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Industry Finance
In an energy-intensive industry energy consumed per unit of product typically accounts for double-digits in percentage of the total manufacturing cost. For example, in India, energy as a percentage of production cost is 15 per cent in textiles, 25 per cent in pulp and paper, and 40 per cent in glass, ceramics and cement industries. Any reduction in specific energy consumption will reduce overall costs significantly, thereby improving overall profit margins. However, investments in energy efficiency are often relegated to the background, citing amongst others the reason of non-availability of investment funds. Reduction in energy consumption per unit of product can improve the financial performance of individual companies and maximize shareholders' return on investment (RoI). Energy consumption can be reduced through recycling of waste, by the shortening of production cycles or trapping of exhaust flue gases to facilitate heat recovery. Co-generation is another option to reduce energy costs and environmental pollution.
Energy efficiency investment opportunities exist at every phase of a business enterprise - at the new project initiation phase as well as at any modernization or expansion phase. Energy efficiency improvements play a vital role in leveraging operating margins. Energy conservation is an investment-oriented activity, competing with other project opportunities. Decisions on the best project investment and financing option requires understanding and evaluation of the options available. However, facility managers are often unaware of the benefits that can accrue from an energy savings project.
New financing schemes are emerging and new elements are being incorporated in the overall evaluation process.
Cost-Effectiveness Analysis
For the development of a financial justification, it is very important to estimate the expected benefits of investment. However, it is not always easy to convert the benefit as economic value of money, which is mostly observed in the social projects such as energy saving and energy efficiency investment. In that case, cost-effectiveness analysis is available.
Cost effectiveness analysis is used to identify and select the least cost alternative to achieve a certain goal. In case the budget is fixed, the project which achieves the best result may be recommended to be chosen. Therefore it's more useful to compare the alternatives for the similar goal.
Think of a simple cost effectiveness analysis. In one city, there may be 500 energy facilities. The city administration may have a budget of US$10,000 to be invested in energy efficiency projects. There may be three alternatives. Project A may be assumed to improve the energy efficiency up to 90 per cent with US$100/unit. Project B is assumed to improve energy efficiency by 50 per cent with US$40/unit. Project C may achieve an 80 per cent performance improvement with only US$60/unit. It would be good to apply project A to all facilities but the limited budget may consider effectiveness, which can be calculated as the ratio of effective rate of project and cost per unit.
Under the above assumptions, project C shows the highest effectiveness. On the other hand, if project C can finance only 50 units due to technical restrictions, it may be better to use B and C at the same time by dividing the budget into $3000 for C and the rest for B.
There are several methods to appraise a project and each method has its own limitations. Prior to any investment decision any or all of the afore mentioned method may be used to rationalize decision making.
Ways and principles of investment financing
After listing available projects and appraising the expected project benefit over the lifetime of the project, the next important step is to evaluate the financing options available. Energy efficiency investment financing must be decided by various considerations such as financing scope - whether retrofit the existing equipment or complete installation of a new one -, and the financing pattern - whether short term or long term. For short term investments, inflation and discounting future incomes are less important.
Ways of investment financing
Ways of investment can be largely categorized into internal and external financing. Internal financing is by nature within management control (does not involve a lender) and warrants little procedural requirements. In the case of external financing, dependent on source and mode, procedural requirements would be significant.
The choice of financing for energy efficiency projects will be governed by considerations of funds available with the project promoters; strategic focus on company's core business dealings; other investment opportunities, i.e., considering opportunity cost of capital and maximizing returns, considering cost of capital, tax and cash flow status.
Self financing
Self-financing means the use of funds from internal accruals. Self-financing does not involve a lender and warrants little procedural requirements. Retained earnings offer the most suitable source for financing investments in energy efficiency. Retained earnings are especially appropriate for profit making entities, which can opt to re-invest surplus rather than paying out dividends to shareholders. Following paragraphs briefly outline alternative forms of self-financing;
Retained Earnings are withheld accrued incomes, which in the normal course of time should have been distributed amongst shareholders as dividends. Reinvesting retained earning will increase the asset base at a much lower cost, even at nil cost, compared to other modes of financing (especially external) which have greater acquisition costs.
Decrease in Assets relates to the sale or transfer of various assets (fixed, current, non-current, non-performing assets). If opportunity cost of retaining the asset is significantly lesser than the returns generated by the energy efficiency project, it may warrant asset disposal.
Trade Credit is a credit arrangement entered into by suppliers and their respective buyers to settle bills after a fixed period. This facilitates better liquidity for the buyer, as diversion of invoice amount for other important commitments is possible. If discount on cash purchase is greater than opportunity cost of availed credit, it is advisable to make cash-down payment.
Accrued expenses are costs, which have been incurred, but payable after fixed duration. Salary, wages, taxes constitute this type of expenses
Deferred Incomes are prior payments received for supply of goods or services at a later date. It is generally nil-cost oriented, along with an added advantage of providing security (advance receipts, caution deposits).
Equity financing relates to raising money from company's existing or new stockholders. Equity financing is supplied and used by its owners in the expectation that a profit, will be earned. However, owners have no assurance that a profit will actually be made or even the equity capital invested will be recovered. There are different categories of equity financing that can be distinguished;
Ordinary Stock is money collected by way of public subscription, either through underwriting or self-registration methods. Offer price can be at discount, par or premium depending on company's standing. Shareholder's "return on investment" is not compulsory but enjoys voting right and say in management.
Rights Stock is money collected from existing shareholders by way of a rights issue. Other features of ordinary stock hold good.
Preference Stock is a combination of debt and common stock arrangement wherein returns through dividends is fixed but not compulsory. However, it has preference over ordinary stock in the payment of dividends and liquidation of assets. It does not enjoy voting rights.
Debt financing
Money can be borrowed from an external source, either through the capital market (bonds, debentures, etc.) or as direct loans, at a fixed cost of capital. Debt financing includes:
Bonds/Debentures is money borrowed from investors and repaid with fixed interest over a period of time. Distinctive feature of bond is that, only interest or coupon rate is paid periodically. Upon its maturity, issuer returns only the face value of bond to the investors. Debentures are unsecured bonds.
Secured Loans is money borrowed from financial institutions at a fixed interest rate to be repaid periodically over a pre-determined period (including moratorium). Unlike bond, interest and installment have to be repaid together. Disbursed amount is safeguarded by "charging of securities" (pledge, hypothecation, mortgage, assignment, set-off or lien).
Unsecured Loans are same as secured loans, except that, clean advances are disbursed, i.e., no security is charged. This type of loan is seldom disbursed except to companies of repute and sound goodwill.
Commercial Papers are unsecured, negotiable, promissory notes, sold in money markets and generally offered to government or companies. In most countries, only large companies can raise money through these instruments.
Factoring Receivables are sale of bills receivables for a discount, to banks or factoring organizations with recourse (bills discounting) or without recourse (bills payable). Resorting to factoring receivables is advisable if opportunity cost of discounted sale is greater than withholding the bill until maturity.
Public Deposits is money borrowed from person(s) by issue of depository receipts at a fixed interest rate and period. The cumulative amount, inclusive of interest and principal, is repaid upon maturity or interest component is paid periodically and principal repaid upon maturity. Borrowers are rated by credit rating agencies.
Third party financing
Third Party financing is availing resources from a party other than self or financial institution, at a cost. In addition to pattern of vendor financed agreement i.e., when lender (vendor) is equipment manufacturer, directly selling to user, there could be a third party who could get involved in providing finances to either or both manufacturer and user. This is applicable particularly when the industry may not wish to take the burden of raising capital for energy efficiency projects and assume the risks associated with the same.
Different third party financing schemes available are:
ESCO Financing - Energy Services Company (ESCO) is a company that provides energy and financial services to an energy consumer. Performance contracting relates to implementation of energy efficiency projects in an existing firm, by an ESCO, which has both technical expertise and financial backing. ESCO bears the risk, by investing its own or borrowed funds. It recuperates its investment over a period of time through shared savings with client. All detailed modalities are governed by firm contracts.
In general, performance contracting is the best option for
(i) organizations with severely constrained cash flows;
(ii) firms with high cost of capital;
(iii) firms lacking sufficient resources, including in-house energy management expertise or an inadequate maintenance capability;
(iv) firms wanting to concentrate more on core business activities, thereby reducing in-house responsibilities, or
(v) firms contemplating new type of a project, having an uncertain reliability.
Experience has shown that performance contracting faces many difficulties including
(i) measurement of savings is cumbersome;
(ii) agreeing on how to share the savings can be difficult;
(iii) preparation of contingency plans that must be incorporated are tough;
(iv) preparation of legal documents can also be painstaking.
Lease Financing is a way of obtaining the right to the use of assets. It is a contract between the owner of the asset (lessor) and user (lessee), wherein the former grants exclusive rights to use the assets for a certain period, in return for payment of rent. There are numerous types of leasing arrangements, ranging from basic rental agreements to extended payment plans for purchases. Basically, there are two types of leases:
- short term lease (true lease)
- long term lease (capital lease)
A primary distinction between the two types of leases is tax payment. In the former, the lessor owns the equipment and receives depreciation benefits. The lessee claims entire lease amount as tax-deductible business expense. In a capital lease, the lessee owns and depreciates the equipment. Typically, only the interest portion of the lease payment is tax-deductible. Additional enticement could be "off-balance sheet" financing thus preserving available credit lines.
Venture Capital is another form of long-term equity finance. The underlying assumption is that the promoter and venture capitalist act as collaborators in business. True venture capital does not remain just confined to high technology; any risky idea can be financed. It is a commitment of capital or shareholdings, for implementation of projects, specializing in new ideas or technologies. Main attributes are long-term investment, equity holding, management support, and vendor development. As energy efficiency improvements call for innovative technology options, it lends credence to adopt venture capital as a source of financing.
Government Grants/Subsidies are an indirect source for meeting or waiving a portion of energy efficiency project costs. Typical cases can be grants provided for utilization of renewable energy sources equipment and demand side management (DSM).
Hire Purchase is obtaining the use of assets by way of a contract agreement between owner and hirer, subject to adherence of following three conditions:
· owner gives possession of his assets to hirer with an understanding that hirer will pay agreed installments over a specified period;
· ownership of asset will transfer to hirer on payment of all installments;
· hirer has option to cancel agreement any time before transfer of asset
Hirer is required to show the hired asset on his balance sheet and is entitled to claim depreciation, although he may not own the asset. In general only the interest part of the hire charge is tax deductible.
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