Explaining the contract Terms of Energy Performance Contracting in China

Yan Li, Renmin University (China), 86-13910533648,

Yueming Lucy Qiu, Stanford University and Arizona State University, 623-209-4725,

Yi David Wang, University of International Business and Economics (China), 623-330-8452,

Overview

Energy service company ("ESCO") uses Energy Performance Contracting ("EPC") to provide energy-saving services to the customers. Under an EPC, an ESCO improves the energy efficiency of its client. An ESCO and a client establish an energy-saving target. Both sides invest in the energy efficiency measures, according to a negotiated share of investment. Within the length of the contract, the ESCO and its client divide up the saved energy bill according a negotiated share. Beyond the contract, the client claims all the saved energy bill if the energy efficiency measures still last. Different EPC projects have different contract terms and different energy efficiency saving target. Thus it is interesting and important to look at how these contract terms influence each other as well as energy efficiency savings. Compared to other conventional energy conservation methods, EPC has been the most effective in conserving energy in western countries since 1970s. Chinese central government began to formulate the policies specialized on EPC in 2010. Since then, ESCOs and EPC activities began to increase quickly in China.

Existing studies on EPC and ESCO mainly uses qualitative or descriptive analysis, mostly at the industry level. Very few studies have analysed the underlying mechanisms of various contract terms at project or contract level. This paper analyses the contract terms of EPC contract both theoretically and empirically. We have identified the following main contract terms which the ESCO and its client mainly negotiate on: energy saving target, length of contract period, total investment, share of investment and share of energy savings. This paper builds a theoretical model to find out the structural relationship among these contract terms. Then, using the information of about 200 EPC contracts in China in 2010 and 2011, we empirically estimated the impacts of various contract terms as well as other exogenous factors on the amount of energy savings under EPC.

The paper is organised as follows: After the introduction the second section gives a brief overview about the EPC industry and related government policies in China. The third section lays out the theorectical models and relevant proposistions. The fouth section describes the dataset. In section five we conduct the econometric analysis and show the results. The final section concludes with policy implications.

Methods

Structural model:

Objective function for ESCO:

(1)

Subject to

(2)

(3)

(4)

(5)

Where

I is the upfront investment (in 10000 yuan, RMB);

is the annual benefit generated by the energy efficiency investment in terms of the dollar value of saved energy;

Is is the ESCO’s share of investment. It is also ESCO’s share of benefit;

T is the contract length (in years);

βI is the total life time of the invested energy efficiency measures;

rs is the discount rate of the ESCO;

rc is the discount rate of the client.

Empirical estimation: regressions based on the structural model

Results

ESCOs tend to assume all the upfront investment. The optimization process shows that, if the share of investment and the share of benefit are the same, then ESCOs will assume 100% of the upfront investment for the energy efficiency measures, in order to maximize its total gain within the contract period. As either the discount rate of the ESCO or the client increases, contract time, investment and the resulted total energy savings decline. As the client requires more minimum profit from the EPC contract, investment and the resulted energy savings both decline.

Conclusions

This paper analyses the contract terms, including total investment, share of investment and contract length, of EPC contracts both theoretically and empirically. Both the theoretical and the empirical results find that:1) if ESCOs have a lower cost of capital and discount rate, the total investment, and energy saving will increase;2) ESCOs tend to assume 100% of the total investment in energy efficiency technologies. Thus providing low cost of capital to ESCO is essential to facilitate the effectiveness of EPC activities in terms of saving energy.

The theoretical results also show that if the client has a higher requirement for minimum profit, the investment and the resulted energy saving will decrease. In addition, lower cost of capital for client can also help increase the investment and energy saving of EPC contracts. This implies that industry clients should be given more incentives to participate in EPC contracts.

References

Chen, K., and Z. F., Xu, 2010. Energy Performance Contracting in China . King and Wood MALLESONS, report. http://www.kingandwood.com/article.aspx?id=Energy-Performance-Contracting-in-China&language=en

Goldman, C. A., N. C., Hooper, J.G., Osborn, 2005. Review of US ESCO industry market trends: an empirical analysis of project data. Energy Policy 33, 387-405

Li, Y., 2012. AHP-Fuzzy Evaluation on Financing Bottleneck in Energy Performance Contracting in China. Energy Procedia 14, 121-126.

Sorrell, S., 2007. The economics of energy service contracts. Energy Policy 35, 507-521