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Playing with Fire and not Getting Burned: Risk Management in Pay-for-Performance

This post is based on a paper presented by OpenEE Senior Data Scientist Hassan Shaban at the ACEEE 2018 Summer Study conference.

Pay-for-performance meter-based energy efficiency programs are on the rise. They encourage market based innovation and competition, and are already driving lower cost savings than traditional programs.

But even with the promise of better savings outcomes, higher quality interventions, fairer allocation of incentives, and happier customers and ratepayers, some players in the industry are understandably nervous. After all, pay-for-performance is a game-changer that introduces new risks and re-allocates others among the different stakeholders.

The good news, however, is that as long as risk can be quantified, it can be either mitigated or priced. Pay-for-performance places the performance risk squarely in the hands of the parties who are in the best position to measure and control it--as long as they have the right tools.

The Benefits of Pay-for-Performance Efficiency

In conventional deemed or custom energy efficiency programs, incentives are calculated based on estimated savings and are usually paid up front, as soon as the intervention is completed.

By contrast, in a pay-for-performance (P4P) system, program administrators offer incentives or other payment either directly to customers or to aggregators (entities that implement or procure energy efficiency in portfolios of buildings) in exchange for energy savings that are typically measured during an agreed-upon performance period.

Pay-for-performance approaches to efficiency are attractive for a number of reasons, including the establishment of more aggressive goals for energy and carbon savings and the fact that returns from easy-to-implement efficiency measures are declining.

By encouraging private investment in energy efficiency assets that come with stable cash flow returns, pay-for-performance offers a first step toward reducing or eliminating the single largest barrier to implementing energy efficiency--upfront cost. And by shifting program performance risk from utilities and ratepayers to aggregators and even to participants (with certain program designs), pay-for-performance gives the parties with the most control over efficiency outcomes the greatest incentive to provide savings.

In order for pay-for-performance to work, however, aggregators and implementers must have confidence that they can understand and manage these new risks.

The Different Flavors of Performance Risk

Energy efficiency performance risks can broken down into two broad categories: implementation risks, which are under the control of the project implementer or aggregator, and measurement/evaluation risks, which stem from the quantification of energy savings. Within these categories, we can distinguish between several subtypes, most of which can be understood and managed to varying degrees. These sources of performance risk are further detailed in the paper.

Sources of performance risk in pay-for-performance efficiency procurements

The Key to Managing Performance Risk: Actuarial Pricing and Portfolio Insurance

The paper discusses ways to better understand and minimize the various sources of performance risk in pay-for-performance efficiency markets. By offering more precise and quantifiable insight into the performance risks associated with an intervention or set of interventions, these strategies allow the efficiency marketplace to manage risk through actuarial pricing.

With actuarial pricing, risks are factored into the savings bid price for pay-for-performance procurements. A bid price in which 100 percent of the performance risk is captured in the unit savings price may alleviate a lot of aggregator performance concerns, but may prove uncompetitive in an open market.

An alternative approach is to purchase a Metered Efficiency Portfolio Insurance Plan (MEPI), which kicks in if certain metrics are not met. By relying on the insurer to cover unexpected performance shortfalls, a MEPI allows an aggregator to bid for a contract at a more competitive unit price.

Strategies for handling performance risk in procurement bids

An approach that balances actuarial pricing with insurance can deliver the largest returns with minimal risk, while ensuring cost-effectiveness and competitiveness in an open market.

Contact OpenEE  for more information about Metered Efficiency Portfolio Insurance and actuarial pricing strategies.