Prevention and control of risk in energy performance contracting

Energy performance/management contracting (EPC or EMC) is a new environmentally friendly business operation model that uses market mechanisms to promote energy saving. The model is being widely implemented internationally. In 2013, energy service companies in China already numbered in excess of 3,000, with a gross output exceeding RMB150 billion (US$24.5 billion). By 2015, the gross output of the energy service industry in China will reach RMB500 billion. In the current climate of concerns about a global energy crisis, EPC has become a rising investment sector vigorously supported by national governments.

Features of the model

Under the EPC model, an energy service company (i.e. the investing and constructing party) executes an energy performance contract with the user to provide energy audit, investment/financing, alteration and construction services to the user, and recovers its investment and profit through sharing of the energy savings. The energy service company seeks to make a profit by providing the customer with professional energy efficiency management, investment/financing and services. The definition of user is relatively broad, including but not limited to owners or users of industry, construction, transport, public agencies, etc. This model not only greatly reduces the funding pressures and technical risks of energy saving alterations, but also fully mobilises the energy user’s incentive for energy saving alterations.

In practice, the models generally used in an EPC are BOT (build-operate-transfer), BOO (build-own-operate), TOT (transfer-operate-transfer), lease financing or combinations of these. The author has had a hand in all the above-mentioned models as used in an EPC project.

The specific method of implementation of an EPC is not necessarily identical to the traditional utility or infrastructure concession model. For example, in a traditional BOT concession model, the project is usually transferred to the government or other title owner without consideration after construction and operation for a certain number of years. With EPC, the transfer may be effected without consideration or for consideration after construction and operation for a certain number of years, and it may be the project that is transferred or equity that is transferred, making for greater flexibility.

As another example, the profits of the investor in a traditional concession project are usually derived from the operating income of the project. But the income of an EPC project is mainly derived from the energy efficiency of the project, in practice taking the form of a commission on the energy savings or custody of the energy charges.

The legal risks

In taking on an EPC project, the investor will face a number of legal risks. The first is the lawfulness risk. The lawfulness of the project is the risk point on which the energy service company should focus the greatest attention when selecting an investment project. In an EPC project, particularly a large alteration or new construction project, attention first needs to be focused on whether the approvals of the relevant government authorities have been secured, and whether recordals have been carried out for the project proposal, planning, environmental assessment, land and construction stages. Should a problem arise in the lawfulness of the project, the objectives for the entire project will be unrealisable.

The second risk is the user’s performance capacity and credit rating. The profit of the energy service company derives from the energy performance contract executed with the user. Whether the user has the capacity to perform the contract, and whether it acts in good faith and maintains a good credit rating, will directly determine whether the energy service company can recover its investment costs and profit on schedule.

The third is project financing risk. Save for the capital of the project, the energy service company is required to seek financing from financial institutions for the other funds required for construction of the project, and given the current monetary policies and the Chinese government’s crackdown on “shadow banks”, financing difficulties have become a concern and risk that all investment projects, including EPC projects, face.

The fourth is the risk of a dispute over title to the project. As China lacks laws and regulations addressing EPC, there are no express provisions on the vesting of the ownership of the energy saving facilities and equipment invested in and constructed by the energy service company, meaning that disputes over title can easily arise.

The fifth is risk of damage to, or destruction of, the project. If the energy service company and user have not expressly provided in advance for the sharing of risks, in the event that the project is damaged or destroyed in a natural disaster or public incident, a dispute can easily arise.

The sixth is project policy risk. To date, governments at each level in China have issued numerous policies supporting EPC projects and new policies may be issued in the course of the implementation of a project. How to ensure that these support policies will be duly implemented is a risk point that an energy service company needs to consider.

Prevention and control of risks

Of most importance is that, in the course of investment decision-making, the energy service company should conduct a detailed legal, financial and technical due diligence to reduce the investment risks to the greatest extent possible.

Second, in the course of the execution of the contract on project co-operation with the energy user, the energy service company should expressly provide for such core matters as the rights and obligations of the parties, vesting of the ownership of the project, etc., to avoid the occurrence of disputes in the course of implementation of the project. Normally, ownership of the project should vest in the energy service company, to facilitate follow-up financing of the project and recovery of the investment costs and profits.

Third, the energy service company and the energy user should expressly provide for insurance and the sharing of risks in the contract, that is, the contract should expressly indicate the proposer, insured and beneficiary, and should establish clearly the principles for the sharing of risks.

Fourth, the energy service provider should require the energy user to provide appropriate security measures to ensure that it can lawfully recover the investment costs and profits. In the author’s experience, security measures, including security, are crucial in determining whether the energy service company can recover its costs and share in the benefits on schedule.