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Cinderella Industries Await Their Prince

Potentially Lucrative Projects Devoted To Clean, Renewable Energy Languish For Want Of Financing

Eric Ng – SCMP | Updated on Oct 27, 2008

The United States’ property bust and the subsequent global credit crunch have many investors fretting that the mainland’s economic miracle is coming to an end. Yet, amid the gloom and doom, renewable energy, energy conservation and pollution control are being tipped to become the next wave of high-growth industries.

China, the world’s second-largest energy consumer and one of the most pollution-prone economies, has huge opportunities for projects devoted to energy efficiency improvement and the generation of clean and renewable energy. The question is how they will be financed.

The nation’s energy consumption per unit of economic output amounted to four times the world average, highlighting a dependence on industries that are energy-intensive but low in value addition and inefficient in their use of energy.

With 80 per cent of its electricity generated from air-polluting coal and with power generation capacity rising at alarming rates, the mainland has become the world’s biggest emitter of sulphur dioxide, which causes acid rain, and carbon dioxide, which contributes to the greenhouse effect.

According to the China Energy Conservation Association, electrical machinery on the mainland consume about 40 per cent more energy than their international counterparts, implying a vast market for solutions and products that improve energy efficiency.

The central government has targeted cutting the nation’s energy consumption per unit of economic output by 20 per cent between 2006 and 2010 and principal pollutants by 10 per cent mainly by ordering the phasing out of outdated and inefficient plants.

“This year is a turning point for the mainland economy’s development [given the drastic slowdown in exports], but I think a new growth area is the clean energy sector, which will become a pillar of growth,” said China Energy Investment Network chief executive Zhang Jie, an adviser to the central government on energy policies.

Beijing said last month it had earmarked 41.8 billion yuan (HK$47.4 billion) to fund projects for energy conservation and pollution reduction. Firms with energy-saving and pollution-cutting projects will also be eligible for reductions in profit and value-added taxes, although details are yet to be released.

This is a small drop in the pond. Lily Zhao Ming, secretary general of the conservation association’s committee on energy service companies, says the sector is estimated to require a whopping 1 trillion yuan of investment between 2006 and 2010 to meet government targets.

The committee implements energy conservation programmes on the mainland funded by the World Bank and Global Environment Facility. .

The mainland’s energy consumption per unit of gross domestic product fell 1.79 per cent year on year in 2006, 3.66 per cent last year and 2.88 per cent in the first half of this year. Given the 20 per cent reduction target between 2006 and 2010, it has a lot of catching up to do.

The lacklustre performance, in part, has to do with the tight control on energy prices at levels much lower than international ones to protect consumers and ensure social stability amid inflation that is the highest in a decade.

High prices have proven to be an effective way to drive conservation and efficiency gains, given experience drawn from the oil crises in the 1970s and 1980s in the US, Europe and Japan.

With inflation easing to a 15-month low last month, all eyes are on Beijing to introduce a new round of price increases for fuel and electricity to ease losses at energy producers. The mainland energy conservation industry’s output, measured as the value of contracts to save energy plus the cost of equipment installed, rocketed to 21.6 billion yuan last year from 1.7 billion yuan in 2003.

The industry is expected to see further explosive growth as more people discover its profit potential, Ms Zhao said on the sidelines of the China Power Oil & Gas conference in Guangzhou last month.

On the renewable energy front, the central government has estimated that it will take 2 trillion yuan of investment to realise its targets for generation capacity in 2020.

So far, wind power has seen the biggest growth, with installed generation capacity expected to surpass 10,000 megawatts this year and reach 20,000 MW by 2010, compared with 5,600 MW last year and 2,600 MW in 2006.

Given the mainland’s less developed markets for bonds, private equity and venture capital – and the fact that the equity market is primarily for companies with established track records of profits – bank loans are the main financing channel for energy efficiency and renewable-energy projects.

However, these are considered nascent, non-mainstream and more risky ventures that are not normally inside the comfort zone of bankers.

Daniel Zhu, president of Transpacific Resources China, an investor in renewable energy and energy efficiency projects, says companies are struggling to find enough funds to tap mushrooming market opportunities.

“At the moment, developers are scrambling to grab hold of projects, but their funding demand is far from being met,” he said. “There is a chicken or egg problem.”

Financiers are cautious about funding start-up projects, but if projects do not get funded, the sector cannot reach maturity.

Venture capital funds, a traditional capital source for start-ups, tend not to be keen to energy efficiency improvement projects because they prefer to invest in highly profitable projects that can be scaled up in size rapidly, Mr Zhu said.

Private equity funds and banks have taken greater interest. A multitude of domestic and overseas funds are seeking opportunities to invest in renewable energy and energy efficiency projects.

While some banks are willing to entertain loan requests, industry insiders say commercial bankers have yet to fully appreciate the business model of energy efficiency projects and tend to be cautious.

“Unlike the construction of fixed assets, such as railways and buildings, energy conservation is often intangible, and its risk and return are a new topic for bankers,” Ms Zhao said. Her association has provided seminars and training courses to commercial bankers to familiarise them with the nascent sector, spurring the likes of Beijing Bank, Huaxia Bank, Industrial Bank and Shanghai Pudong Development Bank to set up specialised departments to tap the sector, she said.

Even so, banks, the main supplier of funds to the sector, require guarantees and collateral based on future cash flows from projects.

Despite the general lack of understanding of energy efficiency projects among outsiders, industry practitioners say energy efficiency projects can be extremely lucrative. They say return on investment can reach as high as 200 per cent, although the norm is closer to 30 per cent.

“People say property is a sector with extravagant profits. I’d say profits in the energy conservation industry are even more extravagant,” Ms Zhao said.

Wang Shaohong, director of the Energy Saving Investment Promotion Centre, cited the mainland’s seventh-largest steelmaker, Shougang, as an example. He said the company spent less than 100 million yuan on nine energy-saving programmes but was able to save more than 118 million yuan a year on energy expenses.

Mr Wang said the fundamental problem with a lack of financing for energy efficiency projects lies in their complexity.

“As energy conservation virtually involves all industries, it is very difficult to find financial experts who also know the industries well,” he said.

In other cases, state banks are often constrained by blanket orders from Beijing not to lend to highly pollution-prone, energy-intensive industries and those with over-capacity problems, even though such companies may want to use the money to enhance energy efficiency.

Chan Ka-keung, head of Greater China investment for Climate Change Capital, a financier of clean-energy projects, said: “Mainland bankers may not be sophisticated enough to understand the ins and outs of energy conservation projects. Sometimes they just cut lending to the banned sectors entirely without taking into account energy conservation projects.”

This is partly mitigated by guarantee programmes provided by development agencies such as the International Finance Corp, a unit of the World Bank, and Asian Development Bank. These agencies act as guarantors whose participation supports the business case for commercial banks to lend to project developers.

There are other ways for companies engaging in renewable energy and energy efficiency improvement projects to apply for financial subsidies. One of them is the so-called Clean Development Mechanism (CDM), a United Nations-led scheme that allows polluters in developed nations subject to pollution caps to meet their obligations by providing funding to projects for the reduction of greenhouse gas emissions in developing nations instead of cutting their own emissions.

Project developers in developing nations can sell emission reduction credits to polluters in developed nations but must demonstrate that without the subsidies their projects would not be viable.

The emission rights trading industry is set for big changes. Reduction commitments under the Kyoto Protocol, to which the CDM is linked, are due to expire in 2012, and negotiators want to seal a new pact at a UN conference in Copenhagen in December next year.

James Graham, commercial director of Camco Group, a company based in Britain that finances and develops greenhouse gas emission reduction projects internationally, expressed optimism about progress towards a global deal.

“The US has indicated that it would like to see larger and industrialising developing nations such as China, India and Brazil make some form of commitment to emission reduction. It is still open as to what form the commitment will take, but hard negotiations are going on at the highest level of governments,” he said.

If China agrees to some form of self-imposed emission reduction target, it would be a boon to the growth of the domestic renewable energy and energy efficiency industry. Mr Graham believes the country will bargain for transfers of technology – such as carbon capture and storage know-how – in exchange for binding commitments, beyond voluntary emission cuts via CDM projects.

The driving forces for greater development of renewable energy and energy conservation projects – higher energy prices, increasing pressure to reduce emissions to avert climate change, and greater government incentives – appear to be in confluence. There could well be a silver lining in the dark clouds of the global economic slowdown.