Net Present Value at 18%: $681,953

Net Present Value at 18%: $681,953

Notes: Total Lease Amount: 2,500,000

However, Since the payments are in advance, the first payment is analogous to a Down-Payment Thus the actual amount borrowed is only = 2,500,000 - 619,218 = 1,880,782 Lease Finance Rate: 12% MARR 18%

Tax Rate 34%

MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5 Accounting Book Value at end of year 5: 669,375 Estimated Market Value at end of year 5: 1,200,000 EOY 5* illustrates the Equipment Sale and Book Value

Taxable Income: = (Market Value - Book Value)

wide" scope of work (to find extra energy savings), than loans or leases on particular pieces of equipment.

With a facility-wide scope, many improvements can occur at the same time. For example, lighting and air conditioning systems can be upgraded at the same time. In addition, the indoor air quality can be improved. With a comprehensive facility management approach, a "domino-effect" on cost reduction is possible. For example, if facility improvements create a safer and higher quality environment for workers, productivity could increase. As a result of decreased employee absenteeism, the workman's compensation cost could also be reduced. These are additional benefits to the facility.

Depending on the host's capability to manage the risks (equipment performance, financing, etc.) the host will delegate some of these responsibilities to the ESCO. In general, the amount of risk assigned to the ESCO is directly related to the percent savings that must be shared with the ESCO.

For facilities that are not in a good position to manage the risks of an energy project, performance contracting may be the only economically feasible implementation method. For example, the US Federal Government used performance contracting to upgrade facilities when budgets were being dramatically cut. In essence, they "sold" some of their future energy savings to an ESCO, in return for receiving new equipment and efficiency benefits.

In general, performance contracting may be the best option for facilities that:

• are severely constrained by their cash flows;

• don't have sufficient resources, such as a lack of in-house energy management expertise or an inadequate maintenance capacity*;

• are seeking to reduce in-house responsibilities and focus more on their core business objectives; or

• are attempting a complex project with uncertain reliability or if the host is not fully capable of managing the project. For example, a lighting retrofit has a high probability of producing the expected cash flows, whereas a completely new process does not have

*Maintenance capacity represents the ability that the maintenance personnel will be able to maintain the new system. It has been shown that systems fail and are replaced when maintenance concerns are not incorporated into the planning process. See Woodroof, E. (1997) "Lighting Retrofits: Don't Forget About Maintenance," Energy Engineering, 94(1) pp. 59-68.

the same "time-tested" reliability. If the in-house energy management team cannot manage this risk, performance contracting may be an attractive alternative.

Performance contracting does have some drawbacks. In addition to sharing the savings with an ESCO, the tax benefits of depreciation and other economic benefits must be negotiated. Whenever large contracts are involved, there is reason for concern. One study found that 11% of customers who were considering EMPs felt that dealing with an ESCO was too confusing or complicated.14 Another reference claims, "with complex contracts, there may be more options and more room for error."15 Therefore, it is critical to choose an ESCO with a good reputation and experience within the types of facilities that are involved.

There are a few common types of contracts. The ESCO will usually offer the following options:

• guaranteed fixed dollar savings;

• guaranteed fixed energy (MMBtu) savings;

• a percent of energy savings; or

• a combination of the above.

Obviously, facility managers would prefer the options with "guaranteed savings." However this extra security (and risk to the ESCO) usually costs more. The primary difference between the two guaranteed options is that guaranteed fixed dollar savings contracts ensure dollar savings, even if energy prices fall. For example, if energy prices drop and the equipment does not save as much money as predicted, the ESCO must pay (out of its own pocket) the contracted savings to the host.

Percent energy savings contracts are agreements that basically share energy savings between the host and the ESCO. The more energy saved, the higher the revenues to both parties. However, the host has less predictable savings and must also periodically negotiate with the ESCO to determine "who saved what" when sharing savings. There are numerous hybrid contracts available that combine the positive aspects of the above options. Application to the Case Study

PizzaCo would enter into a hybrid contract; percent energy savings/guaranteed arrangement. The ESCO would purchase, install and operate a highly efficient chilled water system. The ESCO would guarantee that PizzaCo would save the $1,000,000 per year, but PizzaCo would pay the ESCO 80% of the savings. In this way, PizzaCo would not need to invest any money, and would simply collect the net savings of $200,000 each year. To avoid periodic negotiations associated with shared savings agreements, the contract could be worded such that the ESCO will provide guaranteed energy savings worth $200,000 each year.

With this arrangement, there are no depreciation, interest payments or tax-benefits for PizzaCo. However, PizzaCo receives a positive cash flow with no investment and little risk. At the end of the contract, the ESCO removes the equipment. At the end of most performance contracts, the host usually acquires or purchases the equipment for fair market value. However, for this case study, the equipment was removed to make a consistent comparison with the other financial arrangements.

Figure 25.13 illustrates the transactions between the parties. Table 25.11 presents the economic analysis for performance contracting.

Note that Table 25.11 is slightly different from the other tables in this chapter: Taxable Income = Savings - Depreciation - ESCO Payments.

Figure 25.13 Transactions for a Performance Contract.

25.4.7 Summary Of Tax Benefits

Table 25.12 summarizes the tax benefits of each financial arrangement presented in this chapter.

25.4.8 Additional Options

Combinations of the basic financial arrangements can be created to enhance the value of a project. A sample of the possible combinations are described below.

• Third party financiers often cooperate with performance contracting firms to implement EMPs.

• Utility rebates and government programs may provide additional benefits for particular projects.

• Tax-exempt leases are available to government facilities.

• Insurance can be purchased to protect against risks relating to equipment performance, energy savings, etc.

• Some financial arrangements can be structured as non-recourse to the host. Thus, the ESCO or lessor would assume the risks of payment default. However, as mentioned before, profit sharing increases with risk sharing.

Attempting to identify the absolute best financial arrangement is a rewarding goal, unless it takes too long. As every minute passes, potential dollar savings are lost forever. When considering special grant funds, rebate programs or other unique opportunities, it is important to consider the lost savings due to delay.

Table 25.11 Economic Analysis of a Performance Contract.

ESCO Principal Taxable

EOY Savings Depr. Payments Total Outstanding Income Tax ATCF

0 0

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