The Energy Service Companies (ESCOs) play a crucial role in advancing energy efficiency by way of implementing the retrofit projects at the client premises. The ESCOs finance and implement these projects and get returns for their investments through a larger share of the savings, while the client is allowed to keep a smaller percentage of the savings, until the ESCO recovers the cost of the project.
In India, there are over 120 empanelled ESCOs, of which only 30-35 are actively engaged in implementing energy efficiency projects. The ESCO business model has been there in the country for over three decades, still the ESCOs find the going tough due to a numerous factor. The importance of ESCO business model lies in the fact that, they are expected to play a key role in meeting the NDC targets through implementing EE projects. So, from the climate change mitigation perspective it is imperative to find solutions to the challenges faced by ESCOs in scaling up the business models.
Key challenges faced by ESCOs for financing EE projects
While the ESCOs have a high level of design, technical capabilities, and project management expertise, they face several challenges in raising capital for clean technology projects.
- The foremost reason for the reluctance of Financial Institutions (FIs) to fund ESCO projects is procedural. As ESCOs set up the equipment at the client’s premises, it makes it tedious for FIs to repossess the assets, if required.
- Lack of collaterals and personal securities, which ESCOs are unable to provide due to the small scale of their business, makes traditional financing systems inaccessible to ESCOs. Also, a longer loan sanctioning process delays the start of the projects, making it difficult for ESCOs to retain the client.
- The absence of robust Measurement and Verifications (M&V) system reduces the credibility and transparency in the business model for FIs. Due to this, the ESCO model is given lower credit ratings and the projects end up paying higher interest rates.
- Apart from project financing issues, ESCOs also face challenges in payment recovery from the clients, which poses a question on the absence of robust contract enforcing mechanism in the ESCO business. ESCOs are enforced to take the legal route to settle payment obligations, which is a lengthy process.
Possible Solutions
Having discussed the challenges posed by traditional financing mechanism, the question is: can private equity investment emerge as a promising solution for ESCO business model? Based on the discussions with few private equity investors, the following points need consideration.
- To leverage the benefits of private equity investments, the business model should be scalable and easily replicable in a short period of time. This will help to attract equity investors.
- Instead of calculating the energy saving every month, ESCOs need to create a model similar to utilities that provides the services on an ongoing basis. The ESCOs can own their infrastructure at the customers’ end and sell them the required service.
- The ease of contracting can also be one of the ways to attract equity finance. ESCOs should look for leveraging the technology advantage to overcome the contractual issues. This will help to instil confidence among the investors.
- The ESCO community needs to move out of assets-based lending and start exploring cash-flow based lending options.
- ESCOs need to be careful to understand the requirements of private equity investors. The equity investors look for the following before making any investment:
- Founders of the company plays a crucial role. Equity firms keep a track record of their business strategies and plans. Moreover, equity firms expect from founders to put forward a good management team.
- The business model should be easily staked-up.
- The company should develop a diversified portfolio to attract private equity investors.
- Exit considerations.
For the private equity investors, scale of operations of ESCO business is not a matter of concern, if the business model is scalable and replicable in the future, the investors are willing to invest. Also, the number of companies in the ESCOs sector (ESCO market size) is not a major consideration for the investors, although an increase in number would be an advantage. With regard to the higher exit periods, a longer exit period makes it difficult for investors looking at options for a stake sale.
Further, to address the M&V issues, the ESCOs should explore advanced M&V, which is often referred to as M&V 2.0. This has recently gained much attention among the various industries. The M&V 2.0 technologies are enhancing the current M&V system by increasing the granularity of the available data primarily in terms of finer time scales, and enabling the processing of large volumes of data at high speed, via automated analytics. The advanced M&V systems provide near real-time information which will help the ESCOs and client to make informed decision based on the data and avoid any confusion whatsoever. This will also help instil confidence among the investor and increase the credibility of the ESCO business.
Thus, for ESCOs to ramp up their business, they must look out for non-traditional methods and leverage the different financing opportunities available in the market. They must invest in technology and move towards digitalising the various process involved. This will ultimately lead to greater reliability in energy savings estimates through more streamlined measurement and verification protocols. For instance, the deployment of smart meters, increased penetration of active energy management systems in the industry, and advancements in remote monitoring platforms should aid ESCO market development in the future.
Written by Shirish Bhardwaj, with inputs from Deepak Tewari and Bhaskar Natarajan.
