ESPC Versus Direct Funding for Energy Upgrades
A Defense Logistics Agency installation is evaluating an energy savings performance contract (ESPC) for lighting and HVAC upgrades. The contractor will finance $3.2 million and be repaid from measured energy savings over 12 years. Projected savings are $420,000 in year 1 and escalate 2.5% per year. The contractor receives 80% of actual savings but not less than $310,000 per year. The government pays $25,000 per year for measurement and verification (M&V). The alternative is direct funding with $3.2 million in MILCON funds, which produces the same savings but requires $35,000 per year in government O&M. The real discount rate is 3.0%. The contractor calculates simple payback as 7.6 years ($3.2 million ÷ $420,000). The installation has constrained MILCON funds, and the ESPC is within agency authority. The comptroller must compare the options on a present-value basis, treat the guarantee and M&V correctly, and advise on budget scoring and sensitivity analysis.
1. Evaluate the contractor’s 7.6-year simple payback. What is wrong with it?
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The 7.6-year figure divides the financed amount by gross savings and ignores the government’s actual cash flow. Under the ESPC, the government pays the contractor 80% of savings, so it retains only 20% before M&V. The M&V cost is a real government cost. The guarantee is a floor on the contractor’s payment, not a guaranteed benefit to the government; if savings fall below $387,500, the 80% share is less than $310,000, so the government pays the floor and may have negative net savings. The simple payback also ignores escalation, discounting, and the direct-funding alternative’s O&M. A better simple payback for direct funding would be $3.2 million ÷ ($420,000 − $35,000) ≈ 8.3 years before escalation, but even that is not a present-value measure. The contractor’s payback should not be used as the decision criterion.
2. Compare the ESPC and direct-funding options on a present-value basis. Show your assumptions and calculations.
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Assume savings remain high enough that the 80% share exceeds the $310,000 floor, and use end-of-year cash flows. The 12-year annuity factor at 3% is 9.954. The present value of savings growing 2.5% for 12 years at 3% is $420,000 × [1 − (1.025/1.03)^12]/(0.03 − 0.025) ≈ $420,000 × 11.343 ≈ $4,764,000. For the ESPC, the government keeps 20% of savings: 0.20 × $4,764,000 = $952,800. PV of M&V is $25,000 × 9.954 = $248,850. Net PV of the ESPC ≈ $952,800 − $248,850 = $703,950. For direct funding, net PV = $4,764,000 − PV O&M ($35,000 × 9.954 = $348,390) − $3,200,000 = $1,215,610. Direct funding has the higher net present value by about $511,660, but it requires $3.2 million upfront. If MILCON funds are unavailable or have higher opportunity cost, the ESPC still has positive net PV and may be preferred. If savings fall to $300,000, the floor payment is $310,000 and net cash flow is $300,000 − $310,000 − $25,000 = −$35,000, so the guarantee must be modeled explicitly.
3. What budget-scoring and sensitivity issues should the comptroller address?
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The comptroller must obtain a budget-scoring determination before signing. An ESPC may be scored as an operating lease or as a capital lease/lease-purchase; if the 12-year financing arrangement meets capital-lease criteria, the lease liability may score upfront, potentially requiring procurement funds and eliminating the apparent no-upfront-cost advantage. The contract must include the standard clause making payments subject to the availability of appropriations. M&V is a recurring O&M cost and must be funded each year. The guarantee shifts downside risk to the government, so the comptroller should run sensitivity cases for lower savings, higher M&V costs, lower escalation, a higher discount rate, and contractor nonperformance. The analysis should also consider the baseline methodology, measurement uncertainty, termination costs, and the opportunity cost of constrained MILCON funds. The decision should compare net present value, budget scoring, and risk, not just the contractor’s simple payback.