The challenges of triggering private investment into the energy efficiency sector

The transition to a sustainable-energy future calls for a significant increase in energy efficiency (EE) levels worldwide. World scenarios charting a path towards a sustainable-energy future suggest a maximum of 450 parts per million (ppm) CO2 atmospheric concentrations (1 ppm represents 0.0001% of atmospheric volume). The International Energy Agency (IEA) analysis estimates that end-use efficiency would contribute over 50% of the total CO2 savings needed to achieve the 450-ppm scenario. The IEA developed 25 recommendations, which together represent a saving potential of 8.2 Gigatons/CO2 (equivalent to 1.5 times the current US emissions of CO2 annually) by 2030, pending full implementation without delay. To date, this implementation has been limited among member countries. Despite recent progress, public funds are still insufficient for the financing of EE technologies. Consequently, the private sector can potentially play a large role, especially through private equity funds. However, in spite of the profitability of EE technologies and their numerous advantages, private investors face several important barriers. Governments and international donors need to further incentivise the participation of these investors.

Barriers contributing to suboptimal use of EE technologies

EE presents energy security, environmental benefits and economic advantages. By reducing dependence on fossil resources, countries reduce their energy dependency, thereby increasing their security. The implementation of higher EE levels will reduce the energy bills of consumers and could create many jobs. It has been estimated recently that 150 000 jobs could be created in India if traditional cooking stoves were replaced with biomass cooking technologies in 9 million households (UNEP, 2008), and close to 1 million jobs could be created in the EU by 2020 through reducing emissions by 20%. Considering the present economic crisis, EE measures could result in immediate job creation, energy savings, energy security and environmental benefits. Although EE technologies are commercially available and financially viable, existing households continue to use and purchase less efficient technologies (IEA, 2006). Why do consumers and investors shy away from paying marginally more2 for the energy-efficient alternative? Part of the problem is that saved energy is difficult to see and measure, especially for consumers, making it particularly difficult to finance. Energy-saving technologies may look and perform the same as inefficient technologies, so consumers need help in making informed purchase decisions. Energy consumption is also deeply rooted in economic activities. These are governed by embedded incentive structures, consumer behaviour, rules and regulations, infrastructure design and construction practices, investment decision-making and even cultural considerations. These factors combine to form the market barriers that contribute to suboptimal use of EE technologies in existing buildings (IEA, 2007). Split-incentives – or what economists call ‘principle-agent'3 problems – are an example of such barriers. In such instances, consumers do not have access to the price signal, i.e. in a landlord-tenant situation. This barrier is estimated to account for 3 800 petajoules (PJ) of wasted energy each year, equivalent to around 85% of the total energy used by Spain in 2005 (IEA, 2007). Technical and availability barriers hold when there is a lack of affordable and available EE technology suitable to local conditions; insufficient local capacity to identify, develop, implement, and maintain EE investments; or no distribution or delivery network to get energy-efficient goods to consumers. This is particularly important in developing countries. In developing countries, regulatory policy can also be a major barrier, notably when the profitability of energy providers relies on energy sales, thus creating a disincentive to participate in supporting or delivering EE improvements to consumers. Other regulatory barriers occur when there is a lack of capacity to consider, develop, or enforce minimum energy performance standards or codes; prices of service are set below their marginal costs; or there is uncertainty on recovery of EE program costs.

The twofold challenge of EE financing

Finding the appropriate finance at the right time is also an increasing challenge. The IEA estimates that to reach the 450-ppm scenario, an incremental estimated investment of USD 411 billion would be needed from 2010 to 2030, two-thirds of which should be invested from 2010 to 2020. While both public and private financing levels need to be leveraged to reach these levels, the challenge of EE financing is twofold. Firstly, private investors – whose responsibility is estimated at 86% for covering the incremental financing needed in order to reach the 450-ppm scenario – are still wary of small, scattered and highly technical projects (UNFCCC, 2007). The small size of EE projects, their difficulty in being bundled and their perceived high risks have discouraged investors such as private equity funds and commercials banks; because of a lack of technical understanding of EE projects, they turn away from them. EE projects are often a challenge, more specifically for private equity funds, because they do not lend themselves well to short-term exit strategies. Also, the majority of EE financial requirements are for small loans to cover the upfront costs4 – which are higher than those of less energy-efficient technologies – of insulation, appliances, windows, heating, ventilation and cooling systems. These costs, despite a sometimes rapid payback period (from six months to a year), can prove detrimental. The absence of an internationally recognised measurement and verification protocol, which would allow the translation of technical savings into certain streams of financial revenues, means that investors end up considering EE projects too risky – they are perceived as too much hassle for too little profit. Secondly, the only official link with investors to the carbon market through the United Nations Framework Convention on Climate Change (UNFCCC) – the Clean Development Mechanism (CDM) – has failed as an appropriate mechanism for increased investments in EE projects. While EE projects represent close to 15% of submitted projects to the CDM, they account for only 11.4% of the registered projects and 5.4% of issued certified emission reductions (UNEP/RISOE, 2009). Copenhagen has not resolved the debate around possible reforms to the CDM. No proposal for the facilitation of the financing of end-use EE projects has been put forward. The meeting also fell short of formalising an alternative approach to the CDM through the creation of sector-wide target approaches.

What role can governments and aid agencies play?

Fortunately, mechanisms and instruments to increase private sector involvement in EE projects already exist and are cost-effective; most of them revolve around risk mitigation. Risk mitigation instruments, which focus on reducing the actual risk of EE projects, have been very successful in increasing private sector participation. Loan guarantee programs (LGPs) that have been implemented by the International Finance Corporation (IFC) in China for three years with great success, as well as in Eastern Europe for at least a decade, target the perception that investors have of the operational risks of EE projects. By guaranteeing the counterparty and default risk by up to 75%, the IFC entrust a local private bank to lend money towards an EE project. To date, more than 20 years after the implementation of such a mechanism in Eastern Europe, only two projects have failed. Mechanisms such as the LGP build trust in investors by reassuring them and creating favourable conditions for their in creased involvement. Other successful mechanisms include training, raising awareness, and information dissemination to the private sector on the advantages of EE. The implementation of Public Private Partnerships (PPPs), which induces a tight collaboration between local private financial investors and larger public financial institutions, enables indirect training of private institutions in EE, and reinforces the confidence of the private sector in EE projects. As such, risk mitigation instruments, as well as increased information dissemination, go a long way in setting the basis for increased EE financing. Whereas these initiatives are essentially those of international donors5, governments, on their part, have, to date, made little effort to further improve EE financing.

Sustaining the momentum

Even if the economic meltdown and ensuing stimuli packages have created a momentum towards EE financing – an estimated USD 183 billion is being allocated to ‘clean energy', of which USD 61 billion is being allocated to energy efficiency (IEA, 2009) – this momentum needs to be sustained. Governments cannot expect a robust recovery without a more energy-efficient economy. Increased independence from energy sources, as well as long-term economic sensibility, render EE projects sound investments for both consumers and governments, if not for financial institutions. Governments should ensure that the post-crisis momentum is sustained, as too little money is being allocated to capacity building, training and establishing of institutional experts to gauge the potential long-term success of these new projects. This shortcoming of EE financing means that, to date, no member country has implemented more than 57% of the 25 IEA recommendations. Two countries actually report less than 10% ‘substantial implementation'. Interestingly, evidence shows that government intervention is most successful when targeting the leveraging of private money. The newly created Clean Technology Fund (CTF)6, with an overall pledged amount of USD 4.7 billion, should strive towards such an end through identified tools and instruments. The missed opportunity in the EE market is most significant for private equity investors and venture capitalists. Lacking appropriate exit strategies, they have not yet fully stepped into the market. Governments should focus on creating enabling environments – through risk-mitigation instruments, raising awareness, training and capacity – and viable conditions for the emergence of a secondary market in EE financing for private equity investors and venture capitalists. The time for EE – and the opportunity to trigger a transition to a cleaner-energy future – is now. In the aftermath of the Copenhagen meeting, governments need to focus on the quickest and most cost-effective road towards CO2 emission mitigation. With political willingness to implement and direct money towards creating a sustainable, virtuous circle of investments, a win-win situation will result.

1 The viewpoints expressed in this paper are solely those of the authors; they do not represent those of the IEA or its member countries.

2 Energy-efficient technologies tend to be more expensive; for example, compact fluorescent lamps are, on average, five times more expensive than their incandescent counterparts.

3 ‘Principal-agent' problems refer to potential difficulties that arise when two parties engaged in a contract have different goals and different levels of information; for example, when a landlord provides energy-using appliances but the tenant pays the electricity bill. In this situation, there is little incentive for the landlord to choose the most energy-efficient appliances.

4 These costs referred to expenses incurred at the beginning of a new project.

5 For further initiatives from donors, see the article by Susana Garcia-Robles, Rogerio G. Ramos and Tatiana Chkourenko in this issue of Private Sector and Development. 6 Initiated by the World Bank, the CTF promotes scaled-up financing for the demonstration, deployment and transfer of low-carbon technologies with significant potential for long-term greenhouse gas emission savings. It is expected that the CTF will finance programs in 15 to 20 countries or regions.  

RÉFÉRENCES :

IEA, 2006. Energy Technology Perspectives: Scenarios and Strategies to 2050, OECD/IEA, Paris. 

IEA, 2007. Mind the Gap - Quantifying Principal-Agent Problems in Energy Efficiency, OECD/IEA, Paris.

IEA, 2009. Worldwide Implementation Now Boosting the Economy with Energy Efficiency Financing, OECD/IEA, working paper, Paris. 

UNFCC, 2007. Investment and financial flows to address climate, UNFCC, report. 

UNEP/RISOE, 2009. Base de données.

UNEP, 2008. Green jobs: Towards decent work in a sustainable, low-carbon world, UNEP, report.