By Morgan Bazilian, Ludovico Alcorta, Giuseppe De Simone, and Ascha Pedersen
Energy efficiency (EE) is a foundational aspect of any good energy policy. The economic, security, and environmental benefits of EE have been recognized for decades. In this blog, we briefly consider the economic rationale for industry to invest in EE, and present results from financial analysis of 119 projects which were surveyed across nine manufacturing sub-sectors. While a large body of EE investment-related literature exists, the empirical results we present here focus solely on developing countries.
Energy efficiency investments
in developing countries
offer attractive returns
Among the principal barriers to the full implementation of EE technologies and practices is access to funding. This financing gap and the associated barriers are well documented, and today there are many targeted and innovative financial policies and measures from which policymakers can draw upon. Although the incentives vary considerably between sectors and countries, the policy levers and financial mechanisms involved are often not dissimilar.
Those within the financial sectors in developing countries are not always familiar with the technical details of EE projects, and the scale is usually too small to be handled directly by International Financial Institutions (IFIs). Moreover, the economic return of EE projects is normally embedded in the cost savings generated (i.e., EE projects often use energy savings as a revenue stream and do not create any collateral). Such non-asset-based business models appear excessively uncertain and risky to many financial institutions–especially in developing countries.
UNIDO conducted a survey of 357 manufacturing companies across several sectors in 25 developing countries, inquiring about their EE practices and investments. A central selection criterion for the survey was for firms to have invested in at least one project with the aim to reduce the use or costs of energy. The surveyed firms had approved 119 such projects. The typical project size was below U.S. $100,000. Investments were in the areas of direct equipment replacement (36%), waste reuse (14%), residual temperature reuse (14%), pipes and insulation improvements (13%), improved use of infrastructure (12%), and fuel optimization (11%).
The survey found that the EE investment decision making process is driven by a traditional payback approach: more than 90% of surveyed firms in developing economies used simple payback rules to assess the financial viability of EE projects, with an average payback period of 23 months. The survey found that more in-depth financial assessments, such as internal rate of return (IRR) calculations, were performed only for larger projects. Although the use of simple payback methods to justify EE investment decisions is common practice in developed economies as well, it is generally an inadequate metric from which to accurately assess the real costs and benefits of investments and to compare alternatives.
We calculated IRR of EE investments recorded in the survey. We assumed no resale value and conducted sensitivities on the useful life of projects to determine IRRs comparable across project types. Three-year projects reported an estimated mean IRR of 25%. As expected, the estimated rate rose with longer lifespans: we observed 37% at 4 years, 43% for 5 years, and 50% for 10 years. These rates show higher profitability for EE projects in comparison with average returns in capital markets over similar timeframes. In addition, the profitability of financial investments in countries with high interest rates tends to be eroded by typically higher inflation, which supports the case for investing in EE, especially over longer periods. Estimated IRRs varied considerably across sectors. The sample displayed lower rates of return in projects in process sectors--such as chemicals and cement--than in the product sectors, such as equipment manufacturing and automotive (Table 1).
EE is critical for achieving a low-carbon path for industrial production. Accelerating EE investments needs requires a better understanding of the economic, environmental, and social benefits for manufacturing and financial firms of energy saving technologies. It also requires a better understanding of these practices in developing countries. Decades of implementation of EE projects and ventures have shaped a set of financial mechanisms to foster investments in energy savings technologies and practices. However, the investment delivery mechanisms need “localization” in order to be effective in developing countries. Improvement of EE financing mechanisms necessitates sustained efforts in the establishment of institutional, financial, and industrial settings.
*This blog draws from Alcorta, L.; Bazilian, M.; De Simone, G.; Pedersen, A. (2012). “Return of Investment from Industrial Energy Efficiency: Evidence from Developing Countries.” United Nations Industrial Development Organization, Vienna, Austria. Please see the paper for a full list of references.