Defense contractor BAE Systems is in the business of understanding extreme risks: it designs and makes a variety of technologies for war zones, from communications and surveillance systems to weapons. But it didn’t want to deal with any risks when it came time to invest in becoming more energy efficient. So the company adopted a novel strategy that kept them to a minimum.

In December BAE, which has its U.S. headquarters in Arlington, Virginia, announced a $2 million project to upgrade heating and cooling equipment, pumps, and motors and control systems at its facility in Greenlawn, New York. The company won’t be paying that price for the upgrades, however. Instead, it will pay project developer Metrus Energy an amount based on how much it saves on energy use. Crucially, Metrus will not only develop the project; it has lined up financing to pay for it, and it will pay Siemens Industry to install and maintain the equipment.

The energy service contract will last 11 years and promises to save BAE about $300,000 in annual energy and operational costs. About 70 percent of the savings will come from using less energy, and about 30 percent will result from spending less on maintenance because the equipment is new and improved, says Don Hill, director of facilities in BAE Systems’ Electronic Solutions business. At the end of the contract, BAE will pay for the residual value of the equipment and installation, Hill says. “It frees up capital for us to invest more strategically,” he says.

The project, set for completion in 2011, reflects a growing market for energy efficiency projects in which payment is tied to the amount of energy saved over time. This approach has been common for about two decades in public facilities such as government buildings, academic institutions, and hospitals, says Peter Larsen, a researcher at the Lawrence Berkeley National Laboratory, which has tracked the energy service market for over 15 years and amassed a database of about 3,500 projects.

Project developers typically guarantee certain savings, some or all of which are used to pay the cost of installing and maintaining the equipment; on the assumption that customers will use less energy, the developer charges them less than they would pay the utilities. If the money saved on energy falls below the guaranteed amount, then the energy service company will have to make up the difference. If it exceeds the guaranteed amount, then the customer gets to pocket the extra. Energy service companies tend to set conservative estimates for the savings they could deliver.

“What we’ve found is more than 85 percent of projects in our database met or exceeded the guaranteed amount,” Larsen says.

Companies such as Johnson Controls and Honeywell collected about $4.1 billion in revenue from energy service contracts in 2008, and the figure should increase to around $7.3 billion in 2011, according to a Berkeley Lab study published in June 2010.

Energy service companies generally prefer to tackle larger projects than BAE’s in order to earn good profits. The same is true for banks or other investors that finance this type of project. Large public institutions have been the main target for these companies because many public facilities are in old, worn-down buildings with inefficient wiring and equipment for heating, cooling, and lighting, Larsen says. Private companies tend to carry out smaller energy efficiency projects that they can finance themselves. They also expect a much quicker payback period in order to keep their shareholders happy. The median payback period for a private company’s project is three years, while the median for public projects is eight years, according to Berkeley Lab’s database.

But a growing number of private companies are choosing long-term service contracts, Larsen says. As energy costs rise and reducing carbon footprints becomes a corporate focus, more businesses are undertaking larger, more complex energy efficiency projects. An ideal customer would spend about $1 million on energy per year, says Metrus’s CEO, Bob Hinkle. Metrus then bundles projects into one investment portfolio when it discusses project financing with banks or other types of investors. Hinkle cites an Urban Land Institute report showing that retrofitting commercial buildings for energy efficiency is expected to be a $190 billion market in the United States over the next 10 years.

“Customers generally recognize that energy efficiency is a good thing, but when push comes to shove, they don’t want to use their capital for it,” Hinkle says. “They want to put the capital to work in their main line of business, not in boilers, chillers, or lights.”

Metrus, which is based in San Francisco, was founded in 2009 and was previously part of MMA Renewable Ventures, a company that focused on developing solar-energy projects. The work taking place at BAE’s New York facility is the second retrofit project it has worked on with the defense contractor: Metrus completed a $1 million project for BAE’s facility in Merrimack, New Hampshire, in the fall of 2010. That project, which comes with a 10-year service contract, should save BAE about $200,000 in utility bills alone, according to Metrus (Hill says the energy and operational cost savings should reach $227,000 per year).

For the New Hampshire facility, BAE asked for less expensive upgrades, which included new lighting and sensors that shut off equipment when it’s not in use. Overall, the project should reduce BAE’s carbon emissions by 400 tons per year; the improvements in New York should cut 800 tons. Hill says the company is considering retrofitting its other facilities for energy efficiency as well: Hill’s business group operates 15 main sites, or 4.7 million square feet of indoor space, in the United States.