Energy

Wed, 11/11/2009 - 12:05

In this week's energy guest column, Tristan Edmondson, partner at Mint Research, a clean tech consultancy, explains the opportunities in and challenges to investing in China's relatively untapped Energy Service Company (ESCO) industry.

Tristan Edmondson (left), partner at clean tech consultancy Mint Research, and Stephane Grand (right), managing partner at financial advisory firm SJ Grand. Photo by Susana Braz.

During Beijing's freezing winters my city centre flat becomes unbearably hot. Much to my frustration the only way to cool down is to open the windows - there is no way to regulate the scalding hot water being piped 24 hours a day. That level of inefficiency is replicated across China, resulting in one of the worst ratios of energy use to gross domestic product (GDP), at two and a half times the world average. This creates serious concerns about energy security, harmful pollution in nearly every city and greater exposure to volatile energy prices.

Although energy is relatively cheap and often subsidized in China, the sheer scale of energy inefficiency means that in a country awash in capital there are a considerable number of commercially viable energy efficiency investment opportunities. One way to realize that commercial potential is through ESCOs.

What is an ESCO?

Under an energy performance contract, ESCOs install energy saving technologies and methodologies and then share the resulting savings with the customer, so paying off the capital investment.  Here are two examples:

Honeywell International, acting as an ESCO, helped Asahi's Shenzhen brewery become more energy efficient. Energy saving methods included upgrades to heat recovery, cooling and control systems, with the resulting energy cost savings shared between Honeywell and Asahi. After the energy performance contract expires Asahi will continue to enjoy reduced energy bills at no additional cost.

The production of electricity using energy that would otherwise be discarded is also organized along ESCO lines. Dongying Shengdong EMC Ltd. (DSE) installs electricity-producing boilers that burn waste gases, such as coalmine methane or waste gas from coking plants. Clients of DSE provide waste gas free of charge to act as a feedstock, and buy the on-site electricity from DSE at a lower cost than grid electricity. Revenue-sharing arrangements usually lasting 10 years enable DSE to recoup its capital in about two years, and then maintain a profitable operation and maintenance relationship for the rest of the contract.

The World Bank created China's first ESCO companies back in 1997, and since then together with its commercial arm, the International Finance Corporation, has guaranteed loans worth hundreds of millions of dollars to the energy efficiency industry. According to China's Energy Management Association EMCA, set up by the World Bank to promote the interests of the industry, there are now more than 400 ESCO companies in China. The Asian Development Bank, agencies of the United Nations, and development agencies from various nations also contribute expertise and capital to China's ESCO industry. Chinese government subsidies also aid companies implementing energy performance contracts.

Recent increases in energy costs have created even more potential for energy efficiency projects, but despite the huge potential of China's ESCO industry, it has yet to approach the size of the ESCO industry in the United States, where it is a market worth $6 billion a year.

Why the need for an ESCO research study?

Dr. Stephane Grand, managing partner at SJ Grand, a financial advisory firm, is a fan of the ESCO model. "China's growing ESCO sector is a fascinating industry, not just because of the commercial opportunities, but because of the many economic, legal, technology and policy issues that impact on the industry's development. Every ESCO project is a real test of whether China's legal structures can stand up to such complex contracting, and a keen measure of its developing project finance industry. Whereas the market seems extremely promising, the structural issues can be daunting for a foreign player."

Dr. Grand has 16 years of experience in the Chinese market, providing legal and taxation advice on more than EUR 500 million ($749.95 million) in foreign investment.  He also teaches courses on the legal and financial aspects of doing business in China as an adjunct professor at the Graduate School of Business of the University of Illinois. It was for these reasons that I approached him with the idea of an academic study into China's ESCO industry.

Dr. Grand and I are aiming to shed light on whether China's ESCO market can move beyond relying on financial and technical assistance from development institutions and become a fully functioning, organic and self-perpetuating industry.

We have already spoken to a number of domestic and foreign ESCO companies, development institutions, investment firms and government officials focused on the clean technology sector. From these conversations, and from our own experiences of financing projects in China, we think that because the market infrastructure that enables complex ESCO contracting is less developed here, projects should be 'localized' by adjusting them for Chinese market conditions. However, we believe companies should be careful not to lose the inherent value of the ESCO model when localizing projects in China.

We are presenting our initial findings under the title "Localizing Energy Performance Contracts for the Chinese Market" at the Asia ESCO Conference 2010 in New Delhi from Jan. 14 to Jan. 15.

Challenges in Implementing the ESCO Model

The various factors holding back the growth of China's ESCO industry raise the question of whether it is too early in China's economic development to introduce the concept of energy performance contracting by ESCO companies. It is vital that these issues and their possible solutions are fully understood.

Financing for Chinese ESCOs is very hard to come by. The concept of utilizing energy efficiency in order to create a 'savings stream' runs contrary to China's prevailing business culture of quick returns based on expansion and finding new markets, meaning that Chinese banks are often unwilling to lend for energy efficiency projects producing benefits that appear non-tangible and therefore risky. The size of typical ESCO loans is often too small for Chinese banks to be worthwhile appraising, loan amounts usually range from $1 million to $6 million, much smaller than the large infrastructure projects and production expansion loans that loan officers typically appraise. Instead ESCOs often have to lend their own money, or find investment funds elsewhere, which is often difficult for smaller Chinese firms with little financial expertise.

Running ESCO projects from audit to the end of the energy performance contract is difficult without comprehensive energy measurement standards. Currently, energy efficiency improvement in China is mainly calculated using a variety of metrics, such as an enterprise's consumed electricity, gas or oil or their production volumes, rather than a single standard metric such as British Thermal Units (BTUs) as is used in the West. The problem of energy management, added to the nascent character of China's legal apparatus, means that ESCO contracts are much riskier than in other countries.

Chinese ESCO development is also dependent on domestic ESCO capability. If the appropriate energy efficiency technologies, methodologies and management expertise are not available in China then the huge energy savings potential will not be realized. Chinese ESCOs are currently typically small operations and are often dependent on one technology, such as energy efficient lighting, rather than a full suite of energy saving methodologies.

A report from the Carnegie Endowment, Financing Energy Efficiency in China, argues that various policy contradictions inadvertently inhibit the development of the Chinese ESCO industry:

The 10 percent tax on interest payments means that any company borrowing money for implementing an energy efficiency project must pay 10 percent of the interest payments it makes on the loan to the central government.

The restrictions on lending to steel and cement companies in order to check overcapacity made ESCO lending difficult. Energy efficiency projects are often suspected as a way to avoid investment controls.

Chinese laws concerning the Clean Development Mechanism (CDM) inhibit energy efficiency financing. They do not permit developers to give a discount to a foreign buyer of carbon credits in return for an advance payment which could release capital for ESCO funding.

Perhaps the most damaging government policy to the ESCO industry is a cap on interest rates that discourages "risk-based" lending to energy efficiency projects. Banks are generally not permitted to lend money above an interest rate of around 8 percent, far below what is necessary to cover the risk. What makes this regulatory quirk a missed opportunity is that ESCO projects can have an investment return of more than 50 percent per year with pay back periods of less than two years.

Overcoming the Hurdles

Development institutions have sought to ameliorate these problems through loan guarantees, financial and technical assistance to banks and ESCO companies, as well as help to bundle up ESCO projects to reduce loan transaction costs.

A $200 million World Bank loan together with a $13 million Global Environment Facility (GEF) grant is the basis for a program to train Chinese banks for ESCO lending and partly guarantee ESCO loans.

IFC China Utility-based Energy Efficiency Finance program (CHUEE) is designed to reduce greenhouse gas emissions by creating a sustainable financing mechanism that provides financial support to energy efficiency and renewable energy projects. IFC offers risk sharing for energy efficiency loans by China's commercial banks and provides advice on marketing, engineering, project development, and equipment financing services to banks, project developers, and suppliers of energy efficiency products and services.

The efforts of development institutions have resulted in a growing ESCO industry in China, but one that is not yet fully independent of this development aid.

China's ESCO market is at a critical moment in its history.  Huge energy inefficiencies and a large pool of waiting capital create a fantastic opportunity, and yet there serious structural problems that could stop that potential from being realized. Our proposed study aims to address these problems and will be a public and academic exercise, our motivation being the stimulation of an industry so important for China's economic and environmental sustainability.

China's ESCO market is a useful proxy for China's economic and social development. Whether it will take off depends on the extent to which China can develop sophisticated market institutions and capabilities, if Chinese companies can capture the full-service offerings of their American and European counterparts, whether policy instruments can be aligned with China's goals for energy efficiency and environmental protection, and finally, if ESCOs can adjust their contracting methodologies for the Chinese market. To a large extent, the likelihood that China can develop from a low-cost manufacturing economy to a high technology and knowledge based economy depends on many of these same factors.

Edmondson is carrying out a joint study into the ESCO industry with Dr. Stephane Grand, managing partner at SJ Grand, a financial advisory firm. To learn more about their proposed study, email tedmondson@mintresearch.cn.

A version of this column originally appeared in the Green Leap Forward, a blog about climate change and clean technologies in China.