The Project Life Cycle
This section describes the overall process of developing and executing an energy efficiency project. It is aimed at establishing the foundations for a standardised process and a common language that can be used by financial institutions, project developers and project hosts. As such it is aimed at originators, risk teams and project developers and hosts. Much of the discussion refers to larger scale energy efficiency projects but the basic process for smaller projects is essentially the same.
The technical, economic and financial development of energy efficiency projects follows a similar process irrespective of the project type or size.
From the developer’s perspective, a project goes through the following stages:
From the financial institution’s perspective, a project goes through the following stages:
The development and the financing processes interact at several points and can be iterative.
- Developers and financial institutions often do not speak the same language and it is vitally important to engage and establish a common language at the beginning of, or prior to, the commencement of project development.
- Developers seeking funding for projects should make contact with potential funders as early as possible, or even prior to the start of the development process.
- Developers and funders should establish a clearly defined and commonly understood process with defined inputs and outputs prior to starting project development.
- Financial institutions should work with developers to communicate their process, defined inputs and lending/investment criteria as early as possible in the project life cycle.
- Financial institutions, and developers, need to standardise the development and evaluation process to reduce costs and decision times.
- Financial institutions deploying capital into multiple installations of small projects, for example in the residential sector, must simplify and automate all stages of the project development, assessment and operations life cycle.
- Financial institutions should require the use of internationally recognised standards such as those developed by the Investor Confidence Project (ICP).
- Financial institutions should require the use of Measurement and Verification (M&V) protocols such as those developed by the International Performance Measurement and Verification Protocol (IPMVP).
- M&V reports should be linked to loan/investment servicing as they can provide early warning on lower than expected performance which may affect viability of repayment.
- Lenders and investors should utilise M&V reports to feed into risk analysis which can enable better understanding of risks and more accurate pricing.
The project life cycle
The full project life cycle for an energy efficiency project, along with associated activities and outputs from each stage, is shown in Figure 1. The following sections explain each stage in turn, first from the developer’s perspective and then from the perspective of a financial institution.
From the developers or project host’s perspective there are three stages to a project;
- Development – consisting of:
- Concept design
- Basic design
- Detailed design
- Implementation – consisting of:
- Detailed implementation design
- Operation – consisting of:
- Measurement and Verification
- Operations and M
From the financial institution’s perspective, the stages are:
- pre-financing – consisting of:
- Decision to proceed to underwriting
- Decision to finance
- operations/servicing – consisting of:
- Draw down
These stages are described in-turn below.
The project developer’s perspective
Project developers undertake a technical and commercial development process that leads to a set of information that will allow the project host (where the host is investing their own capital), or a financial institution to make an investment decision. Project development can be carried out by the project host’s internal staff, external energy consultants, a specialised energy services company or a combination acting as a development team. The project development process begins with idea generation, which can be driven by an energy audit or a vendor’s proposal, and then moves through a process of refining technical and commercial data. The process outputs can include an Investment Grade Audit (IGA), which is more detailed and has more accurate costs and savings estimates than standard energy audits.
The development process should always begin with base lining of energy consumption - determining the base level of energy use against which the resulting energy savings are measured. A projection of energy savings relative to the base line for the specific project or projects will then be calculated. Savings are calculated using standard engineering methodologies, usually contained within national guides from engineering bodies or in some cases in national standards, or for larger building projects calculated using a building simulation model. Simulations, if done well, can more accurately assess annual energy consumption and take into account the interactions between different energy efficiency measures. In some geographies, the use of simulation models is still rare. Smaller and simpler projects will not require a simulation model as energy savings will be calculated using standard engineering practices and codes and the cost of modelling cannot be justified - although it should be noted that the cost of simulation modelling is falling
Development of proposed projects can be an iterative process. As well as the technical parts of the development process and the savings calculations the developer will also gather capital cost and operating estimates. Depending on the complexity of the projects involved the development process can be in two parts, initial analysis and detailed analysis. Initial analysis will have a wider range of error in savings and cost estimates than is required for a final decision but should be sufficient to make a decision to spend additional resources in detailed development. In the early stages of project development cost estimates can have an accuracy of +/- 10-15% but as project analysis is refined a higher degree of accuracy is required. For large projects accuracy is likely to come from obtaining firm quotes from suppliers and sub-contractors. Project development will also address the procurement approach, the financing approach, and on-going Operations and Maintenance and Measurement and Verification plans.
The outputs from the development process should include:
- technical description and specifications of proposed energy efficiency measures
- projected energy savings
- projected energy cost savings using assumed energy prices
- estimates of capital cost obtained from budgeting or contractor/supplier quotations
- estimates of Operations and Maintenance (O&M) cost throughout the lifetime of the project
- estimates of the value of other financial benefits e.g. asset value, increased productivity etc
- an approach to contracting and implementing the project
- an O&M plan
- a Measurement and Verification (M&V) plan.
The use of internationally recognised processes such as those of the Investor Confidence Project (ICP) help to standardise the development process, reduce due diligence costs, and reduce performance risks. The ICP is an international programme to standardise the development of energy efficiency projects which can reduce performance risk, reduce due diligence costs and enable aggregation of standardised projects. The ICP’s Investor Ready Energy EfficiencyTM (IREE) certification system requires projects to be developed by accredited project developers and to be independently reviewed by independent Quality Assurance professionals. IREE is available across Europe for tertiary building and apartment block projects, and with the support of the European Commission is being further developed to cover projects in industry, street lighting and district energy. Text Box 3.1 gives more detail on the Investor Confidence Project process and additional ICP resources including the Project Development Specification, the Index of National Resources, and various Project Development templates are referenced in the Resources section of this Toolkit.
One of the key issues in energy efficiency projects is that until recently there has not been a standard way of developing and documenting energy efficiency projects; even where there are national or international standards every project developer uses different methodologies. This is in contrast to energy supply investments such as oil and gas or wind power, both of which have standardised approaches. This lack of standardisation has a number of important negative effects for financial institutions looking to deploy capital into energy efficiency. These are:
- increased performance risk
- increased due diligence cost
- challenges in aggregating projects for subsequent refinancing
- challenges in building teams around ad hoc processes.
This issue, along with that of varying quality standards between project developers, is being addressed by the Investor Confidence Project (ICP) which was developed by the Environmental Defense Fund in the US, and then brought to Europe with support from the European Commission’s Horizon 2020 programme. ICP is now administered by Green Business Certification Inc. (GBCI), a not-for-profit that owns or operates a number of sustainability related indicators including: LEED, GRESB, WELL and EDGE.
The ICP has developed a system of project certification – Investor Ready Energy EfficiencyTM (IREE) which requires projects to be developed by an accredited project developer using the ICP Protocols and to be independently assessed by a Quality Assurance professional. IREE cannot guarantee the end result of a project but it certifies that the project developer has a certain level of competency and that a certified project has been developed and documented to an internationally recognised best practice standard.
In Europe, IREE is available in all EU countries (plus Switzerland) and recognises national standards that can be used to achieve IREE certification, thus allowing for local national regulations and standards. IREE is available for tertiary buildings and residential apartment blocks and is under development for industrial projects, street lighting and district energy.
For more information see the ICP resources in the Resources section of this Toolkit and: http://europe.eeperformance.org
For projects that are seeking external financing the output from the development process, along with information on the project host (credit rating etc.), and information on the proposed deal structure, will be shared with financial institutions to elicit offers of finance. Ideally contact should be made with potential funders early in, or prior to, the development process to ensure the requirements of funders can be incorporated into project development.
Ideally from the perspective of the project host seeking funds, one or more lenders/investors would provide indicative term sheets which will become firm commitments upon completion of satisfactory due diligence, and the project host then signs an agreement with one of them to finance the project.
Once an investment case is built up and an investment decision received a project will move into implementation. For larger projects this can include detailed design followed by construction or installation. For smaller projects, sufficiently detailed design may have occurred prior to the investment decision. Once the project is fully installed it will be commissioned to ensure correct operation and then move forward into its operational lifetime.
Types of implementation contracts
Energy efficiency projects can be implemented via several types of contracts and it is important to distinguish the method of energy efficiency project execution from the type of financing. Many of the types of implementation contract used, with some exceptions, are similar to those used in general construction and engineering contracting. A review of the main types of implementation contracts is included in the Resources section of this toolkit.
On commissioning the project will be handed over to the project host and will become operational. Any associated Operations and Maintenance plan or contract will commence and be an important driver of project performance. The energy performance of projects should be tracked through implementation of Measurement and Verification as specified in the M&V plan. M&V protocols are defined in the International Performance Measurement & Verification Protocols (IPMVP). For larger projects, especially those implemented under and Energy Performance Contract where project performance drives the fees to the contractor (ESCO) an independent M&V specialist may be appointed. For smaller projects the cost of M&V has to be considered alongside the magnitude of the benefits and traditionally the results of many projects, both small and large, have not been closely measured using M&V. The falling cost of metering, sensors and communications technology make M&V more viable for smaller projects.
All energy savings measures are estimates of a counterfactual, i.e. how much energy would have been used without the change in equipment or management. In order to evaluate savings methods of Measurement and Verification were formalised in the 1990s under the International Performance Measurement and Verification Protocol (IPMVP), now managed and maintained by the Efficiency Valuation Organisation (EVO). The Investor Confidence Project draws on IPMVP and other sources to establish M&V practices recommended for lenders and seeks to tie those practices to the entire project development, design, construction, commissioning, and monitoring process.
IPMVP sets out different methodologies including: Stipulated savings, Partial or full measurement in isolation, Whole building measurement and Simulation. For an investor or lender to an efficiency project (or indeed for the asset owner) understanding how savings are measured and which party bears the risk is essential to gauging the risk associated with the investment or loan. Further information is included in the Resources section of this Toolkit.
The financial institution’s perspective
The project life cycle from the perspective of the financial institution is essentially in two stages; pre-financing and operations/servicing. Pre-financing includes; origination, underwriting and the investment decision. Operations includes; investment administration, draw down of funds and on-going servicing for the life of the investment.
The origination of energy efficiency projects can be complex. For financial institutions, different routes to originating projects are possible; including working with existing customers, specific equipment vendors, energy consultants and ESCOs. In most markets, however, there remains a shortage of well-developed projects relative to available capital. Some funds and institutions have allocated capital to energy efficiency but have had difficulties in deploying it at the rates originally envisaged. If the energy efficiency finance industry is to scale up to the levels required to address energy and climate goals this issue needs to be addressed.
One method that has been used successfully by International Finance Institutions (IFIs) and others is to provide Technical Assistance (TA) to help project owners to develop projects to the appropriate technical and financial standards. TA in some form is considered vital to create a viable deal flow, especially as despite the advantages of improving energy efficiency, demand remains low. At the EU level, the ELENA facility (http://www.eib.org/products/advising/elena/index.htm) aims at helping project developers prepare and launch large-scale investment programmes in sustainable energy. The ELENA facility is funded by the European Union and is managed by the EIB, it has already catalyzed around EUR 4 billion of investments with around EUR 100 million of EU public funds.
During the pre-financing stage, and probably before a formal decision to move to full underwriting, lenders will perform preliminary due diligence on the project. Project developers, like financiers, generally seek to avoid costly analysis at the pre-development stage before the execution of the project is more certain. Nevertheless, in order to proceed a lender or investor will require basic information that will determine whether a term sheet will be offered. With the exception of the energy assessment, the list below could just as well describe the materials prepared for the acquisition or refinance of an existing building:
- Preliminary energy assessment with recommendations for energy system improvements, cost estimates within ± 15%, and savings estimates.
- Expected sources and uses of financing for the project, reflecting planned equity contributions and expected loan size and terms;
- Pro forma showing cash flows over time. The pro forma will be project-specific where the borrower is special purpose vehicle (SPV). The pro forma will show the impact of the energy efficiency project on the cash flow of the building;
- Rent roll (if the asset is commercial or residential rental);
- Historical financials for the host asset if it is multi-tenant; balance sheet and financials for the occupant if it is owner-occupied or single-tenant;
- Financials of guarantors or off takers, likely required in the case of a special purpose entity and absolutely required for a PPA or comparable off take agreement;
- Comparables, a set of projects of similar type that validate projections in the pro forma. In a real property transaction, these comparables might be rents or sale prices for comparable buildings. For energy projects they are benchmarked energy usages for more efficient buildings or documented savings from comparable projects, based on methods described in the Investor Confidence Project standards;
- Narrative and diagram of contract structure showing roles, responsibilities and contractual obligations of the parties.
Decision to proceed to underwriting
On the basis of the information provided by the project developer (listed above) the financial institution(s) will decide whether or not to proceed to full underwriting and due diligence.
Underwriting is the formal process of determining value and risk leading to a decision to lend or invest. Underwriting will require the finalisation of project information, including more accurate cost and savings estimates, as well as the procurement and contracting approach to be used. The first step in underwriting is the elaboration of a detailed financial model which can be used for valuation, pricing and risk analysis and the results of the modelling may sometimes be used to modify technical and commercial proposals in an iterative process. For larger projects the technical information may be subject to independent due diligence. Requiring developers to use internationally recognised standards such as those of the Investor Confidence Project may reduce the need to carry out technical due diligence.
The financial model, coupled with information on the project host’s credit rating and any relevant accounting and legal input, will form the basis of underwriting which is described in more detail in the Value and Risk Appraisal section of this Toolkit.
Assuming the outcome of the combined processes meets the investment criteria set by the institution a term sheet or offer will be issued. Following negotiations and any required due diligence and approvals required, financial close will occur, leading to draw down of funds to finance construction and commissioning. Upon completion, there will usually be an inspection to ensure the project is built and is performing to specification and the project then enters a stage of servicing during which loan repayments are made as required by the agreement between the financial institution and the host.
Upon approval by the investment committee of an investor or the credit committee of a lender, the parties proceed to prepare legal documentation for the loan or the investment. In an energy efficiency project this element of the process varies little from that of any other kind of loan or investment but energy efficiency projects also have specific milestones that lenders and investors should require in order to ensure effective implementation and help to ensure project outcomes match pre-development projections.
Specific documentation ensures that energy efficiency projects are well-executed and should be required as a conditions precedent for draw down. These include:
- Design, Construction and Verification (DCV) standards specific to the project that clearly explain to engineers and contractors the design intent of the retrofits, the standards to which they will be built and the steps that will be taken to verify both of these elements.
- An Operations and Maintenance (O&M) plan to ensure the installations are managed and cared for properly.
- Most external financing entities make provision for their inspections at specific stages of project completion. In energy efficiency projects, these inspections should be performed by experienced engineers familiar with retrofits who inspect not only for completion of the work but the execution according to the prescribed standards.
- A Measurement and Verification (M&V) plan that sets out the M&V methodology and the reporting frequency and format.
These and other elements of effective external financing documentation for energy efficiency projects are more fully described in the Investor Confidence Project protocols (see the Resources section of this Toolkit).
A critical step in any construction project, whether of a new apartment building or an energy project, is the external financing entity’s final inspection. For energy efficiency projects like many other construction, mechanical and electrical projects, the last stage of project execution is a process called commissioning. New systems and equipment must be tested under various conditions to ensure they run properly. Loan documentation should require this process as well as a reference standard for executing it and link loan draw down to it.
Servicing of a loan or investment follows the terms laid out in the loan or investment agreements. Energy efficiency projects are no different in this regard from any other loan or investment except that, as described above, the requirements of the borrower may differ.
External financing contracts covenants can and should make borrowers responsible for submitting M&V reports to external financial servicers responsible for ensuring that the project performs, and for calling upon guarantees as necessary for those that under-perform. M&V reports can provide useful additional risk management over and above normal management reports as they can highlight problems such as a reduced level of savings as they develop and can be used to trigger corrective action. Maintaining M&V data will also help lenders to begin to assemble reference datasets that can help in underwriting future energy efficiency projects.