Financing Energy Efficiency in China

“When it is obvious that the goals cannot be reached, don't adjust the goal: adjust the action steps.” - Confucius, The Great Learning

Introduction As the world lurches forward attempting to cope with the reality of our environmental situation, governments around the globe have experimented with a vast array of different policies. For decades, subsidies have been generously doled out to the suppliers of alternative energies – over $10 billion per year of public money is allocated to the development of alternative energies such as wind, solar, nuclear, and biofuels (Farrell, Bressand and Haas). Yet despite this lavish investment of taxpayer money, worldwide carbon consumption has never been higher and global warming shows no signs of slowing. In response, more drastic action has been planned – economists are fashioning carbon taxes along withcapand-trade systems which would effectively raise the market price of carbon to encourage private investment in alternative energy. These programs are being implemented in conjunction with even larger subsidies for alternative fuels, with the hope of a dramatic, to some seemingly impossible, decline in overall carbon consumption. Yet at the cornerstone to all of these proposals is one oft neglected facet of the environmental movement: that of energy efficiency. Energy efficiency has been labeled the “fifth fuel” by some energy analysts, given that it can satiate demand for energy just as easily as coal, oil, gas, or uranium. If instituted on a global level, the International Energy Agency estimates that increased investment in energy efficiency could comprise almost two thirds of the reduction in energy consumption required to get carbon dioxide levels in the atmosphere down to a healthy level (The Economist). However, it is also unique in that unlike investing in renewable energy, investing in energy efficiency is amazingly profitable (even in the short run) for private enterprise. The McKinsey Global Institute estimates that a company investing in energy efficiency can earn an average return of 17% and a minimum return of 10% (Farrell, Bressand and Haas) Despite its potential, there are several forces holding back corporate-level investment in energy efficiency. Many managers are ill informed about the amount that they could potentially save. And even in the event thatthe manager is cognizant of the level of savings, investing in energy saving equipment is often outside of his area of expertise. An investment in efficiency would therefore require significant research by the organization, increasing the transaction costs. In addition, those companies of which energy efficiency does fall within their organizational competencies – usually risk-averse, heavily regulated utilities – often do not invest enough capital in modern, efficient equipment that could significantly improve their bottom line. There is an industry however which attempts to take advantage of this neglected opportunity – an entity called an “Energy Service Company”, or ESCo. The industry developed when real oil prices skyrocketed in the mid to late 1970s,

and has again been growing rapidly, at a rate of 22% per year (Hopper, Goldman and Gilligan 7). The ESCo will contact a company and at no cost to the client, develop a plan to improve energy efficiency and organizes the financing of the necessary capital expenditures. In return, the ESCo will be compensated in proportion to the energy savings associated with the project. This model has proven to besuccessful within the OECD. The development of the ESCo industry, in conjunction with increased awareness by corporations, has decreased the “energy intensity” (i.e. amount of energy generated by each dollar of GDP) of the rich world by about 2% per year (The Economist). While there are still many unfulfilled investment opportunities, the figure is trending in the right direction. The developing world on the other hand is, unfortunately, an entirely different picture. One issue with investing in energy efficiency in emerging markets is the fact that many (in particular the Gulf States, ASEAN, Russia, India, and China) heavily subsidize the price of fuel domestically. The returns of investing in energy efficiency are often heavily correlated with the price of fuel,in that paying more on energy bills is in effect an opportunity cost of not investing in efficient equipment. Also, the forces that hold back managers from investing in efficient systems are often doubly strong in emerging markets, where utilities are even more likely to be state owned. Lastly, most of the investment in energy efficiency in the OECD is structured as project financing – that is, the corporation creates a special purpose vehicle and borrows against the assets to get a lower cost of debt. In the absence of efficient capital markets, ESCos in emerging markets find it excruciatingly difficult to find financing. Fixing the inefficient consumption of energy in emerging markets is imperative to realizing the International Energy Agency’s projection that energy efficiency can represent the bulk of the needed cutback in carbon dioxide output. In particular, Chinese carbon consumption is both staggeringly inefficient and unacceptably high. Just last year China overtook the United States as the world’s biggest emitter of carbon dioxide (Fallows). To anyone that has visited or studied China, it becomes clear that one of the biggest risks facing the world’s fastest growing economy is their obvious pollution nightmare. Yet compared to their Indian or Russian counterparts, there is recognition at all levels of the government that reigning in this problem is essential for the ongoing health of the economy. The rule of Hu Jintao and Wen Jiabao has brought in a new attitude and openness in attempting to address the country's pollution nightmare. Beijing’s goals are quite explicit: by 2010, the government wants energy intensity to decrease by at least 20% and the emission of major industrial pollutants to decrease by at least 10% (the base year being 2006). (Fallows) While there has been some impressive progress, it looks as though China will fall short of the central government’s ambitious goals. A large part of this is due to the challenges ESCos in China have faced in receiving financing for projects. While the government has attempted to provide incentives for companies investing in energy efficiency, the obstacles still outweigh the benefits.

However, to quote the late Joseph Needham, “in China, nothing is easy, but everything is possible.” While the restrictions on financing are real and difficult (especially for foreigners), the impressive returns of energy efficiency projects in China, in some cases well over 60% per year (Hamburger and Sinton), make the market worth revisiting. To this end, this paper will explore ways an institutional investor could structure a deal so as to circumvent the regulatory maze that is the Chinese banking system.

History of the ESCo Industry The creation of the ESCo industry can be dated back to the latter half of the 1970s in response to the international energy embargo. During this period, a handful of U.S. state governments (most notably California and Wisconsin) started implementing “demand side management” (DSM) programs, in which they mandated utilities to provide energy efficiency programs for the energy auditing of residential customers. In 1978, this practice was implemented on a federal level via President Carter’s National Energy Conservation Policy Act of 1978 (Osborn, Goldman and Hopper 1-3). While many utilities simply organized their DSM activities as a subsidiary, some of these companies outsourced their DSM function to small, independent businesses, which would eventually evolve into the modern ESCo. This structure would continue until 1985, when Congress passed the Energy Policy and Conservation Act Amendments, which heavily emphasized public investment in energy efficiency. The amendment would push utility DSM programs to expand in size and scope, further incentivizing the utility to outsource the function (Osborn, Goldman and Hopper 1-3). The utility companies found it easy to do so because of the maturation of independent ESCos, who had expanded their capabilities to include not only audits but also sales, engineering, finance, and construction. As the field started becoming increasingly crowded, many control equipment manufacturers found it necessarily to create ESCos as subsidiaries in order to extend the firm’s sales reach. As the ESCo industry evolved, it grew rapidly. A remarkable aspect to the industry’s growth is its distinctly secular uptrend, largely uncorrelated with energy prices. Throughout the 1990s, the ESCo industry grew at a rate of 20% annualized (Hopper, Goldman and Gilligan 7). In conjunction with this growth there was significant industry consolidation, as larger ESCos bought out smaller ESCos and many utility companies and equipment manufacturers acquired ESCos in order to provide comprehensive service offerings. Growth flagged however between 2002 and 2004, largely due to the Enron bankruptcy (Hopper, Goldman and Gilligan 8). A division of Enron, Enron Energy Services, was among of the largest and highest profile ESCos in the business. The Enron bankruptcy was a significant setback for the ESCo industry. While the collapse of one of the largest ESCos would in and of itself decrease aggregate industry activity, there were several indirect effects which diminished the use of ESCo model. First, companies became far more cognizant of counterparty risk inherent in Energy Performance Contracting. Many ESCo contracts are structured so

that the ESCo guarantees the amount of savings that the client will realize from the investment– if the savings do not materialize, it is common practice that the ESCo makes up the difference. If the ESCo is bankrupt however, the client could potentially be left holding the performance risk of the contract. Secondly, in the wake of the Enron scandal, many corporations were wary of the use of special purpose vehicles (SPVs), which Enron abused in order to manipulate and smoothearnings. Distrustful of SPVs, for a brief period companies were far more likely to issue debentures (unsecured debt backed only by the earnings power of the firm) than engage in off-balance sheet project financing. Because most ESCo financing is structured as project financing through the use of SPVs, many projects were unable to find financing. In this three year period, the industry stagnated, growing at only 3% per year. (Hopper, Goldman and Gilligan 8) In late 2004 however, Congress adopted aggressive energy savings goals for Federal agencies, and specified that they would do so using energy performance contracting. This new avenue for growth reinvigorated the previously stagnant ESCo industry - by 2006, efficiency projects for Federal agencies would represent 21% of the aggregate revenues of the ESCo industry (Hopper, Goldman and Gilligan 13-14). In conjunction with this development, rising demand for energy in Asia almost doubled the price of oil, from under $40 per barrel in 2004 to over $90 by the end of 2007. To this end, ESCos have again been growing rapidly, estimated at over 22% per year. (Hopper, Goldman and Gilligan 8-9) Common ESCo Deal Structure The structure of the deals ESCos undertake varies significantly with the type of client and the country that the project is located in. In general, most of the work an ESCo take on is in the form of a performance contract (or, “energy performance contract”, also called an EPC) in which the ESCo’s return is in one way or another tied to the performance of their energy efficiency improvements. The structure of the EPC can take on many different forms. By far the most common type of structure is known as “guaranteed savings”, in which all of the ESCo’s project costs and fees are paid out of the gross savings annually. The ESCo will then guarantee the amount of savings realized over the life of the contract for the client. If the project fails to realize the projected savings, the ESCo will pay the difference to the customer. Another common contract is “shared savings”, in whichthe ESCo receives a percentage of the net savings in accordance with a contractual formula. In this contract type, the ESCo does not Exhibit 2: Common ESCo Deal guarantee the savings, and the client is not Structures obligated to pay for the cost of any of the upfront investment. The main functional difference between these two contract types is in their financing – in the guaranteed savings EPC, the debt obligation is structured as project financing and formally undertaken by an SPV of the client. For the shared saving EPC, the ESCo realizes the debt obligation themselves. A crucial feature of this financing arrangement is that in the former arrangement the ESCo is taking on the performance risk, while a

banking institution takes on the credit risk of the company. In the latter arrangement, the ESCo is effectively assuming both the performance and credit risk. Due to the fact that most ESCos (over 80% in the United States) are small independent entities (Hopper, Goldman and Gilligan 10-11), it makes sense that the vast majority of contracts are structured as guaranteed savings agreements, seeing as the client most likely has superior debt coverage to the ESCo. Shared savings agreements are more frequently undertaken when the ESCo is a subsidiary of a larger company, such as a utility or an equipment manufacturer. The last type of contract is known as “chauffage”, a full energy services contract. In the chauffage EPC, the ESCo either enters into a buildoperate-transfer arrangement (for industrial equipment) or the ESCo creates an escrow account for the client which holds their utility bills (for commercial projects). In return, the client typically pays the ESCo an annual fee roughly equivalent to the utility bill before the investment. This arrangement is popular in Europe where the complete management of individual assets is common, but much rarer in Asia and North America. In all of the above contracts, it is Exhibit 2: Common ESCo Deal Structures imperative for the ESCo to accurately and legibly measure the actual savings realized. The most common method for savings verification is basedthe savings off of the difference in the client’s utility bills before and after the project. By looking at past utility bills (for electricity and water, generally), the ESCo and the customer set a baseline energy consumption, and the savings is calculated as the difference between the current utility bills and the baseline. While widespread, this approach has a number of drawbacks. Most notably, calculations can quickly become complicated if the client increases their energy consumption or intensity in non-project related parts of the facility. For simplicity, many savings estimates are structured as “deemed/stipulated savings”, by which an independent third party provides a concept study approximating the level of savings for the project before construction begins, which determines the savings throughout the life of the contract. This method’s glaring flaw is that, in the absence of periodic renegotiation, performance risk is transferred from the ESCo to the client. A third method of savings verification involves the actual measurement of energy usage directly related to the installed technology. While expensive, this approach provides the most accurate savings estimates for the contract. Due to declining costs and increasing sophistication, the usage of this method is growing rapidly, especially in Asia where industrial clients are far more common. The actual measurement is split up into three subcategories: retrofit isolation of the implemented technology, whole facility measurement based off of regression analysis, or a calibrated simulation of utility bills. (Hui)

Typically, costs associated with measurement and verification makes up roughly 10% of the total cost of the project. On average, the other 90% of the investment is made up of 20% transaction costs (comprised of project identification and prospecting, legal fees, and a financing premium), 25% equipment design, and 45% capital equipment and installation (Goldman 12). While it obviously varies from project to project, the average total project costs for private sector clients in North America was roughly $840,000 (Osborn, Goldman and Hopper 4-5). For both the ESCo and the client, the investment typically provides very high returns. In the OECD, the median payback period, calculated by simple payback time, for a private sector client is three years (Osborn, Goldman and Hopper 7-9), implying an IRR of around 25%. While impressive, returns are even higher in emerging markets. In China in particular, the average IRR for a project can range from 50% to 60%, with a median payback period of two only years. (Hamburger and Sinton) Energy Efficiency in China To say that China has an environmental problem is a vast understatement. To any visitor, China’s thick smog and toxic waterways leave an enduring impression. Less anecdotally, the situation is indeed appalling – China consumes more than one third of the world’s coal and emits twenty percent of the world’s total CO2emissions. According to some statistics, China has already overtaken the United States as the world’s largest emitter of CO2, despite having an economy one sixth of the size. (Fallows) Furthermore, in accordance with the country’s rapid growth, demand for energy shows little signs of decreasing: China adds 232,000 motor vehicles on their streets per day and power companies can barely expand fast enough to meet demand (Reuters). The World Bank projected that if implicit environmental costs were included in the announced growth rate, China’s GDP growth could be revised downward by between 2.9 to 5.8 percent. It is estimated that 750,000 Chinese people die prematurely each year due to pollution. (Fallows) But while China’s environmental situation is an unmistakable human catastrophe, moving forward, it is also an incredible opportunity. When Hu Jintao and Wen Jiabao wrested control over the People’s Congress from Jiang Zemin and Zhu Rongji in 2004, with them they brought a new attitude in addressing China’s environmental problems. Standing in stark contrast to the government’s approach to other sensitive issues, even official publications from the Communist Party recognize the grave danger of ignoring the environmental situation. Public money is being poured into environmental research, fantastical engineering projects are being undertaken to mitigate the effects of the damage (e.g. Beijing’s artificially made forest, or “green wall”; the south-north water diversion project), and technocrats specializing in environmental issues are reaching levels of unprecedented power within the central government. The 11th 5 year plan for environmental protection, issued in 2007, was quite explicit in its goals: to increase energy efficiency by 20% and decrease emissions of major pollutants by 10% (Fallows). While actual progress to date is falling somewhat short of the government’s ambitious goals, progress is surely being made.

At the heart of this issue is a concept called energy intensity – the amount of energy (measured in units of “TCE” – tons coal equivalent – or “TOE” – tons oil equivalent) it takes to produce one U.S. dollar of economic output. In China, this figure is Exhibit 4: Energy Intensity (in Tons Oil Equivalent) about 2 tons per dollar, compared to .39 tons in the United States, .26 tons in OECD Europe and .13 tons in Japan (Potter, Shen and Taylor 6). In other words, it takes the average Chinese industry 869% more energy than it would in the OECD to produce the same amount of goods. It is in correcting this glaring inefficiency that opportunity lies – due to the fact that China’s industry is so wasteful, the implementation of energy efficient solutions is both cheaper and gives a greater return on investment. This is the reason why ESCos have been able to earn realize such outsized IRRs on their projects in China. The ESCo model was first imported into China in 1998 by the World Bank. The World Bank and the Chinese government were extremely focused in their approach: specifically, they wanted to create institutions to spur the creation of an active ESCo industry within China. The project consisted of two phases, with phase two commencing later, in 2003. Phase one consisted of the World Bank and the Global Environmental Facility created three pilot ESCos located in three different provinces - Beijing, Liaoning, and Shandong. The two international organizations were betting that if the three pilot ESCos were successful, it would provide a catalyst for the entrance of more companies in the industry. In conjunction with the pilot program, phase one also created an ESCo organization which would provide a blueprint for best practices within the industry. (Econoler International 7-8) By any measurement, phase one was an emphatic success. The three pilot ESCos grew steadily, eliciting more entrants into the industry, eventually swelling to a market of over one hundred independent companies. During 2006, these ESCos invested $280 million into 400 projects – generating energy savings equivalent to 21 million tons of coal. Furthermore, gross investment has been doubling year over year ever since the start of the program (World Bank Group). Yet along with this torrid growth, ESCos have also faced difficulties due to systemic problems in China’s economic system.

Exhibit 2: IRRs of ESCo Projects in China

ESCos in China differ from ESCos in North America and Europe in a number of ways. One aspect is that clients in China perceive the value-add of the ESCo to be primarily in the equipment they sell, so many of the ESCos are either equipment manufacturers or are partnered with one. A much more telling difference however is that ESCos in China rarely use a Guaranteed Savings contract, opting instead for

the relatively rarer Shared Savings structure. This is primarily due to the lack of asset-backed off balance sheet financing in China – Chinese banks are far more likely to issue vanilla loans. As such, the ESCos in China are often referred to as “full service” because they provide not only the technology but also the financing of the project. While this model has proven popular with clients, it does have some serious limitations. (Econoler International 21-29) The financing of the full service ESCo’s projects is at times almost a catch-22. Because in the shared savings model the ESCo needs to front the capital for the project themselves, for the ESCo to grow they generally require a large amount of capital. However, ESCos in China rarely have a large amount of capital under management; they are typically small companies with registered capital ranging between $35,000 U.S and $600,000 U.S. (Econoler International 7). Therefore, these companies end up having to borrow from the bank in order to finance projects and grow – but due to the ESCo’s small size and uncertain cash flows, Chinese banks have generally been unwilling to lend. This phenomenon has significantly restricted the ESCo’s potential growth – despite IRRs in excess of 60% and default rates around 2% (World Bank 22), the most common frustration managers of ESCos in China have is “financing”. The difficulties faced by ESCos financing their projects are emblematic of the financial problems of many other small to mid-size private Chinese companies. While China’s gradual transition from state-sponsored communism to free market capitalism has been generally accepted to have been a better approach to reform than the Soviet Union’s “shock therapy”, the policy implies that certain sectors of the economy are still burdened by the yoke of central planning. In particular, it is apparent that the pace of reform in China’s financial system has lagged far behind that of other industries, largely making the banking sector a relic of the misguided policies of Maoist China. China’s Financial System Despite China’s historically high savings rate (depending on the calculation roughly around 50% of income), multitrillion dollar foreign currency holdings, and torrid growth in foreign direct investment, China’s capital markets rank among the smallest in the world. Even in comparison to other emerging market economies, the Chinese equity markets can only provide 25% of the capital that a comparable market could; for commercial debt, this figure is an anemic 2% (Chandler and Gwin 7). Corporate bond markets are practically nonexistent, and the use of derivatives is largely an oddity. China has four major banks (five if one includes the now defunct Agricultural Bank of China, although this Bank is only being kept alive and still making loans due to systematic injections of public money from the central government) – consisting of the Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and the China Merchants Bank – of these, only China Merchants Bank is a private entity. Of the loans given out by Chinese banks, less than 9% percent of the loans are given to private companies, despite the fact

that their share of country’s output is over 65% and expanding rapidly. These circumstances have led to the banking sector’s dwindling productivity of capital. (Chandler and Gwin 8) The failure of the Chinese banks can be directed traced back to the vestiges of central planning. In particular, it is common for leftist governments to enact usury laws, intended to protect borrowers from loans carrying what is perceived to be exploitively high interest rates. However, similar to the effects of many other populist economic policies, what is designed to help individuals has contradictory and often unpredictable side effects. Specifically, the central government mandates that all loans have interest rates capped at a maximum of 8% (Chandler and Gwin 9). Furthermore, foreign entities are by and large prohibited from lending money to China-domiciled entities, even if the entity is a joint venture that the foreign party partially controls. In addition to these restrictions, in stark contrast with international accounting standards where a corporation’s interest expense is generally tax deductable, in China interest expense is not only calculated net of income, but also subject to a 10% VAT (value added tax). (Chandler and Gwin 8) These policies imply that while China continues to grow rapidly, at the base of this phenomenal growth is a financial system that consistently allocates capital in an inefficient manner. Similar to the industrial policies of Japan during the mid 20thcentury, Chinese banks are regulated to not lend out demand deposits but rather lend at a spread from loans borrowed from the central government. In conjunction with the state owned status of most of the banks, it is therefore no surprise that bank loans are largely made out of political convenience rather than economic viability. This appalling system has given rise to the so-called “informal” (illegal) banking sector in China. Based in the entrepreneurial hotbed of Wenzhou (a place that, upon visiting, a local justified unlawful behavior by explaining to me that ‘the mountains are high and the emperor is far away’), most illegal banking is conducted by smaller entities - often with ties to China’s organized crime network that can charge interest rates as high as 5% per month (Zhou). Yet for Chinese SMEs, the informal banking sector is an invaluable resource. Because of the restrictions on interest rates, the ‘big-four’ banks rarely can afford to engage in riskbased lending, rationally opting instead to lend to well capitalized, politically connected corporations and SOEs (state owned enterprises). While a quality survey of the informal financial system has yet to be performed, it is estimated that loans from the underground banks make up almost 50% of the total credit supplied in China. (Zhou) Because of these conditions, conducting monetarily policy is notoriously difficult for China’s central bank, the People’s Bank of China (PBoC). While the most central banks can ordinarily fine tune the money supply using mostly open market operations, the PBoC is required to opt instead for crude industrial policies. In trying to reign in inflationary pressures over the past decade, the central bank has had to resort to rudimentarytechniques such as changing the banks’ reserve requirements

or barring the export of selected products. Of particular concern to the ESCo industry, the PBoC in 2006 barred lending to steel and cement companies altogether, two industries that often represent important customers to energy performance contractors. (Chandler and Gwin 9) Equity financing for foreign investors has similarly anachronistic regulations. Most of the foreign investment rules stem from the defensive mindset required of Asian foreign exchange funds in the 1997 economic crisis. Yet with China’s foreign currency reserves currently standing at well over $1.4 trillion, many of these regulations are decidedly obsolete (Chandler and Gwin 9). Perhaps the most well documented constraint foreign investors have is the inability to acquire more than 50% control of any China-domiciled entity, whether it be for a consolidated joint venture or a direct injection in a Chinese company. In select municipalities in the coastal provinces, it is possible to create a subsidiary under the legal structure of a “wholly foreign owned enterprise”(WFOE), although these WFOEs are also subjected to additional regulations. In addition to this well-known restriction, there are many other constraints that foreign investors face when attempting to make an equity investment. Of these, there have been three in particular that have discouraged foreign investment in energy efficiency projects. First, a potential investor cannot legally invest directly into a project, but must enter into a joint venture with the company. While the joint venture can be structure to provide the return of a direct investment, the creation of the JV adds transaction costs and regulatory delay to the project. Second, and perhaps most bewildering to foreigners, the use of preferred stock is banned in China. Without preferred stock, it can prove very difficult for a foreign investor to get a priority return in a joint venture, a common practice in other emerging markets such as India and Brazil. Lastly, repatriation of profits from the joint venture, while improving, can at times be a long and arduous process. For all of these constraints, legal workarounds do exist and are, out of practicality, implicitly sanctioned by the central government. Yet these solutions can be a costly endeavor for investors without an extensive knowledge of the Chinese legal system. (Chandler and Gwin 11-13) In sum, to any sober observer it seems clear that China’s banking sector needs to undergo rapid and serious reform. To the central government’s credit, even while officials have publicly mocked the structure of western world’s financial system in the wake of the sub-prime debacle, in private the government’s technocrats have been working rapidly to liberalize Chinese finance. Indeed, instead of any distinct ideology, the actions of the Chinese Communist Party over the past couple decades have been marked by pragmatism. Because of this attitude, the Chinese government has been very accommodating of ideas from international organizations for ways to mitigate the problems faced by investors wishing to fund energy efficiency projects.

One plan to alleviate some of the structural problems listen above was the World Bank’s second phase of the GEF Energy Conversation Project. The basic premise behind phase two of the program was for the World Bank to issueloan guarantees to banks investing in Energy Efficiency projects. While it is illegal for a Chinese bank to charge a high interest rate to compensate for a high risk customer (such as lightly capitalized ESCos), the idea was that with the World Bank loan guarantee program the much of the risk would be mitigated, freeing the banks to finance the ESCos. To this end, the World Bank and GEF partnered with one of China’s only loan guarantee agencies (the market for loan guarantees is still miniscule), The China National Investment and Guarantee Co (I&G), to provide a 90% guarantee lasting three years for loans financing energy efficiency projects. Along with the guarantee, I&G has also received technical assistance from the Global Environmental Fund to educate banks on the minutiae of energy efficiency financing. (Blanchard) The results of the program havethus far been mixed. As of 2007 (four years into the program), I&G has issued 85 loan guarantees, totaling $32.1 million U.S. Yet despite the impressive gross numbers, the percentage of ESCo projects ultimately backed by I&G loan guarantees has only been about 9%, far less than originally estimated (Chandler and Gwin 167). The mixed results of this program most likely stem from the structural characteristics of China’s loan guarantee industry, in which banks typically buy primarily only 100% guarantees on their loans, effectively removing all default risk from bank lending. However, due to this practice, China’s loan guarantee companies normally require stringent counterguarantee requirements– that is, collateral posted from the final borrower passed through to the guarantee company. While the World Bank has covered 90% of the loan guarantee for I&G, I&G still is required by the bank to guarantee the remaining 10%. Because of this marginal sum, I&G still requires the end borrower to post some collateral as a counter-guarantee requirement, a clear disincentive for the ESCo to finance using the program. (Blanchard) The second way international organizations have tried to increase incentives for the financing of energy efficiency in China is through the Clean Development Mechanism (CDM) developed by the Kyoto protocol. The CDM is an international cap-and-trade system providing a way for projects that reduce greenhouse gas emissions to generate ’carbon credits’ which can then be sold to carbon emitting industries to legally offset their emissions. The amount of carbon saved is then verified by the CDM (often a lengthy process) to generate a financial security called a “Certified Emissions Reductions” (CERs) which can then be bought and sold on regional climate exchanges. The largest climate exchange is the European Climate Exchange in London, followed by the Chicago Climate Exchange. Recently, due to the fact that 52.7% of expected CER volume stems from China, a climate exchange has opened in Tianjin. (Victor)

Yet the effects of the Kyoto Protocol have also seen mixed results with respect to financing energy efficiency projects in China. This disappointingoutcome stems from the bureaucratic ineptitude from both the CDM and the Chinese central government. Almost comically, the Chinese government considers CER credits as a national resource (a ‘resource’ of course, rooted in the inefficiency of energy usage in the Chinese economy) which in accordance to Chinese law bars any company that is more than 20% foreign owned from generating or selling CERs (Chandler and Gwin 14-15). In addition to this curious rule, the approval process for a CER credit is onerous and lengthy. One of the biggest criticisms of the Kyoto protocol has been that the CDM requires the CDM executive board to approve every single CER produced, a process that can take five months or longer. In addition, because of the CERs’ status as a Chinese natural resource, a company attempting to sell a CER requires further approval in Beijing. In sum, waiting for bureaucratic authorization can often delay payment by over 18 months, a significant period of time when the project undertaken has a simple payback period of 24 months. (Chandler and Gwin 14-15) Conclusion: An Approach for Institutional Investors While the return potential for energy efficiency projects in China has been well documented due to the rapid development of the country’s ESCo industry, there remains an enormous potential to scale up the industry in both size and scope. Especially as the global economy contracts and central banks move to lower interest rates, these EE projects - with IRRs in excess of 50% - could assuredly entice yield-hungry investors. Yet even with governmental support, there appears to be no channels as of now by which large amounts of financing can flow to energy efficiency projects in China. Within this void lies a golden opportunity for financial intermediaries, whether they be securities underwriters (such as investment banks), or alternative investment vehicles (such as development finance institutions). The ESCo industry is in dire need of access of the enormous pool of global capital that China attracts, but the country lacks the financial infrastructure to allocate funds to such an economically and socially attractive investment. One solution that has consistently been proposed at ESCo conferences is creating a ‘super-ESCO’ that would manage the capital flows across the projects of a number of ESCos. Yet a much more direct approach would be for an investment bank to directly invest in each project, and then securitize the cash flows for sale to institutional investors in the United States, Japan, and Europe. While the bank would most likely realize significant legal fees in structuring deals so as to sidestep many of China’s regulations, the sheer size of the returns energy efficiency projects can provide can more than compensate of the legal complexity (underwriting credit default swaps in the United States is also a legal nuisance, but the market has a notional value of $56 trillion). If financed by an international investment bank, the deal structure an ESCo would have with a potential client would still technically be in the form of shared savings. However, the ESCos would no longer be required to front the capital to

make the initial investment, instead beingprovided to the ESCo by the investment bank. In return, the ESCo would pass through the 80% energy savings they would have been entitled to receive on the project to the investment bank. In order to mitigate agency problems, the ESCo would provide a guaranteed level of savings to the bank, similar to that used in the guaranteed savings approach used by ESCos in United States and Canada. The ESCo would instead be compensated with fees, and if the energy savings do not materialize, the ESCo would be responsible to make up the difference. Legally, the project would be required to be structured as an equity investment in a joint venture between the bank and the ESCo, the details of which are provided in Exhibit 3: Once the cash flows are repatriated out of China (most likely into the financial centers of either Hong Kong or Singapore), the projects could then be pooled and infused with credit enhancement provisions. The first defense against default would be the external enhancement of ESCo savings guarantees. However, because of the very small capitalizations of the Chinese ESCos, this provision would guarantee Exibit 3: Hypothetical Deal Structure of an International ESCo Investmentless against default than ensure the smooth cash flows of pooled ESCo projects. In order to make the security investment grade, the bank would instead be required to carry a very large excess spread between the IRR of the projects and the return on the security. This spread would also smooth out the cash flows, and be put into a reserve account that would guard against default. Another possibility for augmenting thereserve account to back the security would be for the bank to sell carbon credits from greenhouse gas savings of the project. While it would be impossible to sell CERs due to China’s regulations regarding the Kyoto Protocol, there exists a similar carbon credit (used mostly in the United States because of our refusal to sign the treaty) called a “verified emissions reductions” (VERs) that is governed not by the CDM but rather by certain best practices. While these credits typically trade at a discount to CERs (at anywhere from 30% to 80% of the CER value), the approval process is many orders of magnitude faster and the VERs would not be subject to China’s CDM regulations (Victor). Once securitized, the bank would be able to sell the product not only to high yield fixed income investors, but a wide array of various customers. With the voluntary carbon offset movement growing strong in the United States (a market of $91 million in 2007), it is conceivable that these securities could also be sold to individual investors as well (Victor).

An Extremely Convenient Truth It is rare for an investment to provide significant economic returns and simultaneously improve social welfare in a direct and visible way. The financing of energy efficiency is perhaps among a handful of alternative investments that accomplish both of these goals, making it one of the most attractive ways that the private market could use its capital. Yet due to the esoteric nature of the investment, it appears that financial intermediaries will need to find innovative channels so that capital can meet its demand. What was outlined in this paper is simply one idea out of many – whatever the structure, it is apparent these projects need and will hopefully find financing. Yet with the high profile collapse of many of Wall Street’s most illustrious investment banks and global markets in turmoil, many voices, ranging from regulators to economists, are questioning the wisdom of ‘financial innovation’. While perhaps derivatives markets do need more transparency (e.g. moving away from OTC markets toward centralized exchanges), it would be a mistake to overregulate the industry. Speculative mania is an intrinsically human characteristic – there have always been booms and busts throughout history, from the Dutch tulipmania in the 17th century to the NASDAQ bubble at the end of the 20th. Because the economic purpose of banks is to facilitate the allocation of capital in accordance to the desire of investors, it makes sense that the fortunes of banks are tied very closely to this boom-bust cycle. As such, the banking sector has always had its crises, entirely uncorrelated with the degree of maturity in the industry – banks have failed before the advent of derivative and asset backed securities, and will fail again in the future regardless of the extent these products will be regulated. While not commonly discussed in business schools, the LDC Debt Crisis in the early 1980s is archetypical of this phenomenon. In 1982, American banks were heavily invested in Latin American debt – the region had been growing rapidly, but the many of the governments dangerously overleveraged themselves due to cheap credit provided by foreign investors. When Paul Volcker raised interest rates to combat oil-based inflation, it elicited a global recession that severely hampered the creditworthiness of many Latin American countries. In August of that year, Mexico defaulted, which triggered a cascade of defaults spreading to Argentina, Brazil, and Venezuela (FDIC 205-206). In the end, American banks lost more on Latin American debt than they had ever made – cumulatively – in the history of the banking sector (Taleb 43). And yet, for some reason, analysts are quick to conclude that financial innovation is the root cause of the current crisis, with barely a breath concerning the enormous speculative bubble in American real estate. In the end, it can difficult to accept that the ups and downs of the business cycle are largely outside of society’s control. It would therefore be a tragedy to scrap financial innovation – which is, at its root, simply a means to apportion capital to where it can be used the most effectively. And with the Earth’s climate dangerously in balance, it is important that the financial services industry find novel ways to best allocate our resources to address this problem, and be allowed by regulators to do so. Western banks may not be effective risk managers, but they are very good at facilitating the efficient movement of society’s scare resources from unproductive industry to industries that can use said resources the best. In this respect, a means to finance energy efficiency in China is well within the economic capabilities of the banking industry.

Indeed, one could argue that from both an environmental and economic perspective, there could not be a better place for capital to be allocated to. As put by James Fallows in “China’s Silver Lining”: “Over the past 20 years, the world got used to a “China price” for manufactured goods – the rock-bottom price for anything coming out of a factory. In the coming 20 years, the world could make use of a “China price” for pollution control, especially greenhouse gases – the rock-bottom requirement of money and resources needed to reduce emissions by a given amount. Precisely because so many Chinese systems are now so wasteful, it will be cheaper and easier to eliminate the next thousand tons of carbon-dioxide or the demand for the next million watts of electricity-generating capacity in China than anywhere else in the world.” As scientists race for a replacement for fossil fuels, it is essential that society find a way to finance their research, whether from public or private sources. Yet while this research is important and will ultimately change the world, it is crucial that in the process we do not forget other, more conventional means of reducing the emission of fossil fuels. It has often been said that ‘man’s reach exceeds his grasp’. An alternative energy is indeed within our reach. However, a more efficient usage of the energy we now have is already within our grasp.

Exhibits
Exhibit 1: Energy Efficiency Projects in China

(source: “Energy Efficiency in China – a Road Map for American Companies”)

Exhibit 2: Structure of ESCo Lending

(source: “Overview of U.S. ESCo Industry: Recent Trends and Historic Performance”)

Exhibit 3: Structure of International ESCo Investment

Exhibit 4: Energy Intensity in Select Regions

(Source: McKinsey Global Institute)

Works Cited
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Sun, Jinying. "Application and Mode Establishment of Asset-backed Securitization in Existing Large-Scale Public Building Retrofit Financing in China ." Building Commissioning for Energy Efficiency and Comfort (2006). Taleb, Nassim. The Black Swan. New York: Random House, 2007. Taylor, Robert P, et al. Financing Energy Efficiency: Lessons from Brazil, China, India and Beyond. Washington D.C.: World Bank, 2008. The Economist. "The Elusive Negawatt." The Economist 8 May 2008. Victor, David. Green Leap Foward. 20 October 2008. 15 November 2008 <http://greenleapforward.com/2008/10/20/china-carbon-forum-2008-review/>. World Bank Group. "World Bank, GEF-Backed Energy Efficiency Programs Expand in China." 14 January 2008. The World Bank News and Broadcast. 19 October 2008 <http://go.worldbank.org/ZC8F200RE0>. World Bank. Project Appraisal Document on a Proposed GEF Grant of SDR 19.7 Million to the People's Republic of China. Project Appraisal. Washington D.C.: World Bank, 2002. Zhou, Xin. International Herald Tribune. 24 November 2008. 1 December 2008 <http://www.iht.com/articles/2008/11/24/business/yuan.php>.

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