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Utility-Affiliated ESCOs: Is the Honeymoon Over?

When deregulation struck five years ago, large utilities scrambled for a piece of the energy service company (ESCO) pie. How have those ventures fared?

When deregulation struck five years ago, large utilities scrambled for a piece of the energy service company (ESCO) pie. How have those ventures fared? Did utilities bite off more than they could chew? Does the business strategy still make sense today? How have these services evolved, and what are the current trends? These are just some of the questions we'll address by reflecting on utility ESCO involvement in the last decade.

In the 1990s, the U.S. power industry began bracing itself for the onslaught of deregulation. Motivated by the market's imminent restructuring and the desire to gain a competitive edge, most large utilities either created their own ESCOs or, more commonly, purchased commercial ones. In just a few years, the number of utility-affiliated ESCOs ballooned from less than 30 to more than 100.

According to a study conducted by the National Association of Energy Services Companies (NAESCO; Washington, D.C., U.S.), revenues for the ESCO industry increased at a 24% annualized rate over the past decade. Although this number has declined since 1996 to 9% annualized revenue growth, it is estimated that present ESCO market activity ranges between US$1.9 billion and US$2.1 billion annually.

About ESCOs

ESCOs offer a range of services that includes site assessments, financing, project installations, maintenance contracts, energy management and building control aimed to improve energy efficiency, productivity and environmental conditions. ESCOs target commercial and industrial (C&I) customers with preferred agreements over 7 to 10 years. Moreover, ESCOs guarantee performance while assuming technical, operational and financial risk.

To achieve cost savings, ESCOs use a variety of practices, including performing energy audits, installing high-efficiency equipment (lighting, HVAC, motors, variable speed drives), and monitoring and controlling energy equipment (usage, demand and operating conditions).

A Flash in the Pan?

Despite the early growth, the formation of utility ESCO subsidiaries has dropped sharply in recent years. Some subsidiaries, such as Entergy Integrated Solutions, have closed their doors for good, and others, such as TeCom, have been sold. Why are some utility-affiliated ESCOs struggling to remain viable?

“In the past five years, most utilities were unrealistic in how they could enter the unregulated market,” says Tim Clemons, president and CEO of Custom Energy (Overland Park, Kansas, U.S.). “Their experience dealing with ratepayers and not customers did not prepare them to enter the market. In most cases, the utilities paid too much for their investment and expected compound growth that could not be accomplished if the business was to be profitable. The performas usually projected losses for several years with high overheads that were not realistic without the steep growth curve. The philosophy was to build the structure and then get the business. In most cases, the business never came profitably.”

From the start, many unregulated ESCO ventures faced great financial challenges because of initial cost structure and unrealistic expectations, but many were doomed because they lacked a fundamental knowledge of how to run the business.

“Primarily, we've seen two approaches to the ESCO model,” says Bob Dickerman, president of Sempra Energy Solutions (San Diego, California, U.S.). “Companies that take the time to build a customer-centric, flexible, sustainable business focused on developing front, middle and back office capabilities so they can deliver on their promises. Or, the other approach is to sell the concept and hope to deliver. And, as we've seen, many ESCOs have failed using the latter method and have exited the business.”

When utility-affiliated ESCOs did not have the infrastructure to deliver the services they wanted to sell, many depended on partnering to fulfill their agreements. These arrangements proved difficult to sustain as savvy customers quickly learned that the utility-affiliated ESCO was another layer of cost that could be avoided. Unless the utility-affiliated ESCO provided financing or performance guarantees that were otherwise unattainable, perceptive customers would do business directly with an experienced ESCO.

A Shift in Services

In the past, ESCOs have relied heavily on performance-based contracting to distinguish themselves from other companies that offered energy-efficiency services.

Performance-based contracting allows C&I customers to bundle numerous projects under one agreement. It also gives customers contractual assurances that installed systems will operate properly while delivering the promised energy efficiencies. According to NAESCO, however, the market share of performance-contracting projects has dipped from 92% to 76% since 1996. The current trend is toward guaranteed savings contracts and design/build or fee-for-service arrangements.

As performance contracting has declined, so has ESCO participation in state and federal energy efficiency programs. These programs were the initial utility entrée into the ESCO arena and project justifications were heavily dependent upon public and ratepayer funding. The decrease of activity can be attributed to improved efficiency benefits and a national decline in utility energy-efficiency spending. Standard performance contract, rebate and demand side management (DSM) are the most common types of energy-efficiency programs.

Most utility-affiliated ESCOs got their start with energy-efficiency programs and performance contracting. However, many have expanded their business to include utility services (chilled water, steam, compressed air, waste water, on-site power and energy management). For example, Custom Energy added a strategy to build, own and operate central plants and inside-the-fence cogeneration plants. The company also added services that are not energy related, such as contracting of electrical and mechanical infrastructure for large customers.

Current Trends and Activity

As competitive electric markets developed in the last decade, power marketers were introduced into the energy services industry. They immediately increased the amount of commodity-based energy services offered. The new services fall under the umbrella of energy management, including risk-related products, aggregation, firm pricing and load management. These services will increase and progress with electric retail competition.

Utilities have been offering traditional energy management services for years to their major accounts as a part of energy-efficiency and DSM programs together with routine assistance over billing concerns. Apparently, the interest in energy management services hasn't waned.

According to a recently released Chartwell survey, 74% of utilities offer their C&I customers some energy management consulting. The utility respondents indicated that energy management was the most popular of the services they provided their C&I customers. A problem revealed in the survey is that only about half of the respondents charge a fee for this service. There are various reasons why certain energy management services are not charged as a separate fee. They are either covered by commodity costs (pass-through or retention) or are subsidized by utility “public-goods” programs. Regardless, the value of energy management services have been established and, ultimately, will be viewed as a stand-alone service in any mature competitive market.

The interest in selling energy-saving products to C&I customers has decreased. In 2001, 48% of utilities offered energy-saving products while the 2002 survey indicated a drop to 34%. The interest was also low (20%) for offerings in building or equipment automation. These products may increase in popularity as technology advances and they are bundled into turnkey packages.

Future of Utility-Affiliated ESCOs

Utilities embarked into the ESCO domain for a myriad of reasons. Mainly, utilities were pursuing market share in a then projected +$200 billion market, believing that the ESCO industry was a natural extension of their own.

Operationally, it made sense for utilities to leverage infrastructure and customer service competencies while integrating complimentary services. However, this strategy required a close relationship with their affiliate or unregulated business unit and, in some cases, employees split time and responsibilities between the regulated and unregulated parts of the business. This brought about concern from ESCO competitors that regulated utilities were subsidizing their own ESCO efforts. The gray line that many utilities drew prompted regulators to get involved and give directives on how utilities must structure this activity. Texas, for example, has established rules as a part of their unbundling efforts that specifically prohibit utilities (except municipals and electric cooperatives) from providing energy services (after Sept. 1, 2000) except for the administration of energy-efficiency programs. As electric unbundling progresses, the functional distinction and clear separation of a utilities operating business will eliminate much of the synergistic ability that previously existed. Consequently, the utilities' market advantage is being eliminated.

Utilities also are moving away from comprehensive ESCO services because utilities are adopting different business strategies. The prevailing belief a decade ago was that if utilities expected to survive in the competitive energy industry, they must grow the business, which for many utilities meant offering value-added energy services in addition to their core business. The current trend is to get back to core utility business. Some utilities have gone so far as to get out of core functional areas (generation, transmission and distribution). The popular business approach is to focus on the core areas you do best and sell or outsource the rest, opposed to the former approach of being the “one-stop-shop for all your energy needs.”

A strong market still exists for energy efficiency and conservation. As restructuring continues, “standard offer” rebate programs, standard performance contracts and DSM activity should bring growth to the energy services market. The utility-affiliated ESCOs that have established themselves as stand-alone businesses should be well positioned to grow. Investor-owned utilities that are still dabbling with energy services are expected to retreat back to facilitating “public-goods” and DSM programs. Municipals and electric cooperatives will probably remain more active with ESCO efforts as value-added and customer retention strategies.

The energy services industry is a big industry and requires broad expertise to be a full-service provider. Except for those utilities that purchased this knowledge and industry experience, very few utilities have migrated into this industry successfully. This could change as energy services evolve to include more commodity-based offerings, but in the meantime, don't expect many utilities offering to be your total energy solutions provider.

Phil Musser, chief technical editor of T&D World, spent eight years during the 1990s involved in ESCO activity with two Midwest utilities. He also served as executive editor of Energy Manager magazine and editor in chief of Power Quality magazine. He is a certified energy manager.

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