Demand for energy efficient buildings offers advantages for contractors.
The abundance of energy services opportunities in the building stock in the United States and abroad is drawing new service providers into the industry. Traditional mechanical, electrical, controls, design-build and general building contractors have recognized their clients’ demand for more efficient, comfortable and productive buildings. These firms have seen energy services companies (ESCOs) deliver higher-margin projects and services that provide significant value and benefits to building owners and occupants.
The founder of one mechanical services provider states, “Moving into the energy services business absolutely sustains the ability to provide the best service to our core customers.” This view has led many traditional contractors to expand into energy services, often seen as a natural extension of their core businesses.
The Energy Services Opportunity
The marketplace for energy services is complex and dynamic. Exhibit 1 outlines subsectors of the energy services market. Many of these energy services are far removed from the work of traditional contractors. Others, such as design and construction of energy efficiency and distributed generation projects, two pillars of the energy services market, are direct extensions of a traditional contractor’s core business.
As shown in Exhibit 2, the market for conventional mechanical and electrical construction declined from 2008-11. During this difficult recessionary period, the energy services market continued to grow. Although the mechanical/electrical markets have recovered since 2012 (and are expected to return to 2008 levels by around 2016), the energy services market has expanded and is expected to continue doing so at a somewhat higher rate than the conventional mechanical/electrical market. Additionally, energy services projects often have higher gross margins than traditional electrical/mechanical projects, because the required services are more specialized, differentiated and often tailored to unique client attributes.
These market fundamentals present an attractive opportunity for contractors who can leverage their current capabilities and expand or shift their strategies to the energy services marketplace — either organically or through acquisitions. This market opportunity has benefited many firm owners who want to solidify their customer relationships and grow revenues and profits. “It is a threat when one of our good clients has a need and we are not able to provide for that need, but it is also an opportunity if we have the right strengths,” states an owner of an HVAC service company.
While expanding into energy services may be attractive, actual implementation can be difficult. As one industry veteran put it, “There are a lot of wannabe players and very few real players. That is the hazard of it all. When you peel back the covers, it becomes clear who is real and who isn’t pretty quick.”
When traditional contractors transition into energy services, the following issues often arise:
Efficiency and Effectiveness of Business Development— Selling an energy services contract (i.e., an energy savings performance contract or a distributed generation project) may be a very different process than the contractor has experienced. Sales cycles can be long and upfront development costs high. Selling often occurs at the building manager/engineering level and at the executive level. Projects often require structured third-party financing. The competition may be different and more entrenched (say pure-play ESCOs), and the selection process may differ.
The Pitfall— Taking too long to develop projects. Spending too much to develop projects. Selling unprofitable projects.
Design Capabilities— There is a shortage of experienced engineers who can quickly and effectively develop energy services projects. Energy services projects often are complex and include performance guarantees.
The Pitfall— Inability to design “market-winning” and long-term-performing energy services projects.
Project Delivery— Energy services projects may be outside the scope of a contractor’s core business. This presents additional project delivery risk, and companies experience expensive project learning curves.
The Pitfall— Inability to deliver a new project type profitably.
Risk Allocation— Energy efficiency and distribution generation projects often require contracts to provide long-term guarantees, such as energy savings or run-time guarantees. Overcommitting (or underperforming) on such guarantees can result in significant losses. Furthermore, there may be indemnification or liquidated damages commitments in energy services contracts that are outside of the normal scope for a contractor.
The Pitfall— Unforeseen losses on guarantees, indemnifications, liquidated damages or similar.
Project Financing— Energy services projects often require third-party financing. Firms must understand how to develop projects that are financeable in the capital markets and acceptable to client CFOs.
The Pitfall— Developing projects that cannot be financed or that are not acceptable to client financial officers.
Balance Sheet Management— The cash flows and working capital needs of energy services projects may differ from a contractor’s standard projects.
The Pitfall— Adversely affecting return on invested capital or damaging the company’s working capital position.
The Energy Services Advantage
Despite the pitfalls noted above, the benefits of gaining traction in the energy services market can outweigh the risks, if the risks are properly managed. Paul Oswald of ESI states, “We saw it [shifting ESI’s focus from a trade contractor to energy services] as a transformation in the business to try and move away from being a commodity….most people pick that kind of service based on your rates.”
The less commoditized service landscape and the dynamic suite of energy services allow firms to easily differentiate themselves with their technological capabilities and project resumes. Furthermore, the energy services marketplace allows many opportunities to grow recurring service offerings. These can include on-the-ground facilities services or more technology-dependent offerings such as monitoring-based commissioning (MBCx).
Many energy services can be expanded across a client’s portfolio of buildings (one service to many buildings). Similarly, an energy services provider can often expand energy services once a strong client relationship has been established (many services in each building). Additionally, certain energy services offerings allow the service provider to remain involved with the project and the client over the long term, putting the service provider in the “first responder” position. This allows a firm to gain a competitive advantage when new projects are being planned. Often, service providers can help shape new projects due to their intimate knowledge of the facility and systems. This proximity to the client allows providers to “mine” for opportunities.
Client relationships earned and maintained through successful energy services can be very important for regional firms that compete with the large national firms. Commenting on the importance of energy services to his customers, the owner of one HVAC service provider stated, “The threat is that the local service companies end up losing the relationship with the owner. Multinationals become a threat to that relationship. Energy services was a way that we could become valuable enough on a local basis to preserve that important link.”
While the opportunities for contractors within the energy marketplace are growing, it’s important to remember that this marketplace is both complex and dynamic. It often requires a different set of skills and a new approach. By taking a calculated approach to the market and factoring in key points, contractors will be well-positioned to take advantage of these opportunities. Q
Russell Clarke is an analyst with FMI Capital Advisors, Inc., FMI Corporation’s Investment Banking subsidiary. He can be reached at 303.398.7249 or via email at email@example.com.
Tim Huckaby is a managing director with FMI Capital Advisors, Inc., FMI Corporation’s Investment Banking subsidiary. He can be reached at 303.398.7265 or via email at firstname.lastname@example.org.