ECO must be something to do with ecology, right? Well, indirectly …sort of, but strictly speaking …no. ECO does relate to the growing green agenda but ECO is an acronym for Energy Company Obligations. The phrase derives from The Electricity and Gas (Energy Company Obligation) Order 2012 (otherwise known as the ECO Order).
This piece of secondary legislation is perhaps not as widely known about as it should be. It should be more widely known because the ECO Order provides a sizeable potential source of funding to developers carrying out redevelopment or improvement works on housing stock.
Enacted in July 2012, and effectively in operation from autumn 2012, the ECO Order has provided a source of funding to a select number of householders and developers. In essence, the ECO Order obliges all sizeable energy companies to procure certain levels of carbon and heat savings. This is done by the energy companies paying householders and developers to install energy saving works in their properties - for example, by introducing double glazing; by adding insulation; or by installing improved efficiency heating products.
Initially it was intended that the ECO funding would be available for developers and householders up to 31 March 2015. However, as the energy companies have been slower than anticipated in meeting their ECO targets, the Government recently announced (in its autumn statement in December 2013) its proposal to extend the duration of the ECO scheme to March 2017. In parallel, the level of targets was reviewed and some of them scaled back.
What is ECO funding?
The wider aims of ECO are twofold: to reduce the UK’s energy consumption and to provide support to people living in fuel poverty. It achieves this by obliging energy suppliers to fund energy efficiency improvements in housing stock. This initiative is worth around £1.3 billion every year. ECO focuses on supporting vulnerable consumer groups and hard to treat homes, imposing a legal obligation on energy companies to meet three targets:
- Carbon Saving Community Obligation (CSCO) - providing insulation measures to households in specified areas of low income
- Home Heating Cost Reduction Obligation (HHCRO also known as Affordable Warmth) - providing heating and insulation measures to consumers living in private tenure properties that receive particular means-tested benefits
- Carbon Emissions Reduction Obligation (CERO) - this covers the installation of measures such as solid wall and hard-to-treat cavity wall insulation.
Proposed changes to ECO funding
Following the autumn statement, a consultation on ECO will now take place in early 2014. The current proposals to extend the scheme to March 2017 mean that energy companies now potentially have an additional two years to meet their targets.
Additionally, the Government has announced its intention to reduce the CERO target, currently met through solid wall insulation, by 33% for the period to March 2015 and has set a target for the period to March 2017 at this reduced level. Energy companies will still need to provide a minimum of 100,000 homes with solid wall insulation but this is a significant reduction. It is also intended to include the ‘easier-to-achieve’ standard cavity wall insulation as an allowable measure under CERO but beware. This is simply a proposal at present and will not be certain until passed by Parliament later this year. Once passed by Parliament, retrospective delivery of the measure will be effective from April 2014.
The Government also proposes to maintain its current ambition for the elements of ECO directed at low-income and vulnerable households (CSCO and HHCRO targets), and then to extend them at the same scale, pro-rata, to 2017. This support is worth approximately £540 million in total.
Access to funding: the opportunity
The opportunity to the large scale developer and housing associations in a nutshell lies in the energy companies' failure to meet their legally imposed targets under ECO. One reason for this failure may be that the ECO initiative was modelled on earlier green incentive schemes aimed specifically at individual householders. So, while energy companies would provide ECO measures direct to those consumers and householders who applied for them, this was not enough.
The lack of success of ECO may also be due to the fact that it was not marketed well and, coupled with a relatively sluggish economy, there was only a moderate take up of the scheme. Energy companies have, consequently, found themselves under a fairly onerous legal obligation to buy high levels of carbon and heat savings with a large amount of available funding but with a lack of knowledgable and willing developers and housing associations to take on the energy-efficiency work.
Energy companies have now refocused and are offering funding to developers and housing associations working on large-scale projects that meet the ECO criteria. By guaranteeing to install ECO measures in housing stock in low-income areas, developers can access the large cash reserves that the energy companies are obliged to pay out. Although funding is unlikely to be structured in a way that makes funds directly available to pay for energy saving works as they are installed, it could be paid on completion of the scheme and installation of the relevant measures. However, the rules surrounding ECO are complex and the ECO rules relating to certification of energy saving works are strict.
New opportunities and new challenges
While the relaxation of the targets and timescales means that energy companies are in a better negotiating position on price, there are new opportunities for switched on developers able to deliver large scale ECO schemes that will satisfy a good portion of the energy companies' targets and who were unable to deliver them within the original timeframe. After all, negotiations work both ways. There is particular potential for developers to make profit where they were planning on including ECO measures in their developments in any event.
Before getting involved with ECO, however, we would counsel a degree of caution. The ECO scheme was not initially designed with large scale projects in mind and there are a number of potential pitfalls that can trip up even the most experienced developers.
The scheme is fundamentally aimed at domestic householders as is much of the contract documentation. All contracts should therefore be subjected to a rigorous review by those with experience of ECO funding to make sure it reflects the reality of the project specification. Typically, the risks are weighted heavily to the detriment of the developer and need to be rebalanced to a commercially acceptable level.
While the process of negotiation can be time-consuming and does not present an attractive prospect, the value added in addressing upfront the peculiarities of drafting we have seen, which could have exempted one energy company from its obligation to pay anything at all for certified measures, should not be underestimated. Further, if investors are involved in the project, they will clearly want to sign off on the level of risk to the potential funding and, therefore, the ultimate profit of the scheme and also have a clear view on how the various funding arrangements interface in practice.
On a practical level, certification of the ECO measures also provides its own unique hurdles. The measures must be certified as compliant with ECO once installed. Before reaching this stage, however, developers and housing associations will need to obtain advice from experienced ECO professionals on, for example, how to calculate the carbon savings. These ECO professionals can also provide valuable support during the development, checking that the measures are being installed in an ECO-compliant manner, assisting in the certification process and liaising with the energy suppliers in terms of reporting the completed measures up the line.
In addition, energy companies are obliged to ensure that any ECO measures are installed by professionals with the appropriate certifications and/or accreditations to satisfy Ofgem. Inevitably, this obligation is passed down to the developer. Any construction tendering process and the drafting of professional appointments should always be carried out with these stringent requirements in mind.
Even if the above steps are taken, there are still some dangers lurking. What happens if a measure is ultimately not certified as ECO-compliant by Ofgem? The energy company will be able to mitigate for the shortfall in the number of carbon savings by purchasing carbon credits direct from the carbon marketplace. Developers may therefore find themselves losing out in this way and, as no energy company will pay for the carbon savings twice, they will either withhold or recoup this cost from a developer who has already paid to install the measure. We therefore advise all developers to negotiate these brokerage clauses to ideally establish some control over the price the energy supplier will pay for any replacement carbon savings.
The proposed amendments to the ECO scheme offer an excellent opportunity to secure finance for the large scale redevelopment of low-cost and vulnerable housing. Yet with great opportunity comes risk. Rushing into ECO funding contracts without a full review and appreciation of the dangers and potential pitfalls could end up costing a developer time, resources and, crucially, money.