This article is the third in a series about performance contracts. Read more about the basics of performance contracts and the economics behind them.
Although performance contracts have the potential to create long-term reductions in energy consumption through minimal capital investments, they also come with risk for all parties involved. Applying a risk management approach to all performance contracts can ensure the common risks are overcome or at least minimized.
Four steps to risk management
Risk management can be applied to any scenario, from minimizing the risk you will spill your coffee to minimizing the risks of performance contracts. The four steps are:
- Risk identification – what risks are possible
- Risk quantification – how likely are the risks
- Risk mitigation – implementing solutions to prevent or respond to risks
- Monitoring – Continuously identifying, quantifying and mitigating risks
Step 1: Identify risks
There are two sides in the relationship formed by a performance contract: the service provider (typically an energy service company, ESCO) and the project recipient.
Risk comes in all shapes and forms, and it there are risks for both the service provider and the recipient. The risks were categorized by researchers from Hong Kong in 2015 (1) into the following categories: economic, financial, project design, installation, technology, operational and measurement/verification. Here are some examples of the risks:
| Risk category | Example |
|---|---|
| Economic | Construction costs increase during project implementation |
| Fuel costs increase during the course of the contract | |
| Financial | If financing is required, the is the potential for a payment default |
| Project design | The final design was not appropriate for the building or site |
| Installation | There were delays during construction from weather or staffing shortages |
| Technology | Final design does not operate as expected |
| Equipment is the wrong size for the facility’s needs | |
| Operational | Improper installation or poor maintenance causes equipment to break down often |
| Unexpected energy consumption from changes in weather, operating conditions or load | |
| Measurement and verification | Data is missing or incorrect |
| Modelling is inaccurate or based on faulty assumptions |
Step 2: Quantify Risks
All risks have the potential to arise, but not all are perceived as important. The researchers from Hong Kong (1) conducted a survey of 34 ESCOs in Hong Kong, which have completed a total of 168 projects. Through the survey, they asked what risks are most important to the project recipients.
“Their primary concerns in considering the use of EPC include possible long payback periods, project complexities and repayment ability.”
The risks were different for the service providers.
“Results indicate that the key risks to ESCOs are possible payment default of hosts after installation, uncertainty of baseline measurement, and increase in installation costs in EPC projects.”
Since every project is different, the nature and extent of risks is never the same. Start by considering all possible risks from Step 1 and analyzing for the likelihood they will arise or the scope of impact.
Step 3: minimize or Mitigate risks
Attention during all stages of a performance contract can minimize the risk. Here are some actions to minimize risk recommended by the researchers from Hong Kong:
| Risk category | How to minimize |
|---|---|
| Economic | Price adjustments |
| Interest rate changes |
|
| Fuel cost adjustments |
|
| Guarantee on energy savings |
|
| Project design | Site visits |
| Due diligence |
|
| Design review |
|
| Installation risk | Option to extend installation time |
| Technology | Acceptance tests |
| Careful design | |
| Operational risks | Monitoring and diagnostics |
| Staff training | |
| Planned maintenance | |
| Monitoring and verification | Create and follow M&V guidelines |
| Regular calibration of diagnostic equipment | |
| Sub-metering |
Step 4: Continuous Monitoring
Throughout project planning, implementation and followup, careful monitoring will catch problems as they arise. Ensure staff are aware of what to watch for in all stages of a project.
Help goes a long way
An extra pair of eyes is key to minimizing risk. Rede Energy Solutions can assist in all stages of risk management. We can examine proposals to evaluate and quantify risks, or follow-up throughout a project’s lifetime for third-party monitoring and verification.
Let us help you minimize risk. Contact us today.