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Managing district energy systems

Headshot of Tom Bucher

Tom Bucher | Director, Power Advisory, Houston | 01 October 2021

What are the different deal structures when buying and selling a district energy system, and how do they impact how each system is operated?

From campus to private system, district energy systems are unique. This can lead to several technical and financial aspects that can impact how either system is operated after its acquisition.

That’s why it’s important to understand and consider these differences as part of the transaction’s technical due diligence before making a deal.

The difference between the two is that campus systems have one payor and private systems have multiple.

District energy systems are localized utility systems often providing power, steam, hot or chilled water to several buildings or facilities through underground distribution infrastructure.

However, for both types of district energy systems, the condition of the current assets must be evaluated by reviewing outage reports, maintenance records and its operating philosophy. Existing environmental and operating permits, notices of violations and onsite injuries should also be examined. And the historic and forecasted capital and operational expenditures must be reviewed, as this helps to understand the system’s ability to maintain ongoing operations.

From here, the technical due diligence is tailored to the type of system being assessed. And while the considerations are not absolute, they provide a general guideline.

Campus systems: tighter tolerances and less allowance for outages

Campus systems are usually owned by, and serve facilities like, university campuses, military installations or large industrial complexes. They’re contracted to either a single or multiple service providers who manage the power, steam, hot or chilled water or distributed generation assets.

When they’re sold, it’s often under a long-term concession agreement. These agreements can be last up to 50 years, after which ownership goes back to the original owner. As a result, the contractual obligations, such as the key performance indicators (KPI), are well defined. They also have tighter tolerances for utility service parameters and less allowance for outages than a private system.

Examining the campus system’s proposed KPIs

Since campus district energy systems rely on a single source of revenue, the system’s failure to meet a KPI can have a significant impact on its financial performance.

During the due diligence phase of an acquisition, the buyer or concessionaire must examine the proposed KPIs. This includes checking to see if they account for common occurrences such as scheduled downtime for inspections and maintenance. The buyer must also make sure the district energy system can provide the required level of service.

Apart from the concession contract, there can be several contracts between various parties. For example, these can be with operators, engineering, procurement, construction (EPC) firms, or equipment vendors.

These contracts become more complex once they’re a portfolio, so it’s crucial to understand how this impacts the parties involved. In some instances, the buyer can contractually pass off the risk of an outage, a missed KPI or construction delay to the party best suited to mitigate it. This could be a third-party system operator or EPC firm responsible for the construction.

How to tell if campus systems will pay off

Profit ultimately motivates the portfolio structure. The intent is to make sure there’s a steady rate of return on the buyer’s equity. The buyer establishes the expected return on equity upfront by sharing financial models. And negotiating agreements on model input assumptions in many campus system transactions.

Therefore, the buyer needs to understand the financial upside scenarios, and the cost or risk involved in achieving them. Theis includes whether there is a financial benefit of investing in more energy efficient assets. And who benefits from a reduced price of fuel inputs based on a contract renegotiation?

The buyer will usually find these answers buried in the contractual paperwork. But it’s important for the buyer to understand these best-case scenarios, and develop a strategy for operating the system post-acquisition.

Private systems: full ownership, more coverage

Private district energy systems are usually city based and owned by a private entity who sells its commodity services to building owners. The building owners either use the services for themselves or their tenants.

Toronto, Amsterdam, Tokyo and Riyadh are some biggest cities served by private district energy systems.

Unlike a campus concession contract, private system sales are typically in full, including ownership of assets, real estate, and sometimes the associated brand. Often, the business also employs operational staff.

Understanding the key drivers of private system viability

In a private system acquisition, there are generally two levers that drive the financial valuation of the assets.

The first lever examines the new owner/operator’s ability to improve system efficiencies and profitability. This can be measured as part of the due diligence. To do this, the contractual relationship between the system owner and customers must be understood, as well as the assets’ levels of technical performance.

For example, the customer’s payment is based on the generation assets’ assumed fuel efficiency. If the owner/operator can make an operational change or investment to improve its efficiency, those fuel savings accrue to the owner.

But to understand whether it’s possibility to achieve these types of cost savings, the technical due diligence must analyze the assets’ current efficiency ratios to identify possible improvements.

The second lever examines the new owner/operator’s ability to add customers without needing new generation assets. As a result, the owner can leverage the system’s existing capacity to generate additional revenue and profit.

This relies on a market view of the surrounding real estate to identify potential customers. It also examines how close they are to the existing distribution system. Then it evaluates their potential impact on the system’s capacity and the risks involved if current customers leave the system.

The customer mix balancing act

Once the key drivers are understood, the type of customers the owner adds, and how they’ll impact the overall customer mix, needs to be analyzed.

A customer mix that’s heavy on residential buildings could mean assets are underutilized during the day on weekdays, when many people are at work. Similarly, a customer mix heavy on office buildings would be underutilized at night and on the weekends.

If the mix is poorly balanced, the buyer will be investing in underutilized asset capacity, which impacts profitability. As such, a seller is likely to forecast significant customer growth to improve and diversify their customer mix, resulting in profits skyrocketing.

The art of the due diligence process prior to purchase must differentiate between ‘certain’ customer growth, a customer acquisition strategy and an asset operational philosophy that the buyer can capitalize on.

Finally, it’s important to ensure the purchase or sale of the private system doesn’t change the regulatory treatment of the assets. In some jurisdictions (e.g. certain Canadian provinces) there are restrictions on the type of entity that can own a district energy system outside of regulatory purview. While regulatory oversight of a system may not be a showstopper, it can create a different set of considerations for financial modeling.

Increased profits. Reduced risks.

Investors who carry out their due diligence with an understanding of these nuances are in a better position to develop comprehensive plans for managing their systems sustainably and profitably. Depending on their objectives, they can forecast realistic profits, add more customers, or pass on the risk to different service providers suitable enough to handle the challenge.

But there are many moving parts. So, carrying out due diligence calls for independent specialists.

Headshot of Tom Bucher

Tom Bucher

Director, Power Advisory

Tom is an analytical and team-orientated manager. His work focuses on market dynamics, strategic positioning and financial analysis across large-scale and distributed renewable resources, microgrid project development, electric vehicles and vehicle infrastructure, energy storage, and district energy system technical due diligence. He has experience in managing relationships, negotiations, projects, and building consensus while constantly improving the methodology and incorporating feedback to deliver results.