THE FEASIBILITY OF PERFORMANCE CONTRACTING IN HUNGARY, POLAND, AND SLOVAKZA
Prepared by Kiona International, Inc.
Under Subcontract to ICF Resources Incorporated
U.S. Agency for International Development Contract No. EUR-0028-C-00-2031-00
July 1995 TABLE OF CONTENTS
PAGE EXECUTIVE SUMMARY INTRODUCTION ...... 1 SECTION 1. PERFORMANCE CONTRACTING ...... 1-1 Performance Contracting in Retrospect ...... 1-2 Typical ESCO Services ...... 1-4 Country Benefits ...... 1-5 Benefits to In-Country Businesses ...... 1-6 Customer Advantages ...... 1-7 Lessons Learned in the West ...... 1-8 Free Audits ...... 1-8 Too Much; Too Soon ...... 1-8 Getting an Accountable Energy Engineer ....1-9 Cost-Effectiveness ...... 1-9 Utility Role ...... 1-10 Underestimating the Key Role Management and Occupants Have. Especially O&M Staff ...... 1-10 The Vital Communications Link ...... 1-10 SECTION 2 . KEY INSTITUTIONAL AND ECONOMIC ELEMENTS .....2-1 Country Conditions ...... 2-1 Political & Economic Elements ...... 2-1 Energy & Environmental Elements ...... 2-5 CustomerElements ...... 2-6 SECTION 3 . HUNGARY . ECONOMIC. POLITICAL. ENERGY AND FINANCIAL CONDITIONS GERMANE TO ENERGY PERFORMANCE CONTRACTING ...... 3-1 Macroeconomic/Political Conditions in Hungary .....3-1 Economic uSnapshotfland Apparent Trends; September 1994 ...... 3-2 Macroeconomic Prospects and Outlook .....3-2 Implications for a Broad Based ESCO Industry ...... 3-3 Financial Barriers ...... 3-4 Related Financial Issues ...... 3-4 Credit Enhancement ...... 3-4 Hungary's Energy Situation ...... 3-5 Electric Power Sector ...... 3-5 Ministry of Environment ...... 3-7 HeatingSupply ...... 3.7 Energy Supplies and Environmental Implications . . 3-8 Energy Consumption ...... 3-9 Energy Savings Potential ...... 3-10 Sources of Funds ...... 3-10 The German Coal Aid Fund ...... Hungarian Government Support for Energy Efficiency Pool Financing ...... EC Energy Center ...... Doing Business in Hungary ...... Some Counsel ...... Current ESCO Activity in Hungary ...... Energy Efficiency Activity ...... Energy Efficiency Measures ...... Potential Markets ...... Deterrents to an ESCO Industry ......
SECTION 4 . POLAND . ECONOMIC. POLITICAL. ENERGY AND FINANCIAL CONDITIONS GERMANE TO ENERGY PERFORMANCE CONTRACTING ...... 4-1 Political/Economic Mid-1994 lrSnapshotwand Apparent Trends ...... 4-1 Private Sector Growth ...... 4-2 Polish Economic/Political issues ...... 4-3 Poland's Energy Situation ...... 4-5 MakingItPay ...... 4-5 Pricing Patterns and Plans ...... 4-5 Consumption By Sector ...... 4-7 The Utility Industry ...... 4-7 Financial Issues Affecting the Growth of an ESCo Industry in Poland ...... 4-8 DoingBusiness inPoland ...... 4-10 Legal Considerations ...... 4-12 Economic. Political. Financial Deterrents to ESCO Industry Growth and Proposed Resolution ...... 4-13
SECTION 5 . SLOVAKIA . ECONOMIC. POLITICAL. ENERGY AND FINANCIAL CONDITIONS GERMANE TO ENERGY PERFORMANCE CONTRACTING ....5-1 Macroeconomic and Political Indicators ...... 5-1 Related Financial Issues ...... 5-4 The Energy Situation ...... 5-5 Electricity ...... 5-6 Heating ...... 5-9 Slovak-American Enterprise Fund ...... 5-7 Sources of Funds ...... *...... 5-10 Slovakian Commercial Banks ...... 5-10 Slovak-American Enterprise Fund ...... 5-10 Ministry of Environment ...... 5-10 Multinational Development Banks (MDBs) ..... 5-11 Slovakian Government Support ...... 5-11 Doing Business in Slovakia ...... 5-11 ESCO Activity in Slovakia ...... 5-12 Energy Efficiency Measures ...... 5-12 Potential Markets ...... 5-13 Deterrents to An ESCO Industry Related to Slovakia's Economic. Political. Financial and Energy Situation; and Possible Resolutions ...... 5-15 SECTION 6 . OVERVIEW OF PERFORMANCE CONTRACTING POTENTIAL 6-1 Hungary: Conclusions & Recommendations ...... 6-1 Recommendations ...... 6-2 Poland: Conclusions & Recommendations ...... 6-4 Recommendations ...... 6-5 Slovakia: Conclusions & Recommendations ...... 6-6 Recommendations ...... 6-7 Supporting the ESCO Market ...... 6-9 APPENDIX A ...... A-1 EXECUTlVE SUMMARY
Hungary, Poland and Slovakia offer large, untapped "reservoirs" of energy efficiency. Tapping into these reservoirs could benefit the national economies of these countries and the environment of the entire region. More efficient operations means more competitive industry, improvements in trade balance and increased employment opportunities. The money now going for wasted energy could up-grade facilities and pay for new jobs. Energy efficiency efforts could off-set some of the economic and social dislocation that will inevitably be caused in all three countries as energy prices increase.
Many leaders in Hungary, Poland and Slovakia recognize energy efficiency could offer these benefits; but like financially starved nation's around the world, they simply don't have the money to support a broad energy efficiency effort. Furthermore, there are pressing demands on the money that is available.
An exciting opportunity exists to squeeze energy waste out of the economies of Poland, Hungary and Slovakia, and use those resources regained to benefit the countries and their citizens. It is called energy performance contracting (EPC). Without any upfront costs to . the owners, EPC can make potential energy cost savings from future years available to upgrade facilities and cut energy costs today.
EPC is not new or untried. 1t is being used successfully in thousands of projects in many western countries and a growing number of neighbor countries, including the Czech Republic.
The firms that offer EPC are called energy service companies (ESCOs). An ESCO identifies energy saving opportunities in a facility or an industrial process; then implements the approved measures at no front-end cost to the owner. All the equipment and services provided by the ESCO are paid from future energy and operational savings. Guaranteed! The ESCO has so much confidence in its services and products that the firm guarantees that all project costs will be covered by money that is now being paid to the utility for wasted energy.
Poland offers the largest market in Eastern Europe. For energy service companies (ESCOs) considering working and investing in Poland, it also offers the greatest energy opportunity for Poland consumes 33 percent of Eastern Europe's primary energy. Furthermore, it is consumed at an energy intensity of 1.78 -- the highest in Europe.
As Poland strives to bring its "social cost" of energy in line with its real cost, energy efficiency can offset much of the economic dislocation these adjustments can cause. The benefits energy efficiency could bring to Poland's transitional economy and its environment are striking. In Hungary the nation's energy situation seems to be at the heart of many of its economic difficulties. The cost of energy to the nation is 16.7 percent of its gross domestic product. Much of the 600 billion forint energy bill to the nation is indirectly borne by the government. This procedure places a heavy burden on the country's budget deficit and diminishes the public awareness of the importance of energy efficiency to the economy.
Energy efficiency is vital to Hungary's national interest, but these concerns are not translated to the local level. There are few consumer level incentives for energy efficiency. In fact, the historically low level of energy prices has acted as a disincentive. This pricing policy has continued and the Hungarian price of energy for industry in US cents/kWh has actually dropped since 1990 (from 7.4 cents/kWh to 5.2 cents/kWh in 1994).
The energy savings potential in Hungary is great. The market is estimated to be 180 billion forint (US $6 billion) at September 1994 energy prices.
To fully analyze the energy situation in Slovaha and to assess the potential for energy performance contracting, it is necessary to realize that the independent Slovak Republic was established only two years ago. Any assessment of the energy situation and its economic implications must also consider the previous development of the region as apart of Czechoslovakia. The heavy industrialization of Slovakia began after World War I1 under a command and control economy. Efficient operations, particularly energy efficient operations, were not a consideration. Energy for the heavy industries was imported and prices were subsidized by the state.
This "inherited" energy situation is at the heart of many of Slovakia's economic difficulties. The heavy dependence on energy imports and the level of energy required for its industrial sector are burdens on the growing economy. The absence of economic/financial analyses in the energy area and the artificially low energy prices for citizens diminishes an awareness of the importance of what energy efficiency could do for the economy. The benefits energy efficiency could bring to Slovakia's transitional economy are striking.
At first glance, it would seem that conditions in all three countries are quite different. However there are broad similarities in the factors that can have an impact on the development of an energy service industry. Where significant differences exist, they are treated in some detail in the specific "country" sections of this report.
The purpose of this report, and the research leading to it, is to examine the feasibility of implementing an ESCO industry in Hungary, Poland and Slovakia, assess what obstacles or deterrents exist to implementing this energy efficiency financing approach, and determine how these difficulties might be resolved. This report offers a "snap shot" of conditions as they appeared to the authors during their fact finding missions --- Poland , July 1994; Hungary, September 1994; and Slovakia, March 1995. Indications of an emerging ESCO industry and growing interest in energy performance contracting are evident. Government agencies in the three countries studied have expressed a growing interest in what an ESCO industry could do for their country's economy and for their nation. In Poland, two new ESCOs show strong prospects, the Polish Foundation for Energy Efficiency (FEWE) and the Polish Power Grid (PPG) are positioning themselves to help foster demand side management (DSM) through ESCO participation.
In Slovakia, with a more recent start, broad support exists for the experimental guaranteed energy savings projects being conducted in Banska Bystrica and Malacky.
In the course of the interviews for this study in Hungary, it was suggested by the Ministry of Finance that income tax holidays might be normalized for ESCOs to give them full relief for five years. It was also suggested that customs duties on imported energy efficiency equipment, not manufactured in Hungary, could be reduced. Several Hungarian ESCOs are emerging.
International ESCOs are becoming active in all three countries, exploring the market, and looking for partners; or, they are already involved in related energy projects.
Barriers to performance contracting exist, but they are not insurmountable as evidenced by the emergence of in-country and international ESCOs on the scene. Financial issues represent the greatest deterrents. Interest rates and inflation are high in Poland and Hungary and moderate in Slovakia. In all three countries the interest rate trend is downward. The economies of the three countries are becoming progressively more stable which will encourage the establishment and growth of an ESCO industry.
Conditions needed for a broad-based ESCO industry are not in place, but favorable changes are in evidence. As the industry begins to take shape, some of the problems that plagued ESCO growth in North America are evident. Potential mistakes, such as reliance on separate attention to electric vs. heating measures; using engineers, who do not understand the time value of money and who have no experience in being accountable for energy saving predictions; etc., are already evident.
A broad-based ESCO industry will take time to establish in all three countries and, depending on changing economic conditions, is probably at least two to three years away. The groundwork, however, is being laid now. Appropriate guidance and support at this juncture could be crucial to the ultimate success of an ESCO industry and to the ability of the region to meet its goal of sustainable development. The timing is excellent to foster the development of an ESCO industry.
Financial issues, for example, dominate any list of barriers to performance contracting in Hungary. Interest rates and inflation, while declining, are high. Interbank interest rates (14- 30 day maturity) were 19.9 percent in late 1994; however, rates to consumers were in the 32-36 percent range, primarily due to the bad debt load the banks are carrying. In late 1994, the inflation rate was reported to be 18.9 percent. Of equal concern is the status of the banking industry, which has little money available and offers only short term loans.
Energy laws, passed by the Hungarian Parliament in 1994, could help some of the utility resistance to energy efficiency. A trend toward lower interest rates and slower inflation is evident. The devaluation of the forint in 1995, however, is a strong possibility. Environmental concerns are strong, and energy efficiency measures which address environmental issues could benefit from reduced interest rates offered by environmental funds.
In Poland the obstacles to the broad implementation of performance contracting include: (a) the structure of the utility industry and the way energy prices are set, which create serious economic constraints as well as institutional resistance to energy saving performance contracting; (b) economic concerns, relatively high interest, and inflation rates plus uncertainties regarding financing; (c) economic conditions, which force cream skimming and reduce opportunities to implement measures with greater savings persistence and environmental benefits; and (d) the technical, financial and legal understandings required for effective performance contracting, which are emerging, are not sufficient to support an industry.
An energy law, before Parliament at the time of the study, would help restructure the utility industry, particularly the price setting mechanism. A strong trend toward lower interest rates and slower inflation is evident. Environmental concerns are strong, especially in Upper Silesia, and energy efficiency measures which address environmental issues could benefit from reduced interest rates offered by environmental funds.
The barriers to performance contracting in Slovakia are much less dominated by interest and inflationary concerns. The barriers in Slovakia include: (a) the utility distributors and their potential resistance to energy efficiency in the private sector; (b) the way energy prices to the public have been set and controlled, which has created serious economic constraints as well as institutional resistance to energy efficiency and performance contracting; (c) uncertainties regarding financing; (d) economic conditions, which force the use of only short paybacks and reduce opportunities to implement measures with greater savings persistence and environmental benefits; and (e) the technical, financial and legal understandings required for effective performance contracting, which are emerging, but are not sufficient to support an industry.
Financial issues are a partial deterrent to performance contracting. Interest rates and inflation rates are relatively high but continue to decline. Commercial rates to consumers were in the 16-20 percent range in March of 1995. In early 1995, the inflation rate was reported to be 12 percent and the Slovak National Bank had dropped the discount rate to 11 percent. Of equal concern is the status of the banking industry, which has limited money available and typically offers relatively short term loans. A broad-based Slovakian ESCO industry may take time to establish and, depending on changing economic conditions, is probably at least two to three years away. The groundwork, however, is being laid now. Appropriate guidance and support at this juncture could be crucial to the ultimate success of an ESCO industry and to the ability of Slovakia to meet its goal of sustainable development. The timing is excellent to foster the development of an ESCO industry.
Performance contracting guidance is critically needed. The timing is excellent to offer seminars and/or conferences, which could help ESCOs move beyond avoidable difficulties. In addition, conferences would also heighten awareness of the benefits of energy efficiency (and more particularly performance contracting) can bring to these economies and environment, encourage U.S. ESCO participation in Hungary, Poland and Slovakia, and help foster the growth of an ESCO industry in Eastern Europe.
COUNTRY- SPECIFIC RECOMMENDATIONS
HUNGARY
1. The extremely high liability the government carries to supplement energy pricing must be brought down. It is an incredible burden for the government, works against energy efficiency, ESCO potential services, and economic well-being.
2. Help the national leadership realize that energy efficiency is a sector free problem and the responsibilities extend far beyond the energy sector per se.
Closely allied to this need, is support for the government's plan to increase energy prices. Guidance should be offered as appropriate so government officials can more readily recognize the value of energy efficiency and performance contracting in significantly reducing the social and economic dislocation caused by these price increase.
POLAND
1. The Polish government has made great strides in bringing the cost per kwh up from its low social cost in 1988 to the level it is today. This pattern needs to continue until energy prices reflect actual costs.
2. Electric pricing is structured to include the regulated end-use price and the "commonly agreed price" (about a 30 percent add on) as it is paid to the distributor. This policy of "commonly agreed price" amounts to a government subsidy and should be phased out if ESCOs are to serve this market most effectively. 3. The tariff structure should be changed; so, generation payments are based on production.
4. The government should consider a clearly defined subsidy in lieu of the hidden, utility "non-payment" subsidy. Farmers, for example, should be obliged to pay their utility bills, but could receive an equivalent in a subsidy. They would not suffer an economic loss (and the government would avoid the political implications). At the same time, farmers would have an incentive to operate more energy efficiently. The result would be better net financial position.
5. Inflation is trending downward and the devaluation is using the crawling peg mechanism. Both are relatively favorable indicators of an economy coming into line, but the combined effect places a financial hardship on those who might otherwise pursue performance contracting. Continued efforts to lower inflation should be encouraged.
6. Provide fixed interest rates, instead of floating rates, in Polish commercial banks for energy efficient projects. Or, encourage more multi-national development money to be available for financing.
7. Develop a mitigating strategy to remove or reduce VAT on energy saving performance contracting.
SLOVAKIA
1. The high liability the government carries to supplement energy pricing must be brought down. It is a heavy burden for the government, works against energy efficiency, ESCO potential services, and economic well-being.
2. Accelerate the privatization process; so transitional organization can more readily access ESCO assistance. Recognize that uncertainties in the privatization program act as ESCO disincentives.
3. Support any government efforts to make the Slovak crown fully convertible.
4. A good place to start applying financial analyses is the energy efficiency projects in progress. The results of the two experiments at Banskii Bystrica and Malacky should be reported in crowns invested, crowns saved and the cost-effectiveness of the project. Economic analyses should accompany any further analysis and implementation of the Handlova project.
Encourage economic/monetary analysis of energy resources, needs, use and energy efficiency opportunities. Apply market economy return on investment analyses to the projects in Handlova, Banskii Bystrica and Malacky. 5. Extend the government sponsored guaranteed savings experiments in heating in the housing sector to electricity usage and add other markets. Use financial analysis in these projects, too.
RECOMMENDATIONS APPLICABLE TO HUNGARY, POLAND AND SLOVAKIA
1. Provide technical assistance and performance contracting guidance to the emerging ESCO market through:
Liaisons, guidance, consultation, which will: o encourage U.S. ESCO involvement; o foster partnerships of successful foreign ESCOs with in-country partners in prime/sub or joint venture relationships o provide business guidance through in-country consultation or documents, particularly in costing projects and the time value of money; o develop pilot, or demonstration, projects in several sectors; and o provide consultation to government officials in establishing an energy data base, which includes monetary consideration.
On-site training and/or seminars, which will: o offer special training for engineers, prospective ESCOs, financiers, and the legal profession in risk assessment and factors unique to performance contracting. Train engineers, who can now perform energy audits, to do the analysis and calculations required by ESCOs; o provide training in energy efficiency practices for operations and maintenance (O&M) personnel; probably through training O&M supervisors to train their people; and o offer seminars for local ESCOs in developing "bankable" projects and for financiers so they can determine when specific performance contracting projects are "bankable."
2. Elicit the support of multi-national development banks (MDBs) and other funding sources to augment or ameliorate the present financial constraints. Consider mechanisms to buy down interest rates, which could leverage relatively small sums into larger economically attractive financing sources while bolstering the commercial banking industries.
To fit typical MDB size loans to smaller energy efficiency financing needs, MDBs should be encouraged to consider pool financing for groups of buildings, such as Hungary's Health Insurance Fund's 170 hospitals; or, use commercial bank management of a pool to fund a series of loans for smaller projects.
vii Tax laws and procedures should be examined to be sure no disincentives or inequities exist that negatively impact moves toward energy efficiency, performance contracting and sound economic policies. Secondarily, the normalization of income tax holidays for ESCOs should be considered as an incentive for them to do business in each country.
Develop a model to facilitate access to revenue streams for institutions, such as schools and hospitals, that currently have no way to retain energy savings. Without access to savings, incentives to use energy more efficiently, and resources to pay for ESCO services, may not exist.
Prepare clearly defined procedures and guidance documents, which will enable ESCOs operating in each country to secure their money within a project; provide for unimpeded opportunities to get money from recalcitrant customers; prepare bankable project to get funding from commercial banks; and allow clear recovery of invested funds and profits as warranted.
Examine the range of AID and MDB efforts in each country and determine where energy efficiency issues, concerns and benefits might be coordinated and incorporated into these on-going programs.
Consumers should have some incentive to pay for metered heating energy consumption; not floor space. The use of metered consumption should be encouraged and the utilization of performance contracting to install meters should be explored.
ESCOs considering investing in energy efficiency projects need to be advised of all financing sources, but particularly the environmental funds, which have such attractive financing terms. If ESCOs are going to be able to access some of the environmental funds, a concerted effort to forge the environment-energy efficiency connection must be made.
Accelerate the privatization procedures so more organizations would be in a position to receive ESCO services.
The money side of energy often seems lost in weighing the benefits of energy efficiency or in making savings calculations. A data base enabling economic analysis of energy use should be developed. Education and training of the money side of energy should be offered energy planners, energy service and energy efficiency financing providers.
Continue technical support to the banks and government in developing procedures that will most effectively support energy efficiency and performance contracting in all countries. Encourage longer term loans and the use of predicted energy savings as collateral. INTRODUCTION
In mid-1994 through early 1995, research was conducted to assess the feasibility of energy efficiency performance contracting in Hungary, Poland and the Slovak Republic, and to examine any barriers that might exist to fostering an energy service company (ESCO) industry in each country. More specifically, the key institutional and economic elements needed for the growth of a successful performance contracting industry in the three nations were examined. Also investigated were the types of energy efficiency investments that would be attractive to energy service companies (ESCOs) and the specific market segments that might interest ESCOs.
To assess these conditions, the investigation involved a literature search and interviews with more than 120 individuals representing; (1) ministries in the three countries, (2) segments of the power sector, (3) foundations and companies dedicated to energy conservation, (4) environmental concerns, (5) private companies, (6) financing sources, and (7) where possible, ESCOs. An attorney was also interviewed in each of the three countries. A list of those interviewed and their respective positions/affiliations is presented in Appendix A.
While conducting the interviews, the opportunity was also used to explain performance contracting and to acquaint the interviewees with its potential benefits to the country, the economy and the environment.
The reader is cautioned that economic and political conditions in the three nations studied are constantly evolving and the findings presented herein offer only a "snap shot" of the situation as it appeared in Poland in July 1994, Hungary in September of 1994. and Slovakia in March 1995. Furthermore, the research was limited to those areas believed to have an impact on the advent of an ESCO industry. The ideas presented here are based in large measure on the perspectives of those interviewed. Even though a broad range of persons were interviewed, they did agree on many important points. There were, however, differences in data provided as well as disagreements as to implications of that data.
This report is a condensed version of the three individual country reports. Section 1 of this report offers a brief overview of performance contracting and a history of the ESCO industry. Mention is made of emerging interests in other areas of the world, including activities in other Eastern European countries, as well as the growing interest of multi- national development banks in this concept. It is followed by a brief description of the lessons learned by ESCOs in the West, especially problems incurred during the evolution of the performance contracting industry, which could have implications (or pose problems) for performance contracting as it develops in Hungary, Poland and/or Slovakia. Section 2 highlights the elements key to successful performance contracting and addresses country- specific findings relevant to those points. Sections 3, 4 and 5 offer summaries of the economic, political and energy, financial conditions in Hungary, Poland and Slovakia, which are key to effective energy efficiency and performance contracting. Section 6 offers some recommendations as to ways an ESCO industry in the three countries might be fostered.
The research leading to this report was conducted by Kiona International under a contract to ICF Resources, a primary contractor to the U.S. Agency for International Development. The document was prepared by Dr. Shirley Hansen, Kiona International, Inc. Research and report material related to financial conditions in Poland and Hungary were prepared by Mr. Thomas Sherwood, International Resources Group.
The authors wish to express their appreciation and gratitude to those who were interviewed and shared their insights into some complex problems. We would especially like to acknowledge our indebtedness to Mr. Marian RutSek of Slovakia, Mr. Andras Morenth of Hungary and Mr. Andzrej Czyz in Poland, who served as excellent mentors and guides, throughout the interview process. Their perceptions and perspectives were extremely valuable in the preparation of this report.
The content of this report rests on the perceptions of the researcher and should not be attributed to those interviewed, the governments of Hungary, Poland and Slovakia, or other identified sources unless cited through direct quotation. Any mention of products, companies or procedures should not be construed as a favoring, or as an endorsement, explicit or implied, by the authors, Kiona International, IRG, ICF Resources, or US AID. The observation, conclusions and recommendations are solely those of the authors and do not necessarily reflect those of ICF Resources or US AID. SECTION 1. PERFORMANCE CONTRACTING
Performance contracting could enable Hungary, Poland and Slovakia to enhance their economies improve their environment; and do so out of funds now being spent on wasted energy. As these countries seek to bring energy prices closer to supply costs, performance contracting could reduce some of the potential social and economic dislocation caused by higher utility bills. In the process of providing energy efficiency services and financing to industry, commercial, public housing sectors, performance contracting can offer exciting business opportunities for the in-country energy service industry, increase employment as well as offer clear advantages for a customer that chooses to cut operating costs through private sector energy financing and services.
Performance contracting allows the customer; e.g., a school, hospital, state agency, commercial business or an industry, to use future energy savings to upgrade facilities and cut operating costs now. Many organizations in the three nations studied are using more energy than they need to, but they lack the financing and/or the expertise to keep the money now being spent for wasted energy. The money, through performance contracting, is made available to the owner/operator of the facility. Energy savings are guaranteed to equal or exceed the cost of the changes needed to achieve those savings.
The energy service company (ESCO), which identifies energy saving opportunities in the customer's building, equipment and/or industrial processes. The ESCO then implements those measures approved by the owner at no initial cost to the owner, maintains the measures for the life of the contract and pruarantees the energy savings. An ESCO provides the engineering services and acts as a construction manager. Through the life of the contract, the ESCO monitors the savings, maintains the installed equipment and serves as an energy efficiency partner to the owner/operator.
A key service the ESCO performs for financial starved organizations is project financing. The ESCO may use its own funds; or it arranges the financing from a broad range of sources, including utilities, commercial banks, or special funds such as pension funds or environmental funds. Since the ESCO guarantees the money for repayment of the loan, risks to banks are reduced and money from funds are leveraged to serve additional purposes.
The purpose of the performance contracting feasibility study in Hungary, Poland and Slovakia was to assess the potential opportunities and barriers to this energy efficiency financing approach. With the help of many political and energy leaders, the potential for energy performance contracting in the country was explored, specific opportunities identified, problems associated with this approach were determined and possible resolutions examined. This report offers a "snap-shot" of such conditions as they existed in Poland in July 1994, in Hungary in September 1994, and Slovakia in March, 1995. PERFORMANCE CONTRACTING IN RETROSPECT
In the late 1970s, Scallop Thermal, a division of Royal Dutch Shell, introduced the concept in North America of using third party financing to improve energy efficiency and cut operating costs. Scallop offered Hanneman Hospital conditioned space for 90 percent of its current utility bill. By upgrading the mechanical system and implementing energy efficient practices, Scallop was able to bring consumption well below the 90 percent level. Scallop paid for its services and made a profit from this difference.
As energy prices continued to climb, the idea of using future energy savings to upgrade facilities and cut operating costs became even more attractive.
In its early stages, the energy financing agreements generally turned on each party receiving a percentage of the energy cost savings. The ESCO received a share to cover its costs and make a profit. The owner also received a share (as well as capital improvements) as an incentive to participate. Since each party received a share of the energy cost savings, this procedure became known as "shared savings."
During the life of the contract, the ESCO expected its percentage of the cost savings to cover all the costs it had incurred, plus a profit. This concept worked quite well as long as energy prices stayed the same or increased.
In the mid-1980s, energy prices began to drop. With lower prices, it took longer than predicted for the firm to recover its costs. Some firms could not meet their payments to their suppliers or financial backers. Companies closed their doors; and in the process, defaulted on their commitments to their shared savings customers. Some suppliers tried to recover costs from the building owners. Lawsuits were filed and "shared savings" was in trouble.
Other troubles also plagued the industry. The concept was sound, but the trust, so essential to a contract based on uncertain future savings, was seriously weakened. Fortunately, some agreements continued to show savings benefits to both parties. Of even greater importance, some companies had guaranteed the savings and they made good on those guarantees.
From this tenuous thread, the "shared savings" industry survived, but its character changed dramatically. Those supplying the financial backing and/or equipment recognized the risks of basing contracts on future energy prices. Higher risks meant higher interest rates, if the money was even available. Insurance that had been available to ESCOs for "shared savings" almost disappeared. By 1983, shared savings agreements had shrunk to approximately 5 percent of the market.
Different financing mechanisms also emerged, but nearly all of them offered energy savings guarantees. Shared savings as a financing mechanism still existed, but its appeal was limited. Instead, the guarantee centered on the reduction in the amount of energy consumed and the dollar savings calculated at current billing rates. Typically, the projected dollar savings were guaranteed to cover any of the associated debt service obligations of the owner. To avoid the risks associated with falling energy prices, ESCOs began setting an energy floor price below which money guarantees would not apply.
The initial attraction to performance contracting was the financing help. Through the years, the ESCO expertise has become equally attractive. For example, a survey of school administrators in the United States as recently as 1988 found that the majority still thought work on the building envelope; e.g., added insulation, double glazing of windows, etc. was the most cost-effective energy saving measures to take. As shown in Figure 1-1, a U.S. Department of Energy analysis showed that building envelope measures average the longest payback (over eight years) of those measures studied. In contrast, control measures paid back in roughly two years. In attempts to cut energy costs, school administrators were not investing money in the most effective place ... instead, they were waiting eight years to get the return on investment that they should have achieved in two years.
COST-EFFECTIVENESS OF ENERGY EFFICIENCY MEASURES
CONTROLS VENTILATION HEATING WAC COOLING LIGHTING ENVELOPE OTHER 0 2 4 6 8 10 PAYBACK IN YEARS U.S. Department of Energy, 1989
FIGURE 1-1. COST-EFFECTIVENESS ANALYSIS FOR BUILDINGS
ESCOs have learned, sometimes at great expense, what works. And what doesn't!! The earlier temptation to invest in elaborate control systems, for example, no longer exists. Today, ESCOs know exactly how sophisticated a system should be in a given facility -- right down to the number of sensing points and control points that are really needed. That expertise can keep owners from investing valuable money in the wrong measures. Today, performance contracting has matured into a viable and reliable way of doing business in North America and many countries throughout the world. In the United States and Canada, federal law allows, even encourages, federal agencies to use performance contracting to cut operating costs. Nearly 4,000 U.S. school systems have some type of performance contract, and these school systems have a many as 800 buildings. Major manufacturers of energy-related equipment have ESCO services and divisions, utilities have developed or acquired ESCOs, and many regional ESCOs have grown from engineering firms, distributorships and mechanical contractors. It is conservative to say that in the United States there are at least ten major national ESCOs and another 30-35 operating on broad regional bases.
In 1994, the International Energy Agency went on record at the Conference on Energy Efficiency in Latin America to support and encourage the ESCO industry. Some version of guaranteed energy savings is now being practiced in France, Germany, Sweden, Spain, Italy, etc. Some ESCO activity is reported in Poland and the Czech Republic has two projects underway. The multi-national banks are increasingly supportive of the energy service company industry. The World Bank conducted a roundtable in September, 1994 to explore the energy efficiency opportunities and assess the viability of creating criteria to foster an ESCO industry in a country as a condition of receiving a World Bank loan. PHARE has begun funding performance contracting in countries, which formerly had command-and-control economies.
TYPICAL ESCO SERVICES
Through the years, ESCO services have become more varied. It has become a customer- driven industry and the customer typically has a selection of ESCO services from which to choose. Services offered by an ESCO usually include:
a facility audit to identify energy and operational savings opportunities;
financing from its own resources or through arrangements with banks or other financing sources;
the purchase, installation and maintenance of the installed energy efficient equipment; possibly maintenance on all energy consuming equipment;
new equipment training of operations and maintenance (08rM) personnel;
training of O&M personnel in energy efficient practices;
8 monitoring of the operations and energy savings, so reduced energy consumption and operating costs persist; and
a guarantee of the energy savings to be achieved.
The popularity of performance contracting rests on the many benefits it delivers. The highlights of the benefits it offers a country, a business offering such a service and the customer are addressed below.
COUNTRY BENEFITS
When private sector energy efficiency financing is used in a country, the benefits include:
reduced reliance on external energy resources, and a reduction in the associated negative impact on balance of trade;
reduced demand for financing power supply investments;
opportunities to upgrade facilities using current and future monies now spent on wasted energy;
an improved economy, which cuts operating/production costs and increases the country's economic competitiveness;
B increased industrialization without concomitant increases in utility generating capacity;
increased employment while reducing the needed capitalization for the same quantity of energy; i.e., an unpublished U.S. Department of Energy study of Russian conditions showed that providing the same megawatts through energy efficiency creates five times as many jobs as producing this energy with only one-eighth the capital investment;
environmental improvement without incurring the costs usually associated with such efforts. In fact, energy efficiency through performance contracting can significantly reduce pollution emissions, such as COz, SO, and NO,, while it "makes" money; and
I a local energy service industry can be created. Using successful ESCOs in primelsub or joint venture with in-country partners has already proved to be an excellent means of technology transfer while creating additional businesses and employment opportunities in the developing country. BENEFITS TO IN-COUNTRY BUSINESSES
An in-country partner, as a joint venture partner or as a subcontractor, is critical to an effective project for foreign ESCOs. The in-country partner brings to the effort the essential knowledge of the culture and how to do business in that culture. A successful ESCO brings risk management experience as well as technical, financial and contractual knowledge. It is proving to be a successful partnership for all parties.
The ideal in-country partner is a designbuild "mechanical contractor," who has heating, ventilation, air conditioning (HVAC), electrical and other related turnkey capabilities, along with experienced project managers to manage the implementation of the projects. In some instances, thermal energy saving expertise and/or a knowledge of industrial process are also important capabilities. An understanding of the financial benefits of energy efficiency is important. Good political connections to enhance marketing efforts, secure the necessary support and/or speed up contract negotiations with large industrial, institutional, and/or commercial customers are also important. The in-country partner should also have experience in the procurement of equipment on an import basis in order to access the current technologies available for energy conservation outside of the country.
The benefits to an in-country partner are substantial from a short-term financial perspective and long-term growth. Offering performance contracting services to its existing customers would allow the in-country partner to provide improved customer relations and expanded services, which includes installing major capital improvements in the customer's facilities at no initial cost to the customer. Performance contracting allows the in-country partner to posture itself into a long-term leadership role by providing its customers with new innovative services, which neither the company nor its competition have previously provided.
From a financial perspective, performance contracting provides a significant positive cash flow benefit to the partner's existing company by creating a substantial amount of business through services without the need for it to acquire any of the significant additional overhead usually associated with increased inventory or greater processing needs. This business growth not only comes from "old" customers, but comes from a "new" customer base.
A third major benefit to the partner, which is a financial benefit, is the fact that no additional fixed resources will have to be obtained in order to implement the performance contracting program. An existing foreign ESCO can provide all support and resources necessary including technical personnel, legal contracts, marketing and performance contracting procedures and methodology to ensure that the program is properly implemented and that project performance risks are reduced.
To summarize, whether an organization chooses to develop its own business, serve as a subcontractor or become a JV partner, performance contracting offers an in-country firm the opportunity to: rn sell to customers who have limited financial resources;
m serve existing customers better;
increase business -- with limited investment;
make more money selling savings and service (than just products);
keep personnel employed;
demonstrate confidence in products and service;
hold down energy costs; and
increase the company's competitiveness.
It also offers businesses an opportunity to serve the country's environmental needs. Energy efficiency is essentially environmentally benign. It is a very cost-effective way to reduce air pollution. Fortunately for all concerned, the avoided utility costs will typically pay for all these benefits.
CUSTOMER ADVANTAGES
The in-country recipient of ESCO services can achieve many business/organizational benefits, including:
rn an immediate upgrade of facilities and reduced operating costs -- without any initial owner investment;
access to the ESCO's energy efficiency expertise. Through savings guarantees, ESCOs have learned from experience just how effective specific energy efficiency measures are under certain conditions and how soon they can pay for themselves;
rn positive cash flow -- most projects generate savings that exceed the guarantee;
the opportunity to use the money that would have been used for required upgrades to meet other needs;
improved and more energy efficient operations and maintenance; normal customer risks are taken by the ESCO, including the guaranteed performance of the new equipment for the life of the contract (not just through a warranty period);
a more comfortable, productive environment; and
services paid for with the money the customer would have paid the utilities for wasted energy.
Performance contracting is probably the best and quickest way to be sure an organization is operating as efficiently as possible. It offers the customer a risk shedding opportunity. The only true risk the customer incurs is finding the right ESCO partner and obtaining a contract that best meets the customer's needs.
LESSONS LEARNED IN THE WEST
The performance contracting concept is simple and the advantages to all parties easily documented. The process, however, is relatively complex. As the industry developed in the west, costly mistakes were made. The potential exists to make many of these mistakes in Slovakia. Some serious mistakes that ESCOs have made that might happen to a developing ' ESCO industry in Slovakia are discussed below.
FREE AUDITS
In their enthusiasm to demonstrate potential savings and the value of what they were offering to customers, ESCOs initially offered potential customers an audit and report at no cost. After expending their time, services -- and money -- too many ESCOs found their audits sitting on a shelf or being given to the owner's friend down the street to implement. Sometimes the owner would look over the report and then comment, "This looks good, but I don't see why we can't make these changes ourself."
Increasingly, ESCOs are stressing that they are in the business of doing projects; not audits. Some agreement expressing owner intent is now typically entered into before the comprehensive audit is performed. A growing number of ESCOs charge for an audit -- and some even add a premium -- if the project doesn't go forward.
TOO MUCH; TOO SOON
Convinced of a good thing, many ESCOs historically spread themselves too thin. They attempted to service too large a geographical area, and/or tried to be all things to all people. Gradually, painfully, they recognized that they needed to specialize in certain market segments, such as hospitals, and to specialize in implementing certain types of measures. They also learned to confine themselves to a doable service area or developed qualified local partners, such as an equipment distributor, to provide maintenance and/or emergency response procedures. Once an ESCO became focused on what it could do best, many sought to build strategic alliances; e.g., a controls company ESCO might establish a relationship with a lighting company.
Others tried to move ahead too fast and became over-extended. As the wise, increasingly grey-haired leaders of the U.S. ESCO industry can attest, performance contracting is front- loaded with risk. These performance contracting leaders will also describe how they eventually learned that performance contracting is essentially risk management; and they conclude, "If you want to stay in the business, you don't take on more risk than you can manage."
GETTING AN ACCOUNTABLE ENERGY ENGINEER
In the 1970s and early 1980s, a stark lesson was learned: all engineers are not energy engineers. Textile engineers, for example, were not apt to understand ways to increase energy efficiency in an office building. Similarly, as the 1980s moved into the 1990s, ESCOs learned that energy engineers, who were not typically held accountable for predicting potential savings of specific measures in specific applications, could cost them a lot of money.
Performance contracting requires a new level of technical competence. ESCO engineers must be able to calculate all the implementation costs and the potential savings; thus, providing an accurate guide to the cost-effectiveness of each measure and a project -- a prediction the ESCO can, and must, bet money on. This presents a new level of risk assessment and a careful appraisal of administrative commitment and operations and maintenance capabilities. The "people" assessments must be factored into cost-effectiveness calculations of measures; i.e., over the typical performance contract extended time frame, consideration must be given to how much affect people will have on controls, windows, etc. Other factors, such a the predicted life of light bulbs, also become critical concerns. ESCO engineers must be held accountable for their predicted costbenefit analysis. This requires the ability to assess organizational commitment, as well as O&M manpower capabilities, training needs and potential project support.
COST-EFFECTIVENESS
Performance contracting is primarily a long term financial transaction and requires the ability to calculate the cost of money over time. Engineers calculating cost-effectiveness must understand the impact of inflation on current money rates, the function of discount rates (to offset the opportunity value of the money), and interest rates if they are to calculate potential savings benefits.
Current economic and political conditions in transition economies make it difficult to predict future energy prices with any certainty.
UTILITY ROLE
Once the utility industry in the United States became aware of the performance contracting industry, it became apparent that they could have a major impact on the growth of the ESCO industry. Utilities can impede, enhance or remain neutral regarding such growth. If the utility looses revenue when its customer makes energy efficiency improvements, there is a disincentive for utilities to support such efforts. If there is no clear benefit or loss, utilities may remain neutral. When the utility actively pursues demand-side management (DSM) and/or is offered a means of off-setting lost revenues, utilities can enhance the growth and have a profound impact on the shape of the industry. After an uneasy beginning, the utilities and ESCOs in the west have established an effective working relationship and a major portion of the utility DSM efforts are now performed by ESCOs.
UNDERESTIMATING THE KEY ROLE MANAGEMENT AND OCCUPANTS HAVE, ESPECIALLY O&M STAFF
In the early days, ESCOs so thoroughly convinced management of the value of their services that many owners took a rather passive role. It soon became apparent that the level of savings was frequently determined by the commitment of management, occupants, operators and maintenance (O&M) personnel. While the absence of management commitment is critical, the greatest deal breakers can be O&M personnel who feel threatened, do not understand how the project can help them do their job more effectively, or who do not feel appreciated. O&M staff can easily ruin the best designed project in the world.
A related mistake was not providing sufficient training for the O&M staff, both on the newly installed equipment and on other energy consuming equipment. A U.S. Department of Energy study of effective energy programs in schools and hospitals found that up to 80 percent of the savings could be attributed to energy efficient O&M practices. But these savings require training.
THE VITAL COMMUNICATIONS LINK
In its early days, projects were treated more like direct sales; not long term partnerships. The contract was signed, the equipment installed and the bills were sent once a month. No further personal contact was planned and projects without this interaction usually suffered. Effective partnership always requires effective communication. When money is involved it becomes critical. ESCOs with high customer satisfaction have a planned communication strategy throughout the contract. SECTION 2. KEY INSTITUTIONAL AND ECONOMIC ELEMENTS
Through the years it has become increasingly obvious that specific elements are valuable to effective performance contracting. Some issues are absolutely crucial from the very first consideration of a potential customer. Elements may pertain to the country or localities' economic, political and social conditions. Others pertain to technical considerations and the customer's credentials.
Indented inserts in the following discussion offers brief synopses of conditions pertinent to the cited key elements for each country.
COUNTRY CONDITIONS
The potential for an energy service company (ESCO) industries in Hungary, Poland and Slovakia are significant. A number of factors all speak to tremendous opportunities on the horizon. Particularly indicative are high energy intensity levels (1.16 to 1.78; expressed in energy per GDP),' with even higher industrial energy intensities in some instances, and a rather heavy energy cost burden on the government.
Performance contracting extends over several years, and the ESCO expenses are heavily front loaded; therefore, political and economic stability of the country can determine whether or not further consideration is even given to performance contracting. If conditions are relatively stable and moving toward greater stability, then other issues are examined.
POLITICAL & ECONOMIC ELEMENTS
POLITICAL STABILITY. The general stability of the government in place is a critical screening factor. A country with a high turn over in parties in power and associated dramatic changes in economic, financial, or banking procedures as well as energy prices, can discourage any long term contracts, especially performance contracts that carry private sector guarantees.
Hungary: Since 1990 parliamentary democracy has been securely established in Hungary. At the end of 1994, one multi-national development bank stated that "Hungary has excelled itself in eastern Europe ..." with reference to its internal political stability.
Ton of oil equivalent/$1,000 (US$1987). Many areas of the world; e.g., Latin America, Africa, Middle East and Southeast Asia are around 0.5. Source: IEA, World Energv Outlook, 1994 Edition. Poland: While the process of privatization has slowed since the 1993 change in administration, it is moving forward. The political situation is relatively stable. ESCOs need to consider potential unrest due to 16 percent unemployment and the associated reduced living standards for a major portion of the population.
Slovakia: There is evidence of movement toward a market economy with the current MeEiar administration, but careful observation and some caution are warranted. Moves away from privatization must be carefully monitored.
ECONOMIC STABILITY. Closely associated with political stability are national economic conditions. Matters that impact on longer term contracts, such as inflation and interest rates, are particularly key.
Hungary: With the change in administration as of July 1994, questions regarding economic changes also emerge. As of September, 1994, the new government had not shown any significant changes in privatization plans.
IMF's October 1994 report characterized the country as relatively stable. The interest and inflation rate trends have been good but may rise. As an indicator of economic stability, IMF reported that inflation had dropped from 35 percent in the early 1990s to 18.9 percent by September 1994. Replacing a turnover tax by a VAT during this period is deemed partially responsible for the current level of inflation. Interests to consumers range from 32 to 36 percent. The difference from the interbank interest rate of 19.9 (14-30 day maturity) is largely attributable to the bad debt load carried by banks.
The price of electricity had not changed since 1992. At the time of the field research, dramatic increases were e~pected.~There is apt to be some negative reaction to increased energy prices when there has not been a commensurate increase in wages.
Heating energy for buildings is sold by cubic meter (m3) and prices are set by local municipalities. The shift from m3 to petajoules by installing meters appears to be a cost-effective measure.
Key considerations: scheduled increases in the cost of electric and heating fuels to "real" cost by the end of 1996 will make more measures attractive. In September 1994, there was strong evidence that the present utility leadership at MVM will resist energy efficiency effort^.^
See Appendix C for prices scheduled for implementation in January 1995.
Since the Fact Finding Mission, MVM Rt. leadership has changed. Poland: Real interest rates are typically considered to be the going interest rate less the inflation rate. Under this procedure, the Polish interest rates of 38 percent with an inflation rate of 30.8 percent in mid-1994, would yield a real interest rate of approximately 7 percent. This interest rate by itself is attractive. If, however, we use an approach that adjusts for the time value of money under high or volatile inflation rates, the real interest rate is even more attractive (currently a 5.5 percent interest rate).
The trend in inflation rate in Poland has dropped from 44.3 percent in the early 1990s to 35.3 percent in 1993 and has now reached roughly 31 percent in 1994.
Slovakia: In March 1995 the Slovakian banks' interest rates were 16-20 percent with an inflation rate of 12 percent, which yielded a real interest rate in the 4-8 percent range.
The inflation rate and interest rate are relatively attractive in Slovakia compared to most of Eastern Europe, however, the rates are still high for EPC and off-setting economic conditions are needed.
FINANCIAL FACTORS. The condition of the banking industry, its ability to make longer term loans and its flexibility to adapt to new contract provisions are all critical factors in financing a broad ESCO industry.
Hungary: In some respects, Hungary appears to be close to plan with its financial strategy. In other areas, they seem to be losing ground. Banking has not reached the sophistication of the West, but terms and conditions are gradually improving. Interest rates remain high and act as a deterrent to all but the shortest paybacks among energy efficiency measures.
In January 1992, the Law on Commercial banks imposed on the Hungarian banking system the Basle-defined standard for capital adequacy. Movements to contain the country's budget deficit claims large sums of credit from the central bank; leaving little for the private sector.
Poland: At present, loans carry "floating" interest rates, which makes them very unattractive for long term contracts.
Poland appears to be on plan with its financial strategy. Foreign debts are down and being further reduced. The deficit is within agreed IMF limits. The interest and inflation rate trends are good. Banking has not reached the sophistication of the West, but terms and conditions are improving. The growth and stability of domestic banking is crucial to long-term growth of a broad-based ESCO industry in Poland. Slovakia: The banking industry in Slovakia is not strong, but some indications of slow growth are evident. Loan terms exceeding five years are available.
In all three countries, the commercial banks do not have sufficient understanding of the EPC process, or the capability to support an ESCO industry. Environmental funds and financial support from multi-national development banks will be necessary to support EPC in the immediate future.
MONETARY FACTORS. The level of foreign investment by ESCOs and their financiers will also be dictated by currency convertibility, who carries the conversion risk, and conditions of repatriation.
Hungary, Poland and Slovakia: Duties, taxes and other monetary factors need careful assessment by ESCOs. Suggested exemptions and forgiveness options, such as those offered by the Hungarian Ministry of Industry and Trade could be very beneficial. They will, however, require time and an in-country presence to maximize such benefits.
Hungarian forints and Polish zlotys are convertible. The Slovak koruna (or crown) is not fully convertible. Slovakia reportedly has inside-country convertibility when accompanied by the appropriate documentation; e.g., an invoice.
ENERGY EFFICIENCY AS AN INVESTMENT. To sell the economic benefits of performance contracting, political decision makers, energy leaders and those who own and/or manage facilities and industries must view energy efficiency as an economic benefit.
Hungary, Poland and Slovakia: The heritage of a command-and-control economy tends to overlook economic assessments in the energy field. Common practice in all three countries is to discuss the investment costs in forints, korunas or zlotys, but calculate the savings in joules -- even with commercial bank loans.
THE POWER SECTOR. The structure of the power sector; i.e., generation, transmission and distribution; how tariffs and energy prices are set; and how they are controlled 7- - influence the utility's position toward energy efficiency and associated revenues. If a utility stands to lose revenues, it is apt to resist energy efficiency. This, in turn, can impact the profitability of any ESCO activity.
An ESCO industry that can be supported by the utilities will grow more readily. The status of demand-side management (as the term is used in the United States) and the opportunity for integrated resource planning are important indicators as to the degree to which the utilities are apt to facilitate performance contracting.
Hungary: The organization of'the power sector is still evolving in Hungary. A tariff strateg that rewards each entity in the power sector chain for supporting energy efficiency will greatly enhance the opportunity to achieve the maximum Hungarian energy and environmental benefits.
Poland: The government's tariff structure sets prices to distributors as well as the amount they will receive from customers. The distributors lose revenues when customers make energy efficiency improvements.
Slovakia: Slovenski5 Elektrirne (SE), the national electric utility, adopted the concept of demand-side management in 1992 and has worked closely with the Canadian Power Smart organization. With the restructuring of the power sector in 1994, SE became a joint stock company. SE is considering becoming an ESCO.
SE sells electricity to 3 distributors and 4 industries. Due to rate structures, the distributors have an incentive to support energy efficiency in public housing, but not in industry.
ENERGY & ENVIRONMENTAL ELEMENTS
Marketing potential for an ESCO industry are frequently revealed by a country's consumption patterns and its energy intensity (energy consumed per gross domestic product). How these factors compare to other countries as well as within a sector in the country are key concerns.
The level of understanding of the benefits energy efficiency can deliver to the environment will affect the support, acceptance and, often, the funding ESCOs can receive.
Hungary: 29 percent of Hungary's population lives in "severely polluted" areas and another 24 percent live in "moderately polluted" areas. The government is well aware of it. Its actions and financial support indicate a strong will to do something about it. There seems to be, however, only limited recognition of the great value energy efficiency can contribute to the environmental effort -- as a mitigating strategy and a financial resource.
Hungary's industries consume a disproportionate amount of energy1GDP. They offer excellent opportunities to address environmental concerns as well as energy efficiency. Due to a history of artificially low energy prices (which are now being raised), energy savings opportunities are excellent across the country.
Poland: Poland is the highest consumer of energy in the region with the highest energy intensity/GDP. As part of its "shock therapy," energy prices were raised early in the 1990s. Savings opportunities are excellent across the country. Poland is an environmental catastrophe and the government is well aware of it. Actions and financial support indicate a strong will to do something about it. Like Hungary, there is only limited recognition of the great value energy efficiency can contribute to the environmental effort -- as a mitigating strategy and a financial resource.
Slovakia: Slovakian energy consumption is relatively high in all sectors. Energy intensity is more than twice most areas of the world.
The representative of the Ministry of Environment, who was interviewed, has an excellent understanding of the relevance energy efficiency has to the environment.
CUSTOMER ELEMENTS
The energy and cost savings opportunities by market sector and by individual enterprise is of great interest to potential ESCOs, but careful customer evaluation by effective ESCOs doesn't stop there.
ABILITY TO KEEP SAVINGS. The performance contracting process must benefit the customer. The customer must be allowed to keep some of the energy cost savings or materially benefit in some other fashion from ESCO efforts. If, for example, the major benefits, such as positive cash flow, go to a central fund, history has shown that the critical customer support for the project is lacking. There also must be a revenue stream that can be accessed; or a way to establish some financial structure so the ESCO can be paid.
Hungary, Poland, and Slovakia: In all three countries, there are sectors which have no, or very little, in-house economic incentives to save energy; e.g., schools and hospitals in Hungary, cannot keep the savings unless specifically allowed to by the municipalities. In this instance, communities can keep savings and become the administrative unit of choice for ESCOs.
The need for facility upgrades/comfort concerns are considered by many to be sufficient incentives to garner in-house cooperation and support from schools and hospitals, even if communities keep the savings. Such incentives, however, may be of short duration as occupants come to accept the improvements.
At the present time, public housing customers in Slovakia cannot keep their savings. If the "experiments" in heating savings-based projects in Banskh Bystrica and Malacky show the value of energy cost savings incentive to customers, it is expected that the law will change. Industry can keep its savings; and, therefore, benefit from performance contracting. CREDITWORTHINESS. The potential customer must be able to exhibit a degree of creditworthiness as well as organizational and financial stability.
Hungary: While there is a growing number of privatized firms and state organizations with strong organizational stability, this area must be researched on a case-by-case basis.
Poland: While privatization is being effectively implemented in some sector and state organizations usually show strong organizational stability, this area must be researched on a case-by-case basis. Potential repatriation problems have to be carefully scrutinized.
Slovakia: Foreign ownership in Slovakian companies is surprisingly high and often adds to organization stability. Creditworthiness must be checked carefully on a case by case basis. Uncertainties related to changing privatization programs must be considered.
In all three countries, there customers which have the present ability to honor financial obligations but have a weak credit history. In these instances, some version of shared savings, which allows the ESCO to carry most or all of the credit burden, may be a viable alternative.
MANAGEMENT COMMITMENT. In addition, experience has shown that successful projects require that top management demonstrate a commitment to the project and that there be some commitment in middle management as well as facility and process supervisors.
Hungary: As always, ESCOs must assess each organization, but the general eagerness in Hungary to move to a market economy and to upgrade facilities without any upfront cost will help. Despite a history of price controls, energy costs are a key factor for management in considering operating costs. Management is increasingly aware of the energy factor due to the projected rapid escalation of prices. Stressing the benefits of energy savings in monetary terms must be stressed.
Poland: Polish managers also display a general eagerness to move to a market economy and to upgrade facilities without any upfront cost. Management is very aware of the energy factor due to the rapid escalation of prices in the last five years. Energy costs are a key factor for management in considering operating costs.
The relationships between management and occupants in cooperatives has not been clearly established, wherever energy decision-making and cost/savings sharing is involved. Conditions have not been established as to the occupants' legal opportunities and responsibilities.
Slovakia: The limited application of economic analysis of energy efficiency in Slovakia will require special education/selling for top management. Extra effort will be required if they are to fully appreciate the financial benefits of performance contracting as well as the permanent financial loss when energy work is delayed.
O&M STAFF. O&M personnel are especially critical to project implementation and long term success. Their attitudes, level of manpower and technical capabilities must be carefully assessed.
Hungary, Poland and Slovakia: As in many hard-pressed countries, skilled 0&M manpower may be in short supply. In many instances, ESCOs will need to supplement existing manpower. Energy efficiency capabilities are limited. Training in energy efficient practices will be essential in almost every case, and should be a planned component of every EPC.
General attitude is good. O&M people know they have problems and will frequently share their frustrations about existing mechanicals in their buildings. The defensive attitude that frequently needs to be over-come in the United States is not prevalent.
BUILDING AND EQUIPMENT CONDITIONS. The condition and longevity of the building and its equipment must be weighed. Current function patterns and the likelihood that they will persist in the same fashion must be taken into account.
Hungary, Poland and Slovakia: While some new construction has taken place in recent years, most buildings are old and many are in desperate need of upgrades. Infrastructure and buildings are frequently in need of major upgrades. Even relatively new equipment may be technologically "outdated" and inefficient.
Performance contracting can help meet these critical needs, but care must be taken to be sure existing energy-related equipment will function as needed, and to ascertain that the facilities warrant the required investment and mechanical conditions can support the measures being considered. HVAC controls, for example, may appear to be a viable measure, but old boilers may not be in a condition to duty cycle -- or much else. Paybacks for boiler work may go beyond the limits of current financial parameters, which could then rule out the related control work.
CUSTOMER ACCESSIBILITY. The ESCO must judge the geographical and logistical accessibility of a given enterprise, and the extent to which this causes an administrative burden. This burden must then be weighed against the economic opportunity.
Hungary, Poland and Slovakia: Major needs and opportunities exist in urban centers, but many smaller towns may not offer economically feasible opportunities. TECHNICAL CONSIDERATIONS
In-country abilities to perform technical, financial and legal services are always a key concern, they become paramount for foreign ESCOs.
Hungary, Poland and Slovakia: There is no need to address the individual disciplines of engineeringltechnical, financial and legal needs as they pertain to performance contracting in any of these countries. Suffice it to say that better understandings and training needs are great in every area, and in every country. The work of those trained under the USAID program can help guide this development.
The legal, engineering and financial talent is there and willing to learn. In-depth training seminars would offer valuable support to the growth of the ESCO industry. Effective demonstration projects would be helpful.
The above concerns are discussed in more detail in Sections 3, 4 and 5, which presents the political, economic, energy and financial conditions for Hungary, Poland and Slovakia respectively. SECTION 3. HUNGARY
ECONOMIC, POLITICAL, ENERGY AND FINANCIAL CONDITIONS GERMANE TO ENERGY PERFORMANCE CONTRACTING
Performance contracting by its nature extends over several years and carries with it many uncertainties. Energy service companies (ESCOs) and their financiers invest heavily at the beginning of energy performance contracts. To have a viable project, they must have some assurance that they will get that money back out -- and show a profit for their efforts. When performance contracting is contemplated in transitional economies, the very nature of performance contracting (its dependence on recovering energy cost savings over time) requires that factors, such as political and financial stability of the country, must be carefully weighed. To the extent that the ESCOs, or the financing source, are foreign, then the convertability of the currency and the ability to repatriate the funds are also key.
This section presents factors related to the broad political, economic and financial stability of Hungary as well as a brief overview of the energy situation. It is designed to help both domestic and foreign ESCOs as well as policy-makers, who would like to foster a Hungarian ESCO industry, consider these conditions. This section concludes with a discussion of financial and business issues, which can directly affect the growth of an ESCO industry in Hungary.
The economic/political status is presented as of September, 1994 and some trends key to performance contracting are also offered. A few critical events relevant to this work, which have transpired since the field research was conducted in September 1994, are referenced in footnotes.
MACROECONOMIC/POLITICAL CONDITIONS IN HUNGARY
Clearly, Hungary remains committed to and respects the principles of democracy, pluralism and market economics. Since 1990, parliamentary democracy has taken strong root in Hungary. The national elections held in Hungary in 1990 and 1994 were reported open, free, and fair.
According to a multi-national development bank, "Hungary has excelled itself in eastern Europe by its internal political stability over the past four years." The elections of 1994 led to the creation of a coalition government, dominated by the Hungarian Socialist Party (HSP), which won 209 of the 386 seats in the Parliament. The Alliance of Free Democrats, with 70 seats, is the HSP's coalition partner.
ECONOMIC "SNAPSHOT" AND APPARENT TRENDS; SEPTEMBER 1994
Hungary began its move toward a market economy in subtle ways over a decade ago. Its efforts to mix market strategies with a command-and-control economy led to the popular description of its economic structure as "goulash communism." This less oppressive centrally planned economic environment enabled many Hungarians to envision the opportunities of a market economy ahead of their Eastern European counter-parts. It also introduced them to frustrations that could have been avoided if they had been able to move more fully into a market economy.
Fiscal policy is critical for the success of stabilization efforts, especially in transitional economies. A key aspect of fiscal adjustment in transitional economies has been the reduction of government expenditures. Hungary has been relatively successful in decreasing spending as a share of GDP, which was excessively high under central planning. Hungary and Poland, however, lag behind their Eastern European counterparts efforts to cut government expenditures vis a vis GDP. Cuts in government spending have mainly been reflected in reductions in subsidies.
Macroeconomic Prospects and Outlook
Economically, the government is striving to reduce its deficit. The focus of economic policy appears to be an attempt to reverse a swing in the current account from a surplus in 1991-92 to a deficit of about US$ 3.5 billion in 1993. One of the key causes of this swing is attributed to the loosening of monetary policy during 1992. In response, monetary policy has been tightened substantially since August 1993. For example, the interest rate on 30-day treasury bills, which exceeded 20 percent prior to September 1993, was above 30 percent in September 1994.
Changes in GDP are good indicators of a nation's economy. In Hungary, GDP growth was minimal during the 1982-87 peri0d.l The government that emerged in 1990 inherited a sick economy of stagnation, showing disturbing symptoms of a large foreign debt. And the cure has been painful. The economic restructuring and privatization resulted in old companies with outdated technologies going bankrupt and a severe decline in output. Many
The Ministry for Environment & Regional Policy. Environmental Indicators of Hun~a~y,p. lo., 1994. 3-2 government programs, even those common to market economies, were disbanded to reduce expenses.
While GDP showed healthy growth in 1991 and 1992, the Hungarian GDP leveled in 1993. The GDP for 1994 was projected by the Ministry of Finance at 1-2 percent. By mid-1994, the International Monetary (IMF) placed the annual GDP percentage change at 1 percent. Industrial production in 1993, however, rose 4 percent and showed a further 8 percent increase in the first half of 1994 (over the first half of 1993).
Government spending as a percentage of GDP has shown a decline from 40 percent in 1991 to 35 percent in 1993. GDP per capita was US$ 3,300 in 1993, which positions the country very favorably when compared to other transition economies.
In its 1994 World Economic Re~ort,~IMF grouped Hungary with several Eastern European countries and the Baltic states, stating, "Sustained financial adjustment coupled with bold liberalization has produced the macroeconomic environment necessary for the resumption of sustained growth."
The inflation rate slowed from 34 percent in 1991 to 21-23 percent during 1992 and 1993. In 1994, it hovered between 18 and 22 percent, with a September 1994 inflation figure of 18.9 per~ent.~
IMPLICATIONS FOR A BROAD BASED ESCO INDUSTRY
Many conditions that could support the establishment of an energy service company (ESCO) industry in Hungary are favorable. The specter of increasing energy prices has engendered support for energy efficiency measures throughout all levels of government and industry. The concept of third party financing is increasingly understood and appreciated. The financial environment for the establishment of an ESCO industry could become more challenging in 1995.
The ability of an ESCO industry in Hungary to grow into anything more than a small scale, short term activity dealing only in projects with very short paybacks, is limited in the short term. Presently, energy savings measures, which exceed 30 percent in savings, are required to offset the high cost of capital.
International Monetary Fund. World Economic Report, Chapter V, p. 65. October, 1994.
Monthly Bulletin of Statistics '94112. FINANCJAL BARRIERS
There are three key issues relating to financing, which create barriers to the establishment of an ESCO industry in Hungary. These are the cost of money, its availability and its term.
In Hungary money from commercial banks costs in excess of 30 percent, and is generally unavailable due to the liquidity crisis in Hungarian banks. When available through commercial banks, it is typically lent for periods of one to three years.
Conditions in Hungary are such that any domestic third party financing is not apt to be achievable on a broad basis for several years to come. The current financial situation in Hungary now cannot support such credits on a commercial basis, and the trend is towards further divergence. Multi-national development banks could help promote EPC, particularly if some of the spreads and margins now assigned (11-15%) could be avoided or brought down.
RELATED FINANCIAL ISSUES
Hungarian energy savings are typically measured in reduced gigajoules; not forints. Growing out of centrally planned economies, the problem is rooted in a misconception that physical units of output are the standard by which energy savings benefit should be measured, and from which all other analyses of benefits should flow.
This misconception has very real consequences; particularly for performance contracting, which is primarily a financial transaction. For example, the Hungarian Credit Bank, which administers a fund to finance energy efficiency measures, has established lending criteria predicated on the energy saved in joules; not the cost savings. When a company proposed a change from heavy fuel oil to gas, the bank recently turned down the loan request because roughly the same amount of energy would have been used (even though the producer would have been able to lower unit costs). Economic analyses has not sufficiently penetrated the energy efficiency market.
Another manifestation of the same problem is a failure to take into account the time value of capital when making analyses of competing investments. When performance contracting project benefits are calculated, the time required to recover the investment makes this a critical issue.
CREDIT ENHANCEMENT
In Hungary, ESCOs may have to develop their own financial sources of capital and, for the most part, use their own balance sheets to implement energy savings programs. Most entities in the country are either unable or unwilling to take on additional debt. ESCOs may need to consider shared savings, rather than the more traditional guaranteed savings approach, since shared savings allows the customer to lease equipment and avoid incurring debt.
Moreover, the standard ESCO "guarantee" of energy performance savings is not yet a "bankable" commodity in the country. Hungarian banking practices are just now coming to grips with the most basic issues of banking. Banks generally will look to secure their credit lines with hard assets covering 200 percent of the value of the credit. Performance guarantees in this setting are viewed as having little or no value as collateral.
HUNGARYS ENERGY SITUATION
Hungary's energy situation is at the heart of a number of its economic problems. Prices have historically been held artificially low, and the government continues to carry a major portion of the energy costs which are not being passed on to consumers.
At the time of the field research in September 1994, the government had just announced that energy prices would be increased by 30 per~ent.~Even with this politically difficult move on everyone's mind, it was very difficult to find out what the Hungarian government was paying for its energy bill. Nor, did they seem aware of the extent to which the government was underwriting a large portion of this cost.
This support for energy prices has placed an enormous burden on the government and contributes towards its growing budget deficit. Artificially low prices have diminished energy consumption as a concern and actually fostered energy ~efficiencies.The inefficiencies were evident on both the supply and demand side of the meter. Very inefficient hot water boilers for district heating are all too common. As a result, the economic impact of higher energy prices will be that much greater.
ELECTRIC POWER SECTOR
The dominant force in providing energy, electricity and heating, in Hungary is Magyar Villamos Miivek Rt. (MVM). In 1993, MVM described the condition of its power stations in general "as uneconomical, inflexible, ineffective and polluting the environment" when compared to Western European norms. It should be noted that the comment appeared in a report, The Stratew of MVM Rt. on Power Station Construction, in which the utility presented the case for new construction. Verbally, MVM stated that several stations were
Within weeks, the government had withdrawn this intended increase. At the end of 1994, however, legislation was passed that provided for dramatic 1995 energy price increases (as high as 60% in some sectors) starting in January. More details on the 1995 energy pricing appear in Appendix C. 3-5 only "good for museums." The proposed power station program according to MVM would cost about "HUF 550-670 thousand million" by the year 2005. Several times during an interview with MVM representatives, they asserted that given the price of energy, energy efficiency was just not economical and a more viable option was the construction of new power plants. There has been some historical opposition to energy efficiency efforts at MVM and in September 1994 mixed views on its benefits were evident.
Combined heat and power (CHP), an international term favored by the Hungarians to address cogeneration, is an increasingly attractive option; it is, however, characterized by MVM as "expensive." A representative of the Law Department for the Ministry of Industry and Trade stated that "...anybody can build [CHP] if they have a market [the grid or a group of consumers] and under specified licensing conditions.
Act No. 48, also addresses some least cost utility planning requirements. $7(l)(d) states that "The Office ... shall... enforce the principle of Least Cost against the Producer, Transmitter and Supplies of electrical energy." MVM says this one sentence requires the utility to consider energy efficiency. $22, (b) states that the "Licensee is obligated to, ...adhere to the principle of Least Cost and make data proving this available to the Office ..." Together, these statements offer the basis for some demand-side management and IRP in Hungary.
The representative of the Ministry of Industry and Trade's Law Department also observed that the electric industry is owed HUF 40 billion in unpaid bills -- approximately half from residences and half from commercial entities. With the end result that much of these costs are borne indirectly by the government.
Distribution
The six distributing companies, with their respective GWh sales, market percentages, peak loads in MW and their load factors are presented in Table 3-1.
Dr. J6sef Nemeth, General Deputy Head, Law Department, Ministry of Industry and trade. In interview, 1994. TABLE 3-1. ELECTRIC ENERGY SOLD BY POWER DISTRIBUTION COMPANIES 1994
Energy sold as Share of sales as Peak load MW Load factor total, GWh total, % (hours) ELMO 7892 26,4 1643 4803 EDASZ 6555 21,9 1115 5878 E-z 5446 18,2 980, 5557 DEDASZ 3713 12,3 746 4977 DGWZ 3241 10,8 599 5410 TIT~Z 3424 11,4 647 5292
HEATING SUPPLY
While heat generation consumes only 19.4 percent (10 percent for district heating) of the primary fuels consumption, it still requires 112 petajoules annually according to MVM's most recent figures. A breakdown of the fuels for heat supply are shown in Table 3-2.
TABLE 3-2. PRIMARY FUELS FOR DISTRICT HEAT SUPPLY
PJ % Nuclear 0.7 0.5 Gas 31.7 42.7 Oil 14.6 37.5 Coal 16.5 22.8
Of the roughly 2.2 Mtoe consumed for heating each year, about half is used in residential and communal sectors and the other half in the industrial sector. District heating is supplied by 78 district heating companies in 109 towns and communities, which supply approximately 650,000 apartments (18,500,000 m3) out of 3.9 million total. The district heating companies either purchase heat from MVMTYsplants and/or generate heat at their own heating plants.
District heating companies are no longer state-owned. Most are owned by local municipalities. In 1991, government subsidies to district heating companies totaled HUF 8.2 billion for residential consumption. Since then, prices have increased (242 percent from June 1990 to June 1991) for a cost of HUF 104.4/m3/yr. The Ministry of Industry and Trade has been continuously committed to improving heat and power production, including cogeneration. The Ministry has stated, "Billing based on metered heat consumption in residential-communal heat supply must be made widely used. This requires, in addition to the technical facilities, the development of legal and technical frame~ork."~
At the end of the 1991/92 heating season, price controls and responsibilities for the district heating systems were turned over to the municipal authorities; so prices now vary. Municipal funds are limited, as most taxing authority is held by the national government. This problem is compounded for municipalities by the network losses in the system -- estimated to be 30-40 percent.
The opportunities for ESCOs to assist municipalities in district heating and other energy matters is great. Clarification of ownership and revenue streams must, of course, precede such assistance in order to assure an economically viable project.
ENERGY SUPPLIES AND ENVIRONMENTAL IMPLICATIONS
Data reported by the Ministry for Environmental Protection and Regional Policy shows that 3.9 percent of Hungary is severely polluted where 28.6 percent of the population live; and another 9.3 percent is moderately polluted where 23.7 percent of the population live. The government and the Ministry are mindful of the health implication and are dedicated to reducing these pollution levels.
Hungary has signed several international agreements pertaining to environmental protection including the Montreal Protocol (1987), the Sofia Protocol (to reduce NO, emissions) 1988, and the Rio Framework to stabilize greenhouse gases (1992).
Money to reduce pollution emissions, which is applicable for energy efficiency measures, is available from The Central Environment Protection Fund. Raising the awareness of the close relation between increased energy efficiency and pollution reduction may be needed to fully access the funds. Terms and conditions for accessing this money are discussed later under "Sources of Funds."
IEA OECD. Enerw Policies in Hunearv, 1991 survey p.126. 3-8 ENERGY CONSUMPTION
In Hungary the energy intensity is high (1.16); however, the 1994 edition of IEAs World Enerw Outlook places it below Poland (1.78) and Romania (1.66).7 When broken out by residential and industrial sectors (Table 3-6), however, Hungary shows a clear disadvantages when total primary energy supply (TPES) is weighed against GDP in the industrial sector. As shown in the far right hand column of Table 3-6, Hungary's industrial energy intensity is roughly four times that of the United States.
TABLE 3-6. ENERGY INTENSITY INDICATORS RESIDENTIAL AND INDUSTRIAL SECTORS FOR HUNGARY AND SELECTED OECD COUNTRIES
RESIDENTIAL INDUSTRIAL toe/1000 m2 Final Elec TPES/Capita TPESIGDP Consumption Consumption Hungary 24.2 2.5 0.86 3.91 United States 18.7 5.8 1.00 1.00 Italy 17.9 2.4 0.85 0.74 Sweden 21.3 8.0 United Kingdom 21.9 4.4
France 1.21 1.04 Austria 1.01 0.90
In 1991, the Ministry of Industry and Trade predicted industry and agricultural consumption would stay relatively the same through the year 2000 with a slight increase in transportation fuels. The largest consumption growth is expected in the combined communal (hospitals, schools, local government buildings) and residential sectors.
International Energy Agency, World Enerw Outlook, 1994 edition, p.205.
Various studies measure energy intensity differently. In residences, it is frequently weighed toe/1,000m2 while in general energy economics it is evaluated in toe/US$1,000 or in TPES against GDP. ENERGY SAVING POTENTIAL
In 1994, it was estimated that Hungary could reduce its energy consumption by 30 per~ent.~ The cost of Hungary's energy bill in 1994 was HUF 600 million. If that 30 percent reduction were to apply to only HUF 400 million in more accessible energy efficiency opportunities, it would reduce the burden on the economy annually by HUF 120 million at 1994 prices. If the average January 1995 26 percent price increase were applied to this figure, the potential savings would grow to HUF 151 million per year. Performance contracting procedures make it possible to bring these potential annual savings forward so they can be applied to energy efficiency improvements and facility upgrades now.
SOURCES OF FUNDS
THE GERMAN COAL AID FUND
As of September, 1994, there appeared to be an attractive source of money in Hungary, which would be available to promote energy efficient projects at subsidized rates.1° This is known by the somewhat misleading name of "The German Coal Aid Fund." In fact, this is a facility offered by the Magyar Hitel Bank Rt., a.k.a. The Hungarian Credit Bank.
While the rates offered are concessionary, there was only $6 million dollars left in uncommitted funds in September 1994. The bank will lend this money at a rate of 50 percent of the floating rate charged by the National Bank of Hungary (currently 25 percent), plus a 3.5 percent spread, to yield a rate of 16 percent as of the date of this report. The maximum lending limit is HUF 50 million (US$ 454,000), and the bank will allow a 85/15 debtlequity ratio. Money can be lent for a maximum of 8 years on a term loan basis, with a two year grace period. A one-half percent commitment/facility fee is charged.
To qualify, a prospective borrower needs to demonstrate to the Bank that its project would save 500 gigajoules per each HUF 1 million lent, and that at least one half of the funds' application will be employed in pursuit of energy savings. As a matter of preference, the Bank would like to see a three year payback on the investment. The Bank requires three year audited financials, and wants 200 percent asset coverage. Over the last two years, the bank has lent out HUF 1.7 billion ($15.5 million) under this credit facility.
Hungarian Energy Authority
lo In late 1994, there appeared to be an increasing potential of MDB financing for energy efficiency in Hungary. HUNGARIAN GOVERNMENT SUPPORT FOR ENERGY EFFICIENCY
The advent of a broad-based ESCO industry would be greatly enhanced if it were underwritten by the Hungarian Government through programs which have, in turn, their main source of money from foreign institutions in the form of grants, transfers, and loan forgiveness schemes.
There are two areas of support, which could be developed in support of energy efficiency and third party financing. They are in the Ministry of Finance and the Central Environmental Protection Fund.
The Ministry of Finance
The first step to facilitate performance contracting by the Hungarian government should be a careful examination of any disincentives or inequities and reduction or removal of such features. The Ministry of Finance has offered to consider broadening the tax code to include investments in energy efficiency under preference items. Specifically, the Hungarian income tax code allows certain organizations a five year tax holiday and a follow-on five year 60 percent tax reduction. The approval process takes at least three months. In discussions with representatives of the Corporation and Venture Section, it .was sungested b~ representatives that this process might be normalized for companies offering energy services. Representatives of the Ministry also indicated that they would be favorably disposed to proposals involving a reduction of certain customs duties on energy efficiency equipment imports, which are not manufactured in Hungary. Hungarian tax rates are very high, running over 40 percent. Consequently, any reduction or elimination of these rates would partially, or fully, eliminate many of the disadvantages associated with the high cost of money.
The Central Environment Protection Fund
Perhaps the most encouraging support for energy efficiency came from discussions with representatives of this Fund. While the mandate of the Fund is to promote environmental projects, it incorporates language which explicitly states that the quality of a project would be enhanced if the environmental impact is accompanied by energy savings. Of the five criteria used to decide whether to support a particular application of funds, the CEPF's charter states that the project must "result in the savings [of] material and energy."
Beyond this "official" support for the concept of energy efficiency, the Director of the Fund enthusiastically endorsed the concept of third party financing and stated that he would willingly incorporate information on EPC opportunities and methodologies into the CEPF's information campaign. CEPF's resources are impressive, and for this reason alone, it could become a very important ally in the establishment of an ESCO industry in Hungary. Each year the Fund collects approximately HUF 2.4 billion (US$ 21.8 million) from gas taxes, voluntary payments from multi-lateral institutions, and a variety of user fees and fines for pollution.
Funds are expended through a) grants (75 percent), b) loan guarantees up to 70 percent of the value of the credit (10 percent), and the balance on expenses and other public educational activities.
Total support cannot exceed 60 percent of the total estimated project cost; and within this overall limitation, grants cannot exceed 30 percent of estimated project costs. Loans can be arranged as: a) interest free for a two year grace period with repayment commencing from the completion of the project and taking one to five years; or b) a Soft Loan with the same terms as in a) above, except that interest will be subsidized from 60-120 percent of the Central Bank base rate; c) longer term loans of from five to fifteen years may be granted in cases having national significance.
POOL FINANCING
The multi-national development banks (MDBs) have historically loaned sums of money in larger amounts than the amounts needed for energy efficiency projects. This is gradually changing and many MDBs are actively searching for ways to assist countries with energy efficiency efforts. The idea of creating a pool of funds to support a large number of smaller energy efficiency projects is growing.
An attractive way to implement pool financing in Hungary might be through existing entities which already have a portfolio of prospective projects; such as the State Holding Company (HSHC), which has 170 companies in its portfolio (with combined assets of HUF 1.3 trillion, or US$ 11.8 billion). The HSHC can borrow in its own right and issue guarantees on behalf of the companies it owns.
Such accommodation could leverage MDB money since a third party guarantees the funds will be paid back; thus, making a revolving fund possible. This procedure could offer rates and terms favorable to the ESCO industry, which would stimulate the development of an ESCO business within Hungary, benefit Hungary's competitiveness and improve its environment. EC ENERGY CENTER
The EC Energy Center was established by the Hungarian government and the European Communities in 1991 and is active in promoting energy projects in Hungary. It is partially supported from the ECUs PHARE provides to Hungary (ECU 85 million in 1993). As part of its continuing programs, the Center has now floated a tender seeking a company to perform a study on setting up a master ESCO, just as the PHARE Office has done in the Czech Republic. The idea would be to create a 5 million ECU fund to underwrite the operations of an ESCO. It is hoped that such a demonstration effort would help foster the growth of the industry in Hungary. It is not envisioned that the ESCO would be operative before 1996.
DOING BUSINESS IN HUNGARY
Transitional economies by definition mean changes of ownership, unstable economic conditions, and short-term planning. Fitting long-term performance contracting in such a context requires special consideration and caution for ESCOs. Some modifications are obvious, such as changing the concept of "long term" into a shorter time frame.
SOME COUNSEL
A visit to law offices in Hungary prompted the following counselll when doing business in transitional economies, specifically Hungary:
a) Don't touch anything before privatization.
b) Competitors of MVM must rely on MVM's good will. MVM is a quasi-monopoly working against privatization and is in a position to block any privatization move.
'c) Legal impediments to energy efficiency include confusion over distribution pipelines and charges for contract carriage. Check this issue before calculating costbenefits.
d) Before electrical generation became state-owned, it had private investors who now want compensation. In 1992-93, nationalization without compensation was declared illegal.
e) Anything installed in a plant before Julv 1993 today belongs to the state. Ownership is not clear for electrical equipment installed in a plant after that date, for the law
Dr. J6zsef Balogh, Koves & Partners, Clifford Chance Budapest. 3-13 is silent. For example, private boilers providing hot water heat to another organization could have a problem.
The 1994 law passed to clarify this issue did not yet have by-laws (regulations) issued and a move to amend was also under consideration.
If an ESCO seeks to improve the efficiency of equipment installed before July 1993 for savings, the factory must have a "complete book," including such legal provisions as a "court of registry stamp" showing equipment belongs to company, deed of foundation, etc.
These concerns are not legal impediments so much as a caution to check and double check all papers. Then, check with MVM. f) Check bank liens and prior claims. If bank has loan, negotiate with the bank, it's safer. g) If reclaimed equipment is in default, then check outstanding tax liability. h) Land registry is highly sophisticated. Get a sheet on the company; where ESCOs will find record surety on real estate. i) Liquidation and secured creditors. Right now workers get paid first, although timing plays a role. State may get taxes.
ESCO contracts should carry an arbitration clause. Arbitration can be settled with "interim remedies" within weeks. Court liquidation takes about 18 months. j). Taxes are very high and very complicated. Special exemptions are made by the ministry on a case by case basis. k) Joint venture ~ppo~tunitiesattract more foreign investors than Poland and Czech Republic combined, because Hungarian process is clear and simple.
1) If money is invested in U.S. dollars, any dividends and money coming out is in U.S. dollars. Convertibility is guaranteed. m) Check for any collective bargaining agreements and assess project impact. Many of the attorney's comments might be summed up by the statement that due diligence is important, but ESCOs must be more diligent in transitional economies.
It was noted by another source, that fringe benefits are 100 percent of salaries. This has lead to "black market hiring" to avoid fringe payments. Statistics that show low salaries, but high incomes, are a clear sign black market is growing this observer warned. These conditions offer ESCOs the opportunity to sell out-sourcing benefits, but it also burdens ESCOs with higher than expected in-house personnel costs.
CURRENT ESCO ACTIVITY IN HUNGARY
ESCO activity has been very limited to date, but the companies interviewed indicated a high level of optimism for business in 1995.
Creditlux, established by GE, along with other firms have been relamping the City of Budapest. Savings contracts are signed by the Lord Mayor's Office. About two dozen projects, amounting to HUF 250 million (US $2.5 million) have been entered into in the last three years. Credilux allows G.E. Tungsram, to sell lamps on a savings basis.
HESCO (Hungarian Energy Services Company) has been in business four years "without much success." HESCO's California investors are not happy with their investment due to the economy and low energy prices. The marketing director cited four problems they have faced:
energy prices are so far from world prices currency devaluation business climate risks and high interest rates banks lack liquidity
In spite of these problems, it was stressed that the political change was very positive for their business.
Centech, operated by an American living in Hungary, is looking for industrial markets. He sees the biggest problems in fluctuating production levels, low energy prices, equipment efficiency, and absence of baseline data. The idea of installing measuring devices to establish baseline and monitor savings was discussed and received enthusiastically.
Controll, run by Tibor Nagy (a recipient of AID "ESC0"12training) has attempted to finance two performance contracting projects without success. Recently Control1 established a relationship with Centech. Mr. Nagy cited the absence of financing as greatest concern; noting the problem with the banks is "too much credit and not
l2 ESCO is used in this AID program for companies offering energy services and are not necessarily ESCOs as the term used in this report. enough assets." He was hopeful that financing sources, such as PHARE, would be emerging.
GellCrt Innovative Bureau of Engineering, (GellCrt B.T.) a private firm created in 1989 by Mr. Miklbs GellCrt (an AID trained "ESCO") has a range of service offerings. GellCrt B.T. includes performance contracts in its offerings and has at least two projects which have been signed by owners and submitted to AID for assistance.
ENERGY EFFICIENCY ACTIVITY
A number of firms and organizations are active in the energy efficiency area. A representative list of firms indicated below could be valuable in-country partners for foreign ESCOs.
EGI/GEA, ContractingEngineering Co. Ltd., dealing with various scale of energy efficiency projects. Contact person: Mr. 201th Lontay, Dept. Head, Phone: (36-1) 2018652.
Bruun & Sorensen Hungary Ltd. consulting engineering firm in the field of energy efficiency project definition and implementation. Contact Mr. Tamhs Uszlb, managing director, Phonelfax (36-1) 2702566
Lambda HIR Ltd. consulting engineering and PR firm, having performed various projects in the field of energy efficiency improvement. Contact Mr. Ghbor Vhgb, director, Phonelfax (36-1) 1290028
Energiaracio Ltd. newly established consulting firm for ESCO activities. Contact Mr. Ghbor VBg6, co-director, Phonelfax (36-1) 1290028
It should also be noted that with USAID support a Hungarian Chapter of the Association of Energy Engineers has nine Certified Energy Managers, qualified by AEE. These members have small scale consulting firms or work as self-employed free lance consultants. Chairman of the Hungarian AEE chapter is Prof. Dr. Tamas Jhszay and Vice-Chair is Miklbs Gell6rt. The CEM Members are listed below.
Inre Majoros Gyorgy Viragh Szaniszlo Milhaly Janos Zhelev Tibor Nagy Albin Zsebik Laszlo Soos Andrhs Morenth Gyorgy Sz. T6th Ed Corcoran GCza Szab6 ENERGY EFFICIENCY MEASURES
Measures being recommended and implemented have been constrained by the relatively low price of energy. The measures being considered by the emerging Hungarian ESCOs are short term measures; e.g., heat flow meters, simple controls and heat exchangers (for cooperatives with district heating). Some maintenanceJquick fix measures, are also attractive. Opportunities at the district heatingJmunicipa1 level also have potential.
Among the larger measures mentioned by interviewees were:
fuel switching improved capacitors boiler upgrades meters new boilers heat exchangers energy efficient motor replacement controls steam trimming weatherstripping
The cost-effectiveness of these measures and others must, of course, be determined on a site by site basis.
Foreign ESCOs must guard against making assumptions based on experiences in other countries. Lighting, for example, may not be nearly as cost-effective as in the West as an energy saving measure, because lights are turned off with constant dedication and the cost of lamps is relatively high.
POTENTIAL MARKETS
Identifying specific market sectors can cause ESCOs to overlook individual opportunities in other sectors. Conversely, there is a tendency to view the whole market as a strong opportunity when each organization within that market requires careful due diligence. With these thoughts in mind, there are several markets worthy of further investigation as well as some individual large state-owned performance contracting candidates.
Without baseline data it is difficult to compare energy opportunities among markets with any accuracy. Other factors, however, help single out certain markets. Some of the markets which currently appear to have potential and could be large enough for MDB financing are:
breweries glasswork aluminum communal facilities, schools and hospitals pharmaceuticals cooperatives some food processing district heating textiles DETERRENTS TO AN ESCO INDUSTRY
GROWING OUT OF HUNGARY'S ECONOMIC, POLITICAL, ENERGY AND FINANCIAL SITUATION; POSSIBLE RESOLUTION
3-1. Large scale ~rivatization- Until the scheduled privatization of many of the large scale organizations is complete and their economic viability/credit worthiness can be independently assessed, these organizations in transition cannot enjoy the benefits of performance contracting.
Resolution: Accelerate the privatization procedures.
3-2. Devaluation of the forint and inflation. The devaluation of the forint and the mid- 1994 inflation rate of 18.9 percent are financial impediments to performance contracting.
Inflation has been trending downward and the devaluation mostly uses the crawling peg mechanism. Both are relatively favorable indicators, but the combined effect places a financial hardship on those who might otherwise pursue performance contracting. ESCOs compare these conditions across countries of interest and go where conditions are most favorable.
Resolution: Tax laws and procedures should be examined to be sure no disincentives or inequities exist and a sound economic policy is in place. Secondarily, offsetting incentives should be explored.
3-3. The money side of enerm often seems lost in weighing the benefits of energy efficiency and making savings calculations. Hungary's financial planners do not seem to be fully aware of the economic implications of the nation's energy bill or the burden the government carries through indirect energy support.
Resolution: Government financial planners and decision-makers need to be more conscious of the economic impacts of energy pricing, the government's share of the cost of energy and its burden to the Hungarian economy, and how current procedures impact the nation's ability to meet other needs.
Education and training of the money side of energy should also be offered energy service and energy efficiency financing providers.
3-4. Enerw urices - Controlled energy prices have not kept pace with inflation; nor met the real cost of energy production. In late 1994, the Parliament took action to raise energy prices, which would bring it closer to its real cost and enhance the benefits of energy efficiency.
Resolution: Strong support should be given to the government's plans to increase energy prices.
3-5. Heating: energv prices. The pricing of heating energy works against the advent of an ESCO industry. Consumers pay by the cubic meters of occupied space; not consumption. Even if they cut consumption, the price could remain the same.
Resolution: Consumer's should have some incentive to pay for metered consumption; not by cubic meters of space. This, in turn, would provide an incentive for the consumer to use heating fuels more efficiently -- and to ESCOs, who can help assure such benefits.
3-6. MVM offers little support for energy efficiency effortsldemand-side management (DSM) measures and integrated resource planning (IRP).
Resolution: The provisions in Act 48, which requires MVM to support energy efficiency and engage in least cost planning should be given strong support by the Hungarian government, AID and MDBs. MVM management needs to work more closely with the government to assure the benefits of energy efficiency are enjoyed by citizens, communals, industry and incorporated into the economy. Some regulatory or supervisory body to oversee MVM may be advisable.
How DSM and IRP might be modified, so energy efficiency becomes a more attractive option in the power sector than increased generating capacity, should be considered in the light of its economic and environmental benefits. In addition, consideration should be given to providing compensation to distributors for any lost revenues as a result of energy efficient activities of their customers.
3-7. A lack of enerw efficiency awareness exists, which is largely prompted by low energy prices. As prices rise, ineffective attempts to operate more efficiently (and the advent of those who take advantage of such concerns) are likely.
Resolution: Guidance through education and training as well as the implementation of energy codes and standards could accelerate an understanding what constitutes effective energy efficient practices and could yield quicker benefits to end users.
3-8. Technical suport for ~erformancecontracting. Local engineering abilities are good and energy auditing capability is growing, but few Hungarian engineers have the expertise or expertise to do auditing for performance contracting. Resolution: provide training for engineers, particularly energy engineers in risk assessment issues pertinent to performance contracting; e.g., assessing organizational commitment, operations and maintenance abilities and training needs, interrelationship of people factors to the payback of measures and the financial aspects of long term energy efficiency financing. SECTION 4. POLAND
ECONOMIC, POLITICAL, ENERGY AND FINANCIAL CONDITIONS GERMANE TO ENERGY PERFORMANCE CONTRACTING
Performance contracting by its nature extends over several years and carries with it many uncertainties. Energy service companies (ESCOs) and their financiers invest heavily at the beginning of energy performance contracts. To have a viable project, they must have some assurance that they will get that money back out -- and show a profit for their efforts. When performance contracting is contemplated in transitional economies, the very nature of performance contracting (its dependence on recovering energy cost savings over time) requires that factors such as political and financial stability of the country, must be carefully evaluated. To the extent that the ESCOs or the financing source is foreign, then the convertability of the currency and the ability to repatriate the funds are also key.
This section presents factors related to the broad political, economic and financial stability of Poland as they appeared during the July 1994 fact finding mission. It also provides a brief overview of the energy situation. It is designed to help both domestic and foreign ESCOs as well as policy-makers, who would like to foster a Polish ESCO industry, consider these conditions. This section concludes with the more apparent obstacles/difficulties in the political, economic area to fostering an ESCO industry in Poland and offers recommendations to offset, mitigate or remove such concerns.
POLITICAL/ECONOMIC MID-1994 "SNAPSHOT"AND APPARENT TRENDS
Poland had one of the fastest growing economies in Europe in 1993 with gross domestic product (GDP) rising about 4 percent. This was the second year of recovery from a GDP drop of 18.2 percent during 1989-91. The official Polish government forecast for 1994 is another 4.5 percent GDP growth. As of mid-1994, Poland continued to show promising economic growth although it is doubtful the 4.5 percent figure would be attained.
A recent survey conducted of finance executives in the European Union (EU), Japan and the United States by Financial Dynamics1 found that 76 percent were optimistic about Poland's economic prospects and 16 percent were optimistic.
In the light of the resurgence of what the press has referred to as a "leftist coalition" in the 1993 elections, this optimism may seem unwarranted; however, a former Minister of
Cited in Jolly, Adam. "Poland: The First European Tiger?" CBI News, May 1994. Jolly states that the survey is available for f 100 by calling 071 831 3113. International Economic Relations for Poland and current President of the Polish Chamber of Commerce stated in late 1993,2"...not a revolution, just different... There is no significant political group with any interest in withdrawing from democracy or a market base. The process of reform has not collapsed." He appears to have been correct in all respects.
While the spin and pace of reform has changed, the process has not. The new government supports tight budgets and so far has stayed within the limits agreed to with IMF; a move that opens the way for new stand-by credits. The new government also backs the mass privatization program, which calls for 400 enterprises, mainly light industry, to be entrusted to 20 national investment funds with listings expected in 1995.
Poland has come under some criticism for the slow pace of large scale privatization; however, focusing on only large scale organizations tends to obscure what has happened in the overall economy. Expansion of the private sector has been dramatic. The private sector now accounts for more than one-half of the Polish GDP and nearly 60 percent of total employment.
PRIVATE SECTOR GROWTH
The rapid expansion of the private sector has come through small scale privatization and the creation of large numbers of new businesses. Today several sectors of the Polish economy are dominated by the private sector; agriculture, retail trade, and construction. Industry, which is mostly state-owned and being privatized slowly, now has a significant share, 37 percent, of its output produced by private firms.
Profitability among Polish firms reached 3.8 percent in 1993, up from 3.1 percent in 1992. While some companies made profits, 41 percent of Polish firms still lost money in 1993 (compared to 43 percent in 1992). An encouraging trend, but not sufficient to create much rejoicing. Lack of financial liquidity, large inter-enterprise debt and large obligations to the state budget are expected to continue to put a heavy drag on profitability for some years to come.
A substantial recovery in industrial output has led the Polish economy over the past two years and this appears to be continuing. In 1992 output grew 3.9 percent and gross industrial output jumped by 6.2 percent in 1993; running ahead of the 4 percent GDP improvement. 19 of the 23 major economic sectors showed growth. Improved productivity played an important role in the previous year's growth, especially considering that industrial employment actually dropped by 1 percent in 1993.
* Andrzej Arendarski, November 8, 1993, address to U.S. Chamber of Commerce, Washington, D.C 4-2 As shown in Table 4-1 below, economic indicators over the years has shown a healthy trend toward economic stability. The zloty was devalued 8 percent in August, 1993 and is being devalued slowly but steadily through the "crawling peg" mechanism.
TABLE 4-1. ECONOMIC INDICATORS
GDP growth rate GDP Per Capita (current $) Inflation (% change, Dec-Dec) Unemployment Foreign Exchange Reserves (million$) Average Exchange Rate (zloty/$l) Foreign Hard Currency Debt (billion) Average Monthly Wage U.S. Economic Assistance (millions) U.S. Charitable Donations (millions)
* Estimated Sources: FCS Warsaw, Polish Statistical Office, U.S. Department of Commerce
The industrial recovery has continued into 1994. Gross industrial output was up 10.6 percent in the first quarter over the same quarter of 1993. This rate of expansion will probably slow, but growth is expected to continue. The official government prediction is for annual growth to be 5.2 percent for 1994.
The industrial sectors which have grown most rapidly ... and attracted considerable interest from foreign investors ... include wood and paper processing, transport equipment, precision industries, electronics, machine building, metalworking, glassworks, chemicals and food processing. Construction is also a strong growth area. The housing industry has declined, but the value of services sold by building construction firms increased 8.6 percent in 1993, the third year of increases. The key to the construction boom appears to be the renovation and modernizing of existing buildings, both commercial and residential, rather than new construction.
POLISH ECONOMICIPOLITICAL ISSUES
The Polish economy is not without its problems. Inflation in Poland was "down to" 30.8 at mid-1994, an improvement over the 35.3 percent in 1993 and the 44.3 percent figure for 1992. Patterns in early 1994 suggest the Polish government inflation target of 27 percent for the year will probably not be met, but the trend towards ?!&i&f iriflkilbn is expected to continue. I Due to the run away inflation at the beginning of the decade, interest rates did not stay fixed, but were allowed to float upward at a percentage above inflation, similar to a variable mortgage rate. While this flexibility offered relief to the banking industry, those carrying the loans all too often found the interest soon exceeded the principal. The net effect for many attempting to repay these loans was extreme hardship; even complete destitution. The bitter irony of all this, especially for those who seized what was viewed as new economic opportunities, was not lost and is captured in the cartoon to the right. Roughly translated, it says "... and then I got this great idea; so I got this loan ..."
Caution regarding new "great ideas" and the means to finance them is very real among would be Polish entrepreneurs ... and future ESCOs.
As long as "floating" interest rates exist, it will be impossible to gauge the true cost of capital, especially for projects of long duration, such as energy performance contracts. If ESCOs are to guarantee that energy cost savings will be sufficient to meet the owner's debt service obligations, floating interest rates could create a disaster.
Real wages continue to slide. Two years of econon~icrecovery have not produced improved standards of living. Discontent over falling living standards was said to be a major factor in the 1993 elections, which brought in a government perceived to be sympathetic to workers' problems. Unless real wages begin to increase, popular discontent with economic reform is apt to continue, which, in turn, could slow the process even more. Polish manufacturing wages in mid-1994 were equated to approximately US$200 per month.
Unemployment continues to be serious problem in Poland and is expected to continue for most of the decade. Nearly three million Poles are out of work; 15.7 percent of the work force. This is up from a 1992 year-end figure of 13.6 percent and would be higher if it were not for active growth of private sector jobs (about 300,000 new jobs in 1993). Job shrinkage in the public sector, as state-owned companies try to reduce expenses and restructure to survive, continues to offset much of the private sector job growth.
Reliance on imported oil, the needed investment to develop the natural gas resources, and the government's intent to continue to bring the current cost of energy up to its "real" cost, all point to higher energy prices. A Polish government's agreement with IMF also assures energy prices will not regress. Increasing prices will make the energy efficiency market more attractive.
POLAND'S ENERGY SITUATION
MAKING IT PAY
The tremendous opportunity to save energy has, to some degree, an off-setting effect on the financial constraints, such as high interest and inflation rates, discussed in the preceding section. Since performance contracting rests on the ability of a project to pay for itself from the energy cost savings, energy savings potential becomes a key factor in determining return on investment; or, in the case of energy, the payback. The following payback formula defines this relationship Investment Payback (yrs.) = ...... Energy Savingslyear
Investments include not only the cost of the equipment/modification and its installation, but the cost of money. However, the equation implies, but does not state, that the need to save energy is more than kilowatt hours (kwh) or gigajowls; it is energy cost savings. If electricity still cost 3.2 zlotys (zl) per kwh as it did in 1988, it would take a long time to recover the cost of a 32 watt fluorescent lamp, which costs about 400,000 zl today, out of the savings. The zlotys/kWh in mid-1994 were 1,449 zl or about US$O.OG/kWh.
Electric costs today have increased rather dramatically from their level under a command- and-control economy and are intended to reach "real cost" by the end of 1995. Higher energy costs motivate reduced consumption when prices are related to the amount consumed.
PRICING PATTERNS AND PLANS
In the 1950s, 1960s, 1970s and most of 1980s, the prices to the end-user were considered subsidized prices. As noted earlier, the end-user price in 1988 was 3.2 zl/kWh. By 1994, the price was 1,449 zl/kWh. Though increases also included inflation, the dramatic escalation of energy prices has been described as shock therapy. Most of the "shock" took place by the end of 1989.
A discussion with a representative of the Ministry of Finance proved to be exceedingly valuable as he had worked closely with energy pricing in Poland for more than 20 years. He provided the statistical scenario that follows: In 1989, only 15 percent of the generating cost was covered by the end-user price; in 1993, it was 86 percent. District heating which had not moved as fast; had reached approximately 58 percent of real cost by 1994.
In 1994, the Ministry of Finance scheduled three price increases of electricity: February 15th by 20 percent, July 1st by 15 percent and October 1st by 20 percent. The February and July increases were completed on schedule and the October increase was expected to go forward as well, at the time the field visit was conducted. The Ministry of Finance has stated that, at the end of 1994, 99 percent of the electrical generating cost and 64 percent of the hot water generating cost will be covered in the pricing mechanism^.^
Two electricity pricing factors are at work: the regulated end-use price, which is set by the Ministry of Finance, and the "commonly agreed price," which is not completely free, but is negotiated. The difference between the regulated price and the "commonly agreed price" is subsidized by the state. If, for example, an industry owns employee housing, the employees pay the owner 100 percent of the regulated price. The industry then pays the distributor a higher price (currently 130 percent). The additional 30 percent is the commonly agreed price. The industry, however, can deduct this difference from its income tax as a direct cost. In effect, owners pay the distributor and recover from the state the commonly agreed price. As presently constituted, this pricing mechanism can confound ESCO energy cost savings calculations unless the situation, as it applies to a given organization, is clearly understood.
Partially due to the deplorable state of some power sector facilities, there is a role for cogeneration and independent power producers. An offering ESCOs could pair with their energy efficiency capabilities. Those considering such an investment, however, should recognize that pricing is still controlled. The Polish Power Grid (PPG) has done a study with the cooperation of specialists from other ministries as to the cost-effectiveness of cogeneration under current pricing. According to the Ministry of Finance, the normative procedure in Poland from the 1970s, which pays for heat by floor space, not consumption, confounds any assessment of heat generated as electricity. It should also be noted that a customer can presently have direct cogeneration with special permission of the Ministry of Industry & Trade, but the Ministry is reportedly not inclined to support such efforts.
Another prevailing problem for the utility industry, and ultimately for ESCOs, is that end users, both individuals and companies, do not always pay their bills. In several sectors, such as agriculture, this has been an accepted practice. Since the state makes up the difference, it is frequently.viewed as a subsidy. A pattern of non-payment, however, does not bode well for performance contracting and is an issue that needs special attention.
Stefan Lober, Ministry of Finance. In interview July, 1994. 4-6 Energy costs are a very big percentage of living costs in Poland. For example, in a typical apartment of 56 m2 total costs are 2 million zl/mo. Of that amount, 1.5 million zl/mo., or 75 percent, goes to pay for electricity and heating. While the Ministry is searching for ways to avoid increasing prices any further, it presently expects to increase energy prices two times in 1995: March 1st by 10 percent and October 1st by 8 percent.
CONSUMPTION BY SECTOR
Total Polish energy consumption is about 4.4 million barrels oil equivalent per day. By sectors, 40 percent of the energy is consumed by industry, 13 percent in transportation, 4 percent in agriculture, 7 percent for commercial buildings and 35 percent in residential buildings.
Taken together, the commercial and residential sectors account for more than 40 percent of the energy consumed in Poland. Considering the nature of most of the housing (primarily apartments) this has significant market implications, especially for district heating.
THE UTILITY INDUSTRY
The current structure of the electric utility industry is not designed to foster energy efficiency. Patterned after the UK model, the utility industry is stratified into the generation, transmission and distribution sectors with tariffs between these horizontal layers set by the Ministry of Industry and Trade. Prices to the end-user are set by the Ministry of Finance. Historically, no accommodation has been made to distributors to compensate for lost revenue resulting from end-user energy efficient practices.
Under current conditions, the Polish Power Grid (PPG), responsible for transmission, must pay the generators for their generating capacity, not pro-duction -- a sit-uation that pro-vides no incentive to the generators to operate their plants more effi-ciently. Nor, can the entire utility industry reason-ably weigh the cost of supply against the cost of demand, as called for in integrated resource planning (IRP) in the United States. Increased energy efficiency cannot benefit the generators under this system. IRPs and demand-side management can only function at the distributor level and only if the distributor is given some incentive to support end user energy efficiency.
The Ministry of Trade and Industry sets the procedures and tariffs the distributors must pay the PPG for electricity. On the other hand, the Ministry of Finance sets the procedures and prices the end-users will pay the distributor for electricity. With both costs and revenues externally set, distributors have little control over their market procedures and will lose revenue if customers buy less by practicing greater energy efficiency. FINANCIAL ISSUES AFFECTING THE GROWTH OF AN ESCO INDUSTRY IN POLAND
[NOTE: At the time of the study, there were three key issues relating to financing which create barriers to the establishment of an ESCO industry in Poland. These were its cost, its availability and its term. A brief discussion of these issues, presented below, are taken from the full report. Those, who wish more information on financial conditions as of July 1994, should refer to the full report, The Feasibility of Performance Contracting in Poland.]
Generally speaking, the financial barriers to the development of an active ESCO industry in Poland are aggravated by:
1) Expensive and restrictive bank credit. 2) The deteriorating balance sheets of State enterprises and the banks that support them. 3) Non-competitive product prices on world markets adversely affecting the balance of trade. 4) An overvalued and only partially convertible currency. 5) The incomplete privatization of the manufacturing industry (only 25 percent of Poland's manufacturing companies are in private hands, and, often, while the company is private, the customer is still the State).
The reasons for this lack of reasonable priced credit are distortions in the banking system (40% - 60% non-performing loans), the absence of active secondary financial markets, high inflation (30%), a negative balance of trade (-$2.3 billion), and an overvalued and depreciating currency (a 50% decline in two years).
The Direction of Interest Rates
Interest rates have been falling over the past three years as the government's fiscal and money policies have reined in inflation. However, the underlying inflation rate (and hence interest rates) has not dropped as fast as the government would have liked. Recently the government has been having problems financing its short term debts through the banking system, and this may cause an upturn in rates.
In June, 1994, the government adopted a plan known as "Strategy for Poland." The plan foresees a 15 percent increase in consumption and a 30 percent growth in investment. Inflation which officially stands at 27 percent (actually 30.8% over the past twelve months) is projected to fall to below 10 percent by 1997. Local Misconceptions
It should be noted that local borrowers do not understand the basis for interest rate differentials between local credits and foreign loans. They see lower foreign rates, and they forget that their higher domestic rates are often accounted for by forward currency devaluation risks. Potential borrowers are quick to want dollar denominated loans, when borrowing in zlotys might prove far cheaper in the long-run. This lack of sophistication is a subtle though very real obstacle to promoting local EPC at the moment.
Credit Enhancement
In Poland, ESCOs will have to develop their own financial sources of capital and, for the most part, use their own balance sheets to implement energy savings programs. Most entities in the country are either unable or unwilling to take on additional debt. As mentioned above, levels of non-performing debt in the country run from 40 to 60 percent of bank portfolios.
Moreover, the standard ESCO "guarantee" of energy performance savings is not yet a "bankable" commodity. Polish banking practice is just now coming to grips with the most basic issues of banking. Many bankers as yet don't know how to qualify a client for credit, and are presently unable to deal with sophisticated transactions.
Polish Government Support in Energy Efficiency
It is quite likely that support for an ESCO industry will have to be underwritten by Polish Government programs which have, in turn, their main source of money from foreign institutions in the form of grants, transfer, and loan forgiveness schemes.
There are two main institutions which touch on the area of energy efficiency and which provide access to subsidized loans and grants. They are the National Agency for Energy Conservation (PKT) and the National Fund for Environmental Protection. Of the two, the former, PKT, holds considerable promise for the support of energy performance contracting. The National Fund for Environmental Protection, while better endowed, might need to redirect some of its focus to value energy efficiency as an environmental benefit. This would help support the establishment of an ESCO industry and see energy efficiency as a matter of national priority before individual transactions could be supported.
TheNational Poland is just now setting up the National Agency for Energy Conservation (PKT). This agency will operate nationwide and be owned by the Polish Industrial Agency, the National Economy Bank, and the National Fund for Environmental Protection (all, in turn, owned by the Polish Treasury). The agency is still being formed, but it is expected that it will be fully functional with a budget of US$75 million within one year. Since the agency is a quasi-governmental institution, it will be able to borrow in its own name, while carrying the risk equivalent of a Government of Poland obligation. This will be important in the next few years as Poland accesses the international bond markets. It is believed that the agency will be able to raise money in those markets as well. This capacity to borrow will augment the agenda of the agency.
PKT's agenda includes, among other tasks, the collection of funds from domestic and foreign sources for the support of investment connected with the "rationalization of energy consumption", and the "construction of a financial support system for effective energy consumption." The agency's director interprets this mandate to encompass the establishment of regional agencies which will be encouraged to function as ESCOs directly and in joint ventures with Polish and foreign companies. The director is familiar with the concept of EPC, and endorses its application in Poland.
The importance of the agency lies in the fact that it will be able to provide financing to energy conservation projects at subsidized rates of interest running from 20%-70% of the then prevailing National Bank of Poland refinancing rate. Hence, were the agency up and functioning now, it would be able to offer money at rates from 6.6% - 23%.
The National Fund For Environmental Protection. As indicated above, this Polish Government owned financial institution could also serve as an important provider of capital in the establishment of an ESCO industry in Poland. The Fund views itself as a means to promote projects which will have a national or supra-national impact, and which require capital investment on a scale not otherwise available. The Fund has focused on environmental projects, as its name would suggest. However, written into the Fund's mandate is the concept of promoting energy efficiency because efficiency is viewed as inextricable tied to environmental improvement.
Often working with the Fund are a host of regional organizations, the mandates of which broadly complement that of the National Fund. These sources may also become important in the dialogue to establish EPC in Poland. The importance of these groups can be seen by the fact that the Provincial Environmental Funds (of which there are 49) accounted for 31 percent of the monies that went into the 1992 environmental protection expenditure of the country verses 27 percent from the National Fund. The remaining 10 percent involved local governments.
DOING BUSINESS IN POLAND
A number of business issues are of key importance to a potential ESCO industry in Poland. Some of the key considerations are addressed below. Convertibility
There are no money transfer problems. Money is fully convertible. (Only limitations on convertibility rests with bond transactions.) Nor, is there any limits on income or money held.
All local transactions must be in zlotys (zl); thereby, putting the risk related to the exchange rate on the individual company, or person. In mid-1994, the exchange rate was 22,700 zl to US$1.00. In January 1995, Poland plans to remove 4 digits from its money; i.e., the same exchange rate will then be 2.2721 per dollar.
Taxes
On July 5, 1993 a sales or turnover tax was replaced by a value added tax (VAT) which was applied to most commercial transactions involving the transfer of goods and also includes paid services and barter transactions. The base VAT rate is 22 percent, with a reduced rate of 7 percent for some items including food products, press publications, some articles for children and building materials. There is a zero percent rate, applied selectively, which applies to exported goods and services, some educational materials and publications. The zero rate is not the same as an exemption under the new system. Small businesses may be exempt from the VAT provided their annual sales in the year preceding the tax year do not exceed 600 million zlotys (US$26,432).
There is also a "Branch Office" income tax. There are three distinct types of recognized branch offices: the so-called branch office (also known as a "representative office"); the technical information office; and the supervisory office. Only a branch office is allowed to perform economic activities and is liable for corporate income tax. Rates are based upon imputed income from a variety of activities ranging from 6 percent on construction and building activity to 40 percent on commissions.
No further tax is added for transfer of profits out of the country and there is no restriction on the repatriation of profits on invested capital.
The tariff and border tax situation in Poland is inconsistent and somewhat confusing. There is a basic six percent border duty on imported goods. This was imposed to replace a border tax, which was eliminated with the introduction of the VAT in 1993. The average Polish duty is 14 percent; however, preferential treatments abound. More than 1,000 line items can be imported from EU countries duty free. In-kind assets; i-e., equipment leased by an ESCO, would probably not pay duty.
There are some provisions for special tax exemptions for joint ventures available by application to the Minister of Finance based upon two qualifications: (1) the contribution of a foreign partner exceeds the zloty equivalent of 2 million ECU; and (2) a) the economic activity will be carried out in regions of high unemployment, or b) the economic activitv will bring modern technolog to Poland, or c) exports will account for more than 20 percent of sales. At present, the tax holiday is for three years.
Joint Venture Opportunities
Joint ventures (JVs) are welcome and the procedures are relatively straight forward. JVs can be established in two ways:
1) limited liability; -- up to 100 percent of the stock can belong to one person. Required investment: 14m zl (US$1,700), a procedure for small businesses; or
2) joint stock company; -- must have a minimum of 3 partners. Required investment: approximately US$40,000.
With either procedure, firms have equality in privileges and restrictions.
There is a two step process to establish a company:
1) Complete a Deed of Incorporation and have it notarized; and
2) Register the Deed; so, the company becomes a legal "person." The approximate time for both steps is one month.
LEGAL CONSIDERATIONS
Licenses to do business, franchises, etc. are national in scope. There are no regional provisions.
Anti-monopoly laws prevent the power grid or distributor from establishing themselves as an ESCO's only customer.
Legal concerns related to collecting over due payments have essentially two phases: judgment and execution. Execution develops in two ways: (1) If this agreement is in written form with established value, such as a car purchase, and payments are in default, the receivable rights can be sold to a bank after judgment and the bank becomes executor. This is very similar to a line of credit. The lessor makes an advance payment of 2.5 percent. Settlement is usually quick; about four days after judgment. (2) Executor sets pre-payment provisions -- 8 to 10 percent. Percentage is typically inverse to size of debt. This procedure can be much slower.
It has been suggested that an agreed upon penalty should be put in the contract if payment is not made on time. This provides more leverage for lessor.
Agreements to protect proprietary concerns, such as non-compete, exclusivity, non- circumventions, or non-disclosure, are all accepted under Polish law. A private attorney in Poland suggests the best protection is to register "know how" in the central Polish patent office. This "know how" cannot be public knowledge. It is possible, for example, that the engineers ability to accurately predict the energy savings from specific measures may qualify.
Should a legal entity, an ESCO partner or customer, change status (by sale or privatization) all contracts are valid and convey. If a firm should split into more than one entity, the agreement must designate which party is responsible for each contract; otherwise, all new firms are responsible for a given contract and all can be sued.
The body of Civil Code in Poland is substantial. There are reportedly "no vacuums."
ECONOMIC, POLITICAL, ENERGY AND FINANCIAL DETERRENTS TO ESCO INDUSTRY GROWTH AND PROPOSED RESOLUTION
4-1. Large scale ~rivatization.Until the scheduled privatization of many of the large scale organizations is complete and their economic viability/credit worthiness can be independently assessed, these organizations cannot enjoy the benefits of performance contracting.
Resolution: Accelerate the privatization procedures.
4-2. Devaluation of the zlotv and inflation. The devaluation of the zloty and the mid-1994 inflation rate of 30.8 are financial impediments to performance contracting.
Inflation is trending downward and the devaluation is using the crawling peg mechanism. Both are relatively favorable indicators of an economy coming into line, but the combined effect places a financial hardship on those who might otherwise pursue performance contracting. ESCOs will compare these conditions across countries of interest and go where conditions are most favorable.
Resolution: Examine tax laws and procedures to first see that all provisions for an energy efficient industry are equitable; then, determine if Poland can offer some offsetting incentives, such as income tax holidays and exemptions on customs taxes for energy efficient goods not produced in Poland. 4-3. Floating interest rates. Long term contracts based on savings projects cannot tolerate the uncertainty that accompanies floating interest rates. It is impossible to gauge true cost of capital and to calculate cost-effectiveness.
Resolution: Provide fixed interest rates in Polish commercial banks for energy efficient projects; or, encourage more multi-national development bank money to be available for this purpose.
4-4. Value added tax (VAT). A base VAT of 22 percent can help fund the Polish government, but it takes money directly out of the performance contracting benefits. The more money that goes into any tax, including VAT, the less there is available for the equipment and the savings. This hampers Polish business efforts to become more competitive and drags down all the associated economic benefits.
Energy cost themselves carry a VAT of 7 percent. A VAT of 7 percent is also placed on energy efficient equipment.
Resolution: Develop a mitigating strategy to remove or reduce VAT on energy saving performance contracting.
ESCOs and their investors must consider the VAT in calculating cost-effectiveness of proposed measures.
4-5. Legal issues. ESCOs from other countries, which could be so valuable in aiding Poland's efforts to improve its economy and environment, fear they will not get payments and/or money out of the project due to legal issues.
Resolution: Prepare clearly defined procedures, which enable ESCOs to secure their money within a project; provides for unimpeded opportunity to get money from recalcitrant customers and/or commercial banks; and allows clear recovery of invested funds and profits.
4-6. Inflation rate. The current inflation rate discourages foreign ESCOs from investing in Poland.
Resolution: Continue political practices that are bringing down inflation rate. Allow interest rates to drop as a reflection of declining inflation; so the old inflation rate does not sustain artificially high levels.
4-7. Commercial banking. The industry is not sophisticated enough to make the kind of loans necessary for an ESCO industry.
Resolution: Provide technical aid to banking industry. Encourage longer term loans. Create better understanding in the banking community of energy performance contracting, its secured risks and its benefits to the economy. Encourage support and reliance on MBDs until commercial banks are up to speed.
4-8. Electric enerw prices. Energy prices at 1,449 zl/kWh, or approximately US$0.06/kWh, offer some inducement to improve energy efficiency. If the real cost of energy, however,,were reflected in the prices, there would be a much greater savings opportunity. This would permit larger investments, more facility upgrades and more environmental benefits.
Resolution: The Polish government has made great strides in bringing the cost per kwh up from its low social cost in 1988 to the level it is today. This pattern needs to continue until energy prices reflect actual costs.
Commonly agreed price. Electric pricing is structured to include the regulated end- use price and the "commonly agreed price" (about a 30 percent add on) as it is paid to the distributor. Should a company pay this add on for its employee housing, the firm can later deduct this amount from its income tax. In effect, the add on is, therefore, a government subsidy. This pricing procedure confounds ESCO calculations and the "add on" offers no incentive to owner or occupant to use energy more efficiently.
Resolution: The policy of "commonly agreed price" amounts to a government subsidy and should be phased out if ESCOs are to serve this market most effectively.
4-9. Heating enerw prices. The pricing of heating energy work against the creation of an ESCO industry. First, consumers pay by the square meters of occupied space; not consumption. Even if they cut consumption, the price remains the same. If consumption is measured by a consumption meter, there is reportedly a 15 percent savings.
Resolution: Consumer's should have some incentive to pay for metered consumption; not floor space. This, in turn, would provide an incentive for the consumer to use heating fuels more efficiently -- and to ESCOs, who can help assure such benefits.
4-10. The horizontal stratification of the power sector and the current tariff structure. The structure limits any vertical energy effortldemand-side management (DSM) measureslintegrated resource planning (IRP).
Resolution: Provide compensation to distributors for lost revenues from more energy efficient customers. Consider how DSM and IRP might be modified, such as adjustments in the tariff structure, so energy efficiency becomes a more attractive option than increased generating capacity. 4-11. Non-~avmentof utilitv bills - Performance contracting is based on energy cost savings, or avoided costs. Monetary savings cannot be made on unpaid bills. Non-payment is an accepted practice in some sections, such as agriculture. Since the government makes up the difference to the power sector, this represents a subsidy.
Resolution: The government should consider a clearly defined subsidy in lieu of this hidden subsidy. If the farmers were obliged to pay their utility bills, but got the equivalent in a subsidy; then, they would not suffer loss (and the government would avoid the political implications). At the same time, farmers would have an incentive to operate more energy efficiently. The result would be better net financial position.
4-12. Pavment for enerating ca~acig- The present practices by the grid of paying the generators for capacity, not production, works against any incentive for increased power plant efficiency.
Resolution: The tariff structure should be changed; so, generation payments are based on production. SECTION 5. SLOVAKIA
ECONOMIC, POLITICAL, ENERGY AND FINANCIAL CONDITIONS GERMANE TO ENERGY PERFORMANCE CONTRACTING
Performance contracting by its nature extends over several years and carries with it many uncertainties. Energy service companies (ESCOs) and their financiers invest heavily at the beginning of energy performance contracts. To have a viable project, they must have some assurance that they will get that money back out -- and show a profit for their efforts. When performance contracting is contemplated in transitional economies, the very nature of performance contracting (its dependence on recovering energy cost savings over time) requires that factors, such as political and financial stability of the country, must be carefully weighed. To the extent that the ESCOs, or the financing source, are foreign, then the convertability of the currency and the ability to repatriate the funds are also key.
This section presents factors related to the broad political, economic, energy and financial stability of Slovakia. It also briefly addresses Slovakia's energy situation. It is designed to help both domestic and foreign ESCOs as well as policy-makers, who would like to foster a Slovakian ESCO industry, consider these conditions. This section concludes with a discussion of business issues, which can directly affect the growth of an ESCO industry in Slovakia.
The economic/political status is presented as of March 1995. Some trends key to performance contracting are also offered.
MACROECONOMIC AND POLITICAL INDICATORS
Due to its historical association with the Czech Republic (CR) as well as its geographical proximity to CR, there has been a tendency to continuously compare the Czech and Slovak Republics. This comparison has tended to overlook the positive economic aspects of Slovakia. When the Slovak Republic is compared with the broader spectrum of transition economies, Slovakia is clearly one of the better performing economies in Central and Eastern Europe.
Macroeconomic indicators such as GDP per capita show Slovakia outperforming Poland. Only Hungary and the Czech Republic have higher GDP per capita in the reforming countries. There is, however, major differences within the Slovak Republic regarding the share of the GDP. In 1993, Bratislava carried a disproportionate 33 percent, while KoSice had the next highest GDP share with only 6 percent. Slovakia also has a very low rate of foreign indebtedness. The country's gross foreign per capita debt was USD 597 in 1994, which was the lowest in Eastern Europe.
A study of Slovakian economy by the Austrian banks notes that "...turbulence on the foreign exchange front after separation also seems to have calmed down a bit and the Slovak Republic slowly seems to be making progress toward real growth."l
Of concern is the high unemployment rate and the budget deficit of over 6% GDP in 1993, which surpassed the 5 percent level agreed upon with the IMF. Real interest rates were actually negative during the 1990-93 transition process, and capital fiight continues to be a problem as savings from internal investors frequently flow out of the country.
As Slovakia exercised its democratic status to vote governments in and out of power, there have been frequent changes in regimes. These changes work to reflect public preferences. However, they also tend to slow economic growth, as changes in administration and administrative policies can temporarily paralyze economic development.
Fall elections in 1994 returned the coalition headed by Vladimir MeEiar to power. While the MeEiar government has been characterized as "left leaning," desires to trade with the west as well as aspirations for the country to be a member of the EU has prompted a focus on a market economy. A slowdown in privatization, however, is expected.
A March 1995 issue of The Slovak S~ectatorcarried a heading "Slovak Diplomacy Shines in EU Negotiations" and showed Prime Minister MeNar's willingness (pictured below) to hear out diplomats, such as EU delegate Jhn LiSuch (TSAR photo).
' The Slovak Republic. After One year of Independence, Bank Austria, Vienna 1994, pp.11-12. 5 -2 Those industries with the greatest 1993 exports were, in descending order, metal processing, machines and tools, chemicals, cars, mineral materials, rubber, paper and pulp, and electronics. Of these, machines and tools (-0.09), cars (0.04), and paper and pulp (-0.04) industries had a negative profitlcost ratio. The fact that these industries were not operating at a profit raises some doubt as to their future potential. The highest profit to cost among the exporters was in water, gas and electric supply industry at +0.23.
The Bank Austria report, "The Slovak Republic After One Year of Independence," further analyzed the situation, noting, "The deficit on the current account was covered by an active capital account of USD 404.0 millon in 1993. Long-term capital transfers of USD 0.9 billion were the most important item on the capital account. Credits taken accounted for USD 0.6 billion in 1993. Back payments of credits amounted to 0.4 billion. Direct investment and portfolio investment were only USD 0.4 billi~n."~
In addition to the general economic indicators discussed above, certain financial issues can affect the ability of a broad-based ESCO industry to grow. Some financial factors are relatively favorable for the creation of an ESCO industry; however, other conditions suggest it will probably take several years to foster any wide-spread industry.
Monetarv ~olicv.The Slovak monetary policy has some restrictive aspects, which have been motivated by the goal of price-level stability. To some extent this somewhat restrictive policy has been counter-balanced by the liberalization of foreign trade and the financial sector, as well as the advent of new small-scale enterprises and a sharp increase in the velocity of money due to privatization.
Inflation. The Slovak Republic has shown a strong stabilization of its inflation from 61 percent in 1991 to 12-13 percent in 1994. A jump to 23 percent in 1993 was clearly influenced by the imposition of the VAT, which was 6 percent on most foods and services, and 25 percent on all other goods.
Discount rates. The Slovak National Bank's discount rate was decreased to 11 percent in March, 1995. Interest rates on savings accounts varied between 6 percent and 9 percent all through 1992 and reached 12 percent in 1993. A comparison of discount rate and interest rates reveals the real interest rate was negative through the reform process and remained low into 1994.
Banking industry. The banking system is comprised of the National Bank of Slovakia, commercial banks, and bankinglfinancial institutions. NBS is the issuing bank and is charged with maintaining a stable currency and coordinating interbank payments and clearing. There were 28 banks in Slovakia as of January 1, 1994, which included three state banks, four banks with state majority participation, three banks with price majority participation, eight
OD.Cit. Bank Austria, p. 23. with foreign capital participation and ten branches of foreign banks. The main foreign investor is Austria.
The General Credit bank (VUB) the Investment and Development Bank (IRB) and the Slovak State Savings Bank are considered the most important banks in Slovakia. The author of the report met with IRB officials during the fact finding mission and found the bank to be very interested in performance contracting, especially for some of its own creditworthy customers. The bank indicated such loans could exceed five years and could be offered as low as 16 percent.
The health of the banking sector is shown in the Table 5-1 balance sheet.
RELATED FINANCIAL ISSUES
Slovakian energy savings are typically measured in reduced gigajoules; not Slovak crowns (SK). This is based on a misconception rooted in the idea that physical units of output are the standard by which energy savings benefits should be measured, and from which all other analyses of benefits should flow.
This misconception has very real consequences; particularly for performance contracting, which is primarily a financial transaction.
TABLE 5-1. SLOVAK FINANCIAL SECTOR BALANCE SHEET SICK billion
Time and saving
foreign currency
.. . . - . - - . . . source: Natlonal Bank ot Slovakia
5-4 A failure to take into account the financial savings and the time value of money when making analyses of competing investments creates inaccurate comparisons. Two examples revealed during the fact finding mission illustrate the point. (1) At the Energy Research Institute (EGU) considerable time was spent with the Director, Mr. Jozef Sellej, and Mr. Peter Sesthk, who did much of the work and report preparation for the Handlova project. In comparing the relative savings benefits of various options, the time value of money was not considered. Payback parameters were apparently not a factor. (2) A report prepared in 1994 by the EC Energy Centre, "Energy Sector of Slovakia," provides valuable data on consumption in PJ, GWh, etc., but no mention is made of the cost or the potential SK savings. The title page does note, "Description based on information from official Slovak bodies;" so it is possible the monetary data were not available.
Finally, the most indicative, surprising and even disturbing example of the failure to grasp the potential of energy savings in monetary terms rather than joules, was the lack of information on the country's energy bill. We could not find out from the officials with whom we met the country's total energy bill for 1994. If the energy burden is not quantified in crowns, there is little appreciation for the economic impact regarding the importation of 75 percent of Slovakia's primary energy. Nor, is there the needed focus on the benefits of energy efficiency.
Energy efficiency needs to be regarded as an investment; a cost-effective investment. In transitional economies where the demands are great and the economy is tight, energy efficiency must compete with other investments, even jobs. The absence of energy saving costbenefit analyses works against a true realization of the value of energy efficiency. When performance contracting project benefits are calculated, the time required to recover the investment makes this a critical issue.
THE ENERGY SITUATION
To fully analyze the energy situation in Slovakia, it is necessary to first recognize that the independent Slovak Republic was established only two years ago. An assessment of the energy situation and its economic implications must also consider the previous development within the Czech and Slovak Federal Republic (CSFR), or Czechoslovakia.
The industrialization of Slovakia began after World War I1 when the CSFR was established in 1918. Under a command-and-control economy, efficient operations, particularly energy efficiency operations, were not a consideration. Much of the industrial development was heavy industry; e.g., building materials, iron and nonferrous metals, chemical plants, etc. as well as crude oil processing and paperfpulp production. Most of the energy for these plants was imported and prices were subsidized by the state. The industrialization of Slovakia began after World War I1 when the CSFR was established in 1918. Under a command-and-control economy, efficient operations, particularly energy efficiency operations, were not a consideration. Much of the industrial development was heavy industry; e.g., building materials, iron and nonferrous metals, chemical plants, etc. as well as crude oil processing and paper/pulp production. Most of the energy for these plants was imported and prices were subsidized by the state.
Slovakia, therefore, inherited high energy consumption in much of its industry. In 1990, immediately following the velvet revolution, 54 percent of the final energy consumption went to industry. By the end of 1991, country-wide consumption had dropped by 2 percent but industry had dropped by 17 percent and had reduced its share of total Slovakian energy consumption to 49 percent. Nevertheless, in 1994 Slovakian industry was still characterized as energy inefficient and industry's share was back over 50 percent. (Some of the drop can be attributed to plant closings.)
The industrial sector continues to offer a logical target for performance contracting, particularly as the country seeks to become more internationally competitive. 61 percent of the coal consumption (brown and imported cooky coal) is used by industry, with power and metallurgy plants consuming over 80 percent of this.
Slovakia is largely dependent on fuel imports; so increased energy efficiency will also favorably impact its balance of trade. Only 25 percent of the primary sources is provided by domestic production. The brown coal is imported from the CR and cooky coal from Ukraine. Crude oil and gas are imported from Russia.
ELECTRICITY
DSM. Slovenskk Elektriirne (SE), the country-wide utility, has had a policy of supporting demand-side management (DSM) since 1992 and is working actively with British Columbia Hydro's Power Smart people to implement it. SE and Power Smart are seeking funding from EBRD for some of the DSM measures.
Of particular interest to ESCOs, who are considering cogeneration, is the SE balance chart for 1993 electricity. As shown in Figure 5-1, of the 27,406 GWh total resources only 18,242 GWh reach the customers; i.e., losses of the three distributors are not included in these figures. BALANCE CHART OF ELECrRfCFP/ IN 1993
Slovak republic
Consumption of 540 Gwh pumped storage p. p. Total Internal Production 23 397 resources 2 177GW.h useof GWh IPP
GWh Supply 18 242 GW.h to the customers
683 GW.h Power plant operational self consumptron Import 40055%, , GVClh, ,, 2 "A 1 - -M'm~"~3: . 1 050 W..h Losses in the grtd *. *"" .-- .. SEP Production of electricity 1 1 022 2 880 GW h Export GW. h - nuclear 540 GW. Consumption for pumping - convec- tional 5 698 thermal GWh GW.h ZSE, regional 6 172 GW.h distribution resources company - hydro 3 459 total GW.R SSE, regtonal 6 765 GW.h distribution company VSE, reg~onal 4 81 5 Gwh drstributron company -356CW.~ Transmrs~on ------. . - losses -. . Power plant operatronal --2self consumptron
FIGURE 5-1.
Transmission. SE also operates the transmission network. The transmission networks of 440kV and 220kV. Figure 5-2 offers a schematic of the transmission network as well as the irnport/export volume in GWh to the CR, Hungary and Ukraine. EXPORT AND IMPORT OF ELECTRICITY (GWh) AND TRANSMISSION' NRWORK
FIGURE 5-2.
Distributors. SE sells directly to four industries and three distributing companies; ZQpadoslovensk6 energetickk zgvody (ZSE [west] Bratislava); Stredoslovensk6 energetickk zAvody (SSE [central], Zilina); and Vjrchodoslovensk6 energetick6 zQvody (VSE [east], KoSice).
While the distributors secure 86 to 95 percent of their power from SE, they also purchase power from industrial companies, generate some of their own power (ZSE and SSE) and ZSE imports 166,310 MWh high voltage power. Total sources for each distributor in 1993 were: ZSE - 6,758,809 MWh; SSE - 7,757,276 MWh; and VSE - 5,087,432 MWh.
Peak load profile for each distribution company by month and combined for the years 1990- 93 are shown in Figure 4-7. While demand has dropped, the peak capacity needs are in the winter. The distributors describe their capacity as "limited."
The distributors pay more for the power plus distribution than they receive in revenues for the power sold to the "public." ("Public" does not include the traditional schools, hospitals and government buildings and typically refers to residential housing in Slovakia.) They are, therefore, very supportive of performance contracting in this residential market. In fact, ZSE is initiating some guaranteed energy saving projects in its area. Energy efficiency in the commercial and industrial sector could cause distributors to lose money; so the support of performance contracting in these sectors is tempered. Representatives of the distributors did point out that with capacity being limited, energy efficiency measures could make it possible to serve additional customers with the same quantity. They would, therefore, gain revenue from more flat (hook up) charges from the additional customers for the same quantity sold.
Pricing. The price of energy is set by the Ministry of Finance. The last energy price increase was in 1993, when a 6 percent VAT was applied.
SE sells to distributors at approximately SK 0.98kWh. The Ministry of Finance reported that SE currently makes a 65 percent profit on the electrical power it sells.
Currently, the selling price "wholesale" (industrial) is SK 1.534/kWh (US$ 0.05kWh). The average price to the public is SK 0.906lkWh (US$ 0.03kWh).
The Ministry has proposed to raise prices to the public by 10 percent in 1995 and 15 percent in 1996. No price increases are scheduled for industry.
At present, there is no plan to adjust the tariff system to compensate distributors for lost revenues due to energy efficiency, or to move toward integrated resource planning. These issues have been overshadowed by needed resources in the near future, concerns that the new nuclear plant may not be finished, and that imports may have to be increased
HEATING
The 44 PJ consumed in 1993 came from state power, heat plants and from industrial plants. By fuel source, 50 percent is brown or hard coal, 35 percent is gas and 15 percent crude oil.
The district heating is supplied primarily to Slovakian cities. District heating carries the burden of old plants that urgently need reconstruction. The economic viability of this reconstruction is compromised by pricing problems, production and supply concerns as well as technical problems related to measurement of consumption, losses in production and transport, and the need for insulation. District heating plants are mostly urban and usually owned by the city or town. A few are owned by cooperatives or by a distributor with cogeneration.
Prices
Heating prices vary from SK 160/GJ to SK 570/GJ depending on the producer's ability and cost to generate the heat. It is the Ministry of Finance's responsibility to correct pricing so it equals the production costs, but a spokesperson for the Ministry declared, "It's not easy." Problems include the irregularities in boiler houses.
The Director of Price Policy appears to be very sensitive to end-users problems in non- insulated buildings. To insulate these buildings would cost about SK 60,000lapartment (US$ 2,000). For the users, this is very expensive and for the state "impossible."
Since 1993, end-users have had two options of payment: 1) by the square meter of floor space; or 2) by metered consumption. About 60 percent of the district heating is measured by family units in multi-family housing. The intent was to have housing fully metered by the end of 1995, but the costs have presented problems. In many instances, the process also requires a hydraulic balance of the heating system at each apartment, which adds to the cost.
The state provides SK 2.4 billion/year (US$ 80 million/year) in subsidies for heating.
SOURCES OF FUNDS
SLOVAKTAN COMMERCIAL BANKS
There appears to be limited money available from commercial banks for energy performance contracting (EPC). The representatives of the IRB indicated the bank would look favorably on funding EPC projects as an additional service to its credit worthy customers. Loans are available for five years or more. An interest rate of 16 percent will require ESCOs to consider only short payback items.
SLOVAK-AMERICAN ENTERPRISE FUND
The Fund expressed a strong interest in helping to foster an ESCO industry in the Slovak Republic. Support is available for the creation of the business itself and might also be available for project financing. The Fund typically takes an equity position in the new business entity, which it supports, and hopes for a relatively early buyout.
MINISTRY OF ENVIRONMENT
The Director of the Branch for the Ministry of Environment displayed an excellent understanding of the relationship of energy efficiency and environmental protection. He described a new fund, which would include energy effi~iency.~He indicated the fund has
' Mr. BeloviE, Director of the Branch, Ministry of Environment, In interview, march 1995. 5-10 been under development for some time and that it is ready to go forward if the support and approval from other sections of the Ministry can be secured.
MULTINATIONAL DEVELOPMENT BANKS (MDBs)
MDBs are active in Slovakia. The World Bank and the European Bank of Reconstruction and Development (EBRD) are offering support for energy efficiency. While the EBRD is in discussions with the utility to aid in its DSM efforts, it is not clear whether funds being made available will extend to performance contracting.
Pool Financing. The multi-national development banks (MDBs) have historically loaned sums of money in larger amounts than the amounts needed for energy efficiency projects. This is gradually changing and many MDBs are actively searching for ways to assist countries with energy efficiency efforts. The idea of creating a pool of funds to support a large number of smaller energy efficiency projects is growing.
Such accommodation could leverage MDB money since a third party guarantees the funds will be paid back; thus, making a revolving fund possible. This procedure could offer rates and terms favorable to the ESCO industry, which would stimulate the development of an ESCO business within Slovakia, benefit the Slovak Republic's competitiveness and improve its environment.
SLOVAKTAN GOVERNMENT SUPPORT
The government of the Slovak Republic through its State Energy Inspection (SEI) office is supporting the experimental projects in Banskh Bystrica and Malacky, which are designed to demonstrate the value of guaranteed energy savings in heating. If the project results have the anticipated positive results, it is hoped that the experiments will foster legislation that would allow organizations to keep their savings; thus, paving the way for performance contracting for heating in the public sector. There seemed to be general agreement among government officials interviewed that these projects have value and similar projects in other market sectors and projects involving electricity should be done. Several of the inteniewees voiced the desire to have the planned legislation cover electrical savings as well.
DOING BUSINESS IN SLOVAKIA
Transitional economies by definition mean changes of ownership, unstable economic conditions, and short-term planning. Fitting long-term performance contracting in such a context requires special consideration and caution for ESCOs. Some modifications are obvious, such as adjusting the concept of "long term" into a shorter time frame. The Slovak Chamber of Commerce and Industry has available a booklet, Slovak Republic - - Your Business Partner, prepared by JUDr. Ing. Pavol Kop%lin 1993 that provides clear descriptions and legal citings for most business issues an ESCO might need. Topics include ' the legislative framework for business activity, the tax system and concessions, depreciation policy, exchange control, foreign trade, labor relations, privatization and bankruptcy provision. It is available from the Chamber.
Several interviewees expressed concern about the absence of contract law. Further exploration revealed that contract law exists, but this perception, by itself, can act as a deterrent.
ESCO ACTIVITY IN SLOVAKIA
Other than the two experimental projects at Banskii Bystrica and Malacky, very little ESCO activity is taking place. Landis & Gyr has an active interest in pursuing the performance contracting and the other control manufacturers, Honeywell and Johnson Controls, are giving it careful consideration. Energy Performance Services, which has the performance contracting projects in the Czech Republic, is carefully evaluating the opportunities in Slovakia and may open an office in the Slovak Republic.
The Austrian company, ~ko~lan,has expressed an interest in developing some performance contracting projects in Slovakia. One of the electrical distributors, ZSE, is in the process of setting up a guaranteed savings project. The nation-wide utility, SE, declared its interest in becoming an ESCO.
Interest is growing. The conditions that would facilitate the growth of an ESCO industry are improving.
ENERGY EFFICIENCY MEASURES
Measures being recommended and implemented have been constrained by the relatively low price of energy. The measures being considered by the emerging Slovak ESCOs are usually short term measures; e.g., heat flow meters, simple controls and heat exchangers. Some maintenance/quick fix measures, are also attractive.
Among the larger measures mentioned by interviewees were:
boiler upgrades new boilers energy efficient motor replacement steam trimming meters heat exchangers controls weatherstripping
The cost-effectiveness of these measures and others must, of course, be determined on a site by site basis.
Projects that incorporate cogeneration with energy efficiency may be attractive in certain industrial markets and geographical areas.
POTENTIAL MARKETS
Identifyrng specific market sectors can cause ESCOs to overlook individual opportunities in other sectors. Conversely, there is a tendency to view the whole market as a strong opportunity when an organization within that market could be weak. Every market requires careful due diligence on a site by site basis. With these caveats in mind, there are several markets worthy of further investigation.
Caution, however, is warranted. With the exception of the chemical industry, Slovakian industry is heavily dependent on imports from and deliveries to the Czech Republic. Most Slovak industries have a high dependence on imports. In examining industrial markets, which in Slovakia are very heterogeneous, it is important to recognize that some segments of the market have different profitability profiles. For example, the fertilizers segment of the chemical industry is profitable and quite competitive.
Many Slovakian products are also sensitive to import restrictions in industrial nations.
Industries warranting consideration include:
chemicals metal production clothiers furniture wood leather processing, especially shoes rubber
Industries in Slovakia face considerable structural change within the next few years. While this makes performance contracting even more attractive to owners, ESCOs must carefully weigh the longevity of the building and its processing equipment as well as the energy consuming equipment that will remain. Until public facilities: (which is housing in Slovakia; not schools or hospitals, unless physically connected to the housing), are charged a higher rate for electricity, they will not good candidates. DETERRENTS TO AN ESCO INDUSTRY RELATED TO SLOVAKIA'S ECONOMIC, POLITICAL, FINANCIAL AND ENERGY SITUATION; POSSIBLE RESOLUTIONS
5-1. Interest rates - While more favorable than some of its neighbors' interest rates, the rates in the Slovak Republic are still too high to encourage the implementation of any measures with longer term paybacks. Longer payback items are critically needed for major upgrades, better savings persistence and greater environmental benefits.
Resolution: Encourage the use of multinational development bank (MDB) financing or environmental funds to buy down the rates where appropriate. Through performance contracting, this will then have the effect of leveraging the financing available and better serve Slovakia's industrial needs. Pool financing, which spreads the risks and makes smaller loans possible, should also be considered.
Tax laws and potential concessions should be examined to be sure they are equitable. Second, Slovakia should determine if some offsetting incentives, such as corporate income tax holidays, can be offered to energy service companies as an inducement to bring their expertise to Slovakia.
5-2. Convertibilitv. ESCOs and investors from other countries must be assured that they will be able to get payments and/or money out of the country. (Internal convertibility does not appear to be a problem.)
Resolution: Steps need to be taken to achieve external convertibility as soon as possible. Greater international recognition of the country's increasing economic stability would help.
5-3. The monev side of enerw. In evaluating the benefits of energy efficiency or in making savings calculations the financial gains are typically overlooked. Slovakia's financial planners do not seem to be fully aware of the economic implications of the nation's energy bill or the burden the government carries through its indirect energy support.
Resolution: A data base enabling economic analysis of energy use should be developed. Government financial planners and decision-makers need to: (1) be more conscious of the economic impacts of artificially low, subsidized energy prices; (2) the government's share of the cost of energy; (3) and its burden to the Slovakian economy; and (4) how current procedures impact the nation's ability to meet other needs. Education and training of the money side of energy should be offered energy planners, energy service and energy efficiency financing providers.
5-4. Leal issues - The relative common conception that there is an absence of contract law could prove to be a deterrent to energy performance contracting.
Resolution: Some effort by the government and the legal community to overcome this perception is needed for all contracting procedures. ESCOs, which might serve Slovakia, must be made aware that the "no contract law" perception is false.
5-5. Economic restructuring efforts - AID and others have many projects going forward to address economic concerns. Some of these could effectively embrace energy efficiency concerns and benefits.
Resolution: Review AID and MDB efforts in Slovakia. Consider where energy efficiency issues, concerns and benefits might be coordinated and incorporated.
5-6. Electric enerw prices. Prices have been held low in the public sector; so there has been little inducement to use energy more efficiently. At the distributor level, loses in the public sector are covered by fees from industry. This works against the competitive position of Slovak industry.
Increased prices in the residential area would permit larger investments by ESCO, enabling them to offer more facility upgrades and more environmental benefits.
Resolution: The Slovakian government has expressed the intention of raising prices to the public by 10 percent in 1995 and 15 percent in 1996. These increases should be encouraged, but it should be noted that the price to the public after these increases will still not equal the current costs to distributors.
Industry, the Slovak economy, and unemployment would all benefit if industry did not have to cover distributor losses. An additional increase to the public in 1997, which would at least reach distributor costs should be seriously considered, with industry experiencing a corresponding relief in its tariff.
5-7. Metering heating consumption. Only if there is a direct relationship between the amount of heating energy consumed and the amount paid will there be the needed incentive to the end-users to conserve. Performance contracting requires metered consumption to calculate savings.
Resolution: Slovakia's desire to get facilities on independent meters should be encouraged. The possibility that ESCOs could provide such metering as part of an energy saving package should be explored. (Small ESCOs in Poland are experiencing a 15 percent savings by changing consumers from "floor space" payments to metered payments.)
5-8. Distributor's revenue losses from enerm efficiencv. At present, any industrial energy savings will cut revenue and reduce distributors' ability to cover losses in public sales.
Resolution: Efforts to implement DSM at the utility level should consider the distributor's needs and adjust tariffs accordingly. If the utility's current profit margin is as high as reported (65 percent), it should be is sufficient to make some accommodation.
5-9. Lack of awareness of the economic value of energv efficiency. The focus at present is on increased production and/or more energy imports to meet future energy needs. There is little awareness of the economic value of energy efficiency, or its value to offset increased production/imports. The inability of many energy decision-makers we interviewed to cite the country's energy bill, or even the annual cost of energy imports, reveals a major factor underlying this problem.
Resolution: Energy planners should be provided an economic analysis of energy production, importation and use in Slovakia -- in crowns. The return on investment (ROI) of certain energy efficiency measures should be included in this analysis.
A good place to start applying financial analyses is the energy efficiency projects in progress. The results of the two experiments at Banski Bystrica and Malacky should be reported in crowns invested, crowns saved and the cost-effectiveness of the project. Economic analyses should accompany any further analysis and implementation of the Handlova project. SECTION 6. OVERVIEW OF PERFORMANCE CONTRACTING POTENTIAL
The potential to save energy in Hungary, Poland and Slovakia is great. Energy intensity is double that of most areas of the world. A large percentage of their energy is imported; so any moves to greater energy efficiency will help the economy, the trade balance, create jobs and make companies more competitive. The countries' industrial sector carries a heavy energy burden. As with any transitional economy, money to support energy efficiency is difficult to find. Opportunities for and potential benefits from energy performance contracting are great.
The following segments of this section serve to summarize those issues with the greatest impact on energy service companies' (ESCOs) opportunities as well as the deterrents to the growth of a broad based industry. A few comments are offered, but the highlights can be primarily found in the recommendations made for facilitating an ESCO industry in each country.
HUNGARY: CONCLUSIONS & RECOMMENDATIONS
As energy prices increase, the opportunity to save energy through performance contracting in Hungary will become more attractive to ESCOs. A market size of 10 million people, an average energy intensity of 1.16, (ton of oil equivalent/US$l,OOO GDP) an industrial energy intensity of 3.91 (TPESIGDP) and a heavy energy burden on the government all speak to tremendous opportunities on the horizon.
Relatively high consumer interest rates ranging from 32 to 36 percent, inflation rates at 19 percent resulting in real interest rates of 11-14 percent as well as existing banking conditions, however, are deterrents. The incorporation of environmental funds in project financing can have a mitigating effect on these financing problems. Environmental funds for energy efficiency purposes, however, are limited and will not support a broad based move of the ESCO industry into Hungary at this time. Without the environment funds domestic ESCOs, foreign ESCOs or joint venture combinations are, with few exceptions, confined to relying on short payback measures unless multi-national funds can be accessed. Relying solely on short payback measures negatively affects project profitability, savings persistence and environmental benefits.
The power sector and current procedures for setting tariffslprices do not encourage ESCO activity. Pending energy legislation before Parliament, particularly changes in price setting, will benefit the industrynl In the meantime, ESCO actions in Hungary may focus on heating energy, provided consumption can be metered effectively.
RECOMMENDATIONS
1. Provide technical assistance and performance contracting guidance to the emerging Hungarian ESCO market through:
Liaisons, guidance, consultation: o encouraging U.S. ESCO involvement o fostering the partnership of experienced ESCOs with in-country partners in primelsub or joint venture relationships o provididg business guidance through in-country consultation or documents, particularly in costing projects and the time value of money; o developing pilot, or demonstration, projects in several sectors; and o providing consultation to government officials in establishing an energy data base, which includes monetary consideration. On-site training and/or seminars: o offering special training sessions for engineers, prospective ESCOs, financiers, and the legal profession in risk assessment and factors unique to performance contracting. Train engineers, who can now perform energy audits, to do the analysis and calculations required by ESCOs; and o providing special training in energy efficiency practices for operations and maintenance (O&M) personnel; probably through training O&M supervisors to train their people.
Encourage the use of environmental funds to support energy efficiency in Hungary.
3. Elicit the support of multi-national development banks and other international funding sources to augment or ameliorate the present financial constraints. Provide a grant to Hungarian banks to buy down interest rates, which could leverage relatively small sums into larger economically attractive financing sources.
To fit typical MDB size loans to energy efficiency needs, MDBs should be encouraged to consider pool financing for groups of buildings, such as the Health Insurance Fund's 170 hospitals; or, commercial bank management of a pool to fund a series of loans for smaller projects.
This legislation was passed subsequent to the September 1994 field research.
6-2 Continue technical support to the banks and government in developing procedures that will most effectively support energy efficiency and performance contracting in Hungary. Encourage longer term loans and the use of predicted energy savings as collateral.
Review patterns of non-payment of utility bills in some sectors with policy makers. This non-payment problem could grow with the anticipated 1995 energy price increases. This non-payment pattern raises cross-subsidy issues for those who do pay and leaves the non-payees without any incentive to operate more energy efficiently. Furthermore, non-payment behavior excludes them from being served by ESCOs; and, therefore, denies the country the opportunity to reduce its energy intensity.
The extremely high liability the government carries to supplement energy pricing must be brought down. It is an incredible burden for the government, works against energy efficiency, ESCO potential services, and economic well-being.
Encourage the government to undertake the comprehensive collection of energy data by first developing a nation-wide data base system. Include energy economics and potential financial benefit of energy efficiency in the data base. Seminars should be offered to bankers to enable them to assess the financial merits of performance contracting projects so they gain the assurance to fund such projects;
Tax laws and procedures should be examined to be sure no disincentives or inequities exist that negatively impacts moves toward energy efficiency, performance contracting and sound economic policies. Secondarily, the normalization of income tax holidays for ESCOs should be considered as an incentive to do business in Hungary.
Help the leadership realize that energy efficiency is a sector free problem and the responsibilities extend far beyond the energy sector per se.
Develop a model to facilitate access to revenue streams for institutions, such as schools and hospitals, that currently have no way to retain energy savings.
Encourage the use of metered consumption for heating rather than the current procedure to pay by floor space (m2); so end-users have an incentive to use energy more efficiently.
Assess the utility's current procedures and its tariff structure, and restructure as appropriate so that no one entity in the power sector suffers unduly from energy efficiency and demand-side management procedures. Accelerate the privatization process; so transitional organization can more readily access ESCO assistance. 14. Give strong support to the government's plan to increase energy prices. Offer guidance so that government officials can more easily recognize the value of energy efficiency and performance contracting in significantly reducing the social and economic dislocation caused by these price increase.
15. Prepare clearly defined procedures and guidance documents, which will enable ESCOs to secure their money within a project; provide for unimpeded opportunities to get money from recalcitrant customers; prepare bankable project to get funding from commercial banks; and allow clear recovery of invested funds and profits as warranted.
16. Examine the range of AID and MDB efforts in Hungry and determine where energy efficiency issues, concerns and benefits might be coordinated and incorporated in these on-going programs.
POLAND: CONCLUSIONS AND RECOMMENDATIONS
The potential for an energy service company (ESCO) industry in Poland is significant. A market size of 40 million people, an energy intensity per gross domestic product of 1.78, the highest energy consumption in the region, and a heavy dependence on coal with its associated environmental problems all speak to tremendous opportunities on the horizon.
Relatively high interest rates (38 percent) and inflation rates (31 percent) as well as existing banking conditions, however, are deterrents. The incorporation of environmental funds in project financing can have a mitigating effect on these financing problems. Environmental funds for energy efficiency purposes, however, are limited and are not apt to support a broad based move of the ESCO industry into Poland at this time. Without the environment funds, the domestic ESCOs, foreign ESCOs or joint venture combinations are, with few exceptions, must confine projects to very short payback items. This necessary use of short paybacks negatively affects project profitability, savings persistence and environmental benefits.
The structure of the power sector and current procedures for setting tariffs/prices do not encourage ESCO activity. Pending energy legislation before Parliament, particularly changes in price setting, would benefit the industry. In the meantime, ESCO actions in Poland to date have focused on heating energy. RECOMMENDATIONS
The Polish government has made great strides in bringing the cost per kwh up from its low social cost in 1988 to the level it is today. This pattern needs to continue until energy prices reflect actual costs.
Electric pricing is structured to include the regulated end-use price and the "commonly agreed price" (about a 30 percent add on) as it is paid to the distributor. This policy of "commonly agreed price" amounts to a government subsidy and should be phased out if ESCOs are to serve this market most effectively.
Consumers should have some incentive to pay for metered heating energy consumption; not floor space. The use of metered consumption should be encouraged and the utilization of performance contracting to install meters should be explored.
Provide compensation to distributors for lost revenues from more energy efficient customers. Consider how DSM and IRP might be modified, such as adjustments in the tariff structure, so energy efficiency becomes a more attractive option than increased generating capacity.
The tariff structure should be changed; so, generation payments are based on production.
The government should consider a clearly defined subsidy in lieu of the hidden, utility "non-payment" subsidy. Farmers, for example, should be obliged to pay their utility bills, but could receive an equivalent in a subsidy. They would not suffer an economic loss (and the government would avoid the political implications). At the same time, farmers would have an incentive to operate more energy efficiently. The result would be better net financial position.
If ESCOs are going to be able to access some of the environmental funds, a concerted effort to forge the environment-energy efficiency connection must be made.
ESCOs considering investing in energy efficiency projects in Poland need to be advised of all financing sources, but particularly the environmental funds, which have such attractive financing terms.
Accelerate the privatization procedures so more organizations would be in a position to receive ESCO services. 10. Inflation is trending downward and the devaluation is using the crawling peg mechanism. Both are relatively favorable indicators of an economy coming into line, but the combined effect places a financial hardship on those who might otherwise pursue performance contracting. Continued efforts to lower inflation should be encouraged.
11. In addition, tax laws and procedures should be examined to see that all provisions for an energy efficiency industry are equitable. Second, determine if Poland can offer some offsetting incentives, such as income tax holidays and exemptions on customs taxes for energy efficient goods not produced in Poland.
12. Provide fixed interest rates, instead of floating rates, in Polish commercial banks for energy efficient projects. Or, encourage more multi-national development money to be available for financing.
13. Develop a mitigating strategy to remove or reduce VAT on energy saving performance contracting.
14. Prepare clearly defined procedures, which enable ESCOs to secure their money within a project; provides for unimpeded opportunity to get money from recalcitrant customers and/or commercial banks; and allows clear recovery of invested funds and profits.
SLOVAKLA: CONCLUSIONS AND RECOMMENDATIONS
The potential for an energy service company (ESCO) industry in the Slovak Republic is unfolding. Slovakia imports approximately 75 percent of its energy. having inherited a heavy historical energy intensity burden, particularly in industry, opportunities to help Slovakia economically are great.
Interest rates ranging from 16 to 20 percent, inflation rates at 12 percent and limitations on available commercial financing, however, are moderate deterrents. The incorporation of environmental funds in project financing can help these financing problems. Environmental funds for energy efficiency purposes, however, are limited and the new fund from the Ministry of Environment is not yet approved. Without the environment funds, the domestic ESCOs, foreign ESCOs or joint venture combinations are, with few exceptions, confined to relying on short payback measures. Relying solely on short payback measures negatively affects project profitability, savings persistence and environmental benefits. The incorporation of environmental funds or funds from multinational development banks into project financing could have a mitigating effect on these financing problems. The current procedures for setting tariffslprices do not encourage ESCO activity in the public sector. In the meantime, ESCO actions in Slovakia may focus on the industrial sector.
The government sponsored demonstration projects in Banski Bystrica & Malacky, as well as growing activity among domestic and foreign ESCOs all offer positive signs of an industry ready to grow very rapidly. The industry is not yet established. A broad-based industry is probably two to three years away. Those who want to influence industry development and be in on the "ground floor" should give serious consideration to establishing a presence in the Slovak market now. The future should be attractive to ESCOs; however, only ESCOs with the financial resources to fund the costs of developing the market can afford to invest in the market place at this early stage. Any reprieve from this long-term planning agenda would appear to be in the use of multi-national development bank funds.
RECOMMENDATIONS
1. Encourage economic/monetary analysis of energy resources, needs, use and energy efficiency opportunities. Apply market economy return on investment analyses to the projects in Handlova, Banski Bystrica and Malacky.
2. Extend the government sponsored guaranteed savings experiments in heating in the housing sector to electricity usage and add other markets. Use financial analysis in these projects, too.
3. Provide technical assistance and performance contracting guidance to the emerging Slovakian ESCO market through
- offering special training sessions for engineers, prospective ESCOs, financiers, and the legal profession - encouraging U.S. ESCO involvement - fostering the partnership of experienced ESCOs with in-country partners in primelsub or joint venture relationships - presenting seminars, conferences for decision - makers - providing business guidance through in-country consultation or documents, particularly in costing projects and the time value of money - training engineers, who can now perform energy audits, to do the analysis and calculations required by ESCOs - providing special training in energy efficiency practices for operations and maintenance (O&M) personnel; probably through training O&M supervisors to train their people.
3. Encourage the implementation of an environmental funding program, which will support energy efficiency in Slovakia. Elicit the support of multi-national development banks and other funding sources to augment or ameliorate the present financial constraints. Provide a grant to Slovakian bank(s) to buy down interest rates, which could leverage relatively small sums into larger economically attractive financing sources.
To fit typical MDB size loans to energy efficiency needs, MDBs should be encouraged to consider pool financing for groups of buildings, or establish commercial bank management for a pool to fund a series of loans for smaller projects.
Continue technical support to the banks and government in developing procedures that will most effectively support energy efficiency and performance contracting in Slovakia. Encourage longer term loans and the use of predicted energy savings as collateral.
Encourage the government to undertake the comprehensive collection of energy data, which includes energy cost information and develop a nation-wide data base.
Help the leadership realize that energy efficiency is a sector free problem and the responsibilities extend far beyond the energy sector itself.
Assess the utility's current procedures and its tariff structure, and restructure as appropriate so that no entity in the power sector suffers unduly from energy efficiency and demand-side management procedures.
Accelerate the privatization process; so transitional organizations can more readily access ESCO assistance.
Give strong support to the government's plan to increase energy prices. Offer guidance so that government officials can more easily recognize the value of energy efficiency and performance contracting in significantly reducing the social and economic dislocation caused by these price increase.
Prepare clearly defined procedures and guidance documents, which will enable ESCOs to secure their money within a project; provide for unimpeded opportunities to get money from recalcitrant customers; prepare bankable projects to get funding from commercial banks; and allow clear recovery of invested funds and profits as warranted.
Examine the range of AID and MDB efforts in Slovakia and determine where energy efficiency issues, concerns and benefits might be coordinated and incorporated in these on-going programs. SUPPORTING THE ESCO MARKET
The growing activity by domestic and foreign ESCOs in all three countries gives all the signs of an industry ready to grow very rapidly. The industry is not fully established, and a broad- based industry is probably two to three years away. Those who want to influence industry development and be in on the "ground floor" should give serious consideration to establishing a presence in this market now. The future should be very lucrative; however, only ESCOs with the financial resources to fund the costs of developing the market and surviving some lean years can afford to invest in the market place at this embryonic stage. The only alternative to this rather stark, long-term planning agenda would appear to be the use of multi-national development bank funds or environmental funds.
In an industry used to long sales cycles and slow market development, the trends are very heartening. For U.S. ESCOs seeking an international presence the search for in-country partners and potential markets should begin.
For those who seek to foster a market economy, energy efficiency and environmental improvements in these countries can gain much by supporting the creation of an ESCO industry. Industry guidance, however, is needed immediately. Conditions are ripe for a fledgling ESCO industry throughout the region to go through some of the painful mistake- ridden growth processes experienced in the United States. Technical assistance to help emerging ESCOs move beyond avoidable difficulties is urgently needed. Technological transfer can be accomplished most expeditiously through encouraging successful foreign ESCOs to develop joint ventures or sub-contract with in-country partners. Further training, particularly in performance contracting risk assessment and developing project financial~legal structures to manage those risks, would benefit energy service and financing relationships. APPENDIX A BUDAPEST IhTERVTEWEES SEPTEMBER 1994
Inteniews conducted by Dr. Shirley Hansen with Andriis Morenth, consultant, in chronological order.
CENETECH Ed Corcoran, Managing Director
K6ves & Partners, legal firm (associated with Clifford Chance) ~6uefBalogh, Attorney
Hungarian Energy Office Prof. Dr. Imre Szabci, President and Executive Director of the Energy Office
State Supervisory (or Authority) of Energy Management and Energy Safety. Jbzsef Nimeth, Project Manager
National Bank of Hungary (Magyar Nemzeti Bank) ~vaTarjiin, General Manager, Department for International Financial Institutions Elvira Romhiinyi, Assistant General Manager, Department for International Development Institutions P61 Nagy, Assistant General Manager, Department of International Financial Relations
Association of Energy Consumers (MESZ) Lajos Nimeth, president Dezso Porpiczy, vice president Mihily Szaniszlb, member of the board Hanna Imrik, Mrs. Szalay, member of the board. Ervin Pelle, managing Director, CREDILUX
EU-Hungary Energy Center Tibor Bertbk, director of the Energy Centre . Ministry of Industry and Trade, Department of Energy Strategy J6zsef Nkrneth, Legal Department MiklBs PoBs, Deputy Director General Antal Pintkr, Senior Advisor Uszi6 Garbai, Section Head
Hungarian Credit Bank (MHB) Rt haSteinhaus& director of the German Coal Aid Fund Mrs. Weores, Liszl6n6, Managing Director, Directorate for Project Financing
BUSZESZ Rt., Budafoki 81esa6 Cr SzeszgyAr - Budafok Yeast and Distillation Plant G6za Szab6, director
HESCO (Hungarian ESCO) Diiniel Benk6, Marketing Director
Lambda HJR, International Propaganda, Advertising and Marketing Ltd. Gtibor Vtig6, director
'R6ntgen 6s K6rh5ztechnikai RbzvCnytArsas6g (RKV) D6niel Szekely responsible for marketing
Controll Tibor Nagy, advisor
Ministry of Finance Groly Taksz, Director General, Corporate and Venture Section Elizabeth G%ti,Head of Department, Corporate and Venture Section Istviin Herczeg, Sen. Counsellor of Min., Corporate and Venture Section
National Headquarters for Penal Authority Ern6 Fenyves, director of investments Pkter Szende, deputy director of investments Tam& Uszlb, managing director, Bruun & Sorensen Hungary KFT Hungarian State Holding Company Laszlb Lengyel, director of energy portfolio Laszlb Becker, Managing Director Industry Portfolio
MVM (Magyar Villamos MGvek Rt.-- Hungarian Power Companies Ltd.) Mihiily Korodi, Public and International Affairs Mihay Bacskii, Manager of Operations Alajos Strobl, Head of Section for Strategies Gkza Kiriily, Public and International Affairs
EGI-ContractingEngineering Co. Ltd. Zoltin Lontay, Head of Department, Energy Conservation, Environmental Technology
Professional Association of District Heating Companies Mikl6s FgbiBn, general secretary; excellent source on district heating.
Public Health Insurance Fund Administration azlbSBndor, Chairman Miiria Pintir, Executive Manager of World Bank Project PMU MikIds GellCrt, Private consultant Nance M. Kyloh, Deputy Project Officer USAID
GellCrt Innovative Bureau of Engineering MiMbs GellCn, C.E.M.,Managing Director
Ministry for Environment and Regional Policy Gtibor Unyi, Head of Department for Environmental Policy Sindor Hargitai, Head of Department, Secretariat of the Central Environmental Protection Fund (CEPF)
Building Industry Gyorgy Kissornly6i, Office Head and Andr6s Somos, Deputy Office Head, Office of Innovation, R+D Foundation for Building Management Albert Dtsi, Chief Councellor, Head of Department, Department of Construction Ministry of Industry & Trade ~gnesSebestytn, Counsellor of the Ministry, Department of Building Industry, Ministry of Industry & Trade Parliament Giibor Szalay, Member of Parliament, Vice-Chairman, Committee on European Community Affairs (He has an EU symbol on his card.) Member of Committee on Economic Affairs.
USAID Hungary Nance M. Kyloh ZolGn Viirkonyi Nedra Huggins-Williams July 21, 1994 (Thursday) Mr. Panek & Mr. Kostrzewa, Energy Conservation Foundation Mr. Stefan Lober, Director of the Department of Finance of National Economy Ministry of Finance July 22, 1994 (Friday) Mr. Dumin, Director Power Distributor of Warsaw (Warsaw in the lead distributor in Poland in energy efficiency and DSM, and Mr. Dumin heads this effort for the distributor.) Mr. Wojciech Brochwicz-Lewifiski, RBDO USAID CDI Environmental Projects July 25, 1994 (Monday) Mr. Lenczewski Polish Power Grid Company Mr. Miroslaw Duda Energy Restructuring Group Mr. Christian Duvigneau The World Bank, Poland July 26, 1994 (Tuesday) Mr. Wojciech Biefikowski, Director of the Foreign Cooperation Department ~ationalEnvironmental Fund Mr. Andrzej Czyz, Deputy President ECOFUND (Apparently, not related to Andrzej J. Czyz. ) July 27, 1994 (Wednesday) Mrs. Maria Jakubowicz, Proj ect Specialist, USAID Warsaw SLOVAKIA INTERVIEWEES MARCH 1995
Energy Measurement and Services, Ltd. Marian RutSek - General Manager
USAID Loren Schulze Martin Brunovslj
State Energy Inspection - Energy Agency Juraj Secko - General Director Miroslav KuEera - Director
Ministry of Economy SzitAs - Head of Energy Section Stefan Herich, Head of Department
Vupex, J.S. Co. Stefan Raninec - Director
European Bank (EBRD) Egbert Johrens - Senior Banker, PowerEnergy Utilities
Landis & Gyr Slovakia Milan BartoS - Director
European Communities Energy Center (ECEC) Bratislava Michael Wild - Director
Slovak Power Plants, Inc. + Power Smart Inc. Jiin Dohfianskjr - Head of Department, Consulting and Advisory Centre Pavel Simko, SE Energy Advisor Eug6nia Maderovii, SE Energy Advisor DuSan Berka, Power Smart Don McPherson, Power Smart
Association of Energy Mangers (ASENEM) Ivan BobBk - President Miroslav Kucera, SEI Jozef Sabaj, President of Orgrez
Central Slovak Power plants (SSE) and West Slovak Power plants (ZSE) Pavel Simko and Eugenia Maderovh of SE Jiin Jurik, Jozef Kriian and Mr. Ciemarie of ZSE Jozef Podola of SSE Slovak Gas Industry (SPP) Peter Kovac, Head of Technical Policy Department Daniela Bolgacova, Technical Rationalization
Slovak Chamber of Commerce and Industry (SOPK) L'ubomir Hanus - Director, Department of International Relations
Ministry of Economy Ivana Rapantova - Director of PHARE program Jean-Pierre Escribe, PHARE
Ministry of Finance Mrs. B6novB - Director of Price Policy
Antimonopoly Office DuSan Valo - Director
Applied Precision Mikul6s Bobik Ladislav Grno
Schubert & Partners, Law Offices Stanislav Schubert Ivan Piterka
Slovak - American Enterprise Fund Iveta GriaEov6 - Assistant to the President
Energy Research Institute (EGU) Jozef Sellej - Director Peter Sesthk, Program Manager
UEOS Komercia, Inc. (potential ESCO) Miroslav Vallo - Director Slavomir SurkoS - Technical Director
Investment and Development Bank (IRB) Norman Polednak - Manager, Correspondent Banking & International Business Dept. J6n Hirner - Risk Analysis
Ministry of Environment Vladirnir BeloviE - Director of Branch