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Financing Options

As has been explained in the process of DSM planning, one of the most essential steps is to arrange for resources to finance a DSM program. Generally, all over the world it has been noticed, that despite being technically and economically feasible, certain DSM programs do not get implemented due to lack of adequate finance. Such a situation often occurs on account of the uncertain nature of outcomes and inherent conflict with the objective of achieving increase in sales. Hence distribution utilities are usually reluctant to undertake DSM measures. In India, the situation is further complicated as more than 90% distribution business is owned by public utilities which are often found wanting in responding to incentive structures. Some of the barriers in implementation of DSM programs, particularly in India, can be listed below as:

• The distribution utilities often lack necessary institutional capacity and funds to develop practical approach for undertaking energy efficiency and demand side management programmes.
• There are barriers relating to untested outcomes.
• Lack of clarity about baseline data and M & V protocol.
• Non-availability of financing options and huge demand – supply gap.

While costs associated with DSM project are usually not significant, due to poor cash situation, utilities find it difficult to arrange necessary funding. Hence, regulatory intervention to ensure adequate funds for distribution utilities for design, development and implementation of DSM programme is usually required.

Sources of financing for energy efficiency projects (including DSM) range from commercial banks to specialized energy efficiency funds to socially responsible investors.

Financing through commercial banks, however, remains difficult in many cases as energy efficiency investments (will be referred to as DSM investments hereafter) often do not meet the standard investment criteria, such as collateral requirements.

However, a growing number of specialized financing sources for energy efficiency are now available, as detailed in this section.

Each financing source has its own set of criteria used to select projects for investment. However, all of the sources described here have one thing in common: their objective is to invest in projects that will generate enough energy savings cash flow to repay their investment.

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Following four major financing sources are usually available to distribution utilities:

1. Multilateral, bilateral and other international institutions/development agencies dedicated to promoting energy efficiency services. These also include dedicated lines of credit or Special funds generated from the levy of additional charges to the end-users.
2. Grants from governmental agencies.
3. Self financing – recovery of costs through tariffs (DISCOM Mode)
4. Private equity, venture capital funds and project finance debt from nationalized banks and other sources.
5. ESCO financing

The analyses of DSM projects worldwide by various DSM experts indicate that the Multilateral, bilateral and other development agencies are usually the financiers of DSM programs undertaken for the developing countries. In the case of developed nations the financing is done by the utilities themselves (Self-financing) without the assistance of other agencies.

In the case of India regulators can play an active role in arranging the funds for utilities to implement DSM initiatives. Also the utilities have to adopt sound marketing strategies to attract private equity and other project finance loans from nationalized banks.

This section describes some of the key sources currently available to finance DSM programs.

1. International Financial Institution and Development Agencies, and special funds

Several international lending and donor institutions have created funds for promoting energy efficiency and conservation in developing countries as well as in countries with economies is in transition. Most of them have specific action plan and/or intervention strategies to support DSM programmes. These institutions include the World Bank Group, the Asian Development Bank, IFC, etc. Similarly, industrialized countries have set up bilateral funding agencies whose mandate is to manage public assistance funds for development. These include, USAID (United Agency for International Development) in the United States, DfID, CIDA, etc.

It is necessary to encourage utilities to approach these agencies for funding these projects not only for funding purposes but also to take benefit of technology, know how, systems and processes involved in evaluation and implementation of projects.

While other sources exist, the institutions and programs listed here have departments that are actively seeking to finance energy efficiency or otherwise environmentally-beneficial projects in emerging markets. These sources are:

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Private, Independent Sources

• Energy House Consortium, which includes E&Co., Environmental Enterprises Assistance
  Fund (EEAF), Energy Holding Company and the International Fund for Renewable Energy and Energy Efficiency (IFREE)
• Global Environment Fund Group

Multilateral Sources

• International Finance Corporation
• World Bank
• Global Environment Facility
• European Bank for Reconstruction and Development

2. Grants from government/ governmental agencies

As has been mentioned above there are several government agencies that give grants or create special funds for the purpose of providing finance for DSM programs. However, direct lending on the part of government (or in the form of grants or aid) has not been a prevalent practice in India so far and hence we will not dwell into its discussion at this stage.

3. Self financing or Recovery of Costs through ARR (can also be called as the DISCOM mode of financing)

Under the DISCOM Mode, the utility funds the DSM project either by utilizing its own funds (may be in the form of a special fund created by the utility for DSM financing or recovery of such costs through ARR) or though borrowings and contract out the certain aspects of the project works and implementation.

Direct costs associated with program administration including design, implementation, monitoring, evaluation and incentives, if not recovered, could impact earnings of the utility. Reasonable certainty of cost recovery is necessary condition for utility program spending, as failure to recover any costs directly impacts utility earnings, and sends a discouraging message regarding further investment. Tariff Regulations, specified by the State Commissions for determining the ARR and Tariff, do not generally have an exclusive provision under which the utilities can book the expenses incurred by it on DSM. Suitable provisions in the Tariff Regulations to allow recovery of DSM related expenditure as a part of Annual Revenue Requirement is one of the simplest way to create necessary funding for the implementation of DSM programs. It would be appropriate that the State Commission may indicate a percentage of the ARR to be utilized for DSM programs. This percentage could be worked out on the basis of the indicated savings from the power purchase costs and peak clipping. In case of approval of the expenses under ARR, the utility is certain about recovering of the costs through consumer tariffs. In this case, the utility funds capital expenditure using same financing principle as used for other capital projects of the utility. This method has been referred to as ‘self financing’.

Sometimes it may be possible to create Special Funds either within the utility or outside the utility which may be used by the utilities for design, development and implementation of demand side management program. Regulatory mechanism could be used for development of mechanism for creation of special funds. Such mechanism could involve levy or surcharge on existing consumption or incremental consumption or incremental demand, depending on the purpose of the fund.

An example of such fund is ‘Load Management Charge’ fund created by various utilities in the State of Maharashtra. In May 2005, under Section 23 of the Electricity Act 2003, MERC directed all consumers to reduce their consumption to certain level. The Commission levied surcharge of Rs. 1/kWh for consumption above norm specified by the Commission. Similarly, the Commission directed rebate of Rs. 0.50 for reduction in consumption below norm set by the Commission. The Commission directed that the amount so collected by the utilities shall be used for promotion of energy efficiency, energy conservation and demand side management. The utilities in the State of Mumbai collected Rs. 70 crore during two months of May and June 2005. Till date, this amount is being utilized by the utilities to run EE/EC/DSM programs in the State.

An example of fund created outside the utility is Urjankur Nidhi created by the Government of Maharashtra by levy of cess of 4 paise on all units sold to commercial and industrial category consumers in the State of Maharashtra. State Energy Conservation Fund envisaged under Energy Conservation Act 2001 is another example of such fund.

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4. Private equity, venture capital funds and project finance debt from nationalized banks and other sources.

Developing a financing structure consists of designing a credit-worthy project and selecting the amounts and likely sources of financing. Choosing financing is more than just allocating risks and selecting between debt (taking on a loan) and equity (selling ownership stakes). There are other mechanisms and structures as well. For example, leasing or vendor financing are viable financing options for many energy efficiency projects and ventures. Similarly, letters of credit or bank guarantees can be arranged to facilitate financing.

ESCO projects, manufacturing and licensing ventures, existing organizations and start-ups can all be financed with debt or equity. For a creditworthy company with significant assets and cash flow, designing a financing structure is a matter of choosing the lowest cost debt or equity options that meet the financing needs of the project. However, the use of both debt and equity entails tradeoffs and riskier ventures in new industries or in developing markets may have more restrictions on the type of financing available.

Debt
Debt options include corporate or project loans under recourse or limited recourse structures, leasing arrangements, and full or limited guarantees. Many funders specify minimum cash flow generation projections, debt coverage, leverage and other financial ratios for projects to qualify for loans. Stronger credit support can sometimes be structured into a transaction by obtaining additional collateral, cash flow, or parent company or third party guarantees for a loan. Debt financing can include options whereby loans convert to some amount of equity ownership if the project is successful, to increase the lender’s rate of return.

Recourse Debt
Financing with recourse is sometimes structured as corporate or balance sheet financing, whereby the debt holder is obligated to the primary sponsor of the project, and the loan must be reported on a company’s balance sheet as a liability. In essence, the company stands behind the project or venture and the related debt, and financiers have recourse to the company’s assets in the event of default. Recourse financing usually has a lower cost than project finance or limited-recourse debt because of its generally lower credit risk. In addition, warranties, guarantees and insurance can provide various forms of recourse to add to the creditworthiness of a transaction. Most energy efficiency (and other project finance type) projects require some degree of recourse to a creditworthy entity.

Limited Recourse Debt or Project Finance
Limited recourse financing is sometimes known as project finance. Under these transaction structures the project is financed largely based on its own merits, and payments are made by the project's cash flows. Financiers have recourse primarily to the project’s cash flow and assets or additional collateral. Compared to recourse financing, structuring financing with limited-recourse is a time-intensive process. It involves a full clarification, mitigation, and allocation of all risks that could have a negative impact on the cash flows from the project or venture. The financing structure allocates risks among the parties in a transaction through contracts and financing agreements. Under these contracts different parties accept varying amounts of responsibility to repay the debt in the event that a project fails and the loan is not repaid. The debt issue has different degrees of recourse to other parties to enforce the project’s payment obligations if a financing contract is broken.

ESCO financing structures are sometimes funded with project finance types of limited recourse debt, although usually additional collateral and credit support is required. Most project financing in developing countries is limited-recourse financing. Private lenders, for example, will often require performance guarantees, assignment of energy savings and performance contracts from project sponsors for these kinds of projects.

Secured Debt
Secured financing refers to when additional assets are pledged to the bank or financier as loan collateral. The assets can be cash, physical equipment or property, or sometimes a bank letter of credit. In the event of a default on the promise to repay the project debt when due, the bank has the right to seize and sell these assets and utilize the proceeds to repay the loan. Collateral liquidation is an expensive and time consuming process and the financier rarely collects close to the full collateral value, even on cash, after legal and other fees. Thus, collateral is never a substitute for a well conceived project with solid cash flows. Guarantees and other types of credit support can provide other assurance or security for debt repayment but are not collateral per se.

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Leasing
Leasing can be used to finance the sale of energy efficiency equipment and services. It is commonly used in vendor financing and ESCO projects and as part of utility programs. Lease financing can also be applied to energy efficiency manufacturing ventures. Leasing works best with simple equipment and large quantities of sales or installations. Large numbers of similar transactions facilitate a statistical approach to managing end-user credit risk. Lease financing is possible only in countries having fairly well developed capital markets and amenable laws (as a rule-of-thumb, select countries that have more than ten private leasing companies).

Guarantees
Guarantees can be provided by parent companies or third parties, and are essentially promises to pay a project's debt under certain conditions. Guarantees can be used to partially mitigate financial, performance (technological and operating) and political risk. These instruments can provide additional credit support for a basically sound transaction, thereby facilitating conventional financing at market rates. Guarantees can be made on part of a loan, debt service or to assure an investor’s return on equity. Most commercial banks will issue or accept guarantees, which can be collateralized to provide additional credit support. Note, however, that guarantees are not usually considered to be collateral. The World Bank/MIGA, Ex-Im Bank and OPIC all offer various guarantee programs for political risk.

Equity
Equity financing involves the ownership of a company or project, and can take a variety of forms.
Equity can come from the project sponsor, or in the form of a private placement or preferred or common stock. Equity usually provides longer term financing for a higher expected rate of return than debt. Usually a minimum of between 20 percent and 30 percent equity in a project is required to obtain debt financing, depending on the company or customer’s credit-worthiness. For larger projects in developing countries, according to the World Bank, the sponsor’s equity stake is usually around 30 percent. Funders providing equity may provide more stable financing but also require significant control of the initiative.

Specialized Financing
All types of projects and ventures are financed through the basic financing mechanisms described above. However, export financing, vendor financing and ESCO financing structures warrant some additional consideration.

Export Financing
Many types of energy efficiency equipment and services are not currently available in developing countries. US vendors and buyers can take advantage of export credits and guarantees supplied by the Export Credit Agencies of the US Government, including the US Export-Import Bank, the Overseas Private Investment Corporation (OPIC) and the US Trade and Development Agency (US TDA), to sell or purchase imported equipment.

Sources of trade finance for large, capital-intensive items include commercial bank export finance divisions and export credit agencies. For multiple sales of lower-priced items, companies should contact commercial banks with trade divisions, equipment distributors and agents. Export financing may be available at better terms than other types of debt for overseas projects due to the collateral value of the equipment being financed.

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Vendor Financing
Vendor financing occurs when a financier provides a vendor with capital to enable them to offer “point of sale” financing for their equipment. Vendor financing works well with high-volume sales of small products to customers in the residential and small commercial/industrial sectors. It is similar to leasing in that vendor financing lends itself to a statistical or portfolio risk management approach to end-user credit risk. Indeed, leasing is the most common form of vendor financing.

Under a vendor finance scheme there are two types of agreements: one between the vendor and the financier; and the other between the vendor and the customer. The vendor/financier agreement defines the terms that can be offered to the customer such as rates, length of term and necessary documentation. A simplified and streamlined credit analysis process reduces transaction costs.

The vendor/customer agreement defines the repayment terms for the loan. For energy-efficient equipment, these agreements can be structured such that the customer payments are lower than the value of the energy savings associated with the new equipment.

5. ESCO Financing (ESCO mode)

This may be considered a part of “specialized financing” methods only; however, we discuss it in detail, as it is the most common mode of financing DSM programs at present.

Under the ESCO Mode, the ESCO signs a contract with the utility to finance and implement project; the ESCO may borrow the project debt and repay it from project revenues.

An energy service company (ESCO) is a professional business providing a broad range of comprehensive energy solutions including designs and implementation of energy savings projects, energy conservation, energy infrastructure outsourcing, and risk management. ESCO also maintains the system to ensure energy savings during the payback period. The savings in energy costs is often used to pay back the capital investment of the project over a five to twenty year period. If the project does not provide returns on the investment, the ESCO is often responsible to pay the difference.

The ESCO mode of financing can be diagrammatically represented as follows:

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ESCOs are usually differentiated on the basis of performance contracts from other firms that offer energy efficiency improvement or energy services, such as consulting firms and equipment contractors. Performance contract is directly linked to the amount of energy saved. In general, energy service includes energy audits, energy management, energy or equipment supply, and other services such as steam supply etc. ESCOs offer similar services as Energy Service Providing Companies (ESPCs). However, in contrast to them, they guarantee the savings and their remuneration is linked to the projects’ performance. ESCOs may also provide or arrange financing. Different type of ESCO business models prevalent in the market are:

Full-Service ESCO: The ESCO designs, finances and implements the project, verifies energy savings and shares an agreed percentage of the actual energy savings over a fixed period with the customer. This is also referred to as the ‘Shared Savings’ approach.

End-Use Outsourcing: The ESCO takes over operation and maintenance of the equipment and sells the output (e.g., steam, heating/cooling, lighting) to the customer at an agreed price. Costs for all equipment upgrades, repairs, etc. are borne by the ESCO, but ownership typically remains with the customer. This model is also sometimes referred to as Chauffage or Contract Energy Management.

ESCO with Third Party Financing: The ESCO designs and implements the project but does not finance it, although it may arrange for or facilitate financing. The ESCO guarantees that the energy savings will be sufficient to cover debt service payments. This is also referred to as the ‘Guaranteed Savings’ approach.

ESCO Variable Term Contract: This is similar to the full-service ESCO, except that the contract term can vary based on actual savings. If actual savings are less than expected, the contract can be extended to allow the ESCO to recover its agreed payment. A variation is the ‘First Out’ model, where the ESCO takes all the energy savings benefits until it has received its agreed payment.

Equipment Supplier Credit: The equipment supplier designs and commissions the project, verifying that the performance/energy savings matches expectations. Payment can either be made on a lump-sum basis after commissioning or over time (typically from the estimated energy savings). Ownership of the equipment is transferred to the customer immediately.

Technical Consultant (with Performance-based Payments): The ESCO conducts an audit and assists with project implementation. The ESCO and customer agree on a performance based fee, which can include penalties for lower energy savings and bonuses for higher savings.

Guidelines on Performance Contract
Performance contracts are different from traditional contracts with energy engineering and consulting companies because the firm contracted is compensated based on actual energy savings resulting from the project implementation, instead of a fixed contract price.

Types of performance contracts
Performance contract is differentiated in two major type of contract i.e. guaranteed savings where the financial risk lies with the utility but the ESCO guarantees a certain percentage of savings, and shared savings where the financial risk lies with the ESCO and the savings are shared between the ESCO and utility for a negotiated period of time. There can also be numerous variations and combinations of these two main types. The essence of a performance contract, common to all types, is that the contract is written so that the investment costs are paid from the savings.
Guaranteed Savings

• The utility takes on the third party financing from a lender, putting the loan on its balance sheet.
• The ESCO guarantees that savings will be sufficient to cover the investment cost, and if they are not the ESCO pays the difference between the realized savings and project payments.
• Excess savings can be shared between the utility and ESCO.

In this scenario the utility takes on no risk even though they finance the project because the guarantee covers the financing cost, a known and quantifiable amount. However, guarantees add more risk onto the ESCO and more risk always trickles through as added cost to the project in the form of a higher percentage of the savings being taken by the ESCO. When a contract includes some form of guarantee, a contractor normally takes out insurance against that guarantee. Such insurance is generally expensive since insurance companies cannot adequately quantify these types of risks unless the contract is for a simple type of project with a long track record, like changing light bulbs, where there are few unknowns in the equation. The cost of the insurance policy is added, with associated mark-ups, to the cost of the contract. In summary, guarantees made by the ESCO may cause them to negotiate a higher, often significantly higher, percentage of the savings to ensure an adequate profit margin to cover all the risk they assume.

There are of course circumstances where a utility is willing to sacrifice some of the savings accrued from the project in order to have a guarantee that brings a high degree of certainty. In India the guaranteed savings type of performance contract is more widespread than the shared savings type due to the lower risk for the utility. On the other hand, most of the ESCOs in India are small and new with inadequate credit histories and financial track records.

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Shared Savings

• The ESCO takes on the risk of third party financing from a lender, putting the loan on its balance sheet.
• The savings are shared between the utility and ESCO with the contract stipulating that the utility will receive a certain percentage of the savings, but it does not guarantee the magnitude of those savings.

In this scenario, the ESCO is still carrying the cost of the project but without the additional cost of the guarantee. In financing EE projects, the cost of the capital for the ESCO is higher than the cost of capital to the Utility. Therefore the client (utility) is not carrying any risk, but then it is also not assured of any savings, although in practice such an outcome is unlikely. The likely outcome from a shared savings performance contract, should circumstances allow for this type of contract, is that the utility may accrue significantly greater financial rewards from the project than if a guaranteed savings contract had been used.

If the energy end-user is sufficiently creditworthy, then guaranteed savings contracts can be used to repay financing, whereby the payments made to the ESCO are based on the measured energy savings. If limited recourse financing to the end-user is sought, shared savings or paid-from-savings contracts are used, with limited liability for the energy end-user. Utilities can also contract with ESCOs to deliver energy savings under their DSM programs. In this case, the ESCO undertakes projects at end-user facilities with financing from the utility. The ESCO is paid under a guaranteed savings arrangement.

Leasing can also be used to finance ESCO projects. End-users are given recourse to the ESCO through extended warranties. Lease payments are contingent on the proper functioning of the equipment. Under this arrangement, payment amounts are set when the lease is executed. This is slightly different than shared savings or other types of performance contracts in that the payments are fixed and agreed upon in advance.

Financing Schemes for EE/DSM programs

Awareness of ESCO financing, in which debt is repaid by energy savings, is growing in India. Several international initiatives such as USAID’s Energy Management Consulting and Training program in India have fostered interest in the ESCO model for energy efficiency project development. However, it is still difficult to secure financing at terms attractive to ESCOs since issues such as project size, collateral and financing terms often arise.

To facilitate easy financing of Energy Efficiency programs including DSM programs a lot of banks in India have come up with attractive schemes. Some of them are listed below:

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