Guest blogger Tristan Edmondson (right), partner at Mint Research, a clean tech consultancy, describes China’s growing Energy Service Company (ESCO) industry.
China has one of the worst ratios of energy use to GDP in the world,two and a half times the world average. This undoubtedly createsinvestment opportunities for a country that is awash in capital. Butdespite the huge potential of China’s ESCO industry, it has yet toapproach the size of the ESCO industry in the US where it is anindustry worth six billion dollars a year.
What is an ESCO?
Under an energy performance contract, ESCOs install energy savingtechnologies and methodologies and then share the resulting savingswith the customer, so paying off the capital investment. Here are someexamples:
- Honeywell International,acting as an ESCO, helped Asahi’s Shenzhen brewery become more energyefficient. Energy saving methods included upgrades to heat recovery,cooling and control systems, with the resulting energy cost savingsshared between the Honeywell and Asahi. After the energy performancecontract expires Asahi will continue to enjoy reduced energy bills atno additional cost.
- The production of electricity using energy that would otherwise bediscarded is also organised along ESCO lines. Dongying Shengdong EMCLtd (DSE) installs electricity-producing boilers that burn waste gases,such as coal mine methane or waste gas from coking plants. Clients ofDSE provide waste gas free of charge to act as a feedstock, and buy theon-site electricity from DSE at a lower cost than grid electricity.Revenue-sharing arrangements usually lasting 10 years enable DSE torecoup its capital in about two years, and then maintain a profitableoperation and maintenance relationship for the rest of the contract.
- Beijing PowerUis a provider of chilled water cool storage technologies that saveenergy. The company has installed solutions under energy performancecontracts for a variety of customers including Shanghai’s PudongAirport, LG Philips’ electronics factories, semiconductor manufacturingplants, five-star hotels and other large-scale air conditioning users.
Although energy is relatively cheap and often subsidized in China, the sheer scale of energy inefficiency means there area considerable number of commercially viable ESCO projects. Recentincreases in energy costs have created even more potential for energyefficiency projects but many hurdles exist that hold back thedevelopment of the ESCO industry.
Dr. Stephane Grand, managing partner at SJ Grand,a financial advisory firm, is a fan of the ESCO model. “China’s growingESCO sector is a fascinating industry, not just because of thecommercial 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 structurescan stand up to such complex contracting. Whereas the market seemsextremely promising, the structural issues can be daunting for aforeign player”
The World Bank created China’s first ESCO companies back in 1997 andsince then together with its commercial arm, the International FinanceCorporation, has lent hundreds of millions of dollars to the energyefficiency industry. According to China’s Energy Management AssociationEMCA,set up by the World Bank to promote the interests of the industry,there are now over 400 ESCO companies in China. The Asian DevelopmentBank, agencies of the UN, and development agencies from various nationscontribute expertise and capital to China’s ESCO industry. Chinesegovernment subsidies also aid companies implementing energy performancecontracts.
Challenges in Implementing the ESCO Model
The support and subsidies that the Chinese ESCO industry currentlyenjoys are necessary to overcome the cultural and institutionalbarriers that inhibit the kind of growth the industry is capable of.The concept of utilising energy efficiency in order to create a‘savings stream’ runs contrary to China’s prevailing business cultureof quick returns based on expansion and finding new markets. ChineseBanks are often unwilling to lend for energy efficiency projectsbecause the benefits appear non-tangible and therefore risky. The sizeof typical ESCO loans is often too small for Chinese banks to beworthwhile appraising, loan amounts usually range from $1m to $6m, muchsmaller than the large infrastructure projects and production expansionloans that loan officers typically appraise. Instead ESCOs must lendtheir own money, or find investment funds elsewhere, often difficultfor smaller Chinese firms with little financial expertise.
Insufficient energy measurement standards affect enterprises’efforts to save energy. Currently, energy efficiency improvement inChina is mainly calculated using a variety of metrics, such as anenterprise’s consumed electricity, gas or oil or their productionvolumes, rather than a single standard metric such as British ThermalUnits (BTUs) as is used in the West..The problem of energy management,added to the nascent character of China’s legal apparatus, means thatESCO contracts are much riskier than in other countries.
Chinese ESCO development is also dependent on domestic ESCOcapability. If the appropriate energy efficiency technologies,methodologies and management expertise are not available in China thenthe huge energy savings potential will not be realised. Chinese ESCOsare currently typically small operations and are often dependent on onetechnology, such as energy efficient lighting, rather than a full suiteof 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 companyborrowing money for implementing an energy efficiency project must pay10 percent of the interest payments it makes on the loan to the centralgovernment.
- The restrictions on lending to steel and cement companies in orderto check overcapacity made ESCO lending difficult. Energy efficiencyprojects 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 togive a discount to a foreign buyer of carbon credits in return for anadvance payment which could release capital for ESCO funding.
- Perhaps the most damaging government policy to the ESCO industry isa cap on interest rates that discourages “risk-based” lending to energyefficiency projects. Banks are generally not permitted to lend moneyabove [an interest rate of around 8 percent, far below what isnecessary to cover the risk. This prevents Chinese bank staff fromstarting to learn about complex project financing since they couldnever loan on such a project in the first place. What makes thisregulatory quirk a missed opportunity is that high risknotwithstanding, ESCO projects can have an investment return of morethatn 50 percent per year with pay back periods of less than two years.
Overcoming the Hurdles
Development institutions have sought to ameliorate these problemsthrough loan guarantees, financial and technical assistance to banksand ESCO companies, as well as help to bundle up ESCO projects toreduce loan transaction costs.
- A US$200 million World Bank loantogether with a US$13 million Global Environment Facility (GEF) grantis the basis for a program to train Chinese banks for ESCO lending andpartly guarantee ESCO loans.
- The Pollution Prevention and Energy Efficiency("P2E2") environmental financing program is joint effort between the USEnvironmental Protection Agency and the Chinese State EnvironmentalProtection Administration is helping Hong Kong-based ESCOs pursueopportunities in Mainland China through loan guarantees from the AsianDevelopment Bank.
- IFC China Utility-based Energy Efficiency Finance program(CHUEE) is designed to reduce greenhouse gas emissions by creating asustainable financing mechanism that provides financial support toenergy efficiency and renewable energy projects. IFC offers risksharing for energy efficiency loans by China’s commercial banks andprovides advice on marketing, engineering, project development, andequipment financing services to banks, project developers, andsuppliers of energy efficiency products and services.
The efforts of development institutions have resulted in a growingESCO industry in China, but one that is not yet fully independent ofthis development aid.
China’s ESCO market is at a critical moment in its history. It hasall the potential of huge energy inefficiencies and a large pool ofwaiting capital and yet arranged against ESCO development are seriousstructural problems. From talking to Chinese and international ESCOs,it has become apparent to me that in many cases, the traditional fullservice ESCO model of providing a facility-wide reduction in energyusage using one hundred percent third party financing is notappropriate in China. Instead a localised version of energy performancecontracting would stand a better chance of success. Much morecommitment is needed from customers than in countries where financingis readily available – for instance rather than approach reluctantbanks, ESCO customers could guarantee energy efficiency loans, orprovide partial financing for projects. Since much of the legal andtechnical apparatus for energy performance contracts is missing inChina, trust between companies is much more important. It is thereforedifficult for ESCOs to approach a customer and initiate a successfulenergy performance contract without having worked with the customerbefore.
China’s ESCO market is a useful proxy for China’s economic andsocial development. Whether it will take off depends on the extent towhich China can develop sophisticated market institutions andcapabilities, Chinese companies can capture the full-servicecapabilities of their American and European counterparts, such policyinstruments can be aligned with China’s goals for energy efficiency andenvironmental protection, and finally, ESCOs can adjust theircontracting methodologies for the Chinese market. To a large extent,the likelihood that China can develop from a low-cost manufacturingeconomy to a high technology and knowledge based economy depends onmany of these same factors.
Mint Research and SJ Grand are jointly writing an academic study of China’s ESCO industry. If you want to contribute or find out more, email tedmondson [at] mintresearch.cn