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Part
2 : Financing of Energy Efficiency Investments: Principal
Options for Industrial Investors
By U V Krishna Mohan Rao *
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1.
Introduction
2. Making the decision to invest
3.
Ways and principles of investment financing
4. Optimizing financial management
5. Promotion of public and private sector investment
for improvement in energy efficiency.
In an energy-intensive industry energy consumed per unit of product
typically accounts for double-digits in percentage of the total
manufacturing cost. For example, in India, energy as a percentage
of production cost is 15 per cent in textiles, 25 per cent in
pulp and paper, and 40 per cent in glass, ceramics and cement
industries. Any reduction in specific energy consumption will
reduce overall costs significantly, thereby improving overall
profit margins. However, investments in energy efficiency are
often relegated to the background, citing amongst others the reason
of non-availability of investment funds. Reduction in energy consumption
per unit of product can improve the financial performance of individual
companies and maximize shareholders' return on investment (RoI).
Energy consumption can be reduced through recycling of waste,
by the shortening of production cycles or trapping of exhaust
flue gases to facilitate heat recovery. Co-generation is another
option to reduce energy costs and environmental pollution.
Energy efficiency investment opportunities exist at every phase
of a business enterprise - at the new project initiation phase
as well as at any modernization or expansion phase. Energy efficiency
improvements play a vital role in leveraging operating margins.
Energy conservation is an investment-oriented activity, competing
with other project opportunities. Decisions on the best project
investment and financing option requires understanding and evaluation
of the options available. However, facility managers are often
unaware of the benefits that can accrue from an energy savings
project.
New financing schemes are emerging and new elements are being
incorporated in the overall evaluation process. In this context,
this paper covers various options available for financing energy
efficiency projects. In section 2, the paper highlights identification
and appraisal for energy efficiency investment projects. Ways
and sources of investment finance available for implementing the
projects are discussed in section 3. Modalities associated with
its actual acquisition, their optimum usage, and risk control
are discussed in sections 4 and 5.
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2.
Making the decision to invest
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2.1
Assessment of energy saving potentials
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The techno-economic feasibility assessment of potential energy
savings includes the following steps.
2.1.1
Energy and environmental audit
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Energy and environmental audit is an important precondition for
gauging energy efficiency and environment impact. This eventually
leads to detailed investigations into energy usage, identification
of savings opportunities, and to a short-listing investment options.
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2.1.2
Pre-feasibility and feasibility assessment
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Pre-feasibility and feasibility assessment is the next key step
to ascertain viability of proposals through preliminary and in-depth
studies. It addresses,
| ....... |
(a) |
Technical issues at the plant engineering division
level, namely plant layout consideration including scope and
limitations for improvement; energy savings and pollution
control potential based on current practices; technology and
vendor availability and management's attitude to change. |
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(b) |
Financial
acceptance at corporate finance department level, namely
economic viability (minimum attractive return on investment;
finance modes and sources, funds procurement at the least
weighted average cost of capital). |
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(c) |
Barriers, risks and other obstacles at micro and macro
level, namely tangible and intangible assessment of the various
obstacles and hurdles; minimization techniques and options
available to counter the same and macro-economic and social
implications as well as environmental aspects. |
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2.2
Building the financial rationale
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Once a project proposal has passed the technical feasibility assessment
and other business considerations, a financial evaluation is undertaken
to ascertain the profitability. The fundamental principle of financial
analysis is to choose the project which provides the most profit.
The economic validity is to be estimated carefully and several methods
are available:
2.2.1
Non-discounted method
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The non-discounted method is adopted for short-term projects in
which the inflation of money value does not need to be considered.
This method compares cost and benefit, and the future cash flows
are not discounted to arrive at the present value. The non-discounted
method is mostly used by companies for short term simple feasibility
calculation.
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The discounted method is applied to long-term projects. In general,
the cost and benefit tend to occur over several years. The value
of a project is to be estimated at present. Therefore future costs
and benefits should be converted to "present value".
Figure 2.1 explains that the value of money of today may not be
of the same value tomorrow, as inflation reduces the purchasing
power of money. The rate to compare the value of money is dependent
on the inflation and is called discount rate (DR). In the economy
with high inflation, a higher discount rate is chosen in financial
assessment of investment. As shown in the second row, $1,000 of
today is after 3 years worth $1,093 with 3 per cent discount rate
and $1,728 with 20 per cent discount rate. The discount rate reflects
the preference for time and the applicable interest rate.
Figure
2.1 A time value of money and discount rate
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Figure
2.2 explains the impact of the selected discount rate for assessment
of a projects financial viability. It is assumed that an investment
is made over a two year period which produces a positive annual
net cash inflow over a ten year period upon commissioning of the
project. In the calculation of the project feasibility three different
inflation or discount rates may be assumed. In the first case, the
discount rate is presumed to be 0 per cent. In the second case,
a discount rate of 5 per cent is assumed. In the third case a discount
rate of 10 per cent is applied to the same project.
Figure
2.2 Cash-flow, discount Rate
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As shown
in Figure 2.2, the economic viability of project may be determined
by the discount rate. Prior to taking a decision, investors may
introduce a sensitivity analysis to determine to which the viability
of their project depends on the discount rate. The most widely employed
methods for evaluation are:
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2.2.2.1 Net present value
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For calculating
the present value of an investment all future net profits are discounted
at the minimum attractive rate of return to determine their equivalent
present value. If investors can choose between alternative investment
options, the preferred choice may be the investment that is expected
to yield the highest return.
Table 2.1 presents an example of calculating the Net Present Value.
There are two projects involving investments of US$ 10 million each.
While the savings of project A is US$ 2.5 million per annum, project
B's savings are accounted to be irregular. The savings are discounted
at 10 per cent discount rate to arrive at the present value. Project
B shows higher net present value (NPV) and may thus be chosen. The
formula to calculate NPV is "S[Cash-flow/(1+DR)n]", in which "DR"
is the discount rate and "n" is the year at which cash flow occurs.
Table
2.1 Illustrative example - Net Present Value (in million
US$)
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2.2.2.2
Internal rate of return (IRR)
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The internal
rate of return (IRR) is the discount rate at which the present value
of the future accrued benefits of an investment equal the cost of
the investment. In case the IRR of a project is higher than social
discount rate, the investment is worthwhile. The higher the IRR,
the more profitable the project. International financing organizations
typically prefer IRR calculation to NPV calculation.
Table 2.2 shows IRR calculations for identical cash flows in project
A and B as assumed above in Table 2.1. The formula used is "0 =
-I0 + S[Cash flow/(1+IRR)n]", where "I0" is initial investment.
In this table, project A has the higher IRR of 21.41 per cent compared
to project B which has IRR of 20.42 per cent. Under NPV calculation
project B was the superior one. From the comparison of the two methods,
it appears that the project recommendation also depends on the method
of feasibility calculation applied.
Table
2.2 Illustrative example - Internal Rate of Return (in
million US$)
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2.2.3
Cost-Effectiveness Analysis
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For the development of a financial justification, it is very important
to estimate the expected benefits of investment. However, it is
not always easy to convert the benefit as economic value of money,
which is mostly observed in the social projects such as energy
saving and energy efficiency investment. In that case, cost-effectiveness
analysis is available.
Cost effectiveness analysis is used to identify and select the
least cost alternative to achieve a certain goal. In case the
budget is fixed, the project which achieves the best result may
be recommended to be chosen. Therefore it's more useful to compare
the alternatives for the similar goal.
Table
2.3 gives an example of a simple cost effectiveness analysis.
In one city, there may be 500 energy facilities. The city administration
may have a budget of US$10,000 to be invested in energy efficiency
projects. There may be three alternatives. Project A may be assumed
to improve the energy efficiency up to 90 per cent with US$100/unit.
Project B is assumed to improve energy efficiency by 50 per cent
with US$40/unit. Project C may achieve an 80 per cent performance
improvement with only US$60/unit. It would be good to apply project
A to all facilities but the limited budget may consider effectiveness,
which can be calculated as the ratio of effective rate of project
and cost per unit.
Under
the above assumptions, project C shows the highest effectiveness.
On the other hand, if project C can finance only 50 unit due to
technical restrictions, it may be better to use B and C at the
same time by dividing the budget into $3000 for C and the rest
for B.
Table
2.3 Illustrative example - Cost Effectiveness Analysis
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There
are several methods to appraise a project and each method has
its own limitations. Prior to any investment decision any or all
of the afore mentioned method may be used to rationalize decision
making.
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3.
Ways and principles of investment financing
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After
listing available projects and appraising the expected project
benefit over the lifetime of the project, the next important step
is to evaluate the financing options available. Energy efficiency
investment financing must be decided by various considerations
such as financing scope - whether retrofit the existing equipment
or complete installation of a new one -, and the financing pattern
- whether short term or long term. For short term investments,
inflation and discounting future incomes are less important (see
Figure 2.3).
Figure
2.3 Key factors to be considered in investment financing
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3.1
Ways of investment financing
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Ways
of investment can be largely categorized into internal and external
financing. Internal financing is by nature within management control
(does not involve a lender) and warrants little procedural requirements.
In the case of external financing, dependent on source and mode,
procedural requirements would be significant.
The choice of financing for energy efficiency projects will be
governed by considerations of funds available with the project
promoters; strategic focus on company's core business dealings;
other investment opportunities, i.e., considering opportunity
cost of capital and maximizing returns, considering cost of capital,
tax and cash flow status. The following figure 2.4 shows the options
of project financing.
Figure
2.4 Ways of Investment Financing
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Self-financing means the use of funds from internal accruals.
Self-financing does not involve a lender and warrants little procedural
requirements. Retained earnings offer the most suitable source
for financing investments in energy efficiency. Retained earnings
are especially appropriate for profit making entities, which can
opt to re-invest surplus rather than paying out dividends to shareholders.
Following paragraphs briefly outline alternative forms of self-financing;
| ....... |
(a) |
Retained Earnings are withheld accrued incomes, which
in the normal course of time should have been distributed
amongst shareholders as dividends. Reinvesting retained
earning will increase the asset base at a much lower cost,
even at nil cost, compared to other modes of financing (especially
external) which have greater acquisition costs.
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(b) |
Decrease in Assets relates to the sale or transfer
of various assets (fixed, current, non-current, non-performing
assets). If opportunity cost of retaining the asset is significantly
lesser than the returns generated by the energy efficiency
project, it may warrant asset disposal.
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(c) |
Trade
Credit is a credit arrangement entered into by suppliers
and their respective buyers to settle bills after a fixed
period. This facilitates better liquidity for the buyer,
as diversion of invoice amount for other important commitments
is possible. If discount on cash purchase is greater than
opportunity cost of availed credit, it is advisable to make
cash-down payment.
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(d) |
Accrued
expenses are costs, which have been incurred, but payable
after fixed duration. Salary, wages, taxes constitute this
type of expenses
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(e) |
Deferred
Incomes are prior payments received for supply of goods
or services at a later date. It is generally nil-cost oriented,
along with an added advantage of providing security (advance
receipts, caution deposits).
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3.1.2
Equity financing (stock financing)
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Equity financing relates to raising money from company's existing
or new stockholders. Equity financing is supplied and used by
its owners in the expectation that a profit, will be earned. However,
owners have no assurance that a profit will actually be made or
even the equity capital invested will be recovered. There are
different categories of equity financing that can be distinguished;
| ....... |
(a) |
Ordinary Stock is money collected by way of public
subscription, either through underwriting or self-registration
methods. Offer price can be at discount, par or premium
depending on company's standing. Shareholder's "return on
investment" is not compulsory but enjoys voting right and
say in management.
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(b) |
Rights Stock is money collected from existing shareholders
by way of a rights issue. Other features of ordinary stock
hold good.
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(c) |
Preference Stock is a combination of debt and common
stock arrangement wherein returns through dividends is fixed
but not compulsory. However, it has preference over ordinary
stock in the payment of dividends and liquidation of assets.
It does not enjoy voting rights.
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Money can be borrowed from an external source, either through
the capital market (bonds, debentures, etc.) or as direct loans,
at a fixed cost of capital. Debt financing includes:
| ....... |
(a) |
Bonds/Debentures is money borrowed from investors
and repaid with fixed interest over a period of time. Distinctive
feature of bond is that, only interest or coupon rate is
paid periodically. Upon its maturity, issuer returns only
the face value of bond to the investors. Debentures are
unsecured bonds.
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(b) |
Secured Loans is money borrowed from financial institutions
at a fixed interest rate to be repaid periodically over
a pre-determined period (including moratorium). Unlike bond,
interest and installment have to be repaid together. Disbursed
amount is safeguarded by "charging of securities" (pledge,
hypothecation, mortgage, assignment, set-off or lien).
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(c) |
Unsecured Loans are same as secured loans, except
that, clean advances are disbursed, i.e., no security is
charged. This type of loan is seldom disbursed except to
companies of repute and sound goodwill.
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(d) |
Commercial
Papers are unsecured, negotiable, promissory notes,
sold in money markets and generally offered to government
or companies. In most countries, only large companies can
raise money through these instruments.
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(e) |
Factoring Receivables are sale of bills receivables
for a discount, to banks or factoring organizations with
recourse (bills discounting) or without recourse (bills
payable). Resorting to factoring receivables is advisable
if opportunity cost of discounted sale is greater than withholding
the bill until maturity.
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(f) |
Public
Deposits is money borrowed from person(s) by issue of
depository receipts at a fixed interest rate and period.
The cumulative amount, inclusive of interest and principal,
is repaid upon maturity or interest component is paid periodically
and principal repaid upon maturity. Borrowers are rated
by credit rating agencies.
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3.1.4
Third party financing
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Third Party financing is availing resources from a party other
than self or financial institution, at a cost. In addition to
pattern of vendor financed agreement i.e., when lender (vendor)
is equipment manufacturer, directly selling to user, there could
be a third party who could get involved in providing finances
to either or both manufacturer and user. This is applicable particularly
when the industry may not wish to take the burden of raising capital
for energy efficiency projects and assume the risks associated
with the same.
Different third party financing schemes available are:
| ....... |
(a) |
ESCO Financing - Energy Services Company (ESCO) is a company
that provides energy and financial services to an energy
consumer. Performance contracting relates to implementation
of energy efficiency projects in an existing firm, by an
ESCO, which has both technical expertise and financial backing.
ESCO bears the risk, by investing its own or borrowed funds.
It recuperates its investment over a period of time through
shared savings with client. All detailed modalities are
governed by firm contracts.
In general, performance contracting is the best option for
(i) organizations with severely constrained cash flows;
(ii) firms with high cost of capital; (iii) firms lacking
sufficient resources, including in-house energy management
expertise or an inadequate maintenance capability; (iv)
firms wanting to concentrate more on core business activities,
thereby reducing in-house responsibilities, or (v) firms
contemplating new type of a project, having an uncertain
reliability.
Experience has shown that performance contracting faces
many difficulties including (i) measurement of savings is
cumbersome; (ii) agreeing on how to share the savings can
be difficult; (iii) preparation of contingency plans that
must be incorporated are tough; (iv) preparation of legal
documents can also be painstaking.
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(b) |
Lease Financing is a way of obtaining the right to the use
of assets. It is a contract between the owner of the asset
(lessor) and user (lessee), wherein the former grants exclusive
rights to use the assets for a certain period, in return
for payment of rent. There are numerous types of leasing
arrangements, ranging from basic rental agreements to extended
payment plans for purchases. Basically, there are two types
of leases:
- short term lease (true lease)
- long term lease (capital lease)
A primary distinction between the two types of leases is
tax payment. In the former, the lessor owns the equipment
and receives depreciation benefits. The lessee claims entire
lease amount as tax-deductible business expense. In a capital
lease, the lessee owns and depreciates the equipment. Typically,
only the interest portion of the lease payment is tax-deductible.
Additional enticement could be "off-balance sheet" financing
thus preserving available credit lines.
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(c) |
Venture Capital is another form of long-term equity finance.
The underlying assumption is that the promoter and venture
capitalist act as collaborators in business. True venture
capital does not remain just confined to high technology;
any risky idea can be financed. It is a commitment of capital
or shareholdings, for implementation of projects, specializing
in new ideas or technologies. Main attributes are long-term
investment, equity holding, management support, and vendor
development. As energy efficiency improvements call for
innovative technology options, it lends credence to adopt
venture capital as a source of financing.
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(d) |
Government
Grants/Subsidies are an indirect source for meeting or waiving
a portion of energy efficiency project costs. Typical cases
can be grants provided for utilization of renewable energy
sources equipment and demand side management (DSM).
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(e) |
Hire
Purchase is obtaining the use of assets by way of a contract
agreement between owner and hirer, subject to adherence
of following three conditions:
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- owner
gives possession of his assets to hirer with an understanding
that hirer will pay agreed installments over a specified
period;
- ownership
of asset will transfer to hirer on payment of all installments;
- hirer
has option to cancel agreement any time before transfer
of asset
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Hirer
is required to show the hired asset on his balance sheet and is
entitled to claim depreciation, although he may not own the asset.
In general only the interest part of the hire charge is tax deductible.
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3.2
Procedures and modalities of external financing
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Investors
aiming to secure external sources for their projects will have
to prepare an investment proposal and fulfill other requirements
stipulated in the application procedures of the respective financing
institutions. The following sections describe the preferred format
of investment proposals, prevailing standard loan application
and disbursement procedures and the project eligibility used by
most commercial financing institutes.
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3.2.1 Investment proposal
preparation
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At
the very beginning, following three basic questions have to
be clarified by the investor:
| ....... |
(a) |
What are the organization's current requirements and objectives? |
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(b) |
Is it possible to satisfy the same with available infrastructure
and current arrangements? |
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(c) |
If no, what are the alternative solutions available to meet
the need? |
The
following, are the most pragmatic steps in the preparation of
investment proposals:
| ....... |
(a) |
Generation of project idea(s); |
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(b) |
Technical evaluation of identified proposals for feasibility
verification; |
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(c) |
Identification of probable vendors supporting the proposals; |
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(d) |
In case of energy saving projects, hypothetical estimation
of projected savings based on reduced energy consumption; |
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(e) |
Evaluation
of accrued cash flows through capital budgeting techniques; |
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(f) |
Selection of project proposal(s) based on acceptance criteria; |
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(g) |
Documentation of report including technical and financial
viability analysis. |
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3.2.2
Loan application procedures
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All loan applications should provide information about the following
:
| ....... |
(a) |
Summary information and overview |
| |
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- Title
- Objective(s)
- Description
(products, process, technology, bi-products, etc.)
- Financial
aspects
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(b) |
Company profile
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| (i) |
Profile/background (include issues since incorporation); |
| (ii) |
Share holding pattern (current and proposed); |
| (iii) |
List of associated companies and subsidiaries; |
| (iv) |
Constitution (include related documentation); |
| (v) |
Credit rating certificate issued by credit rating
agencies ; |
| (vi) |
Sector (whether, public, joint, private, cooperative,
etc); |
| (vii) |
Category (whether, small, medium, large scale and
others); |
| (viii) |
Current activity and business (include details of
last three years); |
| (ix) |
Financial
performance indicators (incl. balance sheets and profit
and loss statements for last three years); |
| (x) |
Convictions or pending obligations (against applicant)
under any act and law ; |
| (xi) |
Whether
existing borrower of concerned finance institution
(provide complete details); |
| (xii) |
Details
of loans availed from other finance institutions or
banks
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(c) |
Detailed
project concept on proposed energy efficiency investment
:
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| (i) |
Installed capacity (include configuration); |
| (ii) |
Estimated generation/savings (units/annum); |
| (iii) |
Capacity/utilization factor; |
| (iv) |
Proposed equipment (include specifications, vendor
quotes); |
| (v) |
Implementation schedule (breakup from tendering to
commissioning); |
| (vi) |
Site/location - provide features, classification and
accessibility; |
| (vii) |
Energy conservation (incl. energy audit report of
approved consultant);
- Project
cost
- Implementation
time
- Expected
savings in energy, coal, oil, gas, other
(before and after)
- Plant
capacity (designed and operating)
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| (viii) |
Requirement of raw materials, electricity, water etc; |
| (ix) |
Commercial
features;
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Breakup
of total cost
Proposed
means of financing (equity, debt, third party,
etc)
Loan
assistance being sought from the finance institution
Security
offered as collateral
Loan
repayment period sought (include moratorium)
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| (x) |
Performance indicators (enclose detailed calculations);
- Debt
service coverage ratio (DSCR)
- Internal
rate of return (of project and company)
[before and after tax]
-
Net present value (of project and company)
[before and after tax]
- Pay
back period (PBP)
|
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| (xi) |
Licenses/permissions
from statutory bodies (encl. clearances copy); |
| (xii) |
Proposed
energy services company's performance records / details; |
| (xiii) |
Enclosures
(wherever applicable, provide supporting documents/records,
to validate each claim) |
|
Any
application to financial institution(s) for loan assistance
should be accompanied with an applicable demand draft (for processing
fees and documentation charges).
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3.2.3 Funding and eligibility criteria
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In
order to satisfy the minimum qualifying standards laid down
in the financial institution's charter, successful loan applicants
would be expected to address the following;
| ....... |
(a) |
Companies must have borrowing power and market to take
up the proposed project ;
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(b) |
Applicant companies must not have accumulated losses (excl.
effect of re-valuation of assets, if any) as per audited
annual accounts of preceding fiscal year;
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(c) |
Applicant company should not be loss making as per audited
annual accounts of immediate last year of operation;
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(d) |
No erosion of paid up equity share capital as per latest
annual report;
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(e) |
Existing debt/equity ratio total borrowings [excl. unsecured
and working capital] to net worth of equity must not exceed
3:1 (including the proposed borrowing from financial institution);
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(f) |
Applicant company should not be classified as a "willful
defaulter";
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(g) |
Trusts/societies should not have accumulated revenue deficit,
or revenue deficit immediately during the past year;
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(h) |
Applicant company should not be in default of payment
of dues to any financial institution, including the one
to which the application is proposed to be submitted;
|
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(i) |
Loan amount should not be utilized for re-financing of
availed financial assistance from any other financial
institution;
|
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(j) |
The
business group, of which incumbent company is a subsidiary,
should not be in default of payment of dues to the corresponding
financial institute;
|
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(k) |
Loan
proposal must not be for cost overrun financing of stagnant
projects;
|
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(l) |
Loan
proposal must not be for procurement of second-hand equipment;
|
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(m) |
Applicant
must not be convicted for criminal/economic offence under
any laws
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3.2.4
Project eligibility and project appraisal
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To determine if the investment is able to realize the required
rate of returns, project appraisals should be performed to forecast
future outcomes by conducting an in-depth probe into the technical
feasibility and economic viability.
Once
financial institutions receive the project proposal, they perform
a project appraisal either through in-house experts or through
authorized external consultants. This includes both technical
and financial re-evaluation of the submitted proposals, to validate
claims made by project promoters. Only those proposals which pass
the stringent appraisal tests, will be eligible for project financing.
Table 2.4 shows how financial institutions breakup project details
into different sections based on all components' relative importance
and measurability.
Table
2.4 Broad based segmentation of project appraisal steps
for energy efficient investment proposals/loan application
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After
comprehensive analysis of project proposals, funds may be sanctioned
or rejected, based on the project's credibility. Upon sanction,
financial institutions place funds at the disposal of the borrowing
entity for withdrawals, subject to adherence of following:
| ....... |
(a) |
Documentation and other related formalities should be
scrutinized and completed/updated, to safeguard advances;
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(b) |
Regional authority's prior approval should be obtained;
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(c) |
Up-front fees should be collected;
|
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(d) |
Advances should be insulated by "charging of securities"
through pledge, hypothecation, mortgage, assignment, set-off,
lien;
|
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(e) |
Cash-flow through the mechanism of escrow account should
be adopted;
|
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(f) |
No adverse change in borrower's business or line of activity
since proposals submission and sanction should be confirmed;
|
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(g) |
Withdrawals should be strictly as per terms of sanction,
i.e., stage wise;
|
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(h) |
Obtain insurance policy cover for loan amount, showing
financial institutions as mortgagee;
|
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(i) |
Government grants or subsidy schemes should be exhaustively
explored;
|
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(j) |
Direct payment should be made to suppliers of equipment,
machinery, or services as per guidelines laid down in
bank or financial institution's governing documents;
|
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(k) |
Review of project mission, at least once a year, should
be undertaken, to provide help, advise and follow-up on
implementation progress;
|
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(l) |
Compulsory submission of project completion report after
total disbursements leading to project commissioning should
be obtained.
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Disbursements
ready for execution require following documents:
| ....... |
(a) |
Loan agreement;
|
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(b) |
Deed of hypothecation;
|
| |
(c) |
Personal guarantee of promoter(s)/promoter directors and
companies;
|
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(d) |
Execution of undertakings, viz., non-disposal of shareholdings
by promoters; meeting of promoter shortfall; compliance
of outstanding loan conditions; non-resignation of whole
time directors without consent;
|
| |
(e) |
Post dated checks of interim loan/disbursement. These
will be returned after completion of final scrutiny. Borrower's
banker must attest signature;
|
| |
(f) |
Copy of the insurance policy.
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3.2.6 Procurement regulations
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Borrowers should demonstrate that procurement procedures adopted
by them are appropriate to the circumstances and that the quality
goods, services and works are purchased at reasonable and competitive
prices. In addition, account should be taken of other relevant
factors such as delivery time, efficiency and reliability of the
goods and works, their suitability for the project and availability
of maintenance facilities, spare parts, quality and competence
of the parties rendering them. The borrower shall provide all
such information and documents reasonably required in connection
with the procurement of any goods, services and works to be financed
by the financial institution.
With respect to equipment financing schemes, where a prescribed
loan amount limit is fixed, purchase from a single qualified supplier,
is acceptable. Wherever funds for sectors like wind farm, small
hydro, co-generation, biomethanation, solar thermal and PV systems
and devices, are to be provided by financial institution of funds
receivable from World Bank, Asian Development Bank or any other
International or Bilateral Agencies, the stipulated procurement
procedures, are to be followed by the borrowers applicable to
the scheme.
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3.2.7 Safeguarding disbursed loans
|
Effective follow-up and monitoring of borrower accounts are major
areas of credit administration. However carefully and meticulously
a project proposal is appraised and considered, unless post-disbursement
control is effective, the whole purpose could be defeated.
Safeguarding can be accomplished by adopting the following covers:
| ....... |
(a) |
Imposition of Restrictive Covenants;
- Asset
Related - firm should maintain a minimum asset
base;
-
Liability Related - firm to refrain from incurring
additional debt or repay existing loan.; but
may be allowed to do so in exceptional circumstances
with concurrence of the lender;
- Cash
Flow Related - firm to refrain from distribution
of cash dividends, capital expenditures, salaries/perks
of managerial staff etc;
- Control
Related - appointment of nominee director on
the borrowing company board, to protect financial
institution's interest.
|
|
| |
(b) |
Periodic verification of submitted financial statements;
|
| |
(c) |
Regular inspection and physical verification of charged
securities and goods;
|
| |
(d) |
Cash flow to be compulsorily channeled through mechanism
of escrow a/c;
|
| |
(e) |
Periodic credit rating of borrower accounts and health
code classification;
|
| |
(f) |
Performance monitoring through regular interactive sessions;
|
| |
(g) |
Compulsory adherence to repayment schedule or loan amortization. |
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4.
Optimizing financial management
|
Optimal capital structure refers to the appropriate proportionate
mix of long-term funds invested in the firm. Optimal financial
management leads to increase in shareholders' return on investment.
It also leads to a debt to equity ratio, which results in least
weighted average cost of capital for the firm.
The capital structure decision is not only applicable at the
time of promotion but also at subsequent financial decisions.
Thus, it is very much applicable in case of energy efficiency
projects involving significant long-term investments.
The capital structure decision making process is shown in figure
2.5. Factors affecting the capital structure include financial
leverage, costs of capital, floating costs and other aspects.
An excellent capital structure should satisfy the criteria of
profitability, flexibility, control, and solvency. In addition
to these, the dividend payout is also an important management
decision.
Figure
2.5 - Process involved in taking capital structure decisions
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4.1 Use of internal
resources
|
A firm may justify a low payout (or high capital retention)
policy for one or a combination of the following reasons:
- Internal
investment opportunities exist;
- Stability
of earnings is warranted;
- Growth-oriented
stockholders want re-investment to leverage their profits;
- Weak
financial capability i.e., limited ability to raise
funds;
- Reduce
dependence on external need for funds and existing high
leverage.
|
A high payout policy (or low capital retention) may be followed
because of:
- Management's
commitment to pay dividends,
- Dividend-oriented
stockholders who want regular income, or
-
Informational value of dividends in the capital market.
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4.2
Identification and use of external sources of funding
|
In practice, firms are found following different debt policies.
Conservative debt policy is justified on the ground that:
(a) It minimizes financial risk;
(b) It provides financial flexibility;
(c) It gives independence from the financial institutions.
Firms that desire to maintain high credit worthiness for their
bonds may, employ very little or no debt. Managers should realize
that financing policy should not be based on subjective considerations,
unverified assumptions and externally determined criteria. For
growing profitable firms, too many obsessions with risk effects
of debt are not desirable, as debt hardly poses a bankruptcy threat.
Stability of firm's earnings would certainly be an important determinant
of its debt policy.
In formulating the corporate financing policy, capital market
considerations are certainly important, but they should not override
strategic issues. Growth through competitive superiority is an
important corporate strategy. A prudent use of debt can lead to
effective competitive capability since the reduction in operating
costs resulting from the low cost of debt and interest tax subsidy
can be either converted into lower prices, or higher return to
shareholders. This competitive advantage will be much more valuable
than any perceived increase in the financial risk, particularly
when the market is price-sensitive. In a bad equity market, firm
may go for debt and undertake strategic investment rather than
forego them in an effort to maintain high credit worthiness and
not borrow. Maintaining a competitive position is far important
than taking pride in remaining a conservatively maintained company.
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4.3 Management of financial
risks
|
All firms and all investment projects are always exposed to same
form of risks. Risks exist because of the inability of the decision-maker
to make perfect forecasts, which cannot be done with certainty
since the future events are uncertain. Cash-flows cannot be forecast
accurately, and alternative sequences of cash-flows can occur
depending on future events. The risk associated with an investment
may be defined as the variability that is likely to occur in the
future returns from the investment. The greater the variability
of expected returns, the riskier is the project.
Following are some ways by which we can control or minimize risks,
if not avoid them:
| ....... |
(a) |
Adopt a conservative debt-equity policy;
|
| |
(b) |
Assess project viability/feasibility using capital budgeting
techniques;
|
| |
(c) |
Verify repayment capabilities;
|
| |
(d) |
Reduce exchange rate risk by hedging against a strong
currency and by balancing purchases with sales. Obtain
government guarantees, if possible;
|
| |
(e) |
Minimize cost overrun risk by adhering to implementation
schedule (firm quotes from approved vendors);
|
| |
(f) |
For technology and pre/post project completion risks ensure
guarantees or insurance;
|
| |
(g) |
For input/supply risks, obtain tied compensation or provide/pay
agreements;
|
| |
(h) |
Reduce environmental pollution risk by adopting eco-friendly
technology options;
|
| |
(i) |
Wherever applicable cover with guarantees, insurance,
indemnities;
|
| |
(j) |
Conduct pessimistic break-even, sensitivity and scenario
analysis of cash-flows;
|
| |
(k) |
Reduce host's risk by using guaranteed savings performance
contract;
|
| |
(l) |
Structure arrangement such that minimum annual saving
is always greater than maximum annual payment;
|
| |
(m) |
Secure fixed interest rate financing for length of project.
Avoid floating rate; |
| |
(n) |
Adopt a diversified capital structure, to ensure risk minimization; |
| |
(o) |
Use statistical techniques to handle risks. Tools available
are probabilistic methods; variance analysis, decision tree
models, simulation modeling, etc.; |
| |
(p) |
Change risk profile by using currency options and derivatives; |
| |
(q) |
Resort to leasing mode as it is good for short-term asset
use, reduces the risk of obsolescence, and offers lesser
responsibility. |
However
prudent risk control may be, zero-risk investment can seldom be
achieved in a changing capital market. Risk is an inherent part
of investment.
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5.
Promotion of public and private sector investment for
improvement in energy efficiency.
|
Promotion of sustainable energy development and use by virtue
of investments in energy efficiency equipment is likely to become
an increasingly important policy issue for lawmakers from industrialized
and developing nations. Keeping the objective of this article
in perspective, a few recommendations are presented below.
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5.1 Governmental initiatives that are
needed for effective investment promotion
| ....... |
(a) |
Establishment and announcement of policy on rational generation,
distribution and efficient energy utilization (all sectors);
|
| |
(b) |
Establishment of time schedules and action plans, spelling
out responsibilities for action to achieve and sustain
energy efficiency, (including sector wise targets for
energy efficiency);
|
| |
(c) |
Establishment of regulatory, feedback/monitoring, technical
assistance mechanisms;
|
| |
(d) |
Promotion of co-generation to reduce dependence on capacity
addition;
|
| |
(e) |
Giving credit for environmental benefits through incentives
and rewards.
|
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5.2
Promotional initiatives that are needed to promote the idea
of energy efficiency and environmental protection with all concerned,
may include the following:
| ....... |
(a) |
Energy efficiency policies/schemes and any overhead support
mechanism should be simple, transparent and fair;
|
| |
(b) |
Financial institutions can sponsor energy efficiency studies
as a pre-cursor to lending for capital equipment;
|
| |
(c) |
Financial institutions may consider EE funding based on
energy efficiency improvements rather than linking with
other activity funding for an organization;
|
| |
(d) |
Promote computerized monitoring of project progress;
|
| |
(e) |
Promote Energy Services Company (ESCO) financing;
|
| |
(f) |
Estimate number of energy managers, auditors required and
initiate commensurate training and/or academic courses at
the university level; |
| |
(g) |
Encourage recycling to save energy, resources and environment
improvement; |
| |
(h) |
Inefficient equipment removed from one plant should not
be installed in another factory subject to its efficiency
level; |
| |
(i) |
Adopt "Energy Labeling" to distinguish goods according to
their energy efficiency. |
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* Energy & Resource Management Specialist,
62, Muthuvel Naicker Street, Kodambakkam, Chennai 600 024
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