Energy performance contracting, a new trend in British industry

Brian Foster, head of industry finance, Siemens Financial Services, discusses the trend of energy performance contracting in UK manufacturing.

Manufacturing sector on the rise

2014 has seen good news – good for the economy as a whole, and good for manufacturing in particular. The UK’s key manufacturer’s index  (UK Manufacturing Purchasing Managers’ Index) used to track the sector’s sentiment has been well above the 50/50 expansion/contraction mark for the year to date, and given that the European aggregated economy seems to have turned the corner, the manufacturing sector seems to have put the doldrums behind it. The British Chambers of Commerce (BCC) revealed in its latest survey (made up of responses from 7,500 businesses) that for both manufacturing and services, all the key Q2 performance indicators are stronger than their long-term averages.

During the recessionary period, aggravated economic conditions, compounded by limited liquidity in the market, propelled many manufacturing firms to put their investment plans on ice. Now, as the economy is gathering steam, manufacturers are warming up to the idea of embarking on essential equipment investments. Accordingly to the latest survey from EEF The Manufacturers’ Organisation and accountants BDO LLP, a balance of change of 28 per cent of companies intended to buy machinery and equipment in the year ahead, down only slightly from the previous quarter’s record-high level of 34 per cent.

Financial bottleneck must not stifle investment ambitions

These are all very welcoming signs for the manufacturing industries. However, translating investment ambitions into reality might not prove straightforward given the financial hurdles facing manufacturers, in particular smaller-sized companies. Successive editions of the Bank of England’s Trends in Lending survey have

shown that the volume of bank loans lent to British businesses has fallen consistently since 2009. This is no doubt the result of tighter lending criteria from the banking community to reduce the risk in their portfolios so that they have to hold less regulatory capital under the formula implemented by the Basel III international banking regulations.

This restricted access to bank lending is particularly significant for the implementation of energy-efficient solutions in industry, as manufacturing businesses are often high energy consumers. Investing in energy-saving solutions can dramatically reduce industrial business’ energy consumption and consequently their operating costs. Newer, energy-efficient technology also often introduces greater productivity and manufacturing capacity – so there are more advantages to be gained than just the energy savings.

The extent to which businesses’ investment plans can be derailed due to a lack of financing is clearly illustrated in a poll from Siemens Industry and the Energy Institute. The survey unveiled that one of the most significant issues facing businesses wanting to invest in energy-efficient technologies has been accessing the required finance. A substantial 88% of respondents said that banks and the financial sector were either not interested in supporting investment in green technologies or provided “little feedback”. Approximately one in ten respondents had “positive feedback” but less than 1% had actually received finance for this type of investment.

So if generalist financiers (the banks) are not creating special schemes to finance green investments, then it is clearly up to the technology providers to do so, either through partnership with a financier, or through their own internal finance arm (like Siemens Financial Services). As this type of approach begins to take off – and it is still in its early days in the manufacturing sector – we are seeing a new solution offering emerging, in the form of energy performance contracting.

In an energy performance contract, the technology provider analyses the manufacturer’s site, predicts the levels of energy savings that can be achieved, and then agrees to deliver the whole solution – technology, implementation, maintenance, measurement – over a given period. With this approach, the technology provider carries out modernisation work in the facility without the need for customer capital expenditure or an immediate cash-out, because the investment costs are covered by the expected energy savings.  Once the upgrade work is completed, an efficiency guarantee or similar commitment comes into force. During this phase, reports on the energy savings achieved are prepared at regular intervals to ensure that targets are met. This requires precise monitoring of installations to ensure that the savings commitment is upheld (including agreed behaviours by both parties) and to enable installations to be fine-tuned for optimum operation.

Of course, each case varies, and some projects will be completely self-funding, others will radically subsidise costs through the resultant energy savings. After the financing period is over, the customers then reaps 100% of the reduction in their facility’s energy costs, and the modernisation work on their property can boost its value too.

Clearly, traditional borrowing cannot always sufficiently fulfil businesses’ financing needs for new investments. Indeed, not only is there an imperative need for manufacturers to explore other financing options, they also need to become more financially nimble in order to adapt to a post-crisis world where working capital optimisation has become a high priority. Siemens research has calculated that over £12 billion a year is tied up in UK manufacturing industry due to outright equipment purchases, capital that could be freed for other business-driven activities if financing solutions, such as energy performance contracting, were more widely employed. Energy-efficient solutions in industry are also becoming an imperative when viewed in a context of rising electricity prices. The manufacturing industry has seen the average price paid for electricity, excluding the Climate Change Levy (CCL), rise from 5.507 pence per kWh in 2006 to 7.749 pence per kWh in 2013, a significant increase of more than 40%. The inexorable rise in energy prices is especially damaging for energy-intensive industries such as chemicals, steel, cement, aluminium, glass, paper and ceramics, squeezing businesses’ hard-earned profits yet further.

Generating growth and saving energy with smart finance   

Financial efficiency has become a critical factor in determining manufacturing business success, especially since relatively recent higher capital adequacy requirements for banks herald a new era of banking with tighter lending conditions. Investing in energy efficiency really does make sense in the high-energy-consumption world of manufacturing, often bringing productivity and capacity benefits as additional benefits from equipment upgrades and technology investments that come as part of the energy performance contracting solution.

The implementation of energy performance contracting in British industry is still at its early stages. However, its attractions are so compelling, with project risk transfer to the solutions provider, that it is difficult to believe these arrangements will not become mainstream by the end of the decade.