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By Qendresa Rugova, Burg Capital GmBH, Vienna
esa.rugova@burgcapital.com
This article is part of a series of two articles on energy efficiency investments covering (1) investment characteristics from a global perspective and (2) existing and emerging financing models for energy efficiency investments and their applicability in the Balkan region.
Energy efficiency is an integral part of global energy policy as it is widely recognized as an effective means of reducing greenhouse gas pollution as well as ensuring long term security of energy supply. Investments in energy efficiency have a direct effect on reducing energy consumption while also improving industrial competitiveness and driving economic growth.
Investments in energy efficiency during the past 25 years have successfully managed to achieve the uncoupling of energy consumption and economic growth as evidenced by the fact that energy consumption per capita in IEA countries dropped to levels of 1980s while income per capita enjoyed a steady growth over the same period. This represents a total saving of USD 5.7 trillion on energy costs in the past 25 years. However, despite the clear economic and environmental case for energy efficiency investments, current annual investment volume is still below policy targets mostly due to unique barriers characterizing energy efficiency. This article explores such energy efficiency investment need to combat climate change as well as and the key barriers preventing such opportunities from reaching the necessary scale.
Investments in energy efficiency during the past 25 years have successfully managed to achieve the uncoupling of energy consumption and economic growth as evidenced by the fact that energy consumption per capita in IEA countries dropped to levels of 1980s while income per capita enjoyed a steady growth over the same period. This represents a total saving of USD 5.7 trillion on energy costs in the past 25 years.
Investments in energy efficiency are driven by global energy policies which establish the framework and incentives for achieving the set goals. At the European Union level, member countries have committed to a 20% energy savings target by 2020 as compared to consumption projections for 2020. To achieve these goals, it is estimated that approximately investments of EUR 84 billion per annum are required.
European Union member countries have committed to a 20% energy savings target by 2020 as compared to consumption projections for 2020. To achieve these goals, it is estimated that approximately investments of EUR 84 billion per annum are required.
Beyond 2020, the EU has greater ambitions of decarbonizing its economy. The EU Energy Roadmap 2050 explores routes towards decarbonisation of the energy system, with implications of major changes in, but not limited to, carbon prices, technology and networks. This roadmap envisages reduction of greenhouse gas emissions to 80-95% below 1990 levels by 2050. To achieve EU’s 2050 decarbonisation target, it is estimated that energy efficiency investment in excess of trillions of euros is to be expected.
The EU Energy Roadmap 2050 envisages reduction of greenhouse gas emissions to 80-95% below 1990 levels by 2050.
According to International Energy Agency’s (IEA)’s 2014 Investment Outlook, global annual investments in energy efficiency in 2013 equaled USD 130 billion. To put it into perspective, the outlook reminds us that this value represents approximately 15% of global annual investments in oil and gas or about 50% of the value invested in renewable generation in the same year signifying its importance in terms of energy policy as well as investment opportunity.
The IEA outlook also estimates future trends of energy efficiency investments in the period of 2014-2035. The 450 Scenario estimates the level of energy efficiency investment required to limit future global warming to 2°C above pre-industrial levels. As per the 450 scenario the cumulative amount of investments in energy efficiency by 2035 reaches USD 13.4 trillion. It should be acknowledged, however, that the COP21 agreement reach in Paris last December targets limiting global temperature increase well below 2°C and proposes efforts to limit the increase to 1.5 degrees. This would signify an even higher level of investment required for the next two decades.
COP21 agreement reach in Paris last December targets limiting global temperature increase well below 2°C and proposes efforts to limit the increase to 1.5 degrees. This would signify an even higher level of investment in energy efficiency required for the next two decades.
In sectoral terms the investment estimate is split as follows:
- the buildings sector accounts for 30% of investments (USD 4 trillion)
- the transport sector represents the largest share of 60% (USD 8 billion)
- the industrial sector represents only 10% (USD 1.4 trillion) of investments
Despite the clear economic and environmental reasons for energy efficiency, the ambitious global targets are failing to translate into actual investments to meet the targets. At the EU level, investment targets are still well under the required rate to be able to achieve the set 2020 goals. Investment in buildings, which represent 40% of final energy use in Europe, is estimated to be about 50% below the required rate to achieve the goals.
The reason for the sluggish progress is mostly due to investment barriers that are unique to energy efficiency. Such barriers result in a weak demand for developing a project pipeline for energy efficiency and consequently weak supply of financing, with the former being the key driver of the process.
The following section summarizes some of the most prevalent challenges and barriers to deploying energy efficiency investments as well as what implications such challenges may have on the financing process.
| Investment characteristics | Description | Implication for investors/financiers1 |
|
(A) Heterogeneous projects |
Energy efficiency constitutes a very diverse nature of measures including a wide array of technologies and measures that can be undertaken to enhance energy consumption efficiency. In addition, investments also differ in terms of end users, for example investments in buildings can be in properties that are commercial, public, public rental, private rental, owner occupied – each category with own distinct characteristics. |
This makes energy efficiency an extremely heterogeneous sector with varying particularities that in turn affect the investment cycle (assessment, financing and monitoring). In addition, the diverse nature of available measures affects investor’s ability to understand investments in terms of technical and operational performance as well as how they compare to other projects. This creates a challenging environment for standardisation of the investment process. |
| (B) Small scale projects | Energy efficiency projects are typically small scale in nature. | Financiers (debt or equity) are accustomed to financing large projects. High transaction costs associated with investments do not always make it worthwhile to focus on individual small scale projects. Aggregation is necessary to reach critical mass for the projects to become attractive from a financing point of view. |
| (C) Cost saving principle and limited collateral | Energy efficiency projects differ from other energy investments as they are based on the saving principle as opposed to generation of revenues from an underlying asset, for example through sale of power.
In addition, energy efficiency investments often lack clear tangible assets which could be used as a collateral. |
Financiers are accustomed to traditional asset based financing models and less familiar with projects which do not have a clear cash flow projection from revenues from an underlying asset.
Limited understanding of energy efficiency projects in conjunction with limited collateral value of investments create a high perception of risk among investors, which translates into high financing costs. |
| (D) High up-front costs | Energy efficient investments require a significant up-front cost due to high costs associated with efficient equipment or systems as compared to less efficient ones.
Moreover, the size of capital outlay is correlated to the scale of efficiency improvements undertaken. Deep refurbishments in buildings or installation of more efficient industrial machinery can represent a substantial upfront investment. |
High up-front costs creates weaker demand for energy efficiency investments and often results in less efficient performance levels as investors opt for investments with lower capital outlays to achieve shorter pay back periods (See E). |
| (E) Long pay-back periods | In order for projects to capture the whole economic energy efficiency potential, optimal levels of investments should be sought. The optimal level is considered to be the level of investmetns where the marginal cost of additional investment reaches the marginal benefit of the discounted steam of future energy savings.
Such optimal levels of investments however typically leads to high up-front costs with very long pay-back periods. |
In practice, however, “lighter” efficiency measures with shorter pay-back periods are preferred by investors/financiers due to liquidity preferences and therefore lower energy efficiency performance levels are achieved i.e. below the theoretical opptimal level.
This is a particularly sensitive area for energy efficiency as it is significantly more difficult to attract long term financing for deep refurbishments due to long pay-back periods. |
| (F) Technical assessments & protocol | Due to the cost savings nature (as opposed to cash-flow generation), each efficiency project needs to establish base-line measurements on consumption based on which future savings are calculated.
As such, measurement, reporting & verification (MRV) and quality assurance processes are required continually throughout the investment period to establish the savings acquired and essentially associated investment returns. |
From a financing perspective, this aspect adds ambiguity to the investment process. Similar to the heterogeneity aspect, investors are typically not familiar with such (MRV) processes and have to rely heavily on external consultants.
Standardization of such processes would significantly reduce this risk and make financiers more comfortable with the process. |
| (G) Split incentives | A situation typically in commercial real estate properties between the landlord and tenant, where neither the owner nor the tenant are incentivized to undertake energy efficiency measures. | The landlord is not incentivized to fund any efficiency measures as the benefits of lower energy bills are passed on the tenant who is liable for paying the bills. In the same manner, the tenant is also not incentivized to fund the upgrade as the long term benefit (the actual investments) stays with the owner. |
| (H) Special expertise (know-how) | As a result of the peculiarities listed above, energy efficiency project requires extensive expertise in technical, regulatory, procurement and financing aspect.
Such expertise is required during the development stage as well as during the operational period. |
Project developers often lack the required in-house expertise to develop projects and may forego such projects by focusing their efforts in other more familiar ventures. |
In order to deliver on the global targets discussed above, it is of paramount importance that the highlighted barriers and challenges are addressed and discussed jointly by all stakeholders invovled. A study commissioned by the European Commission and UNEP FI published in February 2015 has identified some important cross-cutting drivers that must be in place to create the necessary conditions for energy efficiency investments. Some of the identified drivers are:
- Strong, stable and well-enforced regulatory framework
- Common regulation and certification processes for buildings/energy management systems for the industry and SMEs
- Creation of open source databases on the building stocks/ corporate energy efficiency benchmarking databases
- Standardization of and adoption of best practice for: legal contracts, underwriting processes, procurement procedures, adjudication, measurement, verification, reporting, energy performance (contracts and certificates) and insurance
- Project rating system, enabling a transparent assessment of the technical and financial risks of buildings renovation projects and their contracting structure
- Use of public funds to address specific market failures and share risks with the private sector. In addition, public funds should be used for project development assistance to help bridge the gap in terms of expertise requirements during the development stage.
Energy efficiency presents an immense opportunity for investors with global cumulative investment forecasts between 2014 and 2035 reaching a volume of USD 13.5 trillion.
As noted earlier, energy efficiency is considered to be one of the most cost-efficient method of reaching global energy policies and curbing green-house gas emission. Moreover, energy efficiency presents an immense opportunity for investors with global cumulative investment forecasts between 2014 and 2035 reaching a volume of USD 13.5 trillion. Nevertheless, despite the demonstrated economic potential and environmental benefits, energy efficiency investments are still below policy targets predominately due to barriers characterizing the sector. Removal of such barriers would allow standardisation and aggregation of small and heterogenous projects thereby creating a healthy pipeline of proejcts and thus in turn increase investor confidence and investment appetite amongst financiers.
Qendresa Rugova is a Senior Consultant at Burg Capital – a corporate and project finance advisory firm. She specializes in renewable energy, emerging trends in clean technologies and financing models.
REFERENCES:
- Center for Climate and Energy Solution, Outcomes of the U.N. climate change conference in Paris, December 2015
- Christian Hudson, Anne Schopp, Karsten Neuhoff “Financing of Energy Efficiency: Influences on European Public Banks’ Actions and Ways Forward”, May 2013
- Energy Efficiency Financial Institutions Group (EEFIG), Energy Efficiency – the first fuel for the EU Economy – How to drive new finance for energy efficiency investments, February 2015
- European Commission, “Energy Efficiency and its contribution to energy security and the 2030 Framework for climate and energy policy” July 2014
- European Commission, Energy Roadmap 2050, 2011
- EU Energy Efficiency Directive (2012)
- IEA, Energy Efficiency Market Report, Market Trends and Medium-Term Prospects, October 2015
- EA. (2014). Special Report: World Energy Investment Outlook
- Kapur, Hiller, Langdong, Abramson, EDF Environmental Defense Fund, “Show Me the Money, Energy efficiency Financing Barriers and Opportunities”, July 2011
- Sweatman, Peter, Climate Strategy Partners “Financing Mechanisms for Europe’s Buildings Renovation”, January 2012
1Financiers implies all parties supplying the capital required for the uptake of the energy efficiency projects through debt, equity, guarantees or a mix thereof. Such parties may be government public funding, development banks, private banks, private capital through own sources, corporations, institutional investors etc.
