Incoming changes to accounting rules may materially affect energy performance contract structures and risk allocation. But there may be upsides, experts suggest. Brendan Coyne reports
IFRS 16 is a new leases standard that comes into effect on 1 January 2019. It requires virtually all leases to be recognised as on balance sheet. That’s a big change and will affect businesses across all sectors – from those that rent fleets of aircraft, to company cars, to computers.
But the world is not going to stop leasing. Experts suggest IFRS 16 compliance essentially requires a change of contract structure and, potentially, some operational adjustments.
While uncertainty tends to create inertia, IFRS 16 could lead to positive outcomes for energy efficiency service models, suggests Steven Fawkes, European lead on the Investor Confidence Project.
Fawkes says the nub of IFRS 16 means classifying deals as service contracts where suppliers have the right to make decisions on asset operation.
“That is the interpretation that needs to happen so it can be treated as off balance sheet,” says Fawkes. “It is all around how you interpret who is in control of the asset.”
While that may create friction between parties unwilling to cede control over key assets to third parties (see box below), Fawkes believes it creates opportunity for innovation.
“The service aspect is key. But, ultimately, if people want to find a solution [to IFRS 16 compliant models], they will. But it may move us away from pure financing models where risk is not really transferred to more interesting contract forms,” says Fawkes, nodding to pay-for-performance models emerging in the US that revolve around “metering energy efficiency”.
“In those kind of models [the provider] is taking a risk and that can take you into some really interesting areas,” says Fawkes.
He uses the example of a portfolio of 10,000 home retrofits, where half use one contractor, and half use another, with performance analysed to see which performed best.
“Then, if you are paid on performance, you either get good at improving performance or you go out of business. If you are paid on delivering, you must deliver or else – and you are taking a risk. So there is a fit with changes to accounting rules and emerging models of energy efficiency.”
Public sector double whammy
While financiers and energy services companies think they can handle IFRS 16 rule changes, the public sector faces a double whammy in the form of European System of Accounts 2010, or ESA 10, says Kathryn Dapré, head of engineering, energy and sustainability, NHS National Services Scotland.
ESA 10, which is monitored in Europe by Eurostat, governs EU countries’ net debt, how it is accounted and what can be classified as revenue versus capital funding for public sector budgets. Updates from Eurostat have indicated that energy performance contracts (EPCs) now effectively hit capital budgets, unless the EPC contractor is bearing the majority of the risks and rewards associated with the use of an asset.
In Scotland, ESA 10 particularly affects the NHS because it does not have borrowing powers. Trying to find an EPC contract that satisfies both ESA 10 and IFRS 16 is somewhat challenging, says Dapré.
Under her watch, two NHS boards have EPCs in operation, signed off as operating leases before rules changed. The third, procured after ESA1 0 kicked in, is self-funded and about to enter operation.
Dapré is delighted with initial results. “The savings we are achieving and the quality of installations are brilliant. I would have loved to have done more.”
But for now, she faces several tall hurdles.
“If a company genuinely has an off balance sheet structure that complies with IFRAS 16 and ESA 10 they are sitting on gold dust,” says Dapré.
Even if those contracts exist, and companies are willing to share them, the level of contract scrutiny required from Scottish government, and a green light for each individual project under that structure, is not insignificant, says Dapré.
That paperwork must be undertaken before the equally challenging task of selling service contracts both to Boards and to O&M staff can commence.
Dapré thinks ceding control of key items of energy infrastructure could be a deal breaker.
For those reasons, Dapré is “doubtful we will find a model where we can borrow that satisfies both the accountants and the estates departments. Even if it can be proven as off balance sheet, it is a really difficult sell.”
IFRS 16: How will it affect EPC market?
Duncan Child, head of program management, UK energy and sustainability services at Schneider Electric, outlines the firm’s view on IFRS 16 and how it will impact both energy services firms and their customers
The change to IFRS 16 will impact the EPC market, where the EPC is currently procured under an operating lease. Where the EPC is self-funded, then this is not an issue. The implication of this change is that the decision to allow an EPC provider to control the usage of the asset(s), once installed, now becomes critical to the customer’s decision as to whether they want the EPC to be off balance sheet.
Assuming that companies would prefer to have the EPC off balance sheet because of the potential impact to their debt/equity ratio of an on balance sheet EPC, this then implies that for the development of the EPC market, companies/organisations must be willing to accept that if they want to benefit from the energy and cost savings from an EPC then they must permit greater control and operation of their asset to a third party EPC provider.
This could be challenging to some companies as they may not be willing to provide part/full control of their building operation to an EPC provider, especially where this could impact on maintenance operations and possible staffing requirements. On the other hand, this may not be so much of an issue for companies that are already using third-party FM provision.
What’s the upshot?
For businesses, this change to the accounting rules is also creating some uncertainty and indecision as to whether to invest in an EPC. Private sector companies that have a more strategic and proactive mindset towards embracing energy efficiency and the wider sustainability benefits that an EPC project can bring, are generally more accepting of this change and therefore continuing to look at potential EPC projects, whether on or off balance sheet.
On the other hand, companies that have a more responsive and reactive mindset are now becoming hesitant in investing.
This article was originally published as part of an in depth feature on energy finance in the February/March print issue of The Energyst. If you have some responsibility for energy within your organisation, you probably qualify for a free subscription.