Capitalizing on the energy savings potential of the C&I marketplace.
The commercial and industrial (C&I) market for energy efficiency services is often described as having the greatest potential of all nonresidential, building-related energy efficiency markets. Discussion of the imminent boom for the C&I market occurs regularly, but this market has yet to materialize to the extent that many providers have hoped. Historically, the market for building-related energy efficiency services has largely been concentrated with public clients. These include federal facilities and the facilities of municipalities, universities, schools and hospitals (MUSH). The federal and MUSH markets are strong and growing. Nevertheless, when speaking to energy services providers, many continue to note the attractiveness of the C&I market. As a result, industry participants are allocating resources to this client vertical and experimenting with various business models and project financing structures.
The desire to capitalize on the energy savings potential for the C&I marketplace is well-founded. The market is significantly larger than the MUSH market and much less developed. In the U.S., the C&I market potential is nearly three times as that of large as the MUSH market (See Exhibit 1).
Service providers able to penetrate this marketplace will find a competitive landscape far less developed than the federal and MUSH markets. Navigant Research estimates that commercial building owners alone will invest $945 billion globally in energy efficiency retrofits between now and 2023.
With such a large market potential, there are significant resources working on the penetration of the C&I market. Key questions are, why has the C&I market been slow to develop, and what makes the market different now.
Growing Pains Continue
Scaling energy efficiency services in the C&I market has been more difficult than one would expect given the market’s attractiveness. Why? Shouldn’t the market implement all projects with a clear and positive internal rate of return (IRR)? Aren’t projects that save money and create value for building owners a no-brainer? Across the market, we have heard several reasons for the difficulty in selling C&I projects. These can vary depending on the specific submarket and provider.
Lack of Familiarity
Facilities managers and decision-makers in the federal and MUSH markets have become very familiar with the value created through energy efficiency projects. This awareness is facilitated by the “top-down” approach of government entities, with word spreading quickly regarding project benefits. By contrast, the C&I market is more fragmented. It requires a “bottom-up” development of awareness and familiarity in the market as the benefits of energy efficiency projects are recognized and gain visibility. Perceived complexity of some projects — numerous measures and deployment structures, combined with constant technology upgrades — can leave decision-makers hesitant to engage. It is not uncommon for large clients to delay final decisions because of the lack of background and context needed to adequately evaluate a project.
Difficulty in Financing
Project financing for the federal and MUSH markets is very well-established. Credits are generally strong, contract forms are often standardized, projects are larger and often include longer terms, underwriting costs are low, some interest payments are tax-free, off-balance sheet structures are generally not required, and financiers have been servicing these markets for decades. These factors are more challenging in the C&I sector, where credit profiles vary, contract structures are customized, projects may be smaller and for shorter terms, and interest payments are taxable. These dimensions have historically resulted in higher costs of capital and higher underwriting costs for C&I projects.
Long Payback Periods and Misaligned Incentives
In the federal and MUSH markets, comprehensive projects can support long paybacks (say 15–20 years) because the project hosts have a long-term view and often have strong credit ratings (cities and school districts, for example). Facility and business owners may have shorter investment horizons (in some cases, less than five years). Shorter payback period requirements can limit the size and scope of projects. Additionally, building owners’ and tenants’ incentives aren’t always aligned when it comes to facility upgrades and energy efficiency projects. For example, in the commercial real estate market, energy costs are often borne by tenants, not building owners, thereby reducing the incentive for building owners to minimize energy costs.
Long, Complex Sales Cycle
Selling a sizable energy services project to a C&I client is a technical, consultative process that requires convincing multiple layers of an organization — facilities management, engineering, operations, financial, and executive — of the merits of a project. Any of these decision making levels can say no to a project, yet all have to say yes for it to be successful. There is little standardization of projects or contracts, so each becomes a customized project with somewhat uniquely negotiated contract structures. One provider of energy services to C&I customers states, “The director of facilities knows about efficiency, but you also have to focus on the CFO, general manager or the owner”. This becomes increasingly complex with deep retrofits, where projects are higher value and might cross an approval threshold, requiring even more senior executive signoff.
What is Changing Now?
Market participants are working to overcome the barriers noted above. These efforts typically minimize transaction friction by streamlining sales cycle times, reducing transaction costs, lowering project costs (and/or increasing project benefits), and simplifying and reducing the cost of project financing.
Innovative Financing Structures
Successful innovations in financing structures for distributed solar are driving similar efforts in the financing of energy efficiency projects. Yields on financial instruments are at historic lows, and investor appetite for such financial instruments is strong, creating opportunities in the capital markets for innovation in energy efficiency project financing. In addition to the more traditional energy savings performance contracts (predominantly used in the federal and MUSH markets), we see managed services agreements, energy efficiency PPAs, utility service agreements, sale-leaseback structures, Property Assessed Clean Energy (PACE) programs, leveraging of utility demand-side-management (DSM) programs and other variations being utilized to deliver a greater number of projects in the C&I market. Furthermore, we expect to see the same expansion of investment vehicles or funds in the efficiency market that we have seen in solar and wind markets.
New Technologies Lead the Way
Similar to solar, the cost of LED lights (a semiconductor technology) is dropping quickly while quality is improving. Continuous commissioning and energy management systems (software technologies) are also rapidly improving and gaining traction. These and other fast-changing, high-profile, strong ROI technologies will continue to drive adoption of energy efficiency technologies by the C&I market.
Tech-Enabled Selling and Project Delivery
Trends in mobile computing, big-data analytics, remote monitoring, workflow automation, GPS and mapping, software, machine-to-machine communications (the “Internet of Things”) and similar areas that are driving productivity and efficiencies throughout the economy are also being applied to energy efficiency projects. When applied effectively, these technologies can streamline sales and delivery processes, improve quality and enhance ROI.
Growing Awareness
The awareness of solar photovoltaics (PV) has grown tremendously over the last decade. Energy efficiency is currently more economic than solar PV in many instances. Energy storage technologies are also gaining traction. We believe energy efficiency, distributed generation (like solar PV) and energy storage are symbiotic and mutually reinforcing. Providers are getting better at educating their potential C&I clients, and the C-Suite is becoming more sophisticated in its knowledge of energy services, allowing greater ease in bringing projects to life.
End-User Energy Costs
While media headlines speak of cheap fuel prices (oil, natural gas and coal), such prices have not generally translated (and we believe will not translate) into cheaper prices for end users of electricity. Utilities are facing massive infrastructure spending needs. Fuel costs comprise a relatively small portion of end-use energy costs. These and other factors prohibit lower fuel costs from materially affecting end-use energy costs, which are expected to continue to rise over time. Business owners want to lower costs and have optimally functioning facilities. Energy services can accomplish both of these goals for C&I businesses.
These changes will impact the energy landscape in the following two ways:
New Business Models and Best Practices Will Emerge
Companies that effectively overcome the barriers in the C&I market will grow quickly and create significant enterprise value. Technologies and best practices that accelerate client acquisition, reduce selling costs, streamline project delivery, enhance project ROI, standardize contracts, simplify financing solutions and reduce financing costs will gain traction and drive market expansion.
Interest in the Space Is Strong
The significant growth of companies effectively serving the C&I space is likely to continue. Providers that aren’t already leaders in the C&I market or companies looking to enter the space will seek to acquire market leaders in order to position for the potential boom in viable projects. Today, targets with a strong and profitable history in the space are limited, but the numbers of firms that would like to move into the space are many.
By tackling the challenges inherent in the C&I marketplace, service providers are making considerable headway in a vast market. The stage is being set for an exciting future with the emergence of successful companies in the C&I space. Q
Tim Huckaby is the managing director of the Energy Services & Cleantech Group at FMI Capital Advisors. He can be reached at 303.398.7265 or via email at thuckaby@fminet.com. Russell Clarke is a senior analyst with the Energy Services & Cleantech Group at FMI Capital Advisors. He can be reached at 860.463.2439 or via email at rclarke@fminet.com.
1 Throughout this article, the market for Energy Services refers to facility-related energy efficiency services. These services focus on optimizing a facility’s performance (including energy use and uptime) as well as creating a comfortable and productive environment for its occupants.
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