2011 International System Dynamics Conference in Washington, DC
Modeling the Diffusion of Energy Performance Contracting
Carlos Capelo
Associate Professor
Universidade Lusofona - FEG
Campo Grande, 376, 1749-024 Lisboa - Portugal
Phone: +351962831740
carlos.capelo@ my.grupolusofona.pt
Abstract
The Portuguese Energy Policy considers the development of a commercially viable and
competitive market for energy performance contracting (EPC) as a main mechanism to
achieve the objectives of energy efficiency improvement. This paper proposes a study to
investigate how to achieve widespread adoption of energy performance contracting by
means of system dynamics modelling and simulation. To explore and gather insights on
this question, a system dynamics model representing the system of the Portuguese EPC
market at industry level will be created. The simulation of that model will provide a
helpful basis for analysing and explaining the development of key variables, and accel-
erating learning on the managerial, organizational and political adaptation processes
that foster the diffusion of EPC adoption. The first phase of this research project aims
at identifying and analysing the key factors and critical cause-effect relations that drive
the adoption of EPC. With this purpose, a qualitative content analysis on relevant
documents was performed and a set of interviews was conducted. That data was ana-
lysed to capture the critical variables and its interrelation to formulate a preliminary
representation of the system structure as stock and flow diagrams.
Key words: Energy Performance Contracting, Diffusion Simulation, System Dynamics
1. Introduction
Energy performance contracting (EPC) projects focus at the deployment of comprehen-
sive solutions for improving energy efficiency. This type of contract would help to
overcome financial constraints to energy efficiency investments by paying off initial
costs through the future energy cost savings resulting from reduced energy consump-
tion. However, as the present analysis points out, despite of government policies sup-
porting EPC, the EPC market in Portugal is underdeveloped, far from its promised po-
tential. An important question remains — what policies and managerial processes might
expand the attractiveness of the EPC model and foster the diffusion of its adoption in
the Portuguese market?
This paper presents the first steps of an exploratory study about de dynamics of the dif-
fusion of EPC by means of system dynamics modelling and simulation. This research
focuses on how to foster the development of an EPC industry in the Portugal. The key
question is to understand the critical factors of the Portuguese EPC market and the dy-
namic interactions among those factors that will drive the adoption of EPC. To explore
and gather insights on this question, a system dynamics model representing the system
of the Portuguese EPC market at industry level will be created. The simulation of that
2011 International System Dynamics Conference in Washington, DC
model will provide a helpful basis for analysing and explaining the development of key
variables, and accelerating learning on the managerial, organizational and political ad-
aptation processes that foster the diffusion of EPC adoption. The main purpose is to
recommend political and managerial actions that foster reinforcing processes towards a
sustained diffusion of EPC.
The first part of this research project aims at identifying and analysing the key factors
and critical cause-effect relations that drive the adoption of EPC. With this purpose, a
qualitative content analysis on relevant documents was performed and a set of inter-
views was conducted to gather insights and discuss the experience of energy efficiency
experts, national authorities, energy services companies (ESCOs) professionals and en-
ergy end-users regarding the development of an EPC industry in the Portuguese market.
That data was analysed to capture the critical variables and its interrelation to formulate
a preliminary representation of the system structure as stock and flow diagrams.
This paper has the following structure. Section 2 starts with a review of European and
Portuguese energy policies that shape the context of the EPC market, defines the con-
cept of EPC and gives an overview of the current status of the EPC industry in Portugal.
Section 3 presents the objectives and methodology of the present research. Section 4
presents and interprets the data gathered about the factors affecting the adoption of EPC
in the Portuguese market. Section 5 describes the first steps towards the development of
a system dynamics model. Section 6 concludes and presents the following phase of the
present research.
2. Closing the Efficiency Gap through Energy Performance Contracting
The Portuguese policy context
Under the Kyoto protocol, the European Union has agreed to reduce greenhouse gas
(GHG) emissions. In 2006, the European Commission published the Action Plan on En-
ergy Efficiency which aims to realize a 20% energy efficiency improvement by 2020
(EC 2006a). This objective was reinforced in 2007 when the European Commission de-
fined her energy package for the twenty-first century. The package included a 20%
emissions reduction target for greenhouse gases by 2020, among others, to be achieved
by improving energy efficiency by 20% (EC 2007). Realizing this potential requires the
introduction of effective energy efficiency policies on the European and the national
level. According to many energy efficiency advocates and policy makers, most of this
energy savings potential can be effectively realized through performance contracting of
energy efficiency measures. The main mechanism to achieve this objective will be to
improve the functioning of a commercially viable and competitive market for EPC.
In 20 May 2008, the Portuguese Government published the National Energy Efficiency
Action Plan (RCM 80/2008). The objectives were to cut 10% in final energy consump-
tion by 2015 and create and promote Energy Services Companies (ESCO’s) and energy
performance contracting (EPC). The recently published Portuguese National Energy
Strategy (ENE 2020 RCM 29/2010) promotes energy efficiency aiming for a 20 % re-
duction in final energy consumption by 2020. That strategic plan reinforces that the de-
2011 International System Dynamics Conference in Washington, DC
velopment of the ESCOs and EPC market will be a priority, as this will create an energy
efficiency industry with long term relevance (Fernandes, 2010; Zorrinho, 2010).
The Nature of Energy Performance Contracting
The Directive 2006/32/EC of the European Parliament and of the Council of 5 April
2006 on Energy End-use Efficiency and Energy Services (Energy Services Directive)
established the following terminology (Marino et al, 2010):
"energy performance contracting" (EPC): a contractual arrangement between the bene-
ficiary and the provider (normally an ESCO) of an energy efficiency improvement
measure, where investments in that measure are paid for in relation to a contractually
agreed level of energy efficiency improvement;
* "energy service company" (ESCO): a natural or legal person that delivers energy ser-
vices and/or other energy efficiency improvement measures in a user’s facility or prem-
ises, and accepts some degree of financial risk in so doing. The payment for the services
delivered is based (either wholly or in part) on the achievement of energy efficiency im-
provements and on the meeting of the other agreed performance criteria;
Under an energy performance contracting, the ESCO defines and implements a project
to deliver energy efficiency, or a renewable energy project, and uses the stream of in-
come from the cost savings, or the renewable energy produced, to repay the costs of the
project, including the costs of the investment (Bartoldi et al, 2006).
In a typical energy efficiency project supported by an energy performance contract, the
ESCO may: perform energy audits, project design and engineering, install new energy
conversion, distribution and/or control equipment at the client site; finance this invest-
ment, or assist in obtaining finance for the client; operation and control of some equip-
ment, monitoring and verification of performance in terms of energy efficiency; assume
decision rights over a significant proportion of the useful energy streams and final en-
ergy services within the host site; assume decision rights over a significant proportion of
the organisational activities required to provide those streams and services; assume
property rights over some of the assets involved in the energy efficiency project; guar-
antee a particular level of savings in energy consumption or energy costs; take on the
majority of the risks related to the performance of the energy efficiency project, includ-
ing equipment performance risk, and credit risk.
The Economics of EPC
Under an economic point of view, the primary objective of energy performance con-
tracting is to minimise the total cost of supplying energy services, given by the sum of
production costs and transaction costs (Sorrel, 2007). Energy performance contracting is
supposed to allow the client to minimise the total cost for the services that energy pro-
vides.
Production costs include the financing costs of energy efficiency project, the operation
and maintenance costs, and the purchase cost of energy commodities. Transaction costs
include the staff, consulting and legal costs associated with searching for a supplier, ne-
gotiating and writing the contract, monitoring contract performance, enforcing compli-
2011 International System Dynamics Conference in Washington, DC
ance, negotiating changes to the contract when unforeseen circumstances arise and re-
solving disputes (Sorrel, 2007). Production and transaction costs will be incurred by the
client for the case of in-house provision of energy efficiency project as well as for the
case of EPC. In the case of the latter, production and transaction costs will also be in-
curred by the ESCO.
The conditions for a viable energy performance contract are that (Sorrel 2007):
- the contract payments are less than the total savings achieved by the client;
- the contract revenues are greater than the total costs incurred by the ESCO;
- the total saving in production costs achieved through the contract must be greater than
the total increase in transaction costs:
As it is expected EPC to reduce overall production costs but increase overall transaction
costs, the saving in production costs is the key to a successful energy performance con-
tract. EPC viability requires that the savings in production costs are sufficiently large to
offset the transaction cost of contracting. Thus a client will engage in EPC if it can re-
duce its estimated and anticipated total cost at the time of making the decision (Buckley
and Chapman, 1997).
EPC may achieve savings relative to in-house provision of efficiency energy project
through the combination of scale advantages, competitive bidding, and performance in-
centives of outside providers (ESCOs):
- Economies of scale: Many organisations lack the scale to manage energy projects effi-
ciently. As ESCOs specialise in energy management and contract with multiple clients,
they achieve considerable scale economies (Sorrel, 2007; Globerman and Vining,
1996).
- Market incentives: If the energy efficiency project is managed in-house, the relevant
staff will not be affected by the incentives of market competition. Competitive bidding
will provide an incentive to ESCOs to maximize energy savings (Sorrel, 2007; Glober-
man and Vining, 1996).
- Performance incentives: EPC provides an effective incentive to ESCOs to maintain
and improve performance over time. Although such incentives could potentially be pro-
vided by an internal management mechanism (Irrek et al., 2005), the effectiveness will
depend upon the management ability to implement and maintain over time that incen-
tive scheme.
Financing of EPC projects
Finance for an energy efficiency project through EPC refers to the source of capital for
investment in new energy conversion and control equipment. In general three broad fi-
nancing options for financing EPC project can be distinguished: energy user/ client fi-
nancing, ESCO financing, and third party financing which may involve a single purpose
entity (Thumann, 2009).
2011 International System Dynamics Conference in Washington, DC
This study focuses mainly on ESCO financing as this concept is assumed a good intro-
ductory model in EPC developing markets because clients assume no financial risk
(CTI, 2003; Dreessen, 2003). The ESCO financing model refers to financing with inter-
nal funds of the ESCO and may involve own capital or equipment lease. Under an EPC
agreement contract the energy savings are split in accordance with a pre-arranged per-
centage. This percentage depends on the cost of the project, the length of the contract
and the risks taken by the ESCO and the consumer. In this arrangement, the ESCO takes
on the majority of the risks related to the performance of the efficiency project provision
and credit risk as well.
Benefits of Energy Performance Contracting
The primary objective of EPC is to minimise the total cost of supplying energy services.
Thus, EPC allows the client to achieve lower energy costs and may guarantee particular
levels of service provision, such as lighting levels, room temperatures, humidity and
‘comfort’ at reduced cost.
In a conventional ‘turnkey’ energy efficiency project, the contractor is responsible for
design, specification, construction and commissioning, and is paid on project comple-
tion. The contractor has neither the incentive nor the means to optimise the performance
of the energy efficiency project subsequent to its delivery. In contrast, an energy per-
formance contract establishes a link between contract payments and project perform-
ance and schedules these payments at intervals over a long-term period. This provides
the contractor (ESCO) with a long-term incentive to optimize and maintain the perform-
ance of the energy efficiency project (Sorrel, 2007).
The approach involves the transfer of technical risks from the client to the ESCO based
on performance guarantees given by the ESCO. In EPC payment is based on perform-
ance; a measure of performance is the level of energy savings.
ESCOs may have greater access to information, skilled labour and managerial expertise
in the relevant areas and may leverage these benefits by having individual staff serve a
number of clients. Such staff should be able to develop and apply specialist skills that
would not be feasible within the client organisations and to rapidly disseminate learning
benefits between different clients. (Sorrel, 2007)
EPC industry in Portugal — Present status
The present status of the Portuguese EPC industry was recently described by Marino et
al (2010). The markets for energy services and efficient technologies have been devel-
oping since 2008, mainly supported by the energy efficiency programmes of the gov-
ernment. Some of those programs allocated important funds for the support of ESCO
activities. Other program requires industries to perform energy audits and to present and
implement energy efficiency project containing specific measures to reduce energy con-
sumption. At present, the public procurement of new energy projects is assumed as the
main driver for the growth in the EPC market in Portugal. Recently, the Portuguese
government has established new procurement rules (DL 29-2011) in order to facilitate
long term EPC agreements between ESCOs and public administration. With these pro-
2011 International System Dynamics Conference in Washington, DC
grams and governmental commitments to support EPC, a strong boost in this sector was
expected.
Despite of those policies supporting EPC projects, the Portuguese EPC market has been
growing at a slow rate. Approximately 10 firms declare that they are ESCOs. Most of
these companies are small. There are not many cases reported of EPC based projects.
Some companies declare that are using EPC, though other types of non-performance
based contracts are much more frequent (Marino et al, 2010).
3. Research Objectives and Methodology
Problem statement
EPC projects focus at the deployment of comprehensive solutions for improving energy
efficiency. This type of contract would help to overcome financial constraints to energy
efficiency investments by paying off initial costs through the future energy cost savings
resulting from reduced energy consumption. However, as the present analysis points
out, despite of government policies supporting EPC, the EPC market in Portugal is un-
derdeveloped, far from its promised potential. An important question remains — what
policies and managerial processes might expand the attractiveness the EPC model and
foster the diffusion of its adoption in the Portuguese market?
Research objective
This research focuses on how to foster the development of an EPC industry in Portugal.
The key question is to understand the key factors of the Portuguese EPC market and the
dynamic interactions among those factors that will drive the adoption of EPC. Some
specific questions are:
- Why is EPC perceived as an important solution for the improvement of energy effi-
ciency?
- What are essential variables that determine the value of EPC?
- What are critical factors that inhibit or facilitate the diffusion of EPC?
- How do these factors interact with each other?
- What are possible intervention policies and managerial actions to foster the EPC adop-
tion?
Methodology
To explore and gather insights on those questions, a system dynamics model represent-
ing the system of the Portuguese EPC market at industry level will be created. The
simulation of that model will provide a helpful basis for analysing and explaining the
development of key variables, and accelerating learning on the managerial, organiza-
tional and political adaptation processes that foster the diffusion of EPC adoption. The
main purpose is to recommend political and managerial actions that foster reinforcing
processes towards a sustained diffusion of EPC.
2011 International System Dynamics Conference in Washington, DC
This paper describes the first steps towards the development of a system dynamics
model representing the Portuguese EPC market system. The methodological approach
for capturing the critical variables and its interrelation to be included in the simulation
model considers the following data and methods:
- The current research builds on a review of existing literature on factors and barriers
facing the EPC industry (Bartoldi et al, 2006; Goldman et al, 2005; Marino et al, 2010;
OECD and IEA, 2007; Seefeldt, 2003; Soroye, 2010; Steinberger, 2009; Vine, 2005);
- The author conducted informal semi-structured interviews based on a questionnaire.
The purpose of this survey was to discuss the experience of energy efficiency experts,
national authorities, EPC professionals, academia, and financial institutions regarding
the status and development of national EPC industry;
- Qualitative content analysis of documents and texts about this subject was also apply,
seeking to identify perceived factors, barriers and cause-effect relations that might ex-
plain and drive the EPC market development. The texts surveyed include political, legal
and regulatory documents, written interviews with government members, papers issued
by national and regional energy agencies, communications presented in conferences and
workshops on energy efficiency and EPC. Results reported in recent studies concerning
this subject were also considered as secondary data (Marino et al, 2010).
The system dynamics model will be developed according to the standard modelling
process (Sterman, 2000). The present research phase focuses on the step 1 (Problem Ar-
ticulation) and step 2 (Dynamic Hypothesis) of the modelling process. The modelling
step “Dynamic Hypothesis” comprises the development of a theory about the dynamics
characterizing the problem in terms of underlying feedback and stock and flow structure
of the system (Sterman 2000).
1. Problem Articulation
iA
5. Policy
Formulation
& Evaluation
\
4. Testing
3. Formulation
Figure 1: The iterative process of model development (Sterman, 2000)
The dynamic hypotheses and the preliminary representation of the system structure will
be developed according to the following steps:
2011 International System Dynamics Conference in Washington, DC
- Definition of model variables based on data surveyed.
- Formulation of influence and causal loop diagrams. Analysis of positive and negative
feedback loops of the system. These diagrams show the critical variables and their inter-
relations that are involved in the treatment of the research problem.
- Preliminary representation of the system structure as stock and flow diagrams.
4. Adoption of Energy Performance Contracting
4.1 How EPC influences the success of a policy for energy efficiency
The data collected in the present study suggests that Portuguese policy makers under-
stand that EPC may play a significant role in helping Portugal to reach current targets in
the European Commission Directive for energy efficiency (2006/32/EC). The expecta-
tions of that positive contribution of EPC are routed in the causal relations described in
diagram of figure 2. The diagram was built by using the data gathered in the present
study and describes the perceived macro-economic impacts of EPC adoption in terms of
national energy efficiency.
cb Market
incentive oo ™~\,
4 Performance of
———> energy efficiency
initiatives
Improvement of
_7t National energy
efficiency
+. Performance
incentive
Policy to +
foster EPC
adoption Diffusion of
energy efficient
Intensity of Economies of scale _technologies and
EPC adoption and learning effects practices
t
+ Rebound effect
mitigation
+ Number off initiatives
for improving
energy efficiency
Figure 2 — Macro-economic effects of adopting EPC
The success of the national policy for energy efficiency implies to accomplish the im-
provement objectives stated in the PNAEE (Improvement of National Energy Effi-
ciency). In order to meet those objectives, a great number of efficiency measures must
be defined and implemented in public and private corporations (Number of initiatives
2011 International System Dynamics Conference in Washington, DC
for improving energy efficiency). Moreover, all those initiatives must be performing
effective, which means that efficiency projects should effectively produce the estimated
savings over time (Performance of energy efficiency initiatives). The success of energy
efficiency efforts is also influenced by the rebound effect (Hertwich, 2005; Herring and
Roy, 2007). Performance incentive, economies of scale and learning effects, and market
incentive are factors that mediate the effect of the intensity of EPC adoption on the per-
formance of energy efficiency initiatives.
Performance incentive
The EPC model is based on principles of the Performance Economy” (Stahel, 2006),
which optimizes the use or function of goods and services, knowledge and capital. The
economic objective of the EPC is to create the highest possible use value for the longest
possible time while consuming as few energy as possible. Thus there is a performance
incentive of ESCO to design and implement the energy efficiency project in order to
maintain and improve performance over time.
Market incentive
In the case of energy efficiency projects being managed in-house, the staff assigned to
the project will be shielded from the incentives of market competition and top manage-
ment may lack adequate benchmarks to evaluate project performance. Competitive bid-
ding for EPC services will facilitate benchmarking and provide an incentive to ESCOs
to minimise project costs and maximize energy savings.
Economies of scale and learning effects
Many organisations lack the skills and scale to manage energy projects properly. ES-
COs have greater access to information, and skilled staff in the relevant areas. Such staff
is able to develop and apply specialist skills that would not be feasible within the client
organisations and to rapidly disseminate learning benefits between different clients.
Similarly, as ESCOs specialise in management and contract of energy projects with
multiple clients, they achieve considerable scale economies. For example, ESCOs may
obtain quantity discounts on equipment purchases by combining the needs of multiple
client projects.
Diffusion of energy efficient technologies and practices
Since EPC contracts are continuously based on the current state-of-the-art, it would also
accelerate the diffusion rate of the most efficient technologies. Thus, there is a common
idea that EPC will foster constant innovation and will facilitate the diffusion of energy-
efficient technologies and practices.
Number of energy efficient initiatives
The data collected suggests that EPC could minimize the number of energy efficient
initiatives not accomplished due to technical and financial difficulties or long payback.
For many private or public organizations, the up-front capital investment in efficient
equipment seems to be a significant barrier. In such cases, EPC lowers the barrier of the
higher costs of efficient equipment.
Factor of rebound effect mitigation:
2011 International System Dynamics Conference in Washington, DC
Frequently, it has been observed that energy consumption increases after the implemen-
tation of an energy efficiency project. This phenomenon is known as the “‘rebound ef-
fect’’ (Hertwich, 2005; Herring and Roy, 2007). The use of more efficient technologies
may decrease the attention to the level usage of energy services, and consequently the
efficiency gains may be temporarily offset by usage increase for specific energy ser-
vices. The dynamics of this effect is described in causal loop diagram of figure 3. The
“rebound effect” is expected to be mitigated when energy performance contracting is
adopted.
+, Efficiency of
Energy services
Implementation of
energy efficiency B
projects R Attention to usage
of energy services
Usage of / a
Enetsy energy services
Figure 3 — Causal loop diagram representing the rebound effect
4.2 Factors effecting value of EPC
Figure 4 shows the interaction of the main factors affecting the cost and value of im-
plementing energy efficiency projects through EPC model.
White certificates
Energy authorities have assumed that the introduction of White Certificates will influ-
ence positively EPC value and adoption.
Value of future savings
The value of future savings achieved through EPC will depend upon the values of future
energy savings and costs of EPC.
Trend of energy price
The rising trend of energy prices, including energy taxation, is understood as a favour-
able key market driver for EPC. The steady rise in energy prices and taxes has de-
creased the payback time of energy efficiency investments and increased the demand of
energy efficiency investments and therefore EPC. On the other hand, falling and volatile
energy prices are expected to have a negative impact on EPC.
EPC market competitiveness
The value captured by ESCO will depend upon the competitiveness of the EPC market.
Authorities fear that limited competition provides scope for inefficiency and monopolis-
2011 International System Dynamics Conference in Washington, DC
tic pricing by the EPC contractor, which will be reflected in inefficiencies in contract
execution.
Energy expense as
White certificates percent of total
supporting EPC. a expenses
Volatility of
Value of EPC
energy price
Percentage of uw
value captured
by ESCO Value c future
+
savings — Future energy
savings due to
EPC mark ae
prarnet Cost oo
competitiveness \ +
Trend of
energy price
Cost of EPC Perception
+ + of risk
Subsidies mn
for EPC EPC transaction | -
costs sy
Contracting and
Cost of EPC PVM standards
implementation
F Client assets
specificity
Learning effects
Figure 4 — Factors effecting value of EPC
Subsidies available for EPC
It is assumed that subsidies and government programs supporting energy efficiency pro-
jects and EPC may be necessary to foster the first moves of this industry.
EPC transaction costs
Asset specificity and standardization of performance contracting and verification deter-
mine the transaction costs which in turn influence the total cost and feasibility of EPC.
For small projects, EPC may offer large percentage energy savings, but the absolute
savings are likely to be outweighed by the associated transaction costs.
The high level of detailed information required for performance contracting and verifi-
cation is considered costly and time consuming, especially for projects of smaller scale.
To reduce those costs to a reasonable level it is assumed that standards to support effi-
ciently those tasks must be developed and applied. Moreover, it is expected that stan-
dardize contracts and measurement and verification procedures will help energy users
and the financial community better understand EPC.
The specificity of client assets influence the transactions costs as the size and learning
advantages of the EPC contractors should depend upon the nature of the technologies
required to provide the relevant energy services. EPC contractors primarily have exper-
tise in generic technologies. In contrast, most contractors do not have comparable exper-
tise in specific process technologies, which will require high transaction by the ESCO in
hiring and training staff, learning by doing and so on.
2011 International System Dynamics Conference in Washington, DC
Perception of risk and cost of capital
Estimation of energy savings potential and performance verification involve volatility
data which is an important source of risk. This perceived risk forces lenders to increase
the cost of borrowing, which in turn erodes the intrinsic cost-effectiveness of EPC pro-
jects and lowers the overall level of available financial resources.
Learning effects and EPC capabilities
Learning effects in increasing EPC capabilities are often mentioned as important drivers
for decreasing EPC cost elements and increasing the certainty of the estimated future
savings.
4.3 Factors that affect the adoption of EPC
Figure 5 presents the main factors identified that affect the adoption of EPC. These in-
clude regulatory factors, such as legislation, public procurement rules and subsidies
programs; market factors such as, economic value and competitive pressure; behav-
ioural factors, such as the agency problem, aversion to outsource energy projects, aver-
sion to technical risk, the familiarity with EPC contracting and procedures for perform-
ance measurement and verification, and ESCO reputation; and the effects of communi-
cation and word-of-mouth.
Competitive pressures
The effects of cost competition together with the need to improve cash flows and use
off-balance sheet solutions for energy efficiency investments represented a strong factor
for EPC in most firms surveyed.
Investment subsidies and program deadlines played a powerful role in making EPC
attractive for many clients. Beyond providing a financial source, subsidy programs pre-
sented firm deadlines, which fostered a sense of urgency for action which drives EPC
adoption.
Awareness and perception of EPC benefits
Low awareness and scepticism towards the potential benefits of EPC was one of the
most commonly reported barriers to the deployment of EPC projects. Most potential
clients are ignorant of the concept or are reluctant to adopt EPC. The subjects surveyed
revealed a common view about the importance of disseminating information on the
benefits of implementing energy-efficiency projects through EPC, particularly in situa-
tions where there are limited financial or technical capabilities (e.g. in public buildings).
Such communication actions will help to build client confidence with EPC.
Standardization and Familiarity with EPC contracting and performance, meas-
urement and verification (PMV)
The lack of standardization in EPC contracting and performance measurement and veri-
fication (PMV) of project savings is perceived as an important motive for mistrust in the
EPC model both from clients and from financing institutions. Standardizing these proc-
esses will help end-users and the financial community better understand EPC. Also,
transaction costs may be lowered by standardised contracting and PMV.
2011 International System Dynamics Conference in Washington, DC
Communication
a effectiveness
Awareness and
perception of EPC
benefits 4
Aversion to YW Woord-of mouth
technical risk effect
Aversion to outsource
of energy projects
ESCO reputation
Economic :
value of EPC %
+ +4 4
Standardization and
familiarity with EPC
+ it contracting and PMV
Competitive ___——* Adoption of EPC -
pressure
+ +
a Public procurement rules
Subsidy program 7 supporting EPC a
deadlines
Environmental
awareness and
policies
Legislation and regulation i
‘Agency supporting EPC
problem
Figure 5 — Factors that affect the adoption of EPC
ESCO’s reputation
The ESCO’s track record can influence the EPC adoption. Many advocated an accredi-
tation system for ESCOs to provide a qualified and reliable EPC project.
Legislation and regulation supporting EPC
Accordingly to subjects surveyed, environmental awareness and climate change policies
have had a positive effect with the implementation of favourable legislative frameworks
and concrete implementing measures, as well as gaining political support for EPC adop-
tion. For example, the EU Directive on Energy End-Use Efficiency and Energy Services
(2006/32/EC) has stimulated and facilitated investment in energy efficiency and fos-
tered the development of EPC model by requiring Portuguese government to remove
barriers to ESCOs. The European Performance of Buildings Directive (2002/91/EC) and
its recast 2010/31/EU (EPBD) state the minimum requirements to the energy perform-
ance of new and existing buildings and introduce requirements related to national plans
for increasing the energy certification of buildings. These Directives are faced as impor-
tant EPC adoption drivers.
Agency problem
The “principal-agent problem” arises when the person that owns and invests in energy-
saving technologies is not the person paying the energy bills. The case in which deci-
sion makers do not receive the benefits of energy savings was mentioned as being a
considerable barrier to the adoption of EPC.
2011 International System Dynamics Conference in Washington, DC
Aversion to outsource energy management
One factor reported that influences negatively the adoption of EPC it the aversion to
outsource energy management, especially where in-house technical expertise exists.
Public procurement rules
Requirements for public procurement represent another potential barrier for EPC adop-
tion. The public procurement procedures in use in Portugal are very complex and time
consuming, which increments the transaction costs of EPC projects, undermining their
viability. Portuguese laws regarding public market tendering must be designed to facili-
tate EPC adoption.
4.4 The Dynamics of the development of an EPC industry
The analysis of the data surveyed suggests some positive feedbacks that could support
the development of an EPC industry if they were understood and considered by manag-
ers and policy makers. There are also positive feedbacks that support in house energy
projects and established energy services and technologies providers. Figure 6 depicts
many of these loops.
Aveilailty of anergy.
Conmiein 2 secu fo BPC r
i WOU ete ay
Exposed pets
"
- R
fiom EPC
Perception cE aastting Adoption of BFC
‘oeenty awareness and B
eoafidente R a Mates
Builing Familiarity with +
# faniliaiy EPC consnating
FRC Attastivensss el EMIY
Accumulation of
+ +
7 + saat sapsiencr in BFC
Pateegtion of R XY eee, ESCDe and Financ,
‘technical risk Building a institutions)
+
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Cost of
PC
Witngueste inven wi
fe energy efficiency Economic 7 soucces
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sangeet R cupacty
‘tadtionel suppliens ——Reinforsing in a
Bi ‘owe ehatayy Attertiveness of = EPC market +
eojects inhouse energy Nuinher of ESCO2
competitiveness
to +
Hind
ere
jecta
Figure 6 — Causal loop diagram representing the development of an EPC industry
Reinforcing in house energy projects
Clients have defined and implemented in house energy projects helped by energy con-
sultants and suppliers of end-user energy technologies. This model is very familiar to
the firms and enters positive feedbacks that support the attractiveness of in house pro-
jects model offered by established energy consultants and technologies suppliers. When
2011 International System Dynamics Conference in Washington, DC
evaluating the EPC alternative, managers have difficulties in understanding their eco-
nomics and benefits and they perceive it as uncertain and costly. Therefore, the safe de-
cision is to continue using the in house model, which reinforces its familiarity and en-
courages further use in the future.
Building awareness and confidence
The benefits of EPC must be known and understood in order to improve its attractive-
ness. Also, the mutual trust between ESCOs and clients must be achieved, leading to
increased comfort with EPC. The power of word-of-mouth marketing among clients
would help meeting that objective. As EPC is first introduced, there is an intrinsic resis-
tance to the unknown that is mitigated as more EPC is adopted and positive word of
mouth concerning its benefits spreads. However the word of mouth loop only works if
there are enough firms to spread the experience with EPC. If there are not enough new
adopters it may further discourage other firms from adopting EPC.
Building perception of technical risk
One of the main EPC benefits is the transfer of technical risk from the client to the
ESCO. New and more efficient energy technologies involve some technical and opera-
tional risks which may jeopardize future savings and the viability of the project. The
perception of that risk will detract from the attractiveness of in house projects and will
favour the EPC alternative.
Building familiarity
The initial poor attractiveness of EPC can probably be explained by the unusual busi-
ness model. Once the adoption of EPC streams, ESCOs and energy end-users become
familiar with EPC contracting and performance measurement and verification. This
process of building familiarity increases the attractiveness of EPC.
Adjusting regulation
Some legal and regulatory problems will be revealed as EPC adoption evolved. Large
ESCOs and energy efficiency organizations may use these insights to influence the
shape of regulations that favour or lower the cost of EPC. These regulations result in
increased economic attractiveness of EPC.
Learning and increasing of EPC capabilities
One of the most important positive loops is supposed to be the virtuous learning- accu-
mulation of experience loop. This learning process will create and enhance the capabili-
ties of the ESCOs and the financial institutions for implementing EPC projects. As ES-
COs are engaged in EPC projects they gain further experience, most project processes
become less costly and they improve their technical, financial, management and market-
ing abilities in order to develop the market. The lower cost of EPC increases its attrac-
tiveness and encourages further adoption. Also, the financial institutions will start see-
ing EPC businesses as a promising market niche and gradually improve their expertise
when it comes to EPC projects.
Building market capacity and competitiveness
Thanks to the increasing economic attractiveness and accessibility to financing which is
due to the learning effects, an increasing number of ESCOs enter the market.
2011 International System Dynamics Conference in Washington, DC
Market saturation
Market saturation induces a negative loop that limits the growth of EPC industry capac-
ity. The more the EPC adopters on the system, the less the potential projects and the
lower the expected profits from EPC. That causes a process of market saturation and
may discourage new ESCOs to enter the market.
5. Model Development
System Dynamics has a valuable track record for studies in the energy sector. The perti-
nence and legitimacy of using SD in such strategic studies stem from the ability of cap-
turing structural mechanisms and feedback loops, which cause either success or failure.
We intent to develop a simulation model to better identify and understand the factors
that most determine the success in fostering an EPC industry. The purpose of the model
is to help the definition of policies that will increase the adoption of energy performance
contracting. The main model structure will include feedback relationships that represent
the previous discussed dynamics.
Efffect of policy and
regulation
Learning and
capability
effects
Effect of economic
factors oo
Familiarity effects
EPC attractiveness on
Word-of- mouth
effects ™
Population Potential fare Interested ‘Audits in Progress Wy EBC Adopters
Potential Var Become Aware Become Interested || Audit Adoption Rate || EPC Adoption Rate
peciinvemsted interest Lost
Rejecting EPC
Regain Rate Rejectors
Figure 7 — Stock-flow model representing the EPC market.
The subject of the model is the development of an EPC business at industry level. The
market consists of public or private buildings with potential for an energy efficiency
project and may benefit from adopting the EPC model. The geographical focus of the
model will be Portugal. Figure 7 shows a stock-flow diagram representing an initial
conceptualization of the model. The EPC market is modeled as a series of stocks repre-
senting prospective clients at various stages in the adoption cycle. Clients move among
various stages and it is important to understand how clients move between them. This
client choice pipeline (Warren, 2008) is based on the Bass diffusion model (Bass, 1969)
2011 International System Dynamics Conference in Washington, DC
which was extended in order to more closely represent the process of marketing devel-
opment. Based on interviews and previous studies, the stock of potential EPC adopters
was disaggregated into “Population”, “Potential”, “Interested”, “Audits in Progress” and
EPC Adopters.
The stock “Population” represents the total number of organizations that own commer-
cial buildings. These organizations can possibly adopt EPC at some point in the future.
“Potential” consists of organizations that own buildings with economic potential for im-
plementing an efficiency project with EPC considering the current technical and eco-
nomic conditions. The stock Potential is replenished from the stock Population as eco-
nomic, legal and technical conditions evolve and drive the increasing of the number of
buildings with economic potential for implementing an efficiency project with EPC.
These organizations are identified by ESCOs and are object of their marketing and sales
effort to persuade them to learn more about the EPC model.
“Aware” consists of organizations that own buildings with economic potential for im-
plementing an efficiency project with EPC and their decision makers are aware of the
EPC model but have not decide adopting it. ESCOs apply sales effort to convince the
decision makers of these organizations to learn more about EPC to be able to decide to
adopt it.
“Interested” represents organizations that have expressed interest in adopting EPC.
Once a potential client has become an Aware, they will form a favourable or unfavour-
able perception of the EPC and become either an Interested or a Rejector. As potential
clients form a favourable perception of the EPC, they flow (Become Interested rate)
from Aware to Interested. This flow is dependent on some components of EPC attrac-
tiveness, marketing and sales effort and word of mouth. As more organizations decide
to adopt EPC, persons from those organizations will come in contact with persons from
other organizations and spread word about their EPC benefits. It is assumed that many
decision makers will not adopt EPC without heard about its benefits at other similar or-
ganizations.
“Audits in Progress” are organizations that have closed an initial EPC agreement for
performing an energy audit. Potential clients flow from Interested to Audits in Progress
(Audit Adoption Rate) as they are engaged in an energy audit agreement in order to de-
sign an efficiency project. The Audit Adoption Rate is dependent on some components
of EPC attractiveness and sales effort. It is assumed that marketing and word of mouth
are no longer determinant factors at this stage.
“EPC Adopters” are organizations that have contracted energy performance and imple-
mented the associated energy efficiency project. Once the energy audit has performed,
the ESCO presents the client an EPC offer. The clients flow (Adoption Rate) from “Au-
dit in Progress” to EPC Adopters as they sign an EPC agreement and ESCOs install and
to put into operation the efficiency project. The Adoption Rate depends on ESCO sales
and engineering effort, and some components of EPC attractiveness. At this stage, it is
assumed that word of mouth is not relevant.
2011 International System Dynamics Conference in Washington, DC
There is a stock of “Rejectors” which are prospects that lost interest in adopting the
EPC or decided not to adopt.
The simulation model to be developed will consider parameters that represent the exis-
tence of factors that might make some components of EPC more attractive and drive the
adoption cycle: economic factors such as the energy price and the base cost of capital;
government policies, financial incentives and legislation supporting EPC adoption. The
model will allow one to adjust the intensity of those factors. The model will also con-
sider the influence of advertising and word of mouth loop. It is expected that word of
mouth and marketing will have a significant impact on some stages of EPC adoption.
Additionally, other feedback loops will be included in model such as the processes of
building familiarity and enhancing capabilities in dealing with EPC.
The following phase of the present research will involve the formulation of the equa-
tions that determine the rate of potential clients moving along the choice pipeline. Par-
ticularly, the time delays involved in each stage of adoption are of great importance in
this process. Those equations will consider the factors identified in the qualitative sur-
vey that mostly influence the EPC adoption. The quantitative modeling will be based on
prior research on the dynamics of the diffusion of innovative services and products.
6. Conclusion
This paper describes the first steps towards the development of a system dynamics
model for exploring and learning about the diffusion of EPC. The present research
phase focuses on capturing the critical variables and its interrelation to be included in
the simulation model. With this purpose, a review of existing literature on factors and
barriers facing the EPC industry was performed and relevant primary and secondary
data were acquired through informal semi-structured interviews and qualitative content
analysis of documents.
Numerous factors and cause-effect relations were identified that affect the adoption of
EPC. These variables were analysed and considered in a qualitative modelling process
which involved causal and stock-and-flow diagramming. The present phase produced a
stock-and-flow diagram as a first qualitative conceptualization of the intent system dy-
namics model representing the diffusion of EPC at industry level.
Accordingly to the modelling process (Sterman, 2000), the following research phase
will focus on the formulation and testing of the system dynamics model. That phase will
address the quantitative estimation of parameters, relationships and initial conditions, as
well as the test for consistency with the purpose and boundary.
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