would be moreattractive because the company's capital is not tied up in long-term investments, and profits are received faster. The level ofprofits generated would be relatively low, especially for this kindof business case where the investment risks are also taken. Typicalcustomer preferences and ESCo preferences do not currently meetin heating services.

If ESCos are to be made profitable in the residential sector, theirshare of the profit should be higher than the 50% applied here, and

N. Suhonen, L. Okkonen / Energy Policy 61 (2013) 783–787 787

the payback should be shorter. For both customers and ESCos to besatisfied, profits should be higher8. The ESCo model in heatentrepreneurships requires economics of scale.

5. Conclusions

The case study indicates that heat entrepreneurship based onthe ESCo business model is challenging in the residential sectordue to the low level of cash flow and thus savings per customerand the profit sharing between the ESCo and the customer. Themodel would require economies of scale.

In the ESCo model, the interests of customer and the ESCo maydiffer: customers would prefer long-term service periods andlower heat prices from the beginning of the new energy system.ESCo interests are more in shorter contracts and faster investmentpaybacks. The business model could be adjusted to meet thecustomer's needs for external financing, provide lower heat prices,and ensure long term service.

The ESCo can serve as an external financing model and/orlonger term energy service model. If both objectives are includedin the business model, the investment risk should be shared. Thecustomer could, for instance, take the investment cost up to thelevel of a new oil boiler, and the ESCo would finance the partexceeding the purchase of a new oil boiler to allow longer termcontracts and also lower energy costs for the customer from thebeginning.

In Finland, biomass is favoured in district heating systems, butsingle houses and housing associations are turning more and moreto ground heat systems despite the higher investment costs. Thisdifference is due to expected savings in the use phase and avoidingmaintenance services. For biomass to be competitive in singlehouse heating, efficient establishment, use and maintenanceservices must take place.

Due to the challenges faced by ESCOs in the residential sector,the alternative of integrating bioenergy services with the otherhouse maintenance seems to be a more realistic option. Theheating system would remain the customer's responsibility, butthe energy production service would be contracted to the main-tenance company. The heating system renovation to a renewableenergy alternative does result in energy cost savings, allowing thiscontracting. However, there is a need for training in the main-tenance companies before reaching this level of additional activity.

8 Profits result from the price difference between the oil-based heating andpellet heating, as well as available subsidies for renewable energy.

Acknowledgments

This work has been supported by the Intelligent Energy Europeco-financed Bio-Sol-ESCo project and Northern PeripheryProgramme 2007–2014 project MicrE—Micro Energy to RuralEnterprise.

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