Policies to develop renewable energies and energy efficiency are essential in order to tackle the looming energy crisis. Although least developed countries enjoy real potential, the required transformations are hampered by the scarcity of public and private resources. In developed and emerging countries, renewable energy subsidies create “windfall effects” and despite being more profitable, energy efficiency takes second place to the rush for renewable energies.
While emerging countries are just beginning to taste the joys of the consumer society, the latter would already appear to be under threat. Over the past 15 years, the bulk of the increase in the global consumption of fossil fuels (roughly 80%) has been in emerging countries. By 2050, it is estimated that Asia alone will consume more hydrocarbons than all industrialized countries put together consume today. How can this “energy binge” be satisfied with limited resources and how can we prevent anthropogenic climate forcing1 from drawing us into irreversible changes?
Reactions to these major challenges would appear to oscillate between two extremes – some negate the threat, while others promote degrowth. Since it would be untenable to extend the energy model of developed countries to the whole planet and since degrowth is not credible, a paradigm change is required. We consequently have to rethink our energy model and make massive investments in both energy efficiency and renewable energies. However, although both these sectors share the common aim of reducing greenhouse gases, the means employed to develop them are different. This is something that most institutional financing tools tend to ignore. In reality, these sectors obey extremely different logics and investors need to take this into account.
Are investors “ecologists” or bounty hunters?
With the current price of fossil fuels – which is still relatively low – most renewable energies have low profitability levels. These energies are diffuse, often intermittent which sometimes means it is necessary to double investments in order to guarantee a continuous production. Profitability in this sector consequently depends on the feed-in tariff policies implemented by States. For example, Électricité de France (EDF) buys wind power production at a tariff set under a decree in 2006 for 15 years at EUR 0.082 per kilowatt-hour (kWh) – against an average production cost of EUR 0.04 per kWh for EDF’s entire fleet. This way of securing income makes it possible to provide huge amounts of financing for wind projects via bank loans; it guarantees an internal rate of return in the region of 8% and an average return on equity of 22%, according to the Energy Regulation Commission (2006). One may question the relevance of incentives that produce such “windfall effects”. Indeed, it is not certain that this is an optimal way of using public funds because it generates “green rents” that benefit subsidy hunters. This exists in wind power, but is even more prevalent in the case of photovoltaic solar power generation.
Of course, to give a comprehensive argument it would be necessary to consider the cost of the “avoided ton” of CO2, the inevitable loss in the comparative advantage of fossil resources as they become increasingly scarce, the upfront investment cost for technologies which will become more and more efficient and profitable over the years, etc. With the exception of very specific cases (hydropower, remote sites that are not hooked up to the grid, biomass reserves), the fact remains that renewable energies are profitable in Europe only because of the massive subsidies.
Are LDCs “sentenced” to public investment?
The context of renewable energy financing in developed countries is fairly clear, but in developing countries there are two different logics at work. Some emerging countries, such as China, have adopted a subsidy system which is similar to the European model, although there are slight differences: for example, in the wind power sector, there are geographical differences in the kilowatt-hour purchase price paid by the Chinese State which ranges from CNY 0.51 (USD 0.0746 at 17 May 2010) to CNY 0.61 (USD 0.0893), i.e. a bonus of between 50% and 79% if we compare it with the average kWh purchase price for coal energy (CNY 0.34, i.e. USD 0.0497). China is clearly banking on the development of its domestic market with the aim of becoming a world leader in renewable energies and, subsequently, a major exporter thanks to the competiveness of its labor.
The so-called “least developed” countries (LDCs) have a completely different type of problem. A subsidy policy is not possible at all due to the heavy constraints that weigh on public finances. Therefore, projects cannot rely on subsidies in order to reach financial equilibrium and must be based on economic profitability alone. This profitability may sometimes be easier to find in Africa than Europe for several reasons. For example, there is considerable unexploited hydrological potential (Congo Basin, Ethiopian plateaus, Cameroon). Moreover, there can be massive biomass reserves from crops, forests and waste. Due to the low level of population density in some areas, small-scale decentralized production (biomass-fired plants, hydropower, wind power or, in some cases, photovoltaic energy) is less costly than a grid link-up. But it is especially thermal generation (slow speed diesel engines, generators) that is much more costly in Africa than in Europe. With an average production cost of USD 0.18 per kWh, Africa’s electricity is indeed one of the most expensive in the world and this is a major stumbling block to development. Finally, the production deficit comes with a cost: when for instance, South Africa’s national electricity producer carries out load-shedding – which brings mining production to a standstill at a time when raw material prices are the most attractive – the country’s economy is obviously penalized.2 As for rural electrification, it remains widely constrained by a lack of supply. In such a situation any kWh is worth taking: it is better to have expensive energy than no energy at all.
Although some renewable energy production projects in LDCs are profitable even without subsidies, it remains difficult for them to obtain financing as private investors are first and foremost interested in the risk-reward ratio. And yet power generation projects have extremely long life spans – between 20 and 30 years – which rarely coincide with business models that have more immediate targets. In addition, these projects are more exposed to political risks as the producer’s client is generally a public entity. Exit strategies (particularly via initial public offerings) are difficult due to the low level of liquidity on financial markets.3 Although private funds do invest in emerging countries4 (China, Southeast Asia, Brazil), they continue to be reluctant to do so in LDCs due to a high level of risk that – without public subsidies – is not offset by a sufficient level of profitability. Today – and for a long time to come – public development players are the only ones in a position to make equity investments in this context.
Energy efficiency, high but undervalued profitability
Energy efficiency entails producing the same goods or the same services, but by using as little energy as possible. McKinsey Global Institute (2008) estimate that USD 170 billion will need to be invested every year by 2030 in order to improve energy productivity and halve the growth rates of global energy consumption. Lower energy demand would also reduce the need to invest in production infrastructure, as well as the pressure on fossil resources. The International Energy Agency (IEA, 2007) estimate that every dollar invested in energy efficiency reduces by two dollars the amount invested in generating capacity. For local authorities, energy efficiency can lead to huge savings in infrastructure, high levels of profitability and a great potential to reduce CO2 emissions. It is estimated that most of this potential (65%, including 16% for China) can be found in developing countries (McKinsey Global Institute, 2008).
And yet despite being highly profitable, energy efficiency financing continues to face a difficult situation. Looking at the 28 member countries of IEA (mostly industrialized countries), we see that energy efficiency gains stood at 2% per annum p
rior to 1990 for only 1% since that date. In China, “private” investments (most often made by companies with a public shareholding) in energy efficiency only accounted for 4% of total investments in the energy sector in 2008, against 13% in 1982. This significant fall in private investment can be observed in most developing countries.
This can be explained by factors that stem from human resources (production engineers carry little weight in companies, the payment method for operators is unsuitable and does not reward this performance factor, etc), technical resources (the energy performance of equipment is badly measured) or the budgetary logic (separation between investment budgets and operating costs preventing trade-offs, etc.). But of course, the limited access to financing most certainly plays a major role in the lack of interest for energy efficiency. In countries where sources of financing are scarce (LDCs), where investment needs are high (emerging countries), there is internal competition within companies to gain access to the limited financial resources. Most of the time companies give priority to developing their business to the detriment of energy rationalization – as the latter reduces costs rather than generating turnover.
Moreover, the institutional tools implemented to develop energy efficiency, such as equity investment funds, are often the same as those concerning renewable energies. Energy efficiency has less “clarity” and suffers as a result. Energy service companies,5 for example, are often small and find it difficult to raise both financing and capital; focused on the service sector, their industrial results are very limited because the systems are more complex and not so easy to reproduce from one plant to another.
Beauty and the Beast
Renewable energies and energy efficiency are an odd couple, with renewable energies being “the Beauty” in the tale. They are very much in fashion, yet they can sometimes be costly and their results can be questionable. In emerging countries, like in developed countries, these energies manage to break even through subsidies; in LDCs they are often only competitive by default and take advantage of the inefficiency of “classic” energies. Energy efficiency – the Beast, to remain with the metaphor – does not benefit from the same keen interest. It looks like an old and replaced refrigerator, a set of compact fluorescent light bulbs or cogeneration plants and is not very attractive. Annual reports prefer to showcase pale white wind turbines or dark silicon in order to exhibit their conversion to the green revolution. Energy efficiency may be profitable and enjoy sound potential, yet it still remains the poor cousin that does not necessarily inspire confidence.
Both sectors are essential, yet in a context where financial resources are limited, choices in terms of which policies to implement necessarily have an impact on their development and the scale of crowding out effects. The debate about the best possible allocation of these resources cannot be avoided. Although energy efficiency concerns projects of a limited size, it does often generate faster returns on investment than renewable energies. It is consequently more suited to the resources available at the local level, particularly in developing countries. Energy efficiency must become a priority (again) for decision-makers; development agencies unquestionably have a role to play in promoting it – and in prompting a revolution in this sector.
¹ Forcing refers to changes in climate conditions, particularly temperature. Anthropogenic forcing concerns aspects of climate change caused by human activities (greenhouse gas effect, aerosols of human origin, etc.).
² Mining production was paralyzed all over South Africa for five days in March 2008. The Chamber of Mines estimates the cost for South Africa’s economy at some USD 242 million a day.
³ On this topic, see issue number 5 of the magazine Private Sector and Development entitled “Africa’s financial markets: a real development tool?”
4 On this topic, see the article by Jean-Pascal Tranié and Vivek Tandon in this issue of Private Sector and Development.
5 An energy service company (ESCO) is a company that offers a wide range of energy saving solutions.
References / French Energy Regulatory Commission, 2006. Notice of 27 July on the draft decree setting the purchasing conditions for electricity generated by facilities using the mechanical energy of wind as contemplated by article 2 (2°) of the decree n° 2000-1196 of 6 December 2000, official gazette of the French Republic. / IEA, 2007. Mind the Gap – Quantifying Principal-Agent Problems in Energy Efficiency, IEA/OECD, Paris. / McKinsey Global Institute, 2008. The case for investing in energy productivity, McKinsey Global Institute, Perspective.Download in PDF