A Simple Example to Introduce the Basic Financial Arrangements 81The concept of performance contract is the same idea that stands
behind commercial paper: the fact that a future obligation to pay already
has value today. The future obligation in performance contracting is not
derived from serving a debt but rather from the known and unavoidable
cost of heating, cooling and illuminating buildings or fueling industrial
processes.
Administrators around the world are burdened with obsolete,
money-hungry schools, hospitals, etc. built in the low-energy-cost era of
the 1950s and 1960s. Unfortunately, they cannot see affording to re-equip
these structures with the immensely improved energy-use technologies
that have emerged in recent years. They feel compelled to continue to
throw good money after bad to keep buildings in service.
By a kind of financial judo, performance contracting turns this
grim prospect into an asset. Future utility bills can be discounted, while
the commercial debt and the resulting cash can be used today for ret-
rofits.
PERFORMANCE CONTRACTING IN RETROSPECT
In the late 1970s, Scallop Thermal, a division of Royal Dutch
Shell, introduced the concept of using third-party financing to improve
energy efficiency and cut operating costs in North America. Scallop of-
fered to meet a Philadelphia hospital’s existing energy services for 90
percent of its current utility bill. By upgrading the mechanical system
and implementing energy-efficient practices, Scallop was able to bring
consumption well below the 90 percent level. Scallop both paid for its
services and made a profit from this difference.
These early energy financing agreements generally were based
upon each party receiving a percentage of the energy cost savings.
The energy service company (ESCO) received a share to cover its costs
and make a profit. The owner also received a share (as well as capital
improvements) as an incentive to participate. Since each party received
a share of the energy cost savings, this procedure became known as
“shared savings.”
During the life of the contract, the ESCO expected its percentage
of the cost savings to cover all costs it had incurred, plus deliver a
profit. This concept worked quite well as long as energy prices stayed
the same or increased.