Energy Service Companies in China
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 creates investment opportunities for a country that is awash in capital. But despite the huge potential of China’s ESCO industry, it has yet to approach the size of the ESCO industry in the US where it is an industry worth six billion dollars a year.
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 some 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 the 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 organised along ESCO lines. Dongying Shengdong EMC Ltd (DSE) installs electricity-producing boilers that burn waste gases, such as coal mine 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.
- Beijing PowerU is a provider of chilled water cool storage technologies that save energy. The company has installed solutions under energy performance contracts for a variety of customers including Shanghai’s Pudong Airport, LG Philips’ electronics factories, semiconductor manufacturing plants, 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 are a considerable number of commercially viable ESCO projects. Recent increases in energy costs have created even more potential for energy efficiency projects but many hurdles exist that hold back the development 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 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. Whereas the market seems extremely promising, the structural issues can be daunting for a foreign player”
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 lent 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 over 400 ESCO companies in China. The Asian Development Bank, agencies of the UN, and development agencies from various nations contribute expertise and capital to China’s ESCO industry. Chinese government subsidies also aid companies implementing energy performance contracts.
Challenges in Implementing the ESCO Model
The support and subsidies that the Chinese ESCO industry currently enjoys are necessary to overcome the cultural and institutional barriers 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 culture of quick returns based on expansion and finding new markets. Chinese Banks are often unwilling to lend for energy efficiency projects because the benefits 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 $1m to $6m, much smaller than the large infrastructure projects and production expansion loans that loan officers typically appraise. Instead ESCOs must lend their own money, or find investment funds elsewhere, often difficult for smaller Chinese firms with little financial expertise.
Insufficient energy measurement standards affect enterprises’ efforts to save energy. 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 realised. 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. This prevents Chinese bank staff from starting to learn about complex project financing since they could never loan on such a project in the first place. What makes this regulatory quirk a missed opportunity is that high risk notwithstanding, ESCO projects can have an investment return of more thatn 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 US$200 million World Bank loan together with a US$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.
- The Pollution Prevention and Energy Efficiency ("P2E2") environmental financing program is joint effort between the US Environmental Protection Agency and the Chinese State Environmental Protection Administration is helping Hong Kong-based ESCOs pursue opportunities in Mainland China through loan guarantees from the Asian Development Bank.
- 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. It has all the potential of huge energy inefficiencies and a large pool of waiting capital and yet arranged against ESCO development are serious structural problems. From talking to Chinese and international ESCOs, it has become apparent to me that in many cases, the traditional full service ESCO model of providing a facility-wide reduction in energy usage using one hundred percent third party financing is not appropriate in China. Instead a localised version of energy performance contracting would stand a better chance of success. Much more commitment is needed from customers than in countries where financing is readily available - for instance rather than approach reluctant banks, ESCO customers could guarantee energy efficiency loans, or provide partial financing for projects. Since much of the legal and technical apparatus for energy performance contracts is missing in China, trust between companies is much more important. It is therefore difficult for ESCOs to approach a customer and initiate a successful energy performance contract without having worked with the customer before.
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, Chinese companies can capture the full-service capabilities of their American and European counterparts, such policy instruments can be aligned with China's goals for energy efficiency and environmental protection, and finally, 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.
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
