Box 3.1ESCOs and Energy Performance ContractingPity the poor small factory owner. Busy running her business, she thinks there may be opportunities to save onenergy expenses, but does not think it a good gamble to invest time and money in an energy audit. What if thereare no savings? Or suppose the auditor recommends replacing old motors or boilers. Where will the proprietor,already at her borrowing limit, find funds? And how can she be sure that the investment will pay <strong>of</strong>f?Enter the ESCO. Part consultant and part banker, the ESCO <strong>of</strong>fers to reduce the factory’s energy costs by a specifiedamount, splitting the gains with the owner. To do this, the ESCO will finance, purchase, and install any requiredequipment, carrying the loan on its own balance sheet. <strong>The</strong> owner need merely collect the savings.This arrangement is called energy performance contracting and is the canonical form <strong>of</strong> ESCO. It requires reliableenforcement <strong>of</strong> contracts in order to work, given the complicated interdependence <strong>of</strong> lender, ESCO, and client.Other, simpler, arrangements are also possible.Source: IEG, based on Taylor and others 2008.Prescription: Guarantees<strong>The</strong> barrier diagnosis was partially flawed, so the guaranteeswere less transformative than hoped. <strong>The</strong> assumptionwas that banks practice project finance—in other words,they will finance a factory to set up a new assembly line,weighing the cost <strong>of</strong> the equipment against the return itprovides. But, the diagnosis continued, the banks don’tknow how to appraise energy efficiency projects, whichgenerate a cash flow from energy savings rather than fromincreased sales.In reality, most banks in these countries simply do not dopractice project finance, because there is no way to ensurethat they will get returns from that particular piece<strong>of</strong> equipment. <strong>The</strong>y are concerned with getting repaid andtherefore look beyond the project at borrowers’ overallbalance sheets and collateral. So for many banks the coreconstraint is their borrowers’ lack <strong>of</strong> creditworthiness, notthe novelty <strong>of</strong> energy efficiency. However, a better understanding<strong>of</strong> energy efficiency did help banks market loansto their more creditworthy customers. And the ChinaUtility-Based Energy Efficiency project (CHUEE) hashelped banks structure efficiency loans as project finance,putting savings into escrow accounts which substitute forfixed collateral.In China, collateral requirements are onerous. Hence, guaranteeswere important for credit access by cash-strappedESCOs and small and medium enterprises. AlthoughChinese banks welcomed the guarantees, they were notobviously critical to improved credit access by larger enterprises.In CHUEE, which catered to larger firms, 91 percent<strong>of</strong> a sample <strong>of</strong> borrowers said they could have financedtheir energy efficiency investment without the project andits guarantee, though perhaps more slowly (IEG 2010b).In IFC’s European projects, the guarantees, although attractivelypriced, were generally not appealing to banks fortheir small and medium enterprise (SME) or municipallending. <strong>The</strong>se were familiar markets, and the banks werecomfortable bearing the risk <strong>of</strong> lending to these clients.Guarantees were more successful with new or unconventionaltypes <strong>of</strong> projects and borrowers, such as retr<strong>of</strong>ittingapartment blocks by homeowner associations in Hungaryand renewable energy projects in the Czech Republic, whenthe regulatory framework and feed-in tariffs were still untestedand uncertain.It is noteworthy that almost none <strong>of</strong> the guarantees havebeen called. This experience may convince IFC to becomeless risk averse. In the CHUEE project, the IFC’s $207 millionguarantee was not at serious risk, buffered by a GEF-fundedfirst loss guarantee. <strong>The</strong> first loss was much smaller in thecase <strong>of</strong> Hungary’s OTP Schools Energy Efficiency project(see next page).Guarantees helped less creditworthyborrowers but did not trigger markettransformation.In sum, the guarantees were useful for less-creditworthyborrowers in underdeveloped financial markets. But theydid not have a large transformative effect on reducing commercialbanks’ risk aversion and are likely to be a permanentrather than temporary measure.Prescription: ESCOs<strong>The</strong> Energy Conservation Project’s introduction <strong>of</strong> ESCOs(called energy management companies, or EMCs, in China)had significant direct effects. <strong>The</strong> three pilot companies realizedan average financial rate <strong>of</strong> return <strong>of</strong> 18 percent, withassets growing from $20 million in 1999 to $91 million in2006. <strong>The</strong> total ERR (including benefits to the EMC’s clients)was calculated by IEG at 50 percent without CO 2benefits,or 58 percent with CO 2at $6/ton <strong>of</strong> CO 2. Total claimedenergy and CO 2savings were 6 million tons <strong>of</strong> coal equivalentand 18.6 million tons through 2006—below appraisal36 | Climate Change and the <strong>World</strong> <strong>Bank</strong> Group
estimates but still substantial. Note that these are unverifiedex ante estimates.<strong>The</strong> introduction <strong>of</strong> ESCOs had significantdirect effects in China and spurreddevelopment <strong>of</strong> an energy managementindustry.<strong>The</strong> project also spurred the development <strong>of</strong> an EMC industry.As pilots, the EMCs immediately encountered aregulatory obstacle: Should they be regulated as financialinstitutions, leasing companies, or sales outlets? <strong>The</strong> <strong>Bank</strong>and the government worked to address the ambiguities, facilitatingentry <strong>of</strong> other EMCs. This is a good example <strong>of</strong>how pilot projects can reduce the costs <strong>of</strong> followers.In addition, the EMCs participated in training programsand opened their doors to would-be domestic and foreigninvestors. GEF funding was crucial in motivating this opennessto dissemination. In part because <strong>of</strong> these efforts andin part to an ASTAE training program, an industry association<strong>of</strong> EMCs was formed and grew to at least 400 membercompanies by 2007, with a core <strong>of</strong> 40–50 practicing energyperformance contracting.However, the ESCO prescription required adaptation inChina, and it has limits. First, the Chinese ESCOs did notwrite contracts based on measured savings, a practice thatrequires a high degree <strong>of</strong> reliance on contract enforcementand on sophisticated measurement <strong>of</strong> outcomes (box 3.1).<strong>The</strong> three original EMCs have largely relied on agreed exante estimates <strong>of</strong> energy savings, or they simply becameequipment leasing companies. Few <strong>of</strong> the emerging EMCstake a systemic approach to improving process efficiency,but rely instead on promoting specific kinds <strong>of</strong> energyefficiency equipment. Second, there are limits to the ability<strong>of</strong> ESCOs to provide financing. <strong>The</strong> original EMCs hadthe advantage <strong>of</strong> substantial capital at concessional terms.<strong>The</strong> new ones are generally small and even more creditconstrainedthan their clients.Chinese ESCOs adopted a basic model <strong>of</strong>operation akin to equipment leasing.In Hungary, the OTP Schools Project (OTP being the Hungarianbank involved) supports Caminus, an ESCO thatwon an umbrella contract for school heating and lightingupgrades. <strong>The</strong> umbrella contract is a noteworthy policyinnovation, because it drastically reduced the transactioncosts for small municipalities (they do not have to organizeindividual tenders) and engages economies <strong>of</strong> scale for thewinning ESCO. Caminus finances all the investments exceptfor the 20–25 percent paid from European Union grantsand is therefore taking the credit risk for municipalities.However, the scope <strong>of</strong> work does not include insulation,which means that potential cost and CO 2savings may beuntapped.Prescription: Technical assistanceIn Central Europe (Commercializing Energy EfficiencyFinance Program) and Russia (Sustainable Energy FinanceProgram), IFC used donor funding to hire a largein-house team that provided free services to local banks;there is a move now to increase cost recovery. <strong>Bank</strong>s thatIEG interviewed confirmed that they benefited significantlyfrom the technical assistance program, especially trainingon technologies and appraisal <strong>of</strong> energy efficiency projects.It is difficult to assess whether the services provided werecost-effective. (In some cases, projects are unable to trackprecisely the use <strong>of</strong> technical assistance resources.) Somebanks have decided to build on and consolidate this learningby creating dedicated in-house units for energy efficiencyprojects. Staff cuts as a result <strong>of</strong> the financial crisisthreaten the sustainability <strong>of</strong> these changes but may aid indiffusion <strong>of</strong> knowledge through the industry if staff are rehiredelsewhere.<strong>Bank</strong>s benefited from IFC technicalassistance.Prescription: Information dissemination<strong>The</strong> China Energy Conservation Project also sponsored aninformation center, developing energy efficiency case studyexamples and technical guidelines and building outreachnetworks. An internal evaluation found that 6.2 percent <strong>of</strong>a random sample <strong>of</strong> 10,000 enterprises attributed energy efficiencyinvestment to the information center’s influence.<strong>The</strong> claimed impact was 27 million tons <strong>of</strong> coal equivalent<strong>of</strong> energy and 71 million tons <strong>of</strong> CO 2. <strong>The</strong>se are extraordinarynumbers, dwarfing the Energy Management CompanyAssociation’s direct impact. Likely, other factors wereat work, including policy pressure for energy efficiencyimprovements. However, even if overestimated by a factor<strong>of</strong> 10, these impacts would represent a good return on the$10 million invested in the centers.OutcomesEconomic returns, energy savings, and emissionsreductions. Impacts have varied substantially acrossprojects. As noted, the Energy Conservation Project inChina racked up high economic and carbon returns atthe subproject and project level. For CHUEE, which hasbeen analyzed in more depth, subproject and project levelreturns diverge. By June 2009, the guarantee programhad supported $512 million in loans for $936 million inprojects, associated with a claimed GHG reduction <strong>of</strong>14 million tons. However, as noted earlier, CHUEE mayEnergy Efficiency | 37
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Phase II: The Challenge of Low-Carb
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CLIMATE CHANGE AND THE WORLD BANK G
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Figures1.1 GHG Emissions by Sector
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Executive SummaryUnabated, climate
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Table C.2Completed Low-Carbon Energ
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IEG PublicationsAnalyzing the Effec