In developing countries, lack of financing, or inability to access financing, is one of the main barriers to ESCOs (World Energy Council, 2008; Taylor, et al., 2008). The main options for ESCO financing, described above, include: the client, domestic commercial financial institutions, domestic development banks, government energy-efficiency funds, private equity and international agencies.
Some of the key financing barriers include:
Scarce capital and immature banking sector
In some developing countries, the domestic financial institution sector is immature, dysfunctional or unstable, making it very difficult for ESCOs to access local financing (ESMAP, 2006). In addition, where there is scarce capital, energy-efficiency projects must compete with other valuable energy and industrial projects (Vine, 2005).
ESCOs are not aware of how to access financing
There are a large number of international financial support mechanisms that exist in the form of grants, loans and credit facilities. Development banks such as the North American Development Bank and the European Bank for Reconstruction and Development are eager to finance viable
energy-efficiency projects (Hobson, 2009; Storment, 2009). However ESCOs are often not aware of how to access them, or cannot get their potential clients to agree to the loan terms (Urge-Vorsatz, et al., 2007; World Energy Council, 2008). Systems for accessing domestic sources of capital are also often unknown and unclear. ESCOs usually have significant technical expertise but may have limited financial expertise and minimal understanding of financial institution needs (Roy, 2003; Hansen, 2009).
ESCOs and their clients are unknown or not considered creditworthy
The banking systems in many developing countries are conservative and lack knowledge of and experience with energy efficiency, performance-based contracting and ESCOs (Vine, 2005; ESMAP, 2006; World Energy Council, 2008; CRISIL, 2004). ESCOs are therefore considered risky, and high perceptions of risk drive up interest rates. New ESCOs in particular, with limited credit history, projects or references, have difficulty getting financing. Potential clients also often have limited financial capital, making the whole project less creditworthy to financial institutions (Roy, 2003;
Vine, 2005). Public-sector clients, which have been key to jumpstarting and maintaining the ESCO industry in North America, are often considered even less creditworthy than private-sector clients in developing countries (Cowan, 2009). The lack of available success stories reinforces this belief (Karrir, 2005). Unfortunately, ESCOs sometimes discover that their client lacks credit-worthiness only after they have undertaken significant preparatory work for the contract (Urge-Vorsatz, et al., 2007). Failed or less than successful past projects cause the banks to be even more reluctant to lend to ESCOs. This has happened in India where rates of returns on some ESCO projects have proven poor due to hidden and extra costs (IREDA, 2006a).
Conventional financing rules are inconsistent with EPC
Conventional financing rules often present a barrier for ESCOs. Commercial banks tend to be conservative in their lending practices for ESCO-type projects and are often unwilling to be creative in finding ways around their financing rules (Cowan, 2009; Storment 2009). In some developing countries, domestic public development banks adopt similar practices.
Some key challenges include:
Most financial institutions prefer lending for working capital (Sridharen, 2005; ESMAP, 2006;
Taylor, et al., 2008). Energy-efficiency projects or cost-savings projects are non-conventional in that sense. Banks prefer positive cash inflow projects rather than negative cash outflow projects.
Financial institutions have a preference for large projects or large enterprises (Vine, 2005; ESMAP, 2006), partly because they have better financial credentials, and partly because smaller
projects have higher transaction costs. In Mexico, financial institutions believe that projects must cost at least US$50 million to justify the high transaction costs that result from the complex financing required (APEC Energy Working Group, 2006b). However, many energy-efficiency improvement projects cost between US$500,000 and $1 million.
Financial institutions prefer asset-based financing, over cash flow project-based financing (Vine, 2005;
Energy Futures Australia & Danish Management Group, 2005). Project financing considers the project equipment and cash flows as collateral. Most lending is based on the borrower’s credit history, and borrowing capacity is based on collateral, criteria that may be problematic for ESCOS. Lending for ESCO projects in Mexico or Brazil is reportedly considered only if the ESCO or client has cash on deposit or a liquid asset (Day, 2009; Storment, 2009).
ESCOs have difficulty acquiring start-up financing. ESCOs require financing for equipment purchase, upfront costs, project development and capacity-building activities. These are mostly non-asset based investments to be financed without collateral (Roy, 2003; Karrir, 2005; Vine, 2005).
There is often a requirement for short payback periods or returns on investment, which is not always the case with energy-efficiency projects (Karrir, 2005). Payback for energy-efficiency projects can be as short as one year, but also as long as five to ten years. ESCOs require long-term financing in order to grow their operations and carry out subsequent projects.
Banks prefer commercial risk, over technical risk (CRISIL, 2004). Energy-efficiency projects rely on technology to provide savings. However, banks often have little knowledge of technology or experience with assessing the level of risk associated with energy-efficiency technology and therefore tend to be very conservative in their evaluations.
These challenges often result in a commercial banking sector that is unwilling to finance ESCO projects. In China, even in a very active ESCO market, commercial banks will often not provide financing, even at high interest rates (Taylor, 2009). If they are given funding at all, ESCOs in developing countries must often co-finance projects themselves or are given short payback periods and/or very high interest rates and/or are required to have liquid assets in excess of the face value of the loan (World Energy Council, 2008; Day, 2009; Storment, 2009). In Brazil, in the late 1990s, interest rates on ESCO loans were 20 per cent and the terms of the loans were three to four years (Day, 2009). This has improved somewhat, but interest rates on commercial ESCO loans remain around 12 per cent (Day, 2009). Likewise in Mexico, ESCOs must often obtain financing from private equity at very high interest rates ranging from 20 to 30 per cent, compared with domestic financial institution rates in the 9 per cent range (APEC Energy Working Group, 2006b). The high cost of financing restricts the types of projects considered by ESCOs, forcing them to concentrate on projects with a short payback period.