One of the well-known issues in implementing sustainable energy projects for both the public and the private sector is the inability for beneficiaries to add further debt on their balance sheets. Reasons are multiple but in general, for a company, this would increase is debt ration which in turn negatively impact its credit standing, whilst for municipalities, such debt, if not fully repaid from savings is consolidated into the national debt under the Eurostat regulations, which then breach the Maastricht rules.
The difference between off and on balance sheet
The distinction lies in the way the balance sheet implications resulting from the contract are treated: whether they appear in the balance sheet or if they are reflected in the written notes to the accounts. Any measure which would be recognised as an asset in the books of the company, with a corresponding debt recognised in the liability, is a clear “on balance sheet” transaction.
In order for a transaction to be off-balance sheet it needs to have certain key characteristics such as:
The installed equipment does not form an asset for the entity benefitting from the retrofits
The subscriber obtains an economic benefit. The economic benefits will not solely accrue to the subscriber, as the promoter (ESCo) will be motivated to increase the savings. Risks and rewards of the transaction are substantially with the promoter (ESCo).
The use of “as-a-service” model: in fact, because in this model the subscriber or end-client effectively pays for the output of the various pieces of equipment, not providing the service to the expected level is a reason for withholding payment.
Why this is important for small and medium-sized companies
For small and medium-sized companies with limited financial resources, off-balance sheet appears the best solution as it doesn’t increase the financial liabilities recognised under liabilities. Thus, the company may choose to use leverage for other corporate purposes, e.g. related to the sales and marketing growth of the company. Off-balance sheet items, whilst a liability carry a certain conditionality with itself. Whilst they are an important concern for investors when assessing a company's financial health through leverage ratios such as debt-to-equity, as the payments are met from savings, these transactions are rather “riskless”
Moreover, contracts that enable off-balance sheet financing for the client should also be seen as an important selling point for Energy Service Companies (ESCos) because they help accelerate deal closure with end-clients who often do not need to have the assets on their own balance sheet.
Building an effective sales messaging towards your clients
Key attributes to cover in the sales messaging towards your clients when treating the projects off balance sheet are financial benefits, but also the infrastructure design benefits, as well as the system operating benefits. It is important to underline that, in order to guarantee an effective and coherent communication, the financial benefits should be shared by the ESCo’s finance professionals to the customer financial evaluator while the design and operational benefits communicated by the technical professionals to the customer’s technical evaluators. This article will focus on the particular relevance of design and operational benefits for small and medium-sized ESCos.
In the EPC environment, the service provider is designing to satisfy specific performance metrics, resulting in an overall better-performing infrastructure with the customer protected contractually so that design and performance risks are always with the service provider. Moreover, as in the case of off-balance sheet EPC, the service provider is designing, developing, building, owning and servicing the installation and equipment. There is no risk of disaggregation among service professionals and a higher attention in preserving system performance over the life of the contract.
In addition, the service provider is incentivized to introduce new technology improvements throughout the life of the agreement to further increase the energy savings and will have the benefit of any investments internally, that can be shared with the clients as appropriate.
Finally, system performance transparency is built into the service given the contractual obligations of both the client and the service provider. All the factors mentioned above result in lower risks for the client, which in turn underpins the treatment of the contract as “off-balance sheet”
Focus on private sector clients
Agreed on the fact that off-balance-sheet represents a powerful tool for both the public and the private sector, if in the first it is widely accepted because of framed systems and regulations in place, the real challenge today is how to address the market entry barriers to its use in the commercial and industrial sectors.
Private sector clients are typically ROI and cash flow focused with shorter investment time horizons. In this case, ESCOs will need to uncover very good energy savings opportunities to fit in that investment window.
The off-balance sheet approach to EPC is well spread in the industrial sector, especially for energy-intensive activities like industrial gases and cogeneration services, where it gives space for consistent cost reductions, and in the commercial sector focused on small-sized projects, with high origination costs and a more sensitive credit environment. For this segment of the market, standardized contracts and competitive financing with low transaction costs are critical.
Ultimately, the larger commercial sector (e.g. retail) continues to be a challenge as the owners of these properties change frequently, leaving the day-to-day management of those assets to third parties that are not incentivized to participate. However, off-balance-sheet financing for these customers represents an important advantage, as it allows them to demonstrate their carbon reduction activities to their investors base, whilst not burdening their tenants with additional operations and maintenance costs as the investment is recovered through utility savings.
In conclusion, the introduction of off-balance-sheet financing and the as-a-service delivery models can be a real game-changer in the energy market, if it is presented and communicated successfully.
The off-balance sheet contract within the LAUNCH project
Given the importance of this point in the contractual agreements to finance sustainable energy projects, the LAUNCH partners have developed a standardized Energy Performance Contract that can be accepted by auditors and Eurostat as being off-balance sheet. This will bring contractors one step closer to financing their project, as it eliminates the financial burden on their clients. A first draft of the LAUNCH SEAD-End Client contract for testing is available on the LAUNCH official website.
To know more on this topic, we invite you to watch the recording of the last LAUNCH webinar: “The key role of off-balance sheet contracts in building a strong sales message” where the project partners covered the topic from both the financial (investor) and the commercial (contractor) perspectives.
[1] D2.1 Draft SEAD-End Client contract for testing V.02, LAUNCH H2020 Project. The document is downloadable on www.launch2020.eu/launch-deliverables
[2] https://www.investopedia.com/articles/investing/071513/understanding-offbalance-sheet-financing.asp
