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Energy Risk Management

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Social Innovation
Centre
Risk Management for Energy Efficiency Projects in Developing Countries
_______________
Paul KLEINDORFER
2010/18/TOM/ISIC
Risk Management for Energy Efficiency Projects in
Developing Countries
1
Paul Kleindorfer *
*
The Paul Dubrule Chaired Professor of Sustainable D evelopment, Distinguished Research
Professor at INSEAD Social Innovation Centre, Boule vard de Constance, 77305 Fontainebleau
,
France and Anheuser-Busch Professor Emeritus of Man age ment Science and Publi c Pol icy,
The Wharton School of the Universi ty of Pennsylvani a Ph: +33 (0) 1 60 72 91 28
Email:
paul.kleindorfe r@insead.edu
A working paper in the INSEAD Working Paper Series is intended as a means whe reby a faculty researcher's thoughts and findings may be communi ca ted to interested readers. The paper should be considered preliminary in nature and may require re vi sion.
Printed at INSEAD, Fontainebleau, France. K indly do not reproduce or circulate without permission.
1
Paper prepared for the UNIDO Project
“If industrial energy efficiency pays, why is it no t happening?”
Risk Management for EE Projects (V3) 15/3/2010
2
Risk Management for Energy Efficiency Projects in D eveloping Countries
Abstract/Summary
The present paper addresses risk management fundame ntals for energy efficiency (EE) projects in developing countries. The starting point for th is paper is that there are many profitable EE projects in nearly every industrial enterprise that are simply not implemented. Four problems are often identified as the culprits for failing to harvest such projects: 1) lack of a rational and feasible approach to finance these projects; 2) lac k of a rational internal management approach in the enterprise to package these projects in such a manner that they can be identified and implemented while the “plant is running”; 3) the hi gh perceived risk of these projects; and 4) the fact that management is often simply unaware of the existence of EE projects of value. This paper is primarily focused on the third of these fa ilure factors, risk, but touches also on the fourth factor since reducing project risk is predicated on understanding and measurement of EE benefits. The paper begins with a simple framework that emphasizes two dimensions of the organizational and contractual environment of EE pr ojects. The first dimension is the energy intensity (measured, say, in terms of the ratio of energy costs to the total cost of goods sold) for the focal company initiating an EE project--the hig her the energy intensity, the larger the potential payoff from EE, and the greater the ease of focusing management attention on EE. The second dimension is the level of organizational and contractual complexity of a project.
Generally, the larger the number of external partie s involved in a project (both financial and technical), the greater the complexity of assuring the ability to satisfy constraints necessary for successful project completion and the greater the t ransactions costs of contracting. After elaborating this framework and providing examples t o illustrate required risk management, the paper discusses best practices for EE project risk management with illustrative case studies.
Thereafter behavioral and other impediments to effe ctive risk management are described, together with methods for overcoming these impedime nts. The paper then considers the role of carbon offsets as a possible source of co-financing of EE projects, and the risks associated with obtaining such carbon offsets under the CDM process
. Finally, the paper considers the role of
Energy Service Companies (ESCOs) in identifying pro fitable EE projects, in managing these projects and in reducing their risks. The paper co ncludes with recommendations for both companies executing EE projects as well as for inte rnational organizations like UNIDO attempting to promote EE in industry in emerging economies.
Risk Management for EE Projects (V3) 15/3/2010
3
1. Introduction
This report considers the role of risk management i n promoting profitable energy efficiency (EE) projects in industrial enterprises in developing co untries. The paper focuses on developing countries in the middle range of development (e.g., with per capita income greater than $2,000 per annum) where there is a significant industrial sector, although many of the issues here would apply to other countries, both above and below this level of development.
4
The key question posed here is how to improve the payoff in economic and environmental terms from cost- effective energy efficiency projects and initiative
s.
The starting point for this report is the maxim, by now well known in the development literature and is the banner for this entire report, that ther e are many profitable EE projects in nearly every industrial enterprise that are simply not implement ed. Four problems are often identified as the culprits for failing to harvest such projects: 1) lack of a rational and feasible approach to finance these projects; 2) lack of a rational internal mana gement approach in the enterprise to package these projects in such a manner that they can be id entified and implemented while the “plant is running”; 3) the high perceived risk of these proje cts; and 4) the fact that management is often simply unaware of the existence of EE projects of v alue. 5
This paper is primarily focused on the third of these failure factors, risk, but it will b e evident in my discussion of effective risk management approaches that the other three factors noted have an important role to play in understanding and managing the risks of such projec ts. Indeed, without a proper understanding of available financing options and without a viable strategic plan within the enterprise for identifying and implementing EE projects, discussio ns of risk management for projects would lack the requisite foundation for attracting management attention in the first place and for ultimate success in implementation.
In order to understand risk management for industri al EE projects, it is important to have in mind the typical context of these projects in developing countries. A number of factors affect the risk
4
Many studies have been undertaken in the past few years on EE in developed countries. For a review o f some of the best practices research arising from th is, see Itron (2008). These best practices apply b roadly across sectors and countries and are the basis for this study as well. In particular, the principles outlined in this paper are applicable beyond the manufacturing secto r from which most of my examples and discussion are drawn. For instance, the same philosophy could allo w for breakthroughs in EE in energy dependent servi ce sectors such as tourism, building services, after s ales technical support centers and information serv ices. 5
Such basic things as changing incandescent lights that operate 24 hours a day in a hotel or warehouse to high efficiency lighting are often not done despite the payback being accomplished in a matter of weeks. A major role of UNDP in EE has been to field energy auditor s (particularly for government facilities where was te is exceptionally high) to identify areas where EE meas ures are indeed profitable. However, as noted below
, there are many reasons why, in the end, even projects tha t are of recognized value are not implemented.
Risk Management for EE Projects (V3) 15/3/2010
4
of such projects for industry decision makers in de veloping countries. The principal factors impeding implemen tation of EE projects are the following.
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Lack of information on technical issues and on available technical support, including uncertainties about the performance and reliability of energy saving technologies

Uncertainty in energy prices and subsidized energy prices that undermine incentives for EE projects •
Exchange rate risks related to the project, especially for equipment sold in international markets, but also affecting the price of carbon credits and the benefits of increased productivity
(and output) for manufactured goods

Regulatory, governance and contract uncertainties with equipment suppliers, contractors and third parties who may be necessary to implement projects

Related to these contract uncertainties in developing countries are the transactions costs of enforcing contracts, including promises from gov ernments, service providers and energy companies

Limited access to capital/credit, which often pushe s a very short-term payback approach to EE project evaluation

The mismatch of investment costs and energy savings costs, budget and credit constraints and the opportunity costs of exhausting one’s credit limits on energy efficiency rather than on increasing sales

Availability of energy is a critical issue: even wh en manufacturing firms are willing to assume a high unit cost per kWh, energy supply is o ften not only insufficient but unreliable, giving rise in many companies (e.g., sm elting and energy dependent continuous chemical processes) to costly backup and self-generation. Perhaps the biggest problem with EE projects is the fact that these projects are often not seen as being directly aligned with the most important prob lems a business faces in a developing country on a day-to-day basis. Growing the business by ob taining new customers or new contracts is often seen as far more important than internal effi ciency, even for energy intensive sectors.
When coupled with the transactions costs and sheer uncertainty of the results from changing industrial processes, or even lighting and building energy, company management will normally turn their attention to the “main game” which is sa tisfying their current customers and growing sales, while staying within tight budget constraint
s. Overcoming this natural tendency of managers to focus on sales in the here and now rath er than jointly harvesting the longer term and continuing benefits of EE is a central challeng e of implementing EE in developing countries.
6
For a brief background on these factors, and case s tudies illustrating the importance of these issues, see Taylor et al. (2008) and GEF (2009).
Key Problems in implementing
Energy Efficiency Projects in
Developing Countries

Lack of information

Uncertainty in Energy
Prices

Uncertainty in exchange rates •
Regulatory and contract risks •
Enforcing contracts

Access to capital

Credit and budget constraints, which also imply short-term payback requirements

Reliability and availability of energy

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