637
CHAPTER 24
UTILITY DEREGULATION AND ENERGY SYSTEM OUTSOURCING
GEORGE R. OWENS, P.E. C.E.M.
Energy and Engineering Solutions, Inc.
24.0 INTRODUCTION
“ Utility Deregulation,” “Customer Choice,” “ Un-
bundled Rates,” “Re-regulation,” “Universal Service
Charge,” “Off Tariff Gas,” “ Stranded Costs,” “Competi-
tive Transition Charge (CTC),” “Caps and Floors,” “ Load
Profi les” and on and on are the new energy buzzwords.
They are all the jargon are being used as customers,
utilities and the new energy service suppliers become
profi cient in doing the business of utility deregulation.
Add to that the California energy shortages and
rolling blackouts, the Northeast and Midwest outages of
2003, scandal, rising energy prices, loss of price protec-
tion in deregulated states and you can see why utility
deregulation is increasingly on the mind of utility cus-
tomers throughout the United States and abroad.
With individual state actions on deregulating
natural gas in the late 80’s and then the passage of the
Energy Policy Act (EPACT) of 1992, the process of de-
regulating the gas and electric industry was begun. Be-
cause of this historic change toward a competitive arena,
the utilities, their customers, and the new energy service
providers have begun to reexamine their relationships.
How will utility customers, each with varying
degrees of sophistication, choose their suppliers of
these services? Who will supply them? What will it
cost? How will it impact comfort, production, tenants

and occupants? How will the successful new players
bring forward the right product to the marketplace to
stay profi table? And how will more and better energy
purchases improve the bottom line?
This chapter reviews the historic relationships
between utilities, their customers, and the new energy
service providers, and the tremendous possibilities for
doing business in new and different ways.
The following fi gure portrays how power is gen-
erated and how it is ultimately delivered to the end
customer.
1. Generator – Undergoing deregulation
2. Generator Substation – See 1
3. Transmission System – Continues to be regulated
by the Federal Energy Regulatory Commission
(FERC) for interstate and by the individual states
for in-state systems
4. Distribution Substation – Continues to be regu-
lated by individual states
5. Distribution Lines – See 4
6. End Use Customer – As a result of deregulation,
will be able to purchase power from a number
of generators. Will still be served by the local
“wires” distribution utility which is regulated by
the state.
24.1 AN HISTORICAL PERSPECTIVE OF
THE ELECTRIC POWER INDUSTRY

At the turn of the century, vertically integrated
electric utilities produced approximately two-fi fths of

the nation’s electricity. At the time, many businesses
(nonutilities) generated their own electricity. When utili-
ties began to install larger and more effi cient generators
and more transmission lines, the associated increase in
convenience and economical service prompted many
industrial consumers to shift to the utilities for their
electricity needs. With the invention of the electric motor
came the inevitable use of more and more home ap-
pliances. Consumption of electricity skyrocketed along
with the utility share of the nation’s generation.
The Power Flow Diagram
638 ENERGY MANAGEMENT HANDBOOK
The early structure of the electric utility industry
was predicated on the concept that a central source of
power supplied by effi cient, low-cost utility generation,
transmission, and distribution was a natural monopoly.
In addition to its intrinsic design to protect consumers,
regulation generally provided reliability and a fair rate
of return to the utility. The result was traditional rate
base regulation.
For decades, utilities were able to meet increasing
demand at decreasing prices. Economies of scale were
achieved through capacity additions, technological ad-
vances, and declining costs, even during periods when
the economy was suffering. Of course, the monopolistic
environment in which they operated left them virtually
unhindered by the worries that would have been created
by competitors. This overall trend continued until the
late 1960s, when the electric utility industry saw decreas-
ing unit costs and rapid growth give way to increasing

unit costs and slower growth.
The passage of EPACT-1992 began the process of
drastically changing the way that utilities, their custom-
ers, and the energy services sector deal (or do not deal)
with each other. Regulated monopolies are out and cus-
tomer choice is in. The future will require knowledge,
fl exibility, and maybe even size to parlay this changing
environment into profi t and cost saving opportunities.
One of the provisions of EPACT-1992 mandates
open access on the transmission system to “wholesale”
customers. It also provides for open access to “exempt
wholesale generators” to provide power in direct compe-
tition with the regulated utilities. This provision fostered
bilateral contracts (those directly between a generator
and a customer) in the wholesale power market. The
regulated utilities then continue to transport the power
over the transmission grid and ultimately, through the
distribution grid, directly to the customer.
What EPACT-1992 did not do was to allow for “re-
tail” open access. Unless you are a wholesale customer,
power can only be purchased from the regulated utility.
However, EPACT-1992 made provisions for the states
to investigate retail wheeling (“wheeling” and “open
access” are other terms used to describe deregulation).
Many states have held or are currently holding hear-
ings. Several states either have or will soon have pilot
programs for retail wheeling. The model being used is
that the electric generation component (typically 60-70%
of the total bill), will be deregulated and subject to full
competition. The transmission and distribution systems

will remain regulated and subject to FERC and state
Public Service Commission (PSC) control.
A new comprehensive energy bill, EPACT-2005, was
signed into law in 2005, just as this edition was being
fi nalized. Look for expanded discussion of EPACT-2005
in future editions of this chapter. This bill affects energy
production, including renewables, energy conservation,
regulations on the country’s transmission grids, utility
deregulation as well as other energy sectors. Tax incen-
tives to spur change are key facets of EPACT-2005.
ELECTRIC INDUSTRY DEREGULATION TIME LINE
1992 - Passage of EPACT and the start of the debate.
1995 & 1996 - The fi rst pilot projects and the start of
special deals. Examples are: The automakers in
Detroit, New Hampshire programs for direct
purchase including industrial, commercial and
residential, and large user pilots in Illinois and
Massachusetts.
1997 - Continuation of more pilots in many states and
almost every state has deregulation on the leg-
islative and regulatory commission agenda.
1998 - Full deregulation in a few states for large users
(i.e., California and Massachusetts). Many states
have converged upon 1/1/98 as the start of
their deregulation efforts with more pilots and
the fi rst 5% roll-in of users, such as Pennsylva-
nia and New York.
2000 - Deregulation of electricity became common for
most industrial and commercial users and began
to penetrate the residential market in several

states. These included Maryland, New Jersey,
New York, and Pennsylvania among others. See
fi gure 24.1.
2002/3- Customers have always had a “backstop” of
regulated pricing. Now that the transition peri-
ods are nearing their end, customers are faced
with the option of buying electricity on the open
market without a regulated default price.
2003 - During the summer, parts of the northeast and
upper Midwest experience a massive blackout
that shuts down businesses and residential
customers. The adequacy of the transmission
system is blamed.
2005 - EPACT-2005 becomes law
24.2 THE TRANSMISSION SYSTEM AND THE
FEDERAL ENERGY REGULATORY COMMISSION’S
(FERC) ROLE IN PROMOTING COMPETITION IN
WHOLESALE POWER

Even before the passage of EPACT in 1992, FERC
played a critical role in the competitive transformation
of wholesale power generation in the electric power
industry. Specifi c initiatives include notices of proposed
UTILITY DEREGULATION AND ENERGY SYSTEM OUTSOURCING 639
rulemaking that proposed steps toward the expansion
of competitive wholesale electricity markets. FERC’s
Order 888, which was issued in 1996, required public
utilities that own, operate, or control transmission lines
to fi le tariffs that were non-discriminatory at rates that
are no higher than what the utility charges itself. These

actions essentially opened up the national transmission
grid to non-discretionary access on the wholesale level
(public utilities, municipalities and rural cooperatives).
This order did not give access to the transmission grid
to retail customers.
In an effort to ensure that the transmission grid
is opened to competition on a non-discriminatory ba-
sis, Independent System Operators (ISO’s) are being
formed in many regions of the country. An ISO is an
independent operator of the transmission grid and is
primarily responsible for reliability, maintenance (even if
the day-to-day maintenance is performed by others) and
security. In addition, ISO’s generally provide the follow-
ing functions: congestion management, administering
transmission and ancillary pricing, making transmission
information publicly available, etc.
24.3 STRANDED COSTS
Stranded costs are generally described as legitimate,
prudent and verifi able costs incurred by a public utility or
a transmitting utility to provide a service to a customer
that subsequently are no longer used. Since the asset or
capacity is generally paid for through rates, ceasing to use
the service leaves the asset, and its cost, stranded. In the
case of de-regulation, stranded costs are created when the
utility service or asset is provided, in whole or in part,
to a deregulated customer of another public utility or
transmitting utility. Stranded costs emerge because new
generating capacity can currently be built and operated
at costs that are lower than many utilities’ embedded
costs. Wholesale and retail customers have, therefore, an

incentive to turn to lower cost producers. Such actions
make it diffi cult for utilities to recover all their prudently
incurred costs in generating facilities.
Stranded costs can occur during the transition to
a fully competitive wholesale power market as some
wholesale customers leave a utility’s system to buy
power from other sources. This may idle the utility’s
existing generating plants, imperil its fuel contracts,
and inhibit its capability to undertake planned system
expansion leading to the creation of “stranded costs.”
During the transition to a fully competitive wholesale
power market, some utilities may incur stranded costs
as customers switch to other suppliers. If power previ-
ously sold to a departing customer cannot be sold to
an alternative buyer, or if other means of mitigating the
stranded costs cannot be found, the options for recover-
ing stranded costs are limited.
The issue of stranded costs has become contentious
in the state proceedings on electric deregulation. Utilities
Retail access is either currently available to all or some customers or will soon be
available. Those states are Arizona, Connecticut, Delaware, District of Columbia, Illinois,
Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio,
Oregon, Pennsylvania, Rhode Island, Texas, and Virginia.
In Oregon, no customers are currently participating in
the State’s retail access program, but the law allows
nonresidential customers access. Yellow colored states are
not actively pursuing restructuring. Those states are Ala-
bama, Alaska, Colorado, Florida, Georgia, Hawaii, Idaho,
Indiana, Iowa, Kansas, Kentucky, Louisiana, Minnesota,
Mississippi, Missouri, Nebraska, North Carolina, North

Dakota, South Carolina, South Dakota, Tennessee, Utah,
Vermont, Washington, West Virginia, Wisconsin, and
Wyoming. In West Virginia, the Legislature and Governor
have not approved the Public Service Commission’s re-
structuring plan, authorized by HB 4277. The Legislature
has not passed a resolution resolving the tax issues of
the PSC’s plan, and no activity has occurred since early
in 2001. A green colored state signifi es a delay in the
restructuring process or the implementation of retail ac-
cess. Those states are Arkansas, Montana, Nevada, New
Mexico, and Oklahoma. California is the only blue colored
state because direct retail access has been suspended.
*As of January 30, 2003, Department of Energy, Energy
Information Administration
Figure 24.1 Status of State Electric Industry Restructuring Activity*
640 ENERGY MANAGEMENT HANDBOOK
have argued vehemently that they are justifi ed in recover-
ing their stranded costs. Customer advocacy groups, on
the other hand, have argued that the stranded costs pro-
posed by the utilities are excessive. This is being worked
out in the state utility commissions. Often, in exchange
for recovering stranded costs, utilities are joining in settle-
ment agreements that offer guaranteed rate reductions
and opening up their territories to deregulation.
24.4 STATUS OF STATE ELECTRIC
INDUSTRY RESTRUCTURING ACTIVITY
Electric deregulation on the retail level is deter-
mined by state activity. Many states have or are in the
process of enacting legislation and/or conducting pro-
ceedings. See Figure 24.1.

24.5 TRADING ENERGY -
MARKETERS AND BROKERS
With the opening of retail electricity markets in
several states, new suppliers of electricity have devel-
oped beyond the traditional vertically integrated electric
utility. Energy marketers and brokers are the new com-
panies that are being formed to fi ll this need. An energy
marketer is one that buys electricity or gas commodity
and transmission services from traditional utilities or
other suppliers, then resells these products. An energy
broker, like a real estate broker, arranges for sales but
does not take title to the product. There are independent
energy marketers and brokers as well as unregulated
subsidiaries of the regulated utility.
According to The Edison Electric Institute, the
energy and energy services market was $360 billion in
1996 and was expected to grow to $425 billion in 2000.
To help put these numbers in perspective, this market is
over six times the telecommunications marketplace. As
more states open for competition, the energy marketers
and brokers are anticipating strong growth. Energy sup-
pliers have been in a merger and consolidation mode for
the past few years. This will probably continue at the
same pace as the energy industry redefi nes itself even
further. Guidance on how to choose the right supplier
for your business or clients will be offered later on in
this chapter
The trading of electricity on the commodities
market is a rather new phenomenon. It has been rec-
ognized that the marketers, brokers, utilities and end

users need to have vehicles that are available for the
managing of risk in the sometimes-volatile electricity
market. The New York Mercantile Exchange (NYMEX)
has instituted the trading of electricity along with its
more traditional commodities. A standard model for an
electricity futures contract has been established and is
traded for delivery at several points around the country.
As these contracts become more actively traded, their
usefulness will increase as a means to mitigate risk. An
example of a risk management play would be when a
power supplier locks in a future price via a futures or
options contract to protect its position at that point in
time. Then if the prices rise dramatically, the supplier’s
price will be protected.
24.6 THE IMPACT OF DEREGULATION
Historically, electricity prices have varied by a
factor of two to one or greater, depending upon where
in the county the power is purchased. See Figure 24.2.
These major differences even occur in utility jurisdic-
tions that are joined. The cost of power has varied
because of several factors, some of which are under the
utilities control and some that are not, such as:
• Decisions on projected load growth
• The type of generation
• Fuel selections
• Cost of labor and taxes
• The regulatory climate
All of these factors contribute to the range of pricing.
Customers have been clamoring for the right to choose
the supplier and gain access to cheaper power for quite

some time. This has driven regulators to impose utility
deregulation, often with opposition from the incumbent
utilities.
Many believe that electric deregulation will even
out this difference and bring down the total average
price through competition. There are others that do
not share that opinion. Most utilities are already tak-
ing actions to reduce costs. Consolidations, layoffs, and
mergers are occurring with increased frequency. As
part of the transition to deregulation, many utilities are
requesting and receiving rate freezes and reductions in
exchange for stranded costs.
One factor has remained a constant until the early
2000’s. Customers have always had a “backstop” of
regulated pricing until recently. Now that the transition
periods are nearing their end, customers are faced with
the option of buying electricity on the open market
without a regulated default price. The risks to custom-
ers have increased dramatically. And, energy consultants
UTILITY DEREGULATION AND ENERGY SYSTEM OUTSOURCING 641
and ESCOs are having a diffi cult time predicting the
direction of electricity costs.
All of this provides for interesting background and
statistics, but what does it mean to energy managers
interested in providing and procuring utilities, com-
missioning, O&M (operations and maintenance), and
the other energy services required to build and operate
buildings effectively? Just as almost every business en-
terprise has experienced changes in the way that they
operate in the 90’s and 2000 and beyond, the electric

utilities, their customers and the energy service sector
must also transform. Only well-prepared companies will
be in a position to take advantage of the opportunities
that will present themselves after deregulation. Building
owners and managers need to be in a position to actively
participate in the early opening states. The following
questions will have to be answered by each and every
company if they are to be prepared:
• Will they participate in the deregulated electric
market?
• Is it better to do a national account style supply
arrangement or divide the properties by region
and/or by building type?
• How will electric deregulation affect their relation-
ships with tenants in commercial, governmental
and institutional properties?
• Would there be a benefi t for multi-site facilities to
partake in purchasing power on their own?
• Should the analysis and operation of electric de-
regulation efforts be performed in-house or by
consultants or a combination?
• What criteria should be used to select the energy
suppliers when the future is uncertain?
24.7 THE TEN-STEP PROGRAM TO
SUCCESSFUL UTILITY DEREGULATION
In order for the building sector to get ready for
the new order and answer the questions raised above,
this ten-step program has been developed to ease the
transition and take advantage of the new opportunities.
This Ten Step program is ideally suited to building own-

ers and managers as well as energy engineers that are
in the process of developing their utility deregulation
program.
Step #1 - Know Thyself
• When do you use the power
• Distinguish between summer vs. winter, night vs.
day
Figure 24.2 Electricity Cost by State
Average Revenue from Electric Sales to Industrial Consumers by State, 1995 (Cents per Kilowatt-hour)
642 ENERGY MANAGEMENT HANDBOOK
• What load can you control/change
• What $$$ goal does your business have
• What is your 24 hr. load profi le
• What are your in-house engineering, monitoring
and fi nancial strengths
Step #2 - Keep Informed
• Read, read, read—network, network, network
• Interact with your professional organizations
• Talk to vendors, consultants, and contractors
• Subscribe to trade publications
• Attend seminars and conferences
• Utilize internet resources—news groups, WWW,
E-mail
• Investigate buyer’s groups
Step #3 - Talk to Your Utilities (all energy types)
• Recognize customer relations are improving
• Discuss alternate contract terms or other energy
services
• Find out if they are “for” or “agin” deregulation
• Obtain improved service items (i.e., reliability)

• Tell them your position and what you want. Now
is not the time to be bashful
• Renegotiate existing contracts
Step #4 - Talk to Your Future Utility(ies)
• See Step #3
• Find out who is actively pursuing your market
• Check the neighborhood, check the region, look
nationally
• Develop your future relationships
• Partner with Energy Service Companies (ESCOs),
power marketing, fi nancial, vendor and other part-
ners for your energy services needs
Step #5 - Explore Energy Services Now
(Why wait for deregulation?)
• Implement “standard” energy projects such as
lighting, HVAC, etc.
• Investigate district cooling/heating
• Explore selling your central plant
• Calculate square foot pricing
• Buy comfort, Btus or GPMs; not kWhs
• Outsource your Operations and Maintenance
• Consider other work on the customer side of the
meter
Step #6 - Understand the Risks
• Realize that times will be more complicated in the
future
• Consider the length of a contract term in uncertain
times
• Identify whether you want immediate reductions
now, larger reductions later or prices tied to some

other index
• Determine the value of a fl at price for utilities
• Be wary of losing control of your destiny-turning
over some of the operational controls of your en-
ergy systems
• Realize the possibility some companies will not be
around in a few years
• Determine how much risk you are willing to take
in order to achieve higher rewards
Step #7 - Solicit Proposals
• Meet with the bidders prior to issuing the Request
For Proposal (RFP)
• Prepare the RFP for the services you need
• Identify qualifi ed players
• Make commissioning a requirement to achieve the
results
Step #8 - Evaluate Options
• Enlist the aid of internal resources and outside
consultants
• Narrow the playing fi eld and interview the fi nal-
ists prior to awarding
• Prepare a fi nancial analysis of the results over the
life of the project—Return on Investment (ROI) and
Net Present Value (NPV)
• Remember that the least fi rst cost may or may not
be the best value
• Pick someone that has the fi nancial and technical
strengths for the long term
• Evaluate financial options such as leasing or
shared

Step #9 - Negotiate Contracts
Remember the following guidelines when negotiat-
ing a contract:
• The longer the contract, the more important the
escalation clauses due to compounding
• Since you may be losing some control, the contract
document is your only protection
• The supplying of energy is not regulated like the
supplying of kWhs are now
• The clauses that identify the party taking responsi-
bility for an action, or “Who Struck John” clauses,
are often the most diffi cult to negotiate
• Include monitoring and evaluation of results
• Understand how the contract can be terminated
and what the penalties for early termination are
Step #10 - Sit Back and Reap the Rewards
• Monitor, measure, and compare
UTILITY DEREGULATION AND ENERGY SYSTEM OUTSOURCING 643
• Don’t forget Operations & Maintenance for the
long term
• Keep looking, there are more opportunities out
there
• Get off your duff and go to Step #1 for the next
round of reductions
24.8 AGGREGATION
Aggregation is the grouping of utility customers
to jointly purchase commodities and/or other energy
services. There are many aggregators already formed or
being formed in the states where utility deregulation is
occurring. There are two basic forms of aggregation:

1. Similar Customers with Similar Needs
Similar customers may be better served via aggre-
gation even if they have the same load profi les
• Pricing and risk can be tailored to similar cus-
tomers needs
• Similar billing needs can be met
• Cross subsidization would be eliminated
• Trust in the aggregator; i.e. BOMA for offi ce
building managers membership
2. Complementary Customers that May Enhance the
Total
Different load profi les can benefi t the aggregated
group by combining different load profi les.
• Match a manufacturing facility with a fl at or
inverted load profi le to an offi ce building that
has a peaky load profi le, etc.
• Combining of load profi les is more attractive to
a supplier than either would be individually
Why Aggregate?
Some potential advantages to aggregating are:
• Reduction of internal administration expense
• Shared consulting expenses
• More supplier attention resulting from a larger
bid
• Lower rates may be the result of a larger bid
• Lower average rates resulting from combining dis-
similar user profi les
Why Not Aggregate?
Some potential disadvantages from aggregating
are:

• If you are big enough, you are your own aggrega-
tion
• Good load factor customers may subsidize poor
load factor customers
• The average price of an aggregation may be lower
than your unique price
• An aggregation cannot meet “unique” customer
requirements
Factors that affect the decision on joining an aggrega-
tion
Determine if an aggregation is right for your
situation by considering the following factors. An
understanding of how these factors apply to your
operation will result in an informed decision.
• Size of load
• Load profi le
• Risk tolerance
• Internal abilities (or via consulting)
• Contract length fl exibility
• Contract terms and conditions fl exibility
• Regulatory restrictions
24.9 IN-HOUSE VS. OUTSOURCING
ENERGY SERVICES
The end user sector has always used a combination
of in-house and outsourced energy services. Many large
managers and owners have a talented and capable staff
to analyze energy costs, develop capital programs, and
operate and maintain the in-place energy systems. Oth-
ers (particularly the smaller players who cannot justify
an in-house staff) have outsourced these functions to

a team of consultants, contractors, and utilities. These
relationships have evolved recently due to downsizing
and returning to the core businesses. In the new era of
deregulation, the complexion of how energy services are
delivered will evolve further.
Customers and energy services companies are al-
ready getting into the utility business of generating and
delivering power. Utilities are also getting into the act
by going beyond the meter and supplying chilled/hot
water, conditioned air, and comfort. In doing so, many
utilities are setting up unregulated subsidiaries to pro-
vide commissioning, O&M, and many other energy
services to customers located within their territory, and
nationwide as well.
A variety of terms are often used: Performance
Contracting, Energy System Outsourcing, Utility Plant
Outsourcing, Guaranteed Savings, Shared Savings,
Sell/Leaseback of the central plant, Chauffage (used in
Europe), Energy Services Performance Contract (ESPC),
etc. Defi nitions are as follows:
• Performance Contracting
Is the process of providing a specifi c improvement
644 ENERGY MANAGEMENT HANDBOOK
such as a lighting retrofi t or a chiller change-out,
usually using the contractor’s capital and then pay-
ing for the project via the savings over a specifi c
period of time. Often the contractor guarantees a
level of savings. The contractor supplies capital,
engineering, equipment, installation, commission-
ing and often the maintenance and repair.

• Energy System Outsourcing
Is the process of divesting of the responsibilities
and often the assets of the energy systems to a
third party. The third party then supplies the
commodity, whether it be chilled water, steam,
hot water, electricity, etc., at a per unit cost. The
third party supplier then is responsible for the
improvement capital and operations and mainte-
nance of the energy system for the duration of the
contract.
Advantages
The advantages of a performance contract or an
energy system outsourcing project revolves around four
major areas:
1. Core Business Issues
Many industries and corporations have been re-
examining all of their non-core functions to deter-
mine if they would be better served by outsourcing
these functions. Performance contracting or out-
sourcing can make sense if someone can be found
that can do it better and cheaper than what can be
managed by an in-house staff. Then the building
managers can oversee the contractor and not the
complete operation. This may allow the building
to devote additional time and resources to other
core business issues such as increasing revenues
and reducing health care costs.
2. Monetization
One of the unique features of a performance con-
tract or an energy system outsourcing project is

the opportunity to obtain an up front payment.
There is an extreme amount of fl exibility available
depending upon the needs. The amount available
can range from zero dollars to the approximate
current value of the installation. The more value
placed on the up front payment will necessarily
cause the monthly payments to increase as well as
the total amount of interest paid.
3. Deferred Capital Costs
Many electrical and HVAC energy systems are at
an age or state of repair that would necessitate
the infusion of a major capital investment in the
near future. These investments are often required
to address end-of-life, regulatory and effi ciency is-
sues. Either the building owner or manager could
provide the capital or a third party could supply
it and then include the repayment in a commodity
charge plus interest; (“there are no free lunches”).
4. Operating Costs
The biggest incentive to a performance contract
or an energy system outsourcing project is that if
the right supplier is chosen with the right incen-
tives, then the total cost to own and operate the
central plant can be less. The supplier, having
expertise and volume in their core area of energy
services, brings this to reality. With this expertise
and volume, the supplier should be able to pur-
chase supplies at less cost, provide better-trained
personnel and implement energy and maintenance
saving programs. These programs can range from

capital investment of energy saving equipment to
optimizing operations, maintenance and control
programs.
Disadvantages
Potentially, there are several disadvantages to
undertaking a performance contract or an outsourcing
project. The items identifi ed in this section need to be
recognized and mitigated as indicated here and in the
Risk Management section.
1. Loss of Control
As with any service, if it is outsourced, the service
is more diffi cult to control. The building is left with
depending upon the skill, reliability and dedication
of the service supplier and the contract to obtain
satisfactory results. Even with a solid contract; if
the supplier does not perform or goes out of busi-
ness, the customer will suffer (see the Risk Man-
agement section). Close coordination between the
building and the supplier will be necessary over
the long term of the contract to adjust to changing
conditions.
2. Loss of Flexibility
Unless addressed adequately in the contract,
changes that the building wants or needs to make
can cause the economics of the project to be ad-
versely affected. Some examples are:
• Changes in hours of operation
• New systems that require additional cooling
or heating, such as an expansion or renova-
UTILITY DEREGULATION AND ENERGY SYSTEM OUTSOURCING 645

tion, conversion of offi ce or storage space to
other uses, additional equipment requiring
additional cooling, etc.
• Scheduling outages for maintenance or re-
pairs
• Using in house technicians for other services
throughout the building. If this situation oc-
curs in current operation, provisions for ad-
ditional building staff or having the supplier
make the technician available needs to be ar-
ranged. If additional costs are indicated, they
should be included in the fi nancial analysis.
3. Cost Increases
This only becomes a disadvantage if the contract
does not adequately foresee and cover every con-
tingency and changing situation adequately. To
protect themselves, the suppliers will try to put
as much cost risk onto the customer as possible.
It is the customer and the customer’s consultants
and attorneys responsibility to defi ne the risks and
include provisions in the contract.
Financial Issues
The basis for success of a performance contract
or an energy system outsourcing project is divided
between the technical issues, contract terms, supplier’s
performance and how the project will be fi nanced. These
types of projects are as much (if not more) about the
fi nancial deal than the actual supplying of a commodity
or a service. (See Chapter 4 -Economic Analysis and Life
Cycle Costing) The answers to some basic questions will

help guide the decision making process.
• Is capital required during the term of the project?
The question of the need for capital is one of the
major driving factors of a performance contract
or an energy outsourcing project. Capital invested
into the HVAC and electrical systems for effi ciency
upgrades, end of life replacements, increased reli-
ability or capacity and environmental improve-
ments can be fi nanced through the program.
• Who will supply the capital and at what rate?
The answer to the question of who will be supply-
ing the capital should be made based upon your
ability to supply capital from internal operations,
capital improvement funds, borrowing ability and
any special financing options such as tax free
bonds or other low interest sources. If capital is
needed for other uses such as expansions and other
revenue generating or cost reduction measures,
then energy system outsourcing may be a good
choice.
• Is there a desire to obtain a payment up front?
As stated previously, a performance contract or
energy system outsourcing project presents the
opportunity to obtain a payment up front for the
assets of the HVAC and electrical systems. How-
ever, any up-front payment increases the monthly
payment over the term of the contract and should
be considered similar to a loan.
• Does the capital infusion and better operations generate
enough cash fl ow to pay the debt?

This is the sixty-four dollar question. Only by
performing a long-term evaluation of the eco-
nomics of the project with a comparison to the
in house plan can the fi nancial benefi ts be fairly
compared. A Net Present Value and Cash Flow
analysis should be used for the evaluation of a
performance contract or energy system outsourc-
ing project. It shows the capital and operating im-
pact of the owner continuing to own and operate
a HVAC and electrical systems. This is compared
to a third party outsourced option. The analysis
should be for a long enough period to incor-
porate the effect of a major capital investment.
This is often done for a 20-year period. This type
of analysis would allow the building owner or
manager to evaluate the fi nancial impact of the
project over the term of the contract. Included in
the analysis should be a risk sensitivity assess-
ment that would bracket and defi ne the range of
results based upon changing assumptions.
Other Issues
1. Management and Personnel Issues
• Management - Usually, an in-house manager will
need to be assigned to manage the supplier and the
contract and to verify the accuracy of the billing.
An in-house technical person or an outside consul-
tant should have the responsibility to periodically
review the condition of the equipment to protect
the long-term value of the central plant.
• Personnel - Existing employees need to be consid-

ered. This may or may not have a monetary conse-
quence due to severance or other policies. If there
is an impact, it needs to be refl ected in the analysis.
It would usually be to the building’s benefi t if the
years of knowledge and experience represented by
the current engineers could be transferred to the
646 ENERGY MANAGEMENT HANDBOOK
new supplier. Another personnel concern is the
effect on the moral of the employees due to their
fear of losing their jobs.
2. Which services to outsource?
Where there are other services located in the cen-
tral plant that are not outsourced, these need to be
identifi ed in the documents. These could include
compressed air for controls, domestic water, hot
water, etc. A method of allocating costs for shared
services will need to be established and managed
through the duration of the contract.
3. Product specifi cations
The properties of the supplied service need to be
adequately described to judge if the supplier is
meeting the terms of the contract. Quantities like
temperature, water treatment values, pressure, etc.
needs to be well defi ned.
4. Early Termination
There should be several options in the contract for
early termination. The most obvious is for lack of
performance. In this case, lack of performance can
range from total disruption of service to not meet-
ing the defi ned values of the commodity to letting

the equipment deteriorate. There should also be
the ability to have the building owner terminate
the contract if the building owner decides that they
want to take the central plant in-house or fi nd an-
other contractor. If the supplier is in default, then
a “make whole” payment would be required of the
building to terminate the contract in this case.
Risk Management
As with any long-term commitment, the most
important task is to identify all of the potential risks,
evaluate their consequences and probability and then
to formulate strategies that will mitigate the risks. This
could be in the form of the contract document language
or other fi nancial instruments for protection. One of the
most important areas of risk management mitigation is
to choose a supplier that will deliver what is promised
over the entire contract period.
1. How to Choose a Supplier
In addition to price, the following factors are im-
portant to the success of a project and should be
evaluated before selecting a supplier.
• Track record
• Knowledge of your business, priorities and
risk tolerance
• Size
• Financial backing
• Customer service and reporting
• “Staying Power”
2. Long Term Contracts
Because the potential supplier will be investing

capital for increased life, reliability and effi ciency,
the contract needs to be long enough to recover
the costs and provide a positive cash fl ow. The
length of the project can vary from three to fi ve
years for a simple, small-scale project up to ten to
twenty years for one of increased complexity. Cost
impacts at the termination of the contract needs to
be adequately addressed, such as:
• Renewals
• Buyouts
• Equipment leases
• Equipment condition at the end of the con-
tract
3. Changing Assumptions
• Interest rates
• Utility rates
• Maintenance and repair costs
• Areas served (i.e., expansions/renovations/
contractions)
• Regulations; building specifi c, environmental,
OSHA, local codes, etc.
• Utility deregulation
4. Other Risks
• The impact of planned or unplanned outages
of the central plant
• The consequences of the supplier not being
able to maintain chilled water temperature or
steam pressure
• “Take or Pay” This provision of a contract
requires the customer to pay a certain amount

even if they do not use the commodity
• Defaults and Remedies
24.10 SUMMARY
This chapter presented information on the chang-
ing world of the utility industry in the new millennium.
Starting in the 80’s with gas deregulation and the pas-
sage of the Energy Policy Act of 1992 for electricity,
the method of providing and purchasing energy was
changed forever. Utilities began a slow change from
vertically integrated monopolies to providers of regu-
lated wires and transmission services. Some utilities
UTILITY DEREGULATION AND ENERGY SYSTEM OUTSOURCING 647
continued to supply generation services, through their
unregulated enterprises and by independent power
producers in the deregulated markets while others sold
their generation assets and became “wires” companies.
Customers became confused in the early stages of de-
regulation, but by the end of the 1990’s some became
more knowledgeable and successful in buying deregu-
lated natural gas and electricity.
In the early 2000’s, diffi culties have developed in
the deregulated utility arena. California rescinded de-
regulation (except for existing contracts) after shortages,
rolling blackouts and price increases sent the utilities
into a tailspin. The great blackout of 2003 raises concerns
about the reliability of the transmission system. And the
loss of regulated rates provides more challenges to cus-
tomers and their consultants. However, many custom-
ers continue to participate in the deregulated markets
to obtain reduced (or stable) prices, reduce their risk

of big price swings and incorporate energy reduction
programs with energy procurement programs.
Another result of deregulation has been a re-exami-
nation by customers of outsourcing their energy needs.
Some customers have “sold” their energy systems to
energy suppliers and are now purchasing Btus instead
of kWhs. The energy industry responded with energy
service business units to meet this new demand for out-
sourcing. Performance contracting and energy system
outsourcing can be advantageous when the organization
does not have internal expertise to execute these projects
and when other sources of capital are needed. However,
performance contracting and energy system outsourcing
is not without peril if the risks are not understood and
mitigated. Before undertaking a performance contract or
energy system outsourcing project, the owner or man-
ager fi rst needs to defi ne the fi nancial, technical, legal
and operational issues of importance. Next, the proper
resources, whether internal or outsourced, need to be
marshaled to defi ne the project, prepare the Request
for Proposal, evaluate the suppliers and bids, negotiate
a contract and monitor the results, often over a long
period. If these factors are properly considered and
executed, the performance contract or energy system
outsourcing often produce results that could not be
obtained via other project methods.
BIBLIOGRAPHY
Power Shopping and Power Shopping II, A publication of the
Building Owners and Managers Association (BOMA)
International, 1201 New York Avenue, N.W., N.W., Suite

300, Washington, DC 20005.
The Changing Structure of the Electric Power Industry: Historical
Overview, United States Department of Energy, Energy
Information Administration, Washington, DC.
The Ten Step Program to Successful Utility Deregulation for Build-
ing Owners and Managers, George R Owens PE CEM,
President Energy and Engineering Solutions, Inc. (EESI),
9449 Penfi eld Ct., Columbia, MD 21045.
Performance Contracting and Energy System Outsourcing, George
R Owens PE CEM, President Energy and Engineering
Solutions, Inc. (EESI), 9449 Penfi eld Ct., Columbia, MD
21045.
Generating Power and Getting It to The Consumer, Edison Electric
Institute, 701 Pennsylvania Ave NW, Washington, DC,
20004.
The Changing Structure of the Electric Power Industry: An Update,
US Department of Energy, Energy Information Adminis-
tration, DOE/EIA-0562(96)
PJM Electricity Futures, New York Mercantile Exchange (NY-
MEX) web page, www.nymex.com
SOME USEFUL INTERNET RESOURCES
10 Step paper - www.eesienergy.com
State activities - www.eia.doe.gov/cneaf/electricity/chg_str/
State regulatory commissions www.naruc.org
Utilities - www.utilityconnection.com
Maillist -
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649
ERIC A. WOODRUFF, PH.D., CEM, CEP, CLEP
Johnson Controls, Inc.

25.1 INTRODUCTION
Financing can be a key success factor for projects.
This chapter’s purpose is to help facility managers
understand and apply the fi nancial arrangements avail-
able to them. Hopefully, this approach will increase
the implementation rate of good energy management
projects, which would have otherwise been cancelled or
postponed due to lack of funds.
Most facility managers agree that energy manage-
ment projects (EMPs) are good investments. Generally,
EMPs reduce operational costs, have a low risk/reward
ratio, usually improve productivity and even have been
shown to improve a fi rm’s stock price.
1
Despite these
benefi ts, many cost-effective EMPs are not implemented
due to fi nancial constraints. A study of manufacturing
facilities revealed that fi rst-cost and capital constraints
represented over 35% of the reasons cost-effective EMPs
were not implemented.
2
Often, the facility manager does
not have enough cash to allocate funding, or can not get
budget approval to cover initial costs. Financial arrange-
ments can mitigate a facility’s funding constraints,
3
al-
lowing additional energy savings to be reaped.
Alternative finance arrangements can overcome
the “initial cost” obstacle, allowing fi rms to implement

more EMPs. However, many facility managers are either
unaware or have diffi culty understanding the variety
of fi nancial arrangements available to them. Most facil-
ity managers use simple payback analyses to evalu-
ate projects, which do not reveal the added value of
after-tax benefi ts.
4
Sometimes facility managers do not
implement an EMP because fi nancial terminology and
contractual details intimidate them.
5
To meet the growing demand, there has been a
dramatic increase in the number of fi nance companies
specializing in EMPs. At a recent World Energy Engi-
neering Congress, fi nance companies represented the
most common exhibitor type. These fi nanciers are intro-
ducing new payment arrangements to implement EMPs.
Often, the fi nancier’s innovation will satisfy the unique
customer needs of a large facility. This is a great service
however, most fi nanciers are not attracted to small facili-
ties with EMPs requiring less than $100,000. Thus, many
facility managers remain unaware or confused about the
common fi nancial arrangements that could help them
implement EMPs.
Numerous papers and government programs have
been developed to show facility managers how to use
quantitative (economic) analysis to evaluate fi nancial
arrangements.
4,5,6
(Refer to Chapter 4 of this book.)

Quantitative analysis includes computing the simple payback,
net present value (NPV), internal rate of return (IRR), or life-
cycle cost of a project with or without fi nancing. Although
these books and programs show how to evaluate the
economic aspects of projects, they do not incorporate
qualitative factors like strategic company objectives,
(which can impact the fi nancial arrangement selection).
Without incorporating a facility manager’s qualitative
objectives, it is hard to select an arrangement that meets
all of the facility’s needs. A recent paper showed that
qualitative objectives can be at least as important as
quantitative objectives.
9
This chapter hopes to provide some valuable infor-
mation, which can be used to overcome the previously
mentioned issues. The chapter is divided into several
sections to accomplish three objectives. Sections 2 and
3 introduce the basic fi nancial arrangements via a simple
example. In sections 4 and 5, fi nancial terminology is
defi ned and each arrangement is explained in greater
detail while applied to a case study. The remaining sec-
tions show how to match fi nancial arrangements to different
projects and facilities.
25.2 FINANCIAL ARRANGEMENTS:
A SIMPLE EXAMPLE
Consider a small company “PizzaCo” that makes
frozen pizzas, and distributes them regionally. PizzaCo
uses an old delivery truck that breaks down frequently
and is ineffi cient. Assume the old truck has no salvage
value and is fully depreciated. PizzaCo’s management

would like to obtain a new and more effi cient truck to
reduce expenses and improve reliability. However, they
do not have the cash on hand to purchase the truck.
Thus, they consider their fi nancing options.
CHAPTER 25
FINANCING ENERGY MANAGEMENT PROJECTS
650 ENERGY MANAGEMENT HANDBOOK
25.2.1 Purchase the Truck with a Loan or Bond
Just like most car purchases, PizzaCo borrows
money from a lender (a bank) and agrees to a monthly
re-payment plan. Figure 25.1 shows PizzaCo’s annual
cash fl ows for a loan. The solid arrows represent the
fi nancing cash fl ows between PizzaCo and the bank.
Each year, PizzaCo makes payments (on the principal,
plus interest based on the unpaid balance), until the
balance owed is zero. The payments are the negative
cash fl ows. Thus, at time zero when PizzaCo borrows
the money, they receive a large sum of money from the
bank, which is a positive cash fl ow (which will be used
to purchase the truck).
The dashed arrows represent the truck purchase as
well as savings cash fl ows. Thus, at time zero, PizzaCo
purchases the truck (a negative cash flow) with the
money from the bank. Due to the new truck’s greater ef-
fi ciency, PizzaCo’s annual expenses are reduced (which
is a savings). The annual savings are the positive cash
fl ows. The remaining cash fl ow diagrams in this chapter
utilize the same format.
PizzaCo could also purchase the truck by selling a
bond. This arrangement is similar to a loan, except in-

vestors (not a bank) give PizzaCo a large sum of money
(called the bond’s “par value”). Periodically, PizzaCo
would pay the investors only the interest accumulated.
As Figure 25.2 shows, when the bond reaches maturity,
PizzaCo returns the par value to the investors. The
equipment purchase and savings cash flows are the
same as with the loan.
25.2.2 Sell Stock to Purchase the Truck
In this arrangement, PizzaCo sells its stock to raise
money to purchase the truck. In return, PizzaCo is ex-
pected to pay dividends back to shareholders. Selling
stock has a similar cash fl ow pattern as a bond, with a
few subtle differences. Instead of interest payments to
bondholders, PizzaCo would pay dividends to share-
holders until some future date when PizzaCo could buy
the stock back. However, these dividend payments are
not mandatory, and if PizzaCo is experiencing fi nancial
strain, it does not need to distribute dividends. On the
other hand, if PizzaCo’s profi ts increase, this wealth will
be shared with the new stockholders, because they now
own a part of the company.
25.2.3 Rent the Truck
Just like renting a car, PizzaCo could rent a truck
for an annual fee. This would be equivalent to a true
lease. The rental company (lessor) owns and maintains
the truck for PizzaCo (the lessee). PizzaCo pays the
rental fees (lease payments) which are considered tax-
deductible business expenses.
Figure 25.3 shows that the lease payments (solid
arrows) start as soon as the equipment is leased (year

zero) to account for lease payments paid in advance.
Lease payments “in arrears” (starting at the end of the
fi rst year) could also be arranged. However, the leasing
company may require a security deposit as collateral.
Notice that the savings cash fl ows are essentially the
same as the previous arrangements, except there is no
equipment purchase, which is a large negative cash fl ow
at year zero.
Figure 25.1 PizzaCo’s Cash Flows for a Loan.
Figure 25.2 PizzaCo’s Cash Flows for a Bond.
Figure 25.3. PizzaCo’s Cash Flows for a True Lease.
FINANCING ENERGY MANAGEMENT PROJECTS 651
In a true lease, the contract period should be short-
er than the equipment’s useful life. The lease is cancel-
able because the truck can be leased easily to someone
else. At the end of the lease, PizzaCo can either return
the truck or renew the lease. In a separate transaction,
PizzaCo could also negotiate to buy the truck at the fair
market value.
If PizzaCo wanted to secure the option to buy the
truck (for a bargain price) at the end of the lease, then
they would use a capital lease. A capital lease can be
structured like an installment loan, however owner-
ship is not transferred until the end of the lease. The
lessor retains ownership as security in case the lessee
(PizzaCo) defaults on payments. Because the entire cost
of the truck is eventually paid, the lease payments are
larger than the payments in a true lease, (assuming
similar lease periods). Figure 25.4 shows the cash fl ows
for a capital lease with advance payments and a bargain

purchase option at the end of year fi ve.
There are some additional scenarios for lease ar-
rangements. A “vendor-fi nanced” agreement is when
the lessor (or lender) is the equipment manufacturer.
Alternatively, a third party could serve as a fi nancing
source. With “third party fi nancing,” a fi nance company
would purchase a new truck and lease it to PizzaCo.
In either case, there are two primary ways to repay the
lessor.
1. With a “fi xed payment plan”; where payments are
due whether or not the new truck actually saves
money.
2. With a “fl exible payment plan”; where the sav-
ings from the new truck are shared with the third
party, until the truck’s purchase cost is recouped
with interest. This is basically a “shared savings”
arrangement.
25.2.4 Subcontract Pizza Delivery to a Third Party
Since PizzaCo’s primary business is not delivery,
it could subcontract that responsibility to another com-
pany. Let’s say that a delivery service company would
provide a truck and deliver the pizzas at a reduced cost.
Each month, PizzaCo would pay the delivery service
company a fee. However, this fee is guaranteed to be
less than what PizzaCo would have spent on delivery.
Thus, PizzaCo would obtain savings without investing
any money or risk in a new truck. This arrangement is
analogous to a performance contract.
This arrangement is very similar to a third-party
lease and a shared savings agreement. However with a

performance contract, the contractor assumes most of
the risk, (because they supply the equipment, with little
or no investment from PizzaCo). The contractor also
is responsible for ensuring that the delivery fee is less
than what PizzaCo would have spent. For the PizzaCo
example, the arrangement would designed under the
conditions below.
• The delivery company owns and maintains the
truck. It also is responsible for all operations re-
lated to delivering the pizzas.
• The monthly fee is related to the number of pizzas
delivered. This is the performance aspect of the
contract; if PizzaCo doesn’t sell many pizzas, the
fee is reduced. A minimum amount of pizzas may be
required by the delivery company (performance con-
tractor) to cover costs. Thus, the delivery company
assumes these risks:
1. PizzaCo will remain solvent, and
2. PizzaCo will sell enough pizzas to cover
costs, and
3. the new truck will operate as expected and
will actually reduce expenses per pizza, and
4. the external fi nancial risk, such as infl ation
and interest rate changes, are acceptable.
• Because the delivery company is fi nancially strong
and experienced, it can usually obtain loans at low
interest rates.
• The delivery company is an expert in delivery; it
has specially skilled personnel and uses effi cient
equipment. Thus, the delivery company can de-

liver the pizzas at a lower cost (even after adding
a profi t) than PizzaCo.
Figure 25.5 shows the net cash fl ows according to
PizzaCo. Since the delivery company simply reduces
Figure 25.4 PizzaCo’s Cash Flows for a Capital Lease.
652 ENERGY MANAGEMENT HANDBOOK
PizzaCo’s operational expenses, there is only a net sav-
ings. There are no negative fi nancing cash fl ows. Unlike
the other arrangements, the delivery company’s fee is a
less expensive substitute for PizzaCo’s in-house delivery
expenses. With the other arrangements, PizzaCo had to
pay a specifi c fi nancing cost (loan, bond or lease pay-
ments, or dividends) associated with the truck, whether
or not the truck actually saved money. In addition, Piz-
zaCo would have to spend time maintaining the truck,
which would detract from its core focus: making pizzas.
With a performance contract, the delivery company is
paid from the operational savings it generates. Because
the savings are greater than the fee, there is a net sav-
ings. Often, the contractor guarantees the savings.
Figure 25.5 PizzaCo’s Cash Flows for a Performance
Contract.
Supplementary Note: Combinations of the basic fi nance
arrangements are possible. For example, a shared savings ar-
rangement can be structured within a performance contract.
Also, performance contracts are often designed so that the
facility owner (PizzaCo) would own the asset at the end of
the contract.
25.3 FINANCIAL ARRANGEMENTS:
DETAILS AND TERMINOLOGY

To explain the basic financial arrangements in
more detail, each one is applied to an energy manage-
ment-related case study. To understand the economics
behind each arrangement, some fi nance terminology is
presented below.
25.3.1 Finance Terminology
Equipment can be purchased with cash on-hand
(offi cially labeled “retained earnings”), a loan, a bond,
a capital lease or by selling stock. Alternatively, equip-
ment can be utilized with a true lease or with a perfor-
mance contract.
Note that with performance contracting, the build-
ing owner is not paying for the equipment itself, but
the benefi ts provided by the equipment. In the Simple
Example, the benefi t was the pizza delivery. PizzaCo was not
concerned with what type of truck was used.
The decision to purchase or utilize equipment is
partly dependent on the company’s strategic focus. If a
company wants to delegate some or all of the responsi-
bility of managing a project, it should use a true lease,
or a performance contact.
10
However, if the company
wants to be intricately involved with the EMP, purchas-
ing and self-managing the equipment could yield the
greatest profi ts. When the building owner purchases
equipment, he/she usually maintains the equipment,
and lists it as an asset on the balance sheet so it can be
depreciated.
Financing for purchases has two categories:

1. Debt Financing, which is borrowing money from
someone else, or another fi rm. (using loans, bonds
and capital leases)
2. Equity Financing, which is using money from your
company, or your stockholders. (using retained
earnings, or issuing common stock)
In all cases, the borrower will pay an interest
charge to borrow money. The interest rate is called the
“cost of capital.” The cost of capital is essentially depen-
dent on three factors: (1) the borrower’s credit rating, (2)
project risk and (3) external risk. External risk can in-
clude energy price volatility, industry-specifi c economic
performance as well as global economic conditions and
trends. The cost of capital (or “cost of borrowing”) in-
fl uences the return on investment. If the cost of capital
increases, then the return on investment decreases.
The “minimum attractive rate of return” (MARR)
is a company’s “hurdle rate” for projects. Because many
organizations have numerous projects “competing” for fund-
ing, the MARR can be much higher than interest earned from
a bank, or other risk-free investment. Only projects with a
return on investment greater than the MARR should be
accepted. The MARR is also used as the discount rate
to determine the “net present value” (NPV).
25.3.2 Explanation of Figures and Tables
Throughout this chapter’s case study, fi gures are
presented to illustrate the transactions of each arrange-
ment. Tables are also presented to show how to perform
the economic analyses of the different arrangements.
The NPV is calculated for each arrangement.

It is important to note that the NPV of a particular
arrangement can change signifi cantly if the cost of capital,
MARR, equipment residual value, or project life is ad-
FINANCING ENERGY MANAGEMENT PROJECTS 653
justed. Thus, the examples within this chapter are provided
only to illustrate how to perform the analyses. The cash
fl ows and interest rates are estimates, which can vary from
project to project. To keep the calculations simple, end-of-
year cash fl ows are used throughout this chapter.
Within the tables, the following abbreviations and
equations are used:
EOY = End of Year
Savings = pre-Tax Cash Flow
Depr. = Depreciation
Taxable Income = Savings - Depreciation - Interest
Payment
Tax = (Taxable Income)*(Tax Rate)
ATCF = After Tax Cash Flow =
Savings – Total Payments – Taxes
Table 25.1 shows the basic equations that are used
to calculate the values under each column heading
within the economic analysis tables.
been fully depreciated, he/she can claim the book value as a
tax-deduction.*
25.4 APPLYING FINANCIAL ARRANGEMENTS:
A CASE STUDY
Suppose PizzaCo (the “host” facility) needs a new
chilled water system for a specifi c process in its manu-
facturing plant. The installed cost of the new system is
$2.5 million. The expected equipment life is 15 years,

however the process will only be needed for 5 years,
after which the chilled water system will be sold at an
estimated market value of $1,200,000 (book value at
year fi ve = $669,375). The chilled water system should
save PizzaCo about $1 million/year in energy savings.
PizzaCo’s tax rate is 34%. The equipment’s annual main-
tenance and insurance cost is $50,000. PizzaCo’s MARR
is 18%. Since at the end of year 5, PizzaCo expects to sell
the asset for an amount greater than its book value, the
Table 25.1 Table of Sample Equations used in Economic Analyses.
———————————————————————————————————————————————————
A B C D E F G H I J
———————————————————————————————————————————————————
Payments Principal Taxable
EOY Savings Depreciation Principal Interest Total Outstanding Income Tax ATCF
———————————————————————————————————————————————————
n
n+1 = (MACRS %)* =(D) +(E) =(G at year n) =(B)–(C)–(E) =(H)*(tax rate) =(B)–(F)–(I)
n+2 (Purchase Price) –(D at year n+1)
———————————————————————————————————————————————————
*To be precise, the IRS uses a “half-year convention” for equipment
that is sold before it has been completely depreciated. In the tax year
that the equipment is sold, (say year “x”) the owner claims only Ω
of the MACRS depreciation percent for that year. (This is because
the owner has only used the equipment for a fraction of the fi nal
year.) Then on a separate line entry, (in the year “x*”), the remaining
unclaimed depreciation is claimed as “book value.” The x* year is
presented as a separate line item to show the book value treatment,
however x* entries occur in the same tax year as “x.”
Table 25.2 MACRS Depreciation Percentages.

—————————————————————————
EOY MACRS Depreciation Percentages
for 7-Year Property
—————————————————————————
0 0
—————————————————————————
1 14.29%
—————————————————————————
2 24.49%
—————————————————————————
3 17.49%
—————————————————————————
4 12.49%
—————————————————————————
5 8.93%
—————————————————————————
6 8.92%
—————————————————————————
7 8.93%
—————————————————————————
8 4.46%
—————————————————————————
Regarding depreciation, the “modifi ed accelerated
cost recovery system” (MACRS) is used in the eco-
nomic analyses. This system indicates the percent de-
preciation claimable year-by-year after the equipment
is purchased. Table 25.2 shows the MACRS percent-
ages for seven-year property. For example, after the fi rst
year, an owner could depreciate 14.29% of an equipment’s
value. The equipment’s “book value” equals the remaining

unrecovered depreciation. Thus, after the fi rst year, the book
value would be 100%-14.29%, which equals 85.71% of the
original value. If the owner sells the property before it has
654 ENERGY MANAGEMENT HANDBOOK
additional revenues are called a “capital gain,” (which
equals the market value – book value) and are taxed.
If PizzaCo sells the asset for less than its book value,
PizzaCo incurs a “capital loss.”
PizzaCo does not have $2.5 million to pay for the
new system, thus it considers its fi nance options. Piz-
zaCo is a small company with an average credit rating,
which means that it will pay a higher cost of capital than
a larger company with an excellent credit rating. As with
any borrowing arrangement, if investors believe that an
investment is risky, they will demand a higher interest
rate.
25.4.1 Purchase Equipment with
Retained Earnings (Cash)
If PizzaCo did have enough retained earnings
(cash on-hand) available, it could purchase the equip-
ment without external financing. Although external
fi nance expenses would be zero, the benefi t of tax-de-
ductions (from interest expenses) is also zero. Also, any
cash used to purchase the equipment would carry an
“opportunity cost,” because that cash could have been
used to earn a return somewhere else. This opportunity
cost rate is usually set equal to the MARR. In other
words, the company lost the opportunity to invest the
cash and gain at least the MARR from another invest-
ment.

Of all the arrangements described in this chapter,
purchasing equipment with retained earnings is prob-
ably the simplest to understand. For this reason, it
will serve as a brief example and introduction to the
economic analysis tables that are used throughout this
chapter.
25.4.1.1 Application to the Case Study
Figure 25.6 illustrates the resource fl ows between
the parties. In this arrangement, PizzaCo purchases the
chilled water system directly from the equipment manu-
facturer.
Once the equipment is installed, PizzaCo recovers
the full $1 million/year in savings for the entire fi ve
years, but must spend $50,000/year on maintenance and
insurance. At the end of the fi ve-year project, PizzaCo
expects to sell the equipment for its market value of
$1,200,000. Assume MARR is 18%, and the equipment
is classifi ed as 7-year property for MACRS depreciation.
Table 25.3 shows the economic analysis for purchasing
the equipment with retained earnings.
Reading Table 25.3 from left to right, and top to
bottom, at EOY 0, the single payment is entered into
the table. Each year thereafter, the savings as well as
the depreciation (which equals the equipment purchase
price multiplied by the appropriate MACRS % for each
year) are entered into the table. Year by year, the taxable
income = savings – depreciation. The taxable income is
then taxed at 34% to obtain the tax for each year. The
after-tax cash fl ow = savings - tax for each year.
At EOY 5, the equipment is sold before the entire

value was depreciated. EOY 5* shows how the equip-
ment sale and book value are claimed. In summary, the
NPV of all the ATCFs would be $320,675.
25.4.2 Loans
Loans have been the traditional fi nancial arrange-
ment for many types of equipment purchases. A bank’s
willingness to loan depends on the borrower’s fi nancial
health, experience in energy management and number
of years in business. Obtaining a bank loan can be dif-
fi cult if the loan offi cer is unfamiliar with EMPs. Loan
officers and financiers may not understand energy-
related terminology (demand charges, kVAR, etc.). In
addition, facility managers may not be comfortable with
the fi nancier’s language. Thus, to save time, a bank that
can understand EMPs should be chosen.
Most banks will require a down payment and col-
lateral to secure a loan. However, securing assets can
be diffi cult with EMPs because the equipment often be-
comes part of the real estate of the plant. For example, it
would be very diffi cult for a bank to repossess lighting fi xtures
from a retrofi t. In these scenarios, lenders may be willing
to secure other assets as collateral.
Figure 25.6 Resource Flows for Using Retained Earn-
ings
25.7 Resource Flow Diagram for a Loan.
Purchase
Amount
Equipment
Chilled Water
PizzaCo

System Manufacturer
Purchase
Amount
Equipment
Chilled Water
PizzaCo
Loan Principal
Bank
System Manufacturer
FINANCING ENERGY MANAGEMENT PROJECTS 655
25.4.2.1 Application to the Case Study
Figure 25.7 illustrates the resource fl ows between
the parties. In this arrangement, PizzaCo purchases the
chilled water system with a loan from a bank. PizzaCo
makes equal payments (principal + interest) to the bank
for fi ve years to retire the debt. Due to PizzaCo’s small
size, credibility, and inexperience in managing chilled
water systems, PizzaCo is likely to pay a relatively high
cost of capital. For example, let’s assume 15%.
PizzaCo recovers the full $1 million/year in sav-
ings for the entire fi ve years, but must spend $50,000/
year on maintenance and insurance. At the end of the
fi ve-year project, PizzaCo expects to sell the equipment
for its market value of $1,200,000. Tables 25.4 and 25.5
show the economic analysis for loans with a zero down
payment and a 20% down payment, respectively. As-
sume that the bank reduces the interest rate to 14% for
the loan with the 20% down payment. Since the asset
is listed on PizzaCo’s balance sheet, PizzaCo can use
depreciation benefi ts to reduce the after-tax cost. In ad-

dition, all loan interest expenses are tax-deductible.
25.4.3 Bonds
Bonds are very similar to loans; a sum of money is
borrowed and repaid with interest over a period of time.
The primary difference is that with a bond, the issuer
(PizzaCo) periodically pays the investors only the inter-
est earned. This periodic payment is called the “coupon
interest payment.” For example, a $1,000 bond with a 10%
coupon will pay $100 per year. When the bond matures, the
issuer returns the face value ($1,000) to the investors.
Bonds are issued by corporations and government
entities. Government bonds generate tax-free income for
investors, thus these bonds can be issued at lower rates
than corporate bonds. This benefi t provides government
facilities an economic advantage to use bonds to fi nance
projects.
25.4.3.1 Application to the Case Study
Although PizzaCo (a private company) would not
be able to obtain the low rates of a government bond,
they could issue bonds with coupon interest rates com-
petitive with the loan interest rate of 15%.
In this arrangement, PizzaCo receives the inves-
tors’ cash (bond par value) and purchases the equip-
ment. PizzaCo uses part of the energy savings to pay
the coupon interest payments to the investors. When the
bond matures, PizzaCo must then return the par value
to the investors. See Figure 25.8.
As with a loan, PizzaCo owns, maintains and de-
preciates the equipment throughout the project’s life. All
coupon interest payments are tax-deductible. At the end

Table 25.3 Economic Analysis for Using Retained Earnings.
——————————————————————————————————————————————
EOY Savings Depr. Payments Principal Taxable Tax ATCF
Principal Interest Total Outstanding Income
——————————————————————————————————————————————
0 2,500,000 -2,500,000
1 950,000 357,250 592,750 201,535 748,465
2 950,000 612,250 337,750 114,835 835,165
3 950,000 437,250 512,750 174,335 775,665
4 950,000 312,250 637,750 216,835 733,165
5 950,000 111,625 838,375 285,048 664,953
5* 1,200,000 669,375 530,625 180,413 1,019,588
——————————————————————————————————————————————
2,500,000
Net Present Value at 18%: $320,675
——————————————————————————————————————————————
Notes: Loan Amount: 0
Loan Finance Rate: 0% MARR 18%
Tax Rate 34%
MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5
Accounting Book Value at end of year 5: 669,375
Estimated Market Value at end of year 5: 1,200,000
EOY 5* illustrates the Equipment Sale and Book Value
Taxable Income: =(Market Value - Book Value)
=(1,200,000 - 669,375) = $530,625
——————————————————————————————————————————————
656 ENERGY MANAGEMENT HANDBOOK
Table 25.5 Economic Analysis for a Loan with a 20% Down-Payment,
——————————————————————————————————————————————
EOY Savings Depr. Payments Principal Taxable Tax ATCF

Principal Interest Total Outstanding Income
——————————————————————————————————————————————
0 500,000 2,000,000 –500,000
1 950,000 357,250 302,567 280,000 582,567 1,697,433 312,750 106,335 261,098
2 950,000 612,250 344,926 237,641 582,567 1,352,507 100,109 34,037 333,396
3 950,000 437,250 393,216 189,351 582,567 959,291 323,399 109,956 257,477
4 950,000 312,250 448,266 134,301 582,567 511,0241 503,449 171,173 196,260
5 950,000 111,625 511,024 71,543 582,567 0 766,832 260,723 106,710
5* 1,200,000 669,375 530,625 180,413 1,019,588
——————————————————————————————————————————————
2,500,000
Net Present Value at 18%: $710,962
——————————————————————————————————————————————
Notes: Loan Amount: 2,000,000 (used to purchase equipment at year 0)
Loan Finance Rate: 14% MARR 18%
500,000 Tax Rate 34%
MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5
Accounting Book Value at end of year 5: 669,375
Estimated Market Value at end of year 5: 1,200,000
EOY 5* illustrates the Equipment Sale and Book Value
Taxable Income: =(Market Value - Book Value)
=(1,200,000 - 669,375) = $530,625
——————————————————————————————————————————————
Table 25.4 Economic Analysis for a Loan with No Down Payment.
——————————————————————————————————————————————
EOY Savings Depr. Payments Principal Taxable Tax ATCF
Principal Interest Total Outstanding Income
——————————————————————————————————————————————
0 2,500,000
1 950,000 357,250 370,789 375,000 745,789 2,129,211 217,750 74,035 130,176

2 950,000 612,250 426,407 319,382 745,789 1,702,804 18,368 6,245 197,966
3 950,000 437,250 490,368 255,421 745,789 1,212,435 257,329 187,492 116,719
4 950,000 312,250 563,924 181,865 745,789 648,511 455,885 55,001 49,210
5 950,000 111,625 648,511 97,277 745,789 0 741,098 251,973 -47,761
5* 1,200,000 669,375 530,625 180,413 1,019,588
2,500,000
Net Present Value at 18%: $757,121
——————————————————————————————————————————————
Notes: Loan Amount: 2,500,000 (used to purchase equipment at year 0)
Loan Finance Rate: 15% MARR 18%
Tax Rate 34%
MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5
Accounting Book Value at end of year 5: 669,375
Estimated Market Value at end of year 5: 1,200,000
EOY 5* illustrates the Equipment Sale and Book Value
Taxable Income: =(Market Value - Book Value)
=(1,200,000 - 669,375) = $530,625
——————————————————————————————————————————————
FINANCING ENERGY MANAGEMENT PROJECTS 657
of the fi ve-year project, PizzaCo expects to sell the equip-
ment for its market value of $1,200,000. Table 25.6 shows
the economic analysis of this fi nance arrangement.
25.4.4 Selling Stock
Although less popular, selling company stock is
an equity fi nancing option which can raise capital for
projects. For the host, selling stock offers a fl exible re-
payment schedule, because dividend payments to share-
holders aren’t absolutely mandatory. Selling stock is also
often used to help a company attain its desired capital
structure. However, selling new shares of stock dilutes

the power of existing shares and may send an inaccu-
rate “signal” to investors about the company’s fi nancial
strength. If the company is selling stock, investors may
think that it is desperate for cash and in a poor fi nancial
condition. Under this belief, the company’s stock price
could decrease. However, recent research indicates that
when a fi rm announces an EMP, investors react favor-
ably.
11
On average, stock prices were shown to increase
abnormally by 21.33%.
By defi nition, the cost of capital (rate) for selling
stock is:
cost of capital
selling stock
= D/P
where D = annual dividend payment
P = company stock price
However, in most cases, the after-tax cost of capital
for selling stock is higher than the after-tax cost of debt
fi nancing (using loans, bonds and capital leases). This is
because interest expenses (on debt) are tax deductible,
but dividend payments to shareholders are not.
In addition to tax considerations, there are other
reasons why the cost of debt fi nancing is less than the
fi nancing cost of selling stock. Lenders and bond buyers
(creditors) will accept a lower rate of return because they
are in a less risky position due to the reasons below.
• Creditors have a contract to receive money at a
certain time and future value (stockholders have

no such guarantee with dividends).
• Creditors have fi rst claim on earnings (interest is
paid before shareholder dividends are allocated).
Table 25.6 Economic Analysis for a Bond.
——————————————————————————————————————————————
EOY Savings Depr. Payments Principal Taxable Tax ATCF
Principal Interest Total Outstanding Income
——————————————————————————————————————————————
0 2,500,000
1 950,000 357,250 375,000 375,000 2,500,000 217,750 74,035 500,965
2 950,000 612,250 375,000 375,000 2,500,000 -37,250 -12,665 587,665
3 950,000 437,250 375,000 375,000 2,500,000 137,750 46,835 528,165
4 950,0 0 312,250 375,000 375,000 2,500,000 262,750 89,335 485,665
5 950,000 111,625 2,500,000 375,000 2,875,000 0 463,375 157,548 -2,082,548
5* 1,200,000 669,375 530,625 180,413 1,019,588
2,500,000
Net Present Value at 18%: 953,927
——————————————————————————————————————————————
Notes: Loan Amount: 2,500,000 (used to purchase equipment at year 0)
Loan Finance Rate: 0% MARR 18%
Tax Rate 34%
MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5
Accounting Book Value at end of year 5: 669,375
Estimated Market Value at end of year 5: 1,200,000
EOY 5* illustrates the Equipment Sale and Book Value
Taxable Income: =(Market Value - Book Value)
=(1,200,000 - 669,375) = $530,625
——————————————————————————————————————————————
Figure 25.8 Resource Flow Diagram for a Bond.
Purchase

Amount
Equipment
Chilled Water
PizzaCo
Investors
System Manufacturer
Pay-
ments
Bond
658 ENERGY MANAGEMENT HANDBOOK
• Creditors usually have secured assets as collateral
and have fi rst claim on assets in the event of bank-
ruptcy.
Despite the high cost of capital, selling stock does
have some advantages. This arrangement does not bind
the host to a rigid payment plan (like debt financing
agreements) because dividend payments are not manda-
tory. The host has control over when it will pay divi-
dends. Thus, when selling stock, the host receives greater
payment fl exibility, but at a higher cost of capital.
25.4.4.1 Application to the Case Study
As Figure 25.9 shows, the fi nancial arrangement is
very similar to a bond, at year zero the fi rm receives $2.5
million, except the funds come from the sale of stock.
Instead of coupon interest payments, the fi rm distributes
dividends. At the end of year fi ve, PizzaCo repurchases
the stock. Alternatively, PizzaCo could capitalize the
dividend payments, which means setting aside enough
money so that the dividends could be paid with the
interest generated.

Table 25.7 shows the economic analysis for issuing
stock at a 16% cost of equity capital, and repurchasing
the stock at the end of year fi ve. (For consistency of
comparison to the other arrangements, the stock price
does not change during the contract.) Like a loan or
bond, PizzaCo owns and maintains the asset. Thus, the
annual savings are only $950,000. PizzaCo pays annual
dividends worth $400,000. At the end of year 5, PizzaCo
expects to sell the asset for $1,200,000.
Note that Table 25.7 is slightly different from the
other tables in this chapter:
Taxable Income = Savings – Depreciation, and
ATCF = Savings – Stock Repurchases - Dividends
- Tax
25.4.5 Leases
Firms generally own assets, however it is the use of
these assets that is important, not the ownership. Leas-
ing is another way of obtaining the use of assets. There
are numerous types of leasing arrangements, ranging
Table 25.7 Economic Analysis of Selling Stock.
——————————————————————————————————————————————
EOY Savings Depr. Stock Transactions Dividend Taxable Tax ATCF
Sale of Stock Repurchase Payments Income
——————————————————————————————————————————————
0 $2,500,000 from Stock Sale is used to purchase equipment, thur ATCF = 0
1 950,000 357,250 400,000 592,750 201,535 348,465
2 950,000 612,250 400,000 337,750 114,835 435,165
3 950,000 437,250 400,000 512,750 174,335 375,665
4 950,000 312,250 400,000 637,750 216,835 333,165
5 950,000 111,625 2,500,000 400,000 838,375 285,048 2,235,048

5* 1,200,000 669,375 530,625 180,413 1,019,588
2,500,000
——————————————————————————————————————————————
Net Present Value at 18%: 477,033
——————————————————————————————————————————————
Notes: Value of Stock Sold (which is repurchased after year 5 2,500,000 (used to purchase equipment at year 0)
Cost of Capital = Annual Dividend Rate: 16% MARR = 18%
Tax Rate = 34%
MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5
Accounting Book Value at end of year 5: 669,375
Estimated Market Value at end of year 5: 1,200,000
EOY 5* illustrates the Equipment Sale and Book Value
Taxable Income: = (Market Value - Book Value)
= (1,200,000 - 669,375) = $530,625
——————————————————————————————————————————————
Figure 25.9 Resource Flow Diagram for Selling Stock.
Purchase
Amount
Equipment
Chilled Water
System Manufacturer
PizzaCo
Investors
Sell
Stock
Cash
FINANCING ENERGY MANAGEMENT PROJECTS 659
from basic rental agreements to extended payment plans
for purchases. Leasing is used for nearly one-third of all
equipment utilization.

12
Leases can be structured and
approved very quickly, even within 48 hours. Table 25.8
lists some additional reasons why leasing can be an at-
tractive arrangement for the lessee.
Table 25.8 Good Reasons to Lease.
—————————————————————————
Financial Reasons
• With some leases, the entire lease payment is tax-
deductible.
• Some leases allow “off-balance sheet” fi nancing,
preserving credit lines
Risk Sharing
• Leasing is good for short-term asset use, and re-
duces the risk of getting stuck with obsolete equip-
ment
• Leasing offers less risk and responsibility
—————————————————————————
Basically, there are two types of leases; the “true
lease” (a.k.a. “operating” or “guideline lease”) and the
“capital lease.” One of the primary differences between
a true lease and a capital lease is the tax treatment. In a
true lease, the lessor owns the equipment and receives
the depreciation benefi ts. However, the lessee can claim
the entire lease payment as a tax-deductible business
expense. In a capital lease, the lessee (PizzaCo) owns
and depreciates the equipment. However, only the in-
terest portion of the lease payment is tax-deductible. In
general, a true lease is effective for a short-term project,
where the company does not plan to use the equipment

when the project ends. A capital lease is effective for
long-term equipment.
25.4.5.1 The True Lease
Figure 25.10 illustrates the legal differences be-
tween a true lease and a capital lease.
13
A true lease (or
operating lease) is strictly a rental agreement. The word
“strict” is appropriate because the Internal Revenue
Service will only recognize a true lease if it satisfi es the
following criteria:
1. the lease period must be less than 80% of the
equipment’s life, and
2. the equipment’s estimated residual value must be
≥20% of its value at the beginning of the lease,
and
3. there is no “bargain purchase option,” and
4. there is no planned transfer of ownership, and
5. the equipment must not be custom-made and only
useful in a particular facility.
25.4.5.2 Application to the Case Study
It is unlikely that PizzaCo could fi nd a lessor that
would be willing to lease a sophisticated chilled water
system and after fi ve years, move the system to another
facility. Thus, obtaining a true lease would be unlikely.
However, Figure 25.11 shows the basic relationship be-
tween the lessor and lessee in a true lease. A third-party
leasing company could also be involved by purchasing
Figure 25.10 Classifi cation for a True Lease.
Does the lessor have:

≥ 20% investment in asset at all times?
≥20% residual value?
lease period ≤ 80% asset’s life?
Does lessee have:
a loan to the lessor?
a bargain purchase option?
Capital Lease
True Lease
▼
▼
▼
▼
▼
▼
▼
▼
▼▼▼▼▼
▼
▼
yes
no
yes
yes
yes
no
no
no
no
660 ENERGY MANAGEMENT HANDBOOK
the equipment and leasing to PizzaCo. Such a resource

fl ow diagram is shown for the capital lease.
Table 25.9 shows the economic analysis for a true
lease. Notice that the lessor pays the maintenance and
insurance costs, so PizzaCo saves the full $1 million per
year. PizzaCo can deduct the entire lease payment of
$400,000 as a business expense. However PizzaCo does
not obtain ownership, so it can’t depreciate the asset.
25.4.5.3 The Capital Lease
The capital lease has a much broader defi nition
than a true lease. A capital lease fulfi lls any one of the
following criteria:
1. the lease term ≥80% of the equipment’s life;
2. the present value of the lease payments ≥80% of
the initial value of the equipment;
3. the lease transfers ownership;
4. the lease contains a “bargain purchase option,”
which is negotiated at the inception of the lease.
Most capital leases are basically extended pay-
ment plans, except ownership is usually not transferred
until the end of the contract. This arrangement is
common for large EMPs because the equipment (such
as a chilled water system) is usually diffi cult to reuse
at another facility. With this arrangement, the lessee
eventually pays for the entire asset (plus interest). In
most capital leases, the lessee pays the maintenance
and insurance costs.
The capital lease has some interesting tax implica-
tions because the lessee must list the asset on its bal-
ance sheet from the beginning of the contract. Thus,
like a loan, the lessee gets to depreciate the asset and

only the interest portion of the lease payment is tax
deductible.
25.4.5.4 Application to the Case Study
Figure 25.12 shows the basic third-party fi nancing
relationship between the equipment manufacturer, les-
sor and lessee in a capital lease. The fi nance company
(lessor) is shown as a third party, although it also could
be a division of the equipment manufacturer. Because
the fi nance company (with excellent credit) is involved,
a lower cost of capital (12%) is possible due to reduced
risk of payment default.
Like an installment loan, PizzaCo’s lease payments
cover the entire equipment cost. However, the lease
payments are made in advance. Because PizzaCo is
considered the owner, it pays the $50,000 annual main-
tenance expenses, which reduces the annual savings to
$950,000. PizzaCo receives the benefi ts of depreciation
and tax-deductible interest payments. To be consistent
with the analyses of the other arrangements, PizzaCo
would sell the equipment at the end of the lease for its
market value. Table 25.10 shows the economic analysis
for a capital lease.
Figure 25.11 Resource Flow Diagram for a True
Lease.
Lease Payments
Leased Equipment
Chilled Water
System Manufacturer
(Lessor)
PizzaCo

(Lessee)
Table 25-9 Economic Analysis for a True Lease
——————————————————————————————————————————————
EOY Savings Depr. Lease Principal Taxable Tax ATCF
Payments Total Outstanding Income
——————————————————————————————————————————————
0 400,000 400,000 -400,000 -400,000
1 1,000,000 0 400,000 400,000 600,000 204,000 396,000
2 1,000,000 0 400,000 400,000 600,000 204,000 396,000
3 1,000,000 0 400,000 400,000 600,000 204,000 396,000
4 1,000,000 0 400,000 400,000 600,000 204,000 396,000
5 1,000,000 0 1,000,000 340,000 660,000
——————————————————————————————————————————————
Net Present Value at 18%: $953,757
——————————————————————————————————————————————
Notes: Annual Lease Payment: 400,000
MARR = 18%
Tax Rate 34%
——————————————————————————————————————————————
FINANCING ENERGY MANAGEMENT PROJECTS 661
25.4.5.5 The Synthetic Lease
A synthetic lease is a “hybrid” lease that combines
aspects of a true lease and a capital lease. Through care-
ful structuring and planning, the synthetic lease appears
as an operating lease for accounting purposes (enables
the Host to have off-balance sheet fi nancing), yet also
appears as a capital lease for tax purposes (to obtain de-
preciation for tax benefi ts). Consult your local fi nancing
expert to learn more about synthetic leases; they must
be carefully structured to maintain compliance with the

associated tax laws.
With most types of leases, loans and bonds the
monthly payments are fi xed, regardless of the equip-
ment’s utilization, or performance. However, shared sav-
ings agreements can be incorporated into certain types
of leases.
25.4.6 Performance Contracting
Performance contracting is a unique arrangement
that allows the building owner to make necessary
improvements while investing very little money up-
front. The contractor usually assumes responsibility for
purchasing and installing the equipment, as well as
maintenance throughout the contract. But the unique
aspect of performance contracting is that the contrac-
tor is paid based on the performance of the installed
equipment. Only after the installed equipment actually
reduces expenses does the contractor get paid. Energy
service companies (ESCOs) typically serve as contractors
within this line of business.
Unlike most loans, leases and other fi xed payment
arrangements, the ESCO is paid based on the perfor-
mance of the equipment. In other words, if the fi nished
product doesn’t save energy or operational costs, the
host doesn’t pay. This aspect removes the incentive to
“cut corners” on construction or other phases of the proj-
ect, as with bid/spec contracting. In fact, often there is
an incentive to exceed savings estimates. For this reason,
performance contracting usually entails a more “facility-
Figure 25.12 Resource Flow Diagram for a Capital
Lease.

Purchase
Amount
Equipment
Chilled Water
System Manufacturer
Finance
Company
PizzaCo
Leased
Equipment
Lease Payments
Table 25.10 Economic Analysis for a Capital Lease.
——————————————————————————————————————————————
EOY Savings Depr. Payments Principal Taxable Tax ATCF
Principal Interest Total Outstanding Income
——————————————————————————————————————————————
0 619,218 0 619,218 1,880,782 -619,218
1 950,000 357,250 393,524 225,694 619,218 1,487,258 367,056 124,799 205,983
2 950,000 612,250 440,747 178,471 619,218 1,046,511 159,279 54,155 276,627
3 950,000 437,250 493,637 125,581 619,218 552,874 387,169 131,637 199,145
4 950,000 312,250 552,874 66,345 619,218 0 571,405 194,278 136,503
5 950,000 111,625 838,375 285,048 664,953
5* 1,200,000 669,375 530,625 180,413 1,019,588
——————————————————————————————————————————————
2,500,000
Net Present Value at 18%: $681,953
——————————————————————————————————————————————
Notes: Total Lease Amount: 2,500,000
However, Since the payments are in advance, the fi rst payment is analogous to a Down-Payment
Thus the actual amount borrowed is only = 2,500,000 - 619,218 = 1,880,782

Lease Finance Rate: 12% MARR 18%
Tax Rate 34%
MACRS Depreciation for 7-Year Property, with half-year convention at EOY 5
Accounting Book Value at end of year 5: 669,375
Estimated Market Value at end of year 5: 1,200,000
EOY 5* illustrates the Equipment Sale and Book Value
Taxable Income: = (Market Value - Book Value)
= (1,200,000 - 669,375) = $530,625
——————————————————————————————————————————————