China - Second Energy Conservation Project

Document of The World Bank Report No: 24883-CHA PROJECT APPRAISAL DOCUMENT ON A PROPOSED GEF GRANT OF SDR 19.7 MILLION (US$26 EQUIVALENT) TO THE PEOPLE'S REPUBLIC OF CHINA FOR THE SECOND ENERGY CONSERVATION PROJECT September 25, 2002 Energy & Mining Sector Unit China Country Department East Asia and Pacific Regional Office  CURRENCY EQUIVALENTS (As of September 10, 2002) Currency Unit = Yuan Yuan 1.00 = US$0.12 US$1.00 = Yuan 8.3 FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS ASTAE Asia Alternative Energy Programme CAS Country Assistance Strategy DfID Department for International Development DO Development Objective EMC Energy Management Company ESCO Energy Service Company GEF Global Environment Facility IA Implementating Agency IAS International Accounting Standards IBRD International Bank for Reconstruction and Development IP Implementation Progress NGO Nongovernmental Organization PMO Project Management Office SECIDC SETC Energy Conservation Information Dissemination Center SETC State Economic and Trade Commission TA Technical Assistance Vice President: Jemal-ud-din Kassum Country Manager/Director: Yukon Huang Acting Sector Manager/Director: Mohammad Farhandi Task Team Leader/Task Manager: Robert P. Taylor  CHINA SECOND ENERGY CONSERVATION PROJECT A. PROJECT DEVELOPMENT OBJECTIVE ................................................................6 1. Project Development Objective ................................................................. 6 2. Key Performance Indicators ................................................................. 6 B. STRATEGIC CONTEXT ...............................................................6 1. Sector-related Country Assistance Strategy (CAS) Goal Supported by the Project . . 6 2. Main Sector Issues and Government Strategy ................................................................. 7 3. Sector Issues to be Addressed by the Project and Strategic Choices . . 10 C. PROJECT DESCRIPTION SUMMARY ............................................................... 12 1. Project components ................................................................. 12 2. Key Policy and Institutional Reforms Supported by the Project: . ........................................... 16 3. Benefits and Target Population ................................................................. 16 4. Institutional and Implementation Arrangements: .................................................................. 16 D. PROJECT RATIONALE ............................................................... 16 1. Project Alternatives Considered and Reasons for Rejection ................................................... 16 2. Major Related Projects Financed by the Bank and/or Other Development Agencies ............ 17 3. Lessons Learned and Reflected in the Project Design ............................................................ 17 4. Indications of Borrower and Recipient Commitment and Ownership ............... ..................... 17 5. Value Added of Bank and Global Support in this Project ....................................................... 18 E. SUMMARY PROJECT ANALYSIS ............................................................... 18 1. Economic ................................................................. 18 2. Financial ................................................................. 18 3. Technical ................................................................. 19 4. Institutional .................................................................. 19 5. Environmental .................................................................. 20 6. Social .................................................................. 21 7. Safeguard Policies ................................................................. 21 F. SUSTAINABILITY AND RISKS ............................................................... 22 1. Sustainability ................................................................. 22 2. Critical Risks ................................................................. 22 3. Possible Controversial Aspects ................................................................. 24 G. MAIN CONDITIONS ............................................................... 24 1. Effectiveness Condition ............................ 24 2. Other ............................ 24 H. READINESS FOR IMPLEMENTATION ........................... 27 I. COMPLIANCE WITiH BANK POLICIES ........................... 27  ANNEXES Annex 1: Project Design Summary ......................................... 28 Annex 2: Detailed Project Description ......................................... 31 Annex 3: Estimated Project Costs ......................................... 46 Annex 4: Incremental Cost Analysis ......................................... 47 Annex 5: Financial Summary ......................................... 55 Annex 6(A): Procurement Arrangements ......................................... 64 Annex 6(B): Financial Management and Disbursement Arrangements ..................................... 68 Annex 7: Project Processing Schedule ......................................... 71 Annex 8: Documents in the Project File ......................................... 72 Annex 9: Statement of Loans and Credits ......................................... 73 Annex 10: Country at a Glance ......................................... 77 Annex 11: China's EMC Industry ......................................... 79 Annex 12: Flow Chart for Environmental Clearance of Subprojects ...................................... 87  CHINA Second Energy Conservation Project Appraisal Document East Asia and Pacific Region EASEG Date: September 25, 2002 Team Leader: Robert P. Taylor Country Manager/Director: Yukon Huang Sector Manager/Director: M. Farhandi Project ID: P067337 Sector(s): PY - Other Power & Energy Conversion Theme(s): Energy Focal Area: G Poverty Targeted Intervention: N Program Financing Data [ ] Loan [ ] Credit [X] Grant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Amount (US$m): $26.0 equivalent Financing Plan (US$m): Source Local Foreign Total LOCAL COMMUNITIES 1.50 0.00 1.50 GLOBAL ENVIRONMENT FACILITY 25.00 1.00 26.00 LOCAL SOURCES OF BORROWING COUNTRY 215.00 0.00 215.00 Financing Gap Total: 241.50 1.00 242.50 Borrower/Recipient: GOVERNMENT OF CHINA Responsible agency: STATE ECONOMIC AND TRADE COMMISSION Address: No.28 West Street Xuanwumen, Beijing, 100053, P.R.C. Contact Person: Mr. Wang Shumao Tel: 86-10-6360-1354 Fax: 86-10-6360-1353 Email: pmo@public.bta.net.cn ESTIMATED DISBURSEMENTS ( BANK FY/US$M): FY 2003 2004 2005 2006 2007 2008 2009 Annual 11.9 7.0 6.2 0.4 0.3 0.1 0.1 Cumulative 11.9 18.9 25.1 25.5 25.8 25.9 26.0 Project implementation period: 2002-2009   A. Project Development Objective 1. Project Development Objective: (see Annex 1) The objective of the proposed project is to expand domestic investment in energy efficiency projects through the aggressive development of China's nascent Energy Management Company (EMC) inclustry, thereby achieving large-scale energy efficiency improvements and associated reductions in the growth of carbon dioxide emissions and other pollutants. The EMC concept has been successfully demonstrated under Chinese conditions by three large pilot EMCs established in 1997 and developed under the ongoing EC/GEF/IBRD China Energy Conservation Project. Other EMCs are now endeavoring to emerge, and interest in developing this type of business in China is running high. To foster the broad development of an EMC industry in China quickly will require: (a) the introduction and growing participation of China's domestic banks in the business, as the primary source of credit; and (b) massive dissemination of the concept and experiences achieved., supported also with practical technical assistance and operationally-focused training for emerging new EMCs. This project seeks to meet these requirements. EMCs in the Chinese context are similar to energy service companies (ESCOs) operating abroad. The EMCs undertake energy conservation investment project in other "host" enterprises, based on a contract between the EMCs and hosts (e.g., an "energy performance contract"). As developed in the three pilot EMCs, the EMCs are responsible for project design, procurement, installation, financing and energy conservation performance. Host enterprises are obligated to pay the EMC a portion of the energy savings realized (typically about 80%) over the tenor of the contract (typically 1-3 years), as payment for the project package. At the end of the contract, title to the relevant equipment, and all future energy savings arising there from revert to the host enterprise. The emerging Chinese EMCs need not strictly adhere to the model developed by the first three pilot companies. Variations in terms of EMC corporate structure, business lines, contractual arrangements, and role of the EMC in project financing are expected, and healthy. To be defined as an EMC in the Chinese context, the two critical points are: (a) over 50% of the benefits of EMC projects should arise from energy cost savings, in order to be classified as energy conservation projects; and (b) the revenue paid to EMCs by host enterprises should be derived from and be proportional to actual reductions in energy costs, allowing the host enterprise to maintain positive cash flow on the project throughout the project life. 2. Key Performance Indicators: (see Annex 1) The key performance indicators for this project will include total annual energy efficiency investments generated by EMCs, and associated annual energy savings and reductions in carbon dioxide emissions. In addition, a number of other quantitative and qualitative indicators will be monitored and reported in all regular project reports. The key performance indicators were formally agreed at project negotiations and are detailed in Annex 1. B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) Goal Supported by the Project: (see Annex 1) Document number: R98-107 (Progress Report) Date of latest CAS discussion: 05/28/98 The 1997 CAS goals (R97-20 (IDA/R97-14], discussed on March 18, 1997) were to reduce infrastructure bottlenecks by adjusting the investment pattern in favor of water management, energy, transportation, and telecommunications, to adjust the balance between energy development 6  and conservation, and to develop alternative energy sources. The CAS is currently under revision and major themes emerging are assistance to China in its transitions from a command economy to a market economy; and from a rural, agricultural economy to an urban society, focusing on development of the institutional frameworks, and development of environmentally sustainable infrastructure; and addressing the needs of disadvantaged peoples and regions. This project conforms fully with the program's goals to adjust the balance between energy development and conservation, and to improve the environmental sustainability of infrastructure. la. Global Operational Strategy/Program Objective Addressed by the project: The project is consistent with the objectives of GEF Operational Program 5: Removal of Barriers to Energy Efficiency and Energy Conservation. Section 5.7 of OP5 includes support for activities that lead to sustainable "win-win" results that demonstrate local, national, and global benefits through removal of these barriers. 2. Main Sector Issues and Government Strategy: Energy Conservation Efforts in China. Improving energy efficiency has been a cornerstone in China's energy policy for about 20 years. It has long been recognized that continued, long-term economic growth is not physically, financially or environmentally sustainable without dramatic further improvements in energy efficiency. Initially, the Chinese Government employed a series of monitoring and quota mechanisms through the planned economy to promote energy conservation and curtail at least the most blatant cases of energy waste. More recently, the Government has deployed a variety of tools, better suited to the developing market economy, which are similar to those employed in most market economies with sophisticated energy conservation policies. These include: o The economic framework. Reformed for many reasons, the current economic operating framework of most enterprises is far more conducive to improving energy efficiency than previously. Average energy price levels have been basically in line with, or above, energy production costs for a considerable period, and the financial energy costs faced by enterprises are generally close to economic costs. Although further reforms remain necessary, profit motives among enterprises have greatly increased, including in state- owned enterprises, and will increase further with China's accession to the World Trade Organization. o Regulation. Aided by the implementation of an Energy Conservation Law passed in 1997, the Government is endeavoring to develop and implement various efficiency standards and labeling programs for energy-intensive equipment, codes for new buildings, and some unit energy consumption benchmarks for new industrial plant. o Technology development. Various programs are in place to foster the research and development and/or technology transfer from abroad of new, more energy-efficient technologies for a wide range of applications. o Market-based initiatives. Beginning in the early 1990s, China has increasingly tried to capitalize on market forces and incentives to encourage greater energy efficiency, through development of new investment mechanisms, efforts to increase business awareness, and institution building. 7  China has collaborated with a variety of international organizations on each of the these initiatives with a number of important and worthwhile projects. For its part, the Bank has supported the technology transfer agenda, through the development of more energy-efficient small coal-fired boiler models under the GEF-supported China Efficient Industrial Boilers Project. The Bank also is considering possible support for the implementation of building energy efficiency regulations, as part of a possible future Heat Reform and Building Energy Efficiency Project. However, the main focus of the Bank's effort to date, based on the findings of substantial upstream sector work, and following the strong desire of Government counterparts, has been to help develop means to better take advantage of market forces to implement financially attractive energy saving renovation projects. The effort to obtain results using market forces follows the slogan coined by one Chinese counterpart, "Conserve energy and make money." (See China: Energy Conservation Study, February 4, 1993), and China: Issues and Options in Greenhouse Gas Emissions Control, 1994). The sector work mentioned previously, together with other market analyses and many experiences in project implementation, including many case studies undertaken by SETC's Energy Conservation Information Dissemination Center (SECIDC), all have shown that there is very large potential across China for "classic" energy conservation renovation projects which yield sound life- cycle financial retumns today. ("Classic" energy conservation projects may be defined as projects where the primary purposes is energy conservation. Major industrial restructuring and modernization projects also may save large amounts of energy, and are important in the national energy conservation program, but investment decision-making must involve more complex issues, such as long-term enterprise viability, market strategies, etc.) Investment scale for the classic energy conservation projects in industrial or commercial establishments typically ranges from US$50,000-1,000,000, with financial rates of return of 20-40% p.a. or even more, and payback periods generally ranging between 1 and 4 years. However, a large part of this potential remains untouched. The reasons for this paradox, also found in other countries, include: * Inadequate information. Enterprises and individuals generally lack information about energy-saving investments, especially on financial aspects and the implementation experiences of others. Information on new and emerging technologies and project concepts is particularly difficult for many to obtain; * Less interest in operating cost savings. Many enterprises continue to show less interest in investments which result in operating cost savings over the longer term, compared to investments yielding production increases or entry into new markets. Projections of future cash flow from operating cost savings do not seem as tangible a benefit as, for example, a new production line. * Real or perceived insignificance of small projects. Many worthwhile energy conservation investments are relatively small (although the high number of such projects in many enterprises makes aggregate potential rewards large). Although they may yield very attractive internal rates of return as projects, the end result may represent only a percentage point or two savings on total enterprise operating costs, or even less. Particularly if there are other perceived headaches (lack of detailed information, insufficient financing, possible technical risk or operational disruption, etc.) this often results in unenthusiastic responses from enterprise managers; * High transaction costs. If a given enterprise has no experience with a certain type of energy conservation investment, the time required from skilled staff for securing information, analyzing design options, arranging financing, identifying reliable suppliers, etc., may rnake a small project not worthwhile; 8  o Risk. Unless clearly demonstrated otherwise, fears that a new technology may not work, could interrupt production, or may take time to perfect, all inhibit enterprise managers from adopting new energy-saving technologies; o Technology transfer barriers. In some cases, it may be difficult for enterprises to gain access to state-of the-art technologies; and o Difficulties in arranging financing. High loan transaction costs for such types of small projects make commercial lending for many energy conservation projects unattractive to most banks, unless projects can be bundled together, or other pooling measures are adopted. Additional problems for banks may include lack of knowledge about the main technical areas and associated risk factors, reticence to lend for projects where projected operating cost benefits form the main revenue stream and which cannot readily be isolated, or less-than-average collateral values for the diverse, small-sized equipment generally associated with an energy conservation project. With such problems, most enterprises put other projects at the top of their lists when requesting bank loans. The China Energy Conservation Project, and this proposed follow-on effort, are targeted squarely on the development and implementation of solutions to at least partially overcome these barriers to implementation of financially attractive energy conservation investment. The EC/GEF/IBRD China Energy Conservation Project. Approved by the Bank's Board in March, 1998, the objective of the $151 million China Energy Conservation Project is to achieve large, sustained and growing increases in energy efficiency, and associated reductions in growth of carbon dioxide emissions and other pollutants, by (a) introducing, demonstrating and disseminating new project financing concepts and market-oriented institutions to promote and implement energy efficiency measures in China, and (b) developing a more efficient national energy conservation information dissemination program. The project is designed to assist in the transition of China's energy conservation activities from a system based on planned economy concepts to a more market-oriented system, which can be sustained over time and grow with China's economy. The largest component of the project, including financing of $15 million from the GEF, $63 million from IBRD, $4.5 million from the EC, and $54.3 million from domestic sources, supports the establishment and pilot demonstration of EMCs in China for the first time. The project includes a $10 million Information Component, which seeks to strengthen China's national efforts to improve access to specific information concerning successful domestic energy efficiency experience, geared in particular to financial decision makers, through the establishment and operation of SETC's new Energy Conservation Information Dissemination Center. The project also includes a $4 million Project Management and Monitoring Component. (See the Project Appraisal Document, IBRD Report 17030-CHA, February 26, 1998). Energy performance contracting as practiced by the three EMCs under the project (see section Al above), can overcome many of the constraints described previously. By providing design, procurement, financing, and installation services, and guaranteeing positive-cash flow performance as a condition for any payment, the EMCs can overcome many of the problems faced by enterprises with energy conservation projects. If projects are successful, host enterprises basically receive new, more efficient equipment at the end of the performance contract, paid for entirely through energy savings. Through specialization, and replication of similar projects across many enterprises, the EMCs are able to reduce transaction costs. Because the internal economics of the projects are strong, there are sufficient financial returns to both attract host enterprises and provide strong financial returns to the EMCs. Successfully developed in North America and Europe, groups in many developing countries have found the energy performance contracting concept appealing, and made efforts to 9  develop ESCOs. However, it has proven difficult to ramp-up the scale of this approach and attain meaningful levels of investment, as it is a new and relatively sophisticated business, requiring a receptive operating environment and suitable mix of technical, financial risk management, procurement, contracting and marketing skills. In the Chinese case, where it was a totally new concept, it was decided, therefore, to put maximum effort initially on the development of corporate working models of meaningful scale to pioneer the mechanism, and test and adapt it in the Chinese market. If successful, yielding good financial results, the experiment could then be more broadly disseminated. Project implementation to date has been fully satisfactory, and the three EMCs, founded in Beijing, Liaoning and Shandong, are successfully developing markets, building human capital and progressively growing their businesses. Formed in 1997 with shareholders' capital of between RMB 20 and 34 million each (US$ 2.4-4.1 million), and recipients of large-scale technical assistance, the three small companies utilized an EC grant to implement initial sets of pilot subprojects in 1998. In mid-1999, the companies began to develop their portfolios, using GEF, IBRD and other financial resources. As of March 2002, the three EMCs have entered into 208 energy performance contracts with aggregate investments of over US$45 million (including GEF financing of $9.5 million). Their businesses are growing rapidly: in 2002, the three companies plan to enter into 83 new performance contracts, totaling almost $26 million in new investment. Average annual financial rates of return to the EMCs of subprojects have been in excess of 20% per year, although these may decline somewhat in the future as their markets mature. Repayment by client enterprises has been very good, and with few exceptions, payments have been made according to contracts. Profits from earlier investments are beginning to be realized and all three EMCs declared corporate profits for 2001. Additional information of the experience of the three EMCs is provided in Annex 11. Following publicity by SETC of the efforts so far, new EMCs are beginning to form, and more groups and business are becoming interested in exploiting the potential for energy performance contracting. 3. Sector Issues to be Addressed by the Project and Strategic Choices: (see also Annex 11) Now is the appropriate time to harvest the investments made in the demonstration EMCs and to begin a larger scale program to develop the EMC industry in China, based on these successful working models. All parties recognized during the design and preparation of the China Energy Conservation Project that the initial development of the pilot EMCs would need to be followed by a major dissemination and expansion effort, under a Phase II GEF project, in order for the full benefits and vision of the program to be truly realized. Provisions for this are reflected in the original Project Appraisal Document, legal agreements and Minutes of Project Negotiations. Originally, Phase Il activities were included in a large first project package, but at project appraisal it was decided to split components for which GEF financing was sought, so that the detailed design of Phase II could build upon the initial implementation experience of the first.three EMCs, and be best catered to evolving needs. The Bank and the Government agreed that the follow-up GEF support would be sought about 18 months after the effectiveness of the first project. Through the demonstration effort, the main achievements in developing EMCs to date include: * The concept of energy performance contracting has been shown to be viable under Chinese conditions. Promotion of this market mechanism has now become an important part of the Government's overall energy conservation policy; 10  o The three EMCs have successfully pioneered corporate models and business strategies incorporating both the financial and technical sides of the energy performance contracting business; o Contract models, standard financing terms and benefit sharing regimes, energy savings verification methods, host enterprise selection criteria and credit controls, and project negotiation and management methods all have been worked out, tested and revised in over 200 projects, to best meet the practical needs in the Chinese economic system; and o Market demand for energy performance contracting services has been demonstrated to be strong and broadly based across a variety of sectors, especially if the EMCs are able to provide project financing. The three working models have attracted the attention of others. As of November, 2001, some 6 small new EMCs had been formed, with registered capital of RMB 10 million ($1,200,000) or less. An additional 15-20 groups have established some types of subsidiaries to operate EMC-type businesses. Over 200 firms have expressed interest to SETC in establishing EMC-type businesses. However, these new initiatives remain very small, and, while many groups have tried out some small energy performance contracting projects, little investment has actually been made (see also Annex 11). Following surveys and many discussions with emerging/prospective EMCs and banking institutions, SETC's Project Management Office (PMO) and the Bank project team have concluded that the main barriers constraining rapid new EMC development today include: o Lack of awareness of the basic concept. Despite the steady efforts of SETC to publicize the concept of energy performance contracting, the idea remains basically unknown by most groups, except for some groups specialized solely on energy conservation work. Given the vastness of China, truly massive efforts are required to raise awareness. o Lack of knowledge and skills to operate EMC businesses. Energy performance contracting, as operated by the EMCs to date, is both a novel and sophisticated business concept. Key capacities required include (a) excellent and up-to-date knowledge of energy conservation technologies and their practical application, in order to provide value-added to customers and minimize technical risks; (b) ability to assess and minimize host enterprise credit risks, employing various credit appraisal techniques and a variety of options to secure repayment prospects; (c) sophisticated corporate financial management, including project portfolio risk management; and (d) contract, procurement and project implementation management. Mixtures of these skills can in principle be gained through business alliances, well conceived staffing policies and extensive training , but practical knowledge from past experience is critical. There is rich experience in the range of business issues among the three EMCs and ESCOs abroad, but transfer of this knowledge and experience is a daunting task. o Lack of creditfinancingfor EMC business development. Although policies may change in the future, all banks in China remain subject to interest rate regulation, which allows only minor variations in rates and hence does not enable loan pricing based on risk. Thus, since returns are largely fixed, Chinese commercial banks focus primarily on loan security issues and are particularly risk adverse. While a number of banks have noted the potential advantage of the EMC businesses in bundling projects together, and minimizing transaction costs, loans for energy performance contracting, either directly to host enterprises or EMCs, are perceived as being very risky. This is due to the lack of 11  widespread experience with the mechanism, lack of established track records within prospective new EMCs, and difficulties in structuring the type of strong collateral and/or guarantee arrangements typically required by Chinese lenders. Liaoning EMC (one of the pilot EMCs) has successfully pioneered a strategic partnership and line-of-credit arrangement vwith a Chinese commercial bank, but only after demonstrating a track record of successful subprojects, strong management, a viable business plan, and with the benefit of GEF and IBRD financial commitments already in place. Difficulties in securing sufficient equity financing. Equity financing is especially important if EMCs are to provide at least some financing for their projects. Securing equity investrnent also is often subject to the problems noted above, and is often a chicken-and- egg problem with respect to credit financing: If credit financing can be secured, equity investments are easier to obtain, and visa versa. The proposed Second Energy Conservation Project has been designed by SETC's PMO and its advisors, together with the Bank project team, to help overcome these barriers to rapid development of China's EMC industry as efficiently as possible. Furthermore, in order to foster development of an EMC industry which is sustainable in the market on commercial terms, two additional objectives were set as requirements for project design: (a) direct grants to new or emerging EMCs should be avoided, and (b) the Chinese. banking industry must be engaged as the key source of credit financing, replacing the donor financing in the demonstration phase. Indeed, the active participation of the banking sector is the remaining key piece of the market framework needed for operation of a sustainable EMC industry, as the third necessary player in this triangular business, joining the EMCs and host enterprises. C. Project Description Summary 1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown): Indicative Bank % of GEF % of Component Sector Costs % of financin Bank financing GEF (US$M) Total g financing (uJS$M financing (US$M) equivalent) EMC Guarantee Prograrms 238.8 98.5 0.00 0.0 23.80 91.5 EMC Services 3.1 1.3 0.00 0.0 1.60 6.2 Project Monitoring, 0.60 0.2 0.00 0.0 0.60 2.3 Reporting and Evaluation Total Project Costs 242.5 100.0 0.00 0.0 26.00 100.0 Total Financing lRequired 242.5 100.0 0.00 0.0 26.00 100.0 The proposed project includes three components: (a) an EMC Service Component, designed primarily to provide in-depth, practical technical assistance to new and emerging EMCs on setting up and developing their businesses; (b) a Project Monitoring, Reporting and Evaluation Component to support the coordination and evaluation work of SETC's PMO; and (c) an EMC Loan Guarantee Program, designed to provide new and emerging EMCs with enhanced 12  opportunities to receive loans from domestic banks, and to engage the banks in the development of a sustainable EMC industry. EMC Service Component. This component will support the development and key initial activities of an EMC Service Association, which will operate as a service-oriented trade association to provide a range of services to member EMCs or prospective member EMCs. The objective of the EMC Service Association is to assist in the creation of a sustainable EMC industry in China, by providing technical assistance and training services to emerging EMCs, promoting the EMC business in society at large, and developing a cohesive, mutually supporting network among member EMCs. A core EMC Service "Group" already has been formed, within SETC's PMO, and begun operations. During 2003 and following the expansion and further development of its EMC membership, the EMC Service Group will be transformed into a permanent, independent legal entity (termed here the "EMC Service Association"), independent from the Govemment and dedicated to providing service to its EMC members. A major technical assistance program to support the initial operations of the EMC Service Group is already underway, supported with grant financing of about $2.5 million from the United Kingdom's Department for Intemational Development (DfID) and implemented through the Bank's Asia Alternative Energy Programme (ASTAE). Proposed additional financing during the project implementation period for the EMC Service Association includes $1.6 million equivalent in GEF grant funds and about $1.6 million in membership fees, service fees and other sources of Association revenue. ASTAE-DJID EMC Service Activities. Approved in March 2001, and launched in May 2001, the ASTAE-DfID project is being implemented over about two years. Initial major activities include: (a) development and initial delivery of a massive and sophisticated training program for new EMCs, including an introductory course, and advanced, interactive workshops on EMC corporate development and business strategy, EMC project development and management, EMC financial management, and new and emerging business opportunities; (b) definition of the optimal long-term institutional arrangement for the EMC Service Association, based in part on the operational experiences of ESCO Associations intemationally; and (c) a series of activities to raise awareness conceming the EMC industry in local banks, to help bank officials to understand the details of the business, and to provide EMCs with customized technical assistance in their preparation of applications for loan finance. The ASTAE-Df[D project plays a critical role in the overall project, as it provides for a large-scale effort on corporate and business plan development for new EMCs prior to the initiation of the proposed loan guarantee program, which must await GEF Phase II project start-up. Proposed GEF-financed Aspects. GEF support over a five-year period is proposed to follow-on from the ASTAE-DfID activities, and to build the EMC Service Group/Association into a self-sustaining and permanent institution, publicly acknowledged as the central institution representing and servicing the national EMC industry in China. In addition to a further deepening of the Association's massive training programs, major efforts are required to develop the Association's advocacy functions to support the EMC industry, for intemational liaison, and to develop sophisticated membership coordination, networking, and customized support functions. GEF funds also will be used to support initial start-up core costs of the Association, which will then be gradually phased out and replaced with the Association's revenues over a 5-year period, so that the Association can sustain its operations once the GEF funds are exhausted. The Bank reviewed and agreed to the Service Group's overall five-year financial plan at project appraisal. The Group also will provide a further, more detailed year-by-year work program proposal for agreement with the Bank by the end of 2002. These two plans will provide benchmarks for subsequent project supervision. 13  Project Monitoring, Reporting and Evaluation Component. The critical Project Monitoring, Evaluation and Reporting Component will require $600,000 equivalent of GEF support, and will be irmplemented by SETC's PMO. The PMO will maintain the Special Account for the GEF financing of incremental operating costs and consulting services and will oversee GEF disbursements. The PMO will be responsible for compiling reports on project status, on progress meeting performance indicators (especially energy savings levels), and on financial management, based in large part on information provided by the other two implementing entities (the EMC Service Association and Guarantee Program Implementing Agency). The PMO will be responsible for all project procurement work (consisting of consulting services only), although details may prepared by the other two implementing entities. As the PMO also will operate the bank account for the Guarantee Program Capital Reserve Specialized Fund, for SETC, the PMO also will need to engage qualified experts to assist the Government in the supervision of the Guarantee Program and its account. EMC Loan Guarantee Program. A new EMC Loan Guarantee Program will be established under the project in China to enhance the ability of EMCs to obtain commercial loan financing from domestic banks. The central objective of the Program is to achieve maximum EMC investment in energy efficiency over the long term. To achieve this, the program must seek to: (a) maximize guarantee transactions, leveraging capital resources as much as possible, to facilitate as much lending to EMCs as possible; (b) preserve its capital base, to the extent feasible while meeting other objectives, through commercially-oriented operation, in order to maintain resources for revolving, long-term use; and (c) engage and strengthen the involvement of domestic banks in the program as much as possible, so that the banks become increasingly familiar and comfortable with lending to the EMC industry, and are increasingly willing to undertake EMC credit risks themselves. The Guarantee Program will be operated by one (or possibly several) Guarantee Program Implementing Agency (IA), according to a Guarantee Program Implementation Agreement between the IA and the Government, which must be approved by the Bank before any funds can be disbursed for this component. The China National Investment and Guaranty Co. (I&G) is expected to be appointed as IA for the Program at the outset. I&G is China's only national guarantee company, and maintains the longest track record of any company in China's nascent loan guarantee business, and the widest credibility in the Chinese market. The Terms of Reference for an Implementation Agreement were agreed during project appraisal, and the principal terms and conditions required have been included in the negotiated GEF Grant Agreement. The Program will be implemented incrementally, with flexibility to incorporate adjustments, if required based on emerging experience, and if agreed between the Government, IA and the Bank during annual formal program reviews and two Mid-Term Project Reviews. Continuation of the appointment of an IA will be contingent upon satisfactory performance, as determined during the above reviews. The IA with I&G will focus in particular on development of the Program during the 30-month period leading up to the first Mid-Term Project Review, which will involve intensive, customized work to implement at least 20-30 guarantee transactions. The first four individual guarantee transactions for each type of guarantee will be subject to the Bank's prior review, providing for intensive review until sufficient experience is gained with specific EMC-Lk guarantee agreement models. EMCs are expected to develop their own businesses, independently, using service from the EMC Service Group/Association where necessary. For loan financing, they should approach domestic banks. If there is a need for some support to close a loan or line-of-credit, EMCs and the relevant bank may apply to the Program for a partial guarantee. Guarantees may be for loans 14  directly to EMCs, EMC host enterprises, or various combinations of these. The Program will offer partial credit guarantees of up to 80-90% of loan principal amount initially, and declining amounts over time. The Program will be open to any potential applicants operating EMCs or otherwise engaged in energy performance contracting in China. Guarantee periods are expected to range between 1-3 years, and amounts are expected to be relatively small. Hence, guarantee commitments will "revolve" fairly quickly. GEE resources of $22 million equivalent will be utilized to establish the EMC Guarantee Program Special Fund, which is the fund against which guarantee commitments will be made. (Multiple Funds will be established if more than one IA participates.) This capital reserve fund will be placed in a first-loss position for the program's guarantees The IA will assume a portion of the default risk relating to the leveraging of the reserve with guarantee commitments over and above the reserve balance. The Fund will be operated by the SETC's PMO, acting for the Government, and the Fund will remain the property of the Government of China under all circumstances. The Fund will (a) be a separate account, retaining its own legal identity; (b) have its own strict financial accounting, monitoring, control and reporting system that complies with Bank requirements and International Accounting Standards (LAS). Income from investments of the guarantee reserve and from guarantee fees will accrue to the Fund. Based on the provisions of the Guarantee Program Implementation Agreement, the IA will (a) undertake conservative investment of these funds, in line with agreed investment criteria; (b) enter into guarantee cormmitments against the reserve; (c) pay for defaults, according to agreed procedures; and (d) receive compensations for costs, as well as any accruing incentives payments. As an account operated by SETC's PMO all withdrawals will require the approval of SETC or its PMO, according to procedures in the Implementation Agreement. At the end of the seven-year project implementation period, the Fund balance will remain in the Fund for continued use to backstop EMC loan guarantees developed by the IA, unless it is agreed by the Bank and the Government that these remaining funds should be deployed for other, specifically agreed greenhouse gas reduction activities and projects. Annex 2 provides additional details. The EMC Loan Guarantee Program also includes $1.8 million equivalent of GEF grant financing to support a portion of the costs associated with the Program start-up and the intensive development of initial transactions during the first several years. Transactions costs are expected to be especially high initially, as the provision of loan guarantees is an entirely new business. Strong emphasis has been put on the development of an initial pipeline of at least 20-30 transactions during the first two years. The IA is already preparing an initial set of 5-10 transactions for immediate implementation upon grant effectiveness. If the Guarantee Program develops a good reputation, and the banking sector considers the capital reserve to be a suitably liquid and credible, the IA may eventually be able enter into guarantee commitments of 3-5 times the capital reserve. GEF seeks to maximize guarantee capacity from the capital reserve, aiming at guarantee commitments exceeding the capital reserve level from the first year onwards. Even with very conservative assumptions on the willingness of the market to accept leveraged guarantee commitments, the guarantee facility will be able to support EMC-sponsored energy conservation investment of at least some $250 million over the seven-year project period. This equates to a leveraging of about II to 1, in terms of investment over the period per dollar of GEF resources.' In the Illustrative Case presented in Annex 5, the somewhat less conservative assumptions on leveraging result in EMC investment levels of about $310 rnillion over seven years. 15  Use of GEF financing for the guarantee facility conforms with the GEF's strong desire to develop "contingent financing" modalities for "win-win" energy efficiency projects. The GEF seeks arrangements where its grant funds may be used to compensate for (buy down) the risks considered too high by commercial investors but, in cases where the risks are indeed successfully overcome in project implementation, direct grants for financially successful projects are avoided. This project component will be one of the first major projects in the Bank adopting a contingent financing approach. No direct grants will be provided to EMCs or end-users. Upon project completion, remaining funds, which are expected to be substantial, can be retained for further use in the guarantee program or reallocated for other greenhouse gas abatement projects. 2. Key Policy and Institutional Reforms Supported by the Project: None-the project is expected to be implemented within the current Chinese environment. 3. Benefits and Targelt Population: The project will provide large, cost-effective reductions in energy use, GHG emissions and other pollutants (e.g., total suspended particulates and sulfur dioxide). Preliminary estimates of direct energy savings benefits over a ten year period total some 64 million tons of coal equivalent, equal to about 43 million tons of carbon (see Annex 4). Reduced energy costs in production yield benefits to Chinese consumers, while reduced local and global pollution benefit both local and global populations. Because this project builds upon the investrnents made in the first phase of the China Energy Conservation Project, contingent financing is employed, and the Chinese energy efficiency market is so large, the cost effectiveness of GEF's projected net investment in the project is extremely high, at some $10-25 US cents/ton of carbon avoided. This would be among the lowest cost per ton of carbon avoided in the GEF's entire portfolio. Institutional and Implementation Arrangements: The SETC will be responsible for coordination of project implementation, working together with the Ministry of Finance and other agencies and research units. The SETC's Project Management Office (PMO), established in 1995, has been effectively conducting project coordination activities for the first China Energy Conservation Project, and will continue its work during this second phase. The details of project implementation, however, will be the responsibility of the EMC Service Group/Association, and the Guarantee Program Implementing Agency (IA). The institutional set-up for the EMC Service Group/Association and for the implementation of the Guarantee Program is discussed in Section Cl above, and especially Annex 2. D. Project Rationale 1. Project Alternatives Considered and Reasons for Rejection: Project design was a gradual process over two years, during the implementation of the first Energy Conservation Project, involving many consultations with the three demonstration EMCs, new and emerging EMCs, domestic banks, central and local government officials, and international and domestic industry experts. Incorporation of a major investment (guarantee) component was included, as opposed to sole reliance upon information dissemination and capacity building, following surveys and repeated discussions with both new and merging EMCs and domestic banks, who outlined the severe constraints facing EMCs applying for loans with limited track records and 16  assets. Operation of a competitive, small grant program for new and emerging EMCs was considered during the early stages of project design. However, it was decided to rely on the guarantee mechanisms only, and avoid direct grants to the EMCs, both to increase the leverage and potential benefits from the limited funds available, and to conform with the GEF's interests in promotion of "contingent finance" projects. 2. Major Related Projects Financed by the Bank and/or Other Development Agencies completed, ongoing and planned). Latest Supervision Sector Issue Project (PSR) Ratings (Bank-financed projects onlv) Implementation Development Bank-financed Progress (IF) Objective (DO) Energy Efficiency EC/GEF/IBRD S S China Energy Conservation Project Energy Efficiency China: Efficient Industrial Boilers S S Energy Efficiency IFC Hungary EE Cofinancing Program Energy Efficiency Romania-GEF Energy Efficiency Project (FY03) Other development agencies IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons Learned and Reflected in the Project Design: Experience gained promoting EMCs/ESCOs in other Bank/GEF projects, and in a variety countries, was fully reviewed and incorporated in the project design, particularly through active involvement of the task team in the Bank's Energy Efficiency and Environment Thematic Group. Contingent finance arrangements developed in IFC's Hungary Energy Efficiency Guarantee Project and the GEF Romania Energy Efficiency Project were closely reviewed, and elements from these projects have been incorporated in the project design. The task team has also exchanged views with Brazilian experts involved in the GEF/IBRD Brazil Energy Efficiency Project, who also are considering the development of a loan guarantee program for ESCO projects. As planned prior to submission of this project to the GEF Council, the PMO and Bank team also have completed, particularly through the Mid-Term Project Review for the first China Energy Conservation Project, (a) an evaluation of implementation results of the initial pilot project in the EMC Demonstration Component, (b) an assessment of lessons learned, identification of issues requiring resolution, and proposed solutions: (c) conferences and consultations on EMC results with the domestic financial community, and (d) arrangements for suitable counterpart financing (see Annex 11). 4. Indications of Borrower and Recipient Commitment and Ownership: Borrower commitment and ownership is high. Development and expansion of the EMC industry has become one of the main directions of the Government's program to align its energy conservation strategy with the developing market economy. As mentioned in section DI, development of this project has involved many consultations with various stakeholders, to develop a broad consensus on approach. SETC already has formed the EMC Service Group, and has engaged highly qualified consultants and experts from different sectors to undertake project preparation. 17  5. Value Added of Bank and Global Support in this Project: With the active support and involvement of GEF, the Bank and Chinese teams have worked exceptionally closely since 1995 to develop energy performance contracting as a new investment mechanism in the Chinese market. The joint team has built new institutions, adapted foreign models to Chinese conditions, and addressed and solved a wide range of issues, some of which never had been encountered before. It is very important to continue the GEF/Bank/Chinese joint effort on past the initial, successfully demonstration phase, through to the most critical dissemination and expansion phase. This will require additional institutional building challenges and additional innovative arrangements, building upon the relationships already developed. As with the first project, GEF support of this second project fulfills a role which no other entity can. There is no alternative investor willing and able to place sufficient funds in the high- risk position of the proposed new guarantee program capital reserve, in order to achieve the potential broad global benefit expected. E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) 1. Economic (see Annex 4): [ ] Cost benefit NPV=US$ million; ERR = % (see Annex 4) ] Cost effectiveness [X] Incremental Cost [ ] Other (specify) Analysis of the incremental costs and the global environmental benefits of the project are outlined in Annex 4. 2. Financial (see Annex 4 and Annex 5): As described in Section Cl and Annex 2, the EMC Loan Guarantee Program will be implemented by one or several Guarantee Program Implementing Agencies (IAs), based on Implementation Agreements to be entered into between the Government and the lAs, and approved by the Bank. Financial projections for the program of the IA(s) will be reviewed as part of the review and approval of the various Implementation Agreements. Arrangements for the first Implementation Agreement are being prepared by I&G, in collaboration with the Bank team and the Government, and although this IA's documentation is likely to include a notional long-term forecast of the possible evolution of the Program, the focus of formal financial appraisal will be on the arrangements for the first 2-3 years. In order to gauge the potential outcomes of the Program, the Bank team has modeled a ten- year period of operating of the Guarantee Program, as designed and based on Chinese conditions, working together with PMO, its consultants, and I&G staff. An "illustrative case" projection is presented in Annex 5. Given the market uncertainties involved in this new Program, however, the most important part of this analysis is the sensitivity analysis of the various key factors and risks involved in the Program. This analysis is critical for determining both upside and downside potential, and for detailed design of the incentives schemes for the IA. The analysis is presented in Annex 5. Specific risks, which are quantified in the Annex, are also discussed in Section F below. Fiscal Impact: N/A 18  3. Technical: EMCs need to focus on project concepts with minimal technical risk to obtain the best retums, but they also need new ideas to develop market share. While most projects are expected to involve well-proven technology and concepts, the EMC Service Component also includes specific technical assistance to help EMCs develop new project opportunities. 4. Institutional: 4.1 Executing agencies: Under the coordination of SETC's existing PMO, project implementation will be undertaken by a new entity--the EMC Service Association--and by new project units in the Implementing Agency or Agencies operating the Guarantee Program. Although successfully achieved under the first project, such institution building is always a challenge, and is a major focus of project preparation. Given the recent Govemment reforms and change in the reduction of the role of government agencies such as SETC in project implementation, however, both the Bank and Chinese teams feel strongly that the effort required for institutional building is necessary and most worthwhile. The Energy Service Group is already formed, under the umbrella of the PMO, as is capable of dispatching project implementation responsibilities (as it has done for the ASTAE- DFID EMC Training Project in 2001 and 2002). Deliberate plans have been made for the transformation of this Group into the permanent EMC Service Association. For the Guarantee Program, the key will be: (a) flexibility to undertake practical arrangements with various entities, as the Program and market develops; (b) the incremental approach, involving gradual development of the business and step-by-step reviews and evaluations; (c) intensive preparations to develop transactions during the first two years, which have already begun; and (d) provision of a program of technical assistance and training for all concerned parties. 4.2 Project management: Overall project coordination and day-to-day oversight of activities will be conducted by SETC's PMO, which has been in effective operation since 1995. The PMO will assist the EMC Service Group and Guarantee Company in matters relating to intemational donor/Bank project management. 4.3 Procurement issues: No procurement activities are involved in the capital reserve component of the EMC Loan Guarantee Program, or in the incremental operating cost support to EMC Loan Guarantee Program lAs and the EMC Service Group/Association. The project does include procurement of services, in all three project components, which is discussed in detail in Annex 6. 4.4 Financial management issues: Especially given the need for upfront disbursement of GEF funds for the EMC Guarantee Program Special Fund, establishment of and monitoring mechanisms for suitable financial management, control mechanisms and procedures, and audit requirements for the Fund have been a major aspect of project preparation. Annex 6 provides greater detail on this, as well as arrangements for the other aspects of the project. 19  5. Environmental: Environmental Category: F (Financial Intermediary Assessment) 5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (including consultation and disclosure) and the significant issues and their treatment emerging from this analysis. This financial intermediation project will result in major positive impacts on the environment, in terms of improved energy efficiency, reduced air pollution, and reduce greenhouse gas emissions. No major adverse environmental issues are associated with the project. The EMC Loan Guarantee Program will indirectly support hundreds of small subprojects, which will be identified during project implementation. Few, if any, will involve any negative environmental or safety issues. To both ensure that any potential negative environmental impacts are identified and properly mitigated, and that energy savings and associated environmental benefits are properly monitored and reported, the Environmental Review and Impacts chapter of the project's Operations Manual has already been prepared, and reviewed and approved by the Bank. (Execution of the Operations Manual, including the environment chapter, is also a condition of grant effectiveness.) The chapter defines a procedure for Environmental Review of all EMC subprojects supported by the EMC Loan Guarantee Program. The procedure requires EMCs to (a) screen subproject according to an agreed Environmental Review Checklist, and (b) ensure that subproject host enterprises receive review and approval of local Environmental Protection Bureaus for any subprojects for which potential negative environmental impacts might exist. The Operational Manual chapter also specifies a list of types of enterprises for which environmental hazards preclude any form of guarantee program support. The Operations Manual chapter details a procedure for reporting of energy savings and associated environmental benefits for all subprojects supported by the Guarantee Program. Annex 12 shows the Flow Chart for Environmental Clearance of Subprcijects in the Operations Manual chapter. 5.2 What are the main features of the EMP and are they adequate? N/A 5.3 For Category A. and B projects, timeline and status of EA: Date of receipt of final draft: NA 5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EA report on the environmental impacts and proposed environment management plan? Describe mechanisms of consultation that were used and which groups were consulted? N/A 5.5 What mechanisms have been established to monitor and evaluate the impact of the project on the environment? Do the indicators reflect the objectives and results of the EMP? As environmental benefits are the main objective of this project, the project key performance indicators include systematic monitoring and reporting of energy savings and greenhouse gas emissions reductions resulting from project activities. 20  6. Social: 6.1 Summarize key social issues relevant to the project objectives, and specify the project's social development outcomes. No resettlement is anticipated in this project. No social hardships are anticipated as a result of the project, which will support relatively minor industrial and commercial building energy conservation retrofits and equipment renovation. 6.2 Participatory Approach: How are key stakeholders participating in the project? Project design has included consultations with a wide range of stakeholders, in the central and local government, research units, NGOs, and industrial, commercial and financial enterprises. Through the efforts of the SETC's PMO, the emerging EMC Service Group, and the marketing staff of the proposed Guarantee Program, major efforts are being initiated to increase awareness about EMCs in general, and opportunities for project support in particular. Access to initial technical assistance will be open to any interested parties. Access to more advanced training and technical assistance also will be open and transparent, but will require a specified level of corporate development. 6.3 How does the project involve consultations or collaboration with NGOs or other civil society organizations? NGOs and other civil society organizations involved in energy efficiency in China are a potentially important vehicle for marketing of the EMC concept and assisting groups to form EMC business proposals. 6.4 What institutional arrangements have been provided to ensure the project achieves its social development outcomes? N/A 6.5 How will the project monitor performance in terms of social development outcomes? N/A 7. Safeguard Policies: 7.1 Do any of the following safeguard policies apply to the project? Policy Applicability Environmental Assessment (OP 4.01, BP 4.01, GP 4.01) Yes Natural Habitats (OP 4.04, BP 4.04, GP 4.04) No Forestry (OP 4.36, GP 4.36) No Pest Management (OP 4.09) No Cultural Property (OPN 11.03) No Indigenous Peoples (OD 4.20) No Involuntary Resettlement (OP/BP 4.12) No Safety of Dams (OP 4.37, BP 4.37) No Projects in International Waters (OP 7.50, BP 7.50, GP 7.50) No Projects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60) * No 21  7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies. N/A F. Sustainability and Risks 1. Sustainability: The development of a self-sustaining (and growing) EMC industry in China is the objective of this project. The project has been designed specifically to achieve this objective, by aiming to involve dornestic banks as the financiers of the industry, thus completing the full necessary market framework, and by developing a service-oriented EMC Association for mutual EMC assistance. A key goal of the EMC Service Component is to develop the EMC Service Group/Association into a permanent institution. The Component and its project implementation plan are being designed to best ensure that the Association is fully self-sustaining by the end of the project, and able to operate effectively without outside revenue enhancement. The primary goal of the EMC Loan Guarantee Program is to assist new EMCs to overcome initial barriers in obtaining loan financing, and to develop domestic bank financing into the principal source of EMC credit. The Guarantee Program operated by the IA should be able to provide EMC loan guarantees as long as necessary. 2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1): Establishment and operation of the new EMC Loan Guarantee Program is by its nature a high risk proposition. Despite the successful initial demonstration, the EMC business is basically new to China. Actively employed for less than a decade, the operation of credit guarantees by specific guarantee companies also is relatively new in China, especially as a commercial as opposed to a political/social instrument. The nature of the project conforms with GEF's contingent grant financing model: while the initial risks of the Guarantee Program preclude its establishment based on commercial investment, and it is expected that the full amount of the capital reserve will not be retained through the end of the project, the design of the project to mitigate operational risks as much as possible, and provide incentives for both maximum energy efficiency investment and capital reserve retention, provides an excellent environment for an exceptionally high return in terms of greenhouse gas emissions reductions. The main risks of the Program (also discussed in detail in Annex 5), and accompanying adopted mitigation measures, include: * Slower than expected development of EMC loan guarantee transactions. This could be caused by (a) slower than expected establishmenit of new EMCs and/or slow growth in their subproject investments, and/or (b) slow and cumbersome' development of guarantee transactions, given the multiple players involved and newness of the business. These are substantial risks; The EMC Service Component is designed specifically to assist new EMCs to become established and to grow effectively. The EMC Service Group has begun its training and technical assistance work well over one year in advance of planned project effectiveness, benefiting from ASTAE-DfID support, which helps to defray the risk of excessively slow start-up. The EMC Service Group and I&G (the expected first Implementing Agency or IA) have begun to develop the first 5-10 transactions for the Guarantee Program, well in advance of project effectiveness. Additional ASTAE-DfID and 22  GEF financing support, as well as organizational efforts, have been made for a very intensive effort to develop the new loan guarantee transactions during the first 2-3 years involving the Bank team, the PMO, the EMC Service Group, the IA, the local banks and the emerging EMCs. Finally, the compensation/incentive scheme set forth in the Guarantee Program Implementing Agreement for the IA will be tied to attainment of specific performance indicators, which will be reviewed and adjusted, if necessary, during the formal annual Program reviews and the project mid-term reviews. o Poor market acceptance of the Program's guarantees. This is rated a moderate risk because GEF funds will be disbursed upfront into the EMC Guarantee Program Special Fund, and because I&G, which is the most well established guarantee company in China, is expected to be assigned as IA at the outset of the project. O Lack of willingness of local banks to share EMC loan risks above token risk-sharing levels. This is a substantial risk, especially in the early years of the Program, given the incomplete banking reforms in China. Unwillingness by the banks to share a substantial portion of credit risks will reduce the leverage achieved by the GEF resources, and slow the desired eventual development of increasing direct local bank-EMC financing, without use of the Guarantee Program. Although the pace of further banking sector reforms is uncertain and outside of the control of this project, substantial reforms are expected over the next 3-5 years, which should improve the ability of banks to be compensated for incurring risk. The Program also can mitigate this risk somewhat through early and intensive engagement of local banks in the program, and by including incentives for the IA to maximize leverage of the GEF resources. o Insufficient market acceptance of guarantee fees at levels commensurate with risks and costs. This is a substantial risk. Incomplete financial reforms have caused risk-adjusted prices for credit to be artificially low. Program guarantee fees for the relatively risky parts of the portfolio can only be raised over the current commonly accepted rates of 1.0-2.0% gradually, as reforms proceed. Depending on the other operational results of the Program (e.g. defaults and costs), this may cause modest losses to the capital reserve, and hence a modest reduction in guarantee commitments which can be made against that reserve. Overly aggressive pricing, however, will undermine the ability of the Program to meet its primary objective of maximizing energy efficiency investments. Incentives measures will be included in the Implementation Agreement with the IA to encourage maximum guarantee revenue, requiring a balancing of efforts to maximize both transaction volume and guarantee fee revenue per transaction. The effectiveness of such incentives during initial operation will be reviewed at the first Project Mid-term Review. o Excessive loan default rates. Unless properly mitigated, excessive default rates are a substantial risk. Means to minimize defaults have been a key focus of both the Bank team and the Government. Mitigation measures which will be adopted include: (a) structuring of loans to EMCs with counter-guarantee, EMC equity collateral, and host-enterprise subproject repayment arrangements which ensure that loan defaults are prohibitively costly to EMCs; (b) structuring of loans to take full advantage of the risk mitigation opportunities offered by energy performance contracting, through EMC portfolio diversification, linkages of loans with energy performance contracts with strong host enterprises, etc.; (c) some portion of risk-sharing by the local banks, who are best aware of local enterprise strengths and weakness; (d) intensive technical assistance to the EMCs and local banks in the preparation and review of transactions during the start-up years, including involvement of the SETC's PMO and the Bank team; and (e) inclusion of a strong disincentive for 23  defaults, and incentives to recoup subrogation losses, in the compensation scheme established with the IA. * Guarantee Program operating cost overruns. Unless properly mitigated, this also is a substantial risk. Mitigation measures include explicit operating cost limitations in the Implementation Agreement, cost-reduction incentives in the compensation scheme established with the IA, and the incremental approach of the Program. Operating cost issues will be an important aspect of the annual program reviews and project mid-term reviews. For the EMC Service Component, the principal risk is the risk of ineffective institutional development. This risk is being mitigated through ongoing major capacity building investments with ASTAE-DflD support, and the gradual and considered approach to the development of the permanent EMC Service Association, led by the SETC and the EMC Development Steering Committee (see Annex 2). 3. Possible Controversial Aspects: None identified. G. Main Conditions 1. Effectiveness Condition A condition of effectiveness is that the Operations Manual, acceptable to the Bank, has been duly adopted by the Recipient. 2. Other [classify according to covenant types used in the Legal Agreements.] The following specific assurances, in addition to the general assurances in most other GEF Grant Agreements, were obtained at project negotiations to include in the GEF Grant Agreement. * The Recipient will have all relevant records and accounts, including the project's Special Account, audited each fiscal year by independent auditors acceptable to the Bank, furnish these to the Bank not later than 6 months after the end of each fiscal year, furnish to the Bank other related information requested by the Bank, and retain relevant records. The Recipient will also cause each Guarantee Program Implementing Agency to have the records, accounts and financial statements of the EMC Guarantee Program Special Fund audited each fiscal year by independent auditors acceptable to the Bank, furnish these to the Bank not later than 6 months after the end of each fiscal year, furnish to the Bank other related information requested by the Bank, and retain relevant records. * The Recipient will furnish to the Bank a financial monitoring report, in form and substance satisfactory to the Bank, which sets forth sources and uses of funds for he Project, both cumulatively and for the period covered by the report, showing separately funds provided under the Grant, and explaining variances between actual and planned uses of such funds. The first report will be furnished to the Bank not later than 45 days after the end of the first semester after project Effectiveness, and every semester thereafter. * The Bank will have rights of suspension (pursuant to Section 6.02 (p) of the General Conditions), if (a) the Operations Manual is amended, suspended, abrogated, repealed or waived without the prior concurrence of the Bank, and this materially and adversely 24  affections the ability of the Recipient to perform any of its obligations under the Grant Agreement, or (b) a Guarantee Program Implementation Agreement is amended, suspended, abrogated, repealed or waived without the prior concurrence of the Bank, and this materially and adversely affects the ability of he Recipient or Guarantee Program Implementing Agency to perform any of their obligations under the Grant Agreement. o The Recipient will promptly refund, and/or cause a Guarantee Program Implementing Agency to refund, to the Bank the GEF proceeds disbursed by the Bank, and the investment income generated by the Special Fund, in whole or in part, at the Bank's option, if (a) the Bank shall have determined that any payment made with GEF funds or interest income generated therefrom was used for any expenditure not consistent with provision of the Gant Agreement; (b) the Bank shall have determined that the Recipient or a Guarantee Program Implementing Agency shall have failed to perform any obligations consistent with the Grant Agreement or the respective Guarantee Program Implementation Agreement; (c) expenditures from the GEF grant or from interest income generated therefrom were made which are prohibited by a decision of the United Nations Security Council taken under Chapter VII of the UN Charter; (d) expenditures from the GEF grant or interest income generated therefrom were made under contracts involving corrupt or fraudulent practices by representatives of the Recipient or Guarantee Program Implementing Agency, without timely and appropriate action satisfactory to the Bank to remedy the situation; or (e) the Operations Manual, the charter of a Guarantee Program Implementing Agency, or a Guaranty Implementation Agreement has been amended, suspended, abrogated, repealed or waived in a manner which, in the opinion of the Bank, would materially and adversely affect the implementation of the Project or attainment of its objectives. Concerning the EMC Service Component, assurances were obtained that the Recipient will, through SETC: o Until the establishment of an EMC Service Association, maintain the EMC Service Group with qualified and experienced management and competent staff in adequate numbers, with terms of reference, funds and other resources acceptable to the Bank; O Cause the EMC Service Group by December 31, 2002 to prepare a time-bound Project Implementation Plan satisfactory to the Bank, and thereafter implement said plan in a manner acceptable to the Bank; and o By December 31, 2003, establish a successor entity to the EMC Service Group, satisfactory to the Bank, to be known as the EMC Service Association, and execute a performance contract with the EMC Service Association, all in a manner and substance acceptable to the Bank. Concerning the Project Management and Monitoring Component, assurances were obtained that the Recipient will, through SETC: o Maintain its Project Management Office in SETC, with functions and sufficient and adequate resources acceptable to the Bank and competent staff in adequate numbers, including a qualified and experienced manager to coordinate, monitor and supervise the implementation of the Project. 25  * Maintain policies and procedures adequate to enable it to monitor and evaluate on an ongoing basis, in accordance with indicators acceptable to the Bank, the carrying out of the Project and the achievement of its objectives; and * Prepare, under terms of reference satisfactory to the Bank, and furnish to the Bank, (i) semi-annually by May 31 and November 30 of each year, commencing May 31, 2003, and (ii) on or about November 30, 2004 and April 30, 2007, reports integrating the results of agreed monitoring and evaluation activities on the progress achieved in carrying out the Project, and setting out the measures recommended to ensure the efficient carrying out of the Project in the future period. The Recipient should review with the Bank the two Mid - Term Project reports referred to above by January 31, 2005 and June 30, 2007, and take all measures required to ensure the efficient completion of the Project based on the conclusions and recommendations of these reports and the Bank's views on the matter. Concerning the EMC Loan Guarantee Program, assurances were obtained that: * The Recipient will (i) Execute a Guarantee Program Implementation Agreement, in form and substance acceptable to the Bank, with at least one Guarantee Program Implementing Agency and, for each executed Guarantee Program Implementation Agreement, furnish the Bank with evidence satisfactory to the Bank that said Guarantee Program Implementation Agreement between the Recipient and a Guarantee Program Implementing Agency has been duly authorized and executed in compliance with the provisions of this Agreement; and (ii ) subsequent to the execution of Each Guarantee Program Implementation Agreement, establish with the proceeds of the GEF Trust Fund Grant, a Special Fund in respect of said Guarantee Program Implementing Agency, which Agreement shall provide for, inter alia: (A) the ownership of the said Special Fund by the Recipient; and (B) the guidelines and procedures for the management and operation of the said Special Fund by the Guarantee Program Implementing Agency with which the Recipient executes a Guarantee Program Implementation Agreement. * No withdrawals will be made for the EMC Loan Guarantee Program disbursement category until the Bank has been furnished with evidence satisfactory to the Bank that a Guarantee Program Implementation Agreement between the Recipient and a Guarantee Program Implementing Agency, acceptable to the Bank, has been duly authorized and executed in compliance with the provisions of the GEF Grant Agreement and is valid and enforceable in accordance with its terms. * Each of the Guarantee Program Implementation Agreements shall include the terms and conditions detailed in Schedule 6 of the Grant Agreement, satisfactory to the Bank. (These terms and conditions are detailed in Annex 2 of the PAD.) * Except for such portions for which a refund to the Bank is required (see above), the Recipient may keep in perpetuity Grant proceeds disbursed to it under the EMC Guarantee Program Special Funds category, but only for the purposes of: (i) continuing the EMC loan guarantee program as set forth in the Grant Agreement, or (i) using such funds in a manner satisfactory to the Bank and in accordance with a plan provided to the Bank by December 31, 2009 for the future use of such funds, consistent with the objectives of reducing greenhouse gas emission in China, and revised as necessary by the Closing Date to fully incorporate the comments of the Bank. 26  H. Readiness for Implementation [ 1 1. a) The engineering design documents for the first year's activities are complete and ready for the start of project implementation. 1. b) Not applicable. 2. The procurement documents for the first year's activities are complete and ready for the start of project implementation. [X] 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality. 4. The following items are lacking and are discussed under loan conditions (Section G): 1. Compliance with Bank Policies [ I This project complies with all applicable Bank policies. [X] The following exceptions to Bank policies are recommended for approval. The project complies with all other applicable Bank policies. On August 2, 2002 senior management approved a waiver of the requirements under OP12.00 and OP14.40 that the Bank follow its normal policies and procedures relating to disbursements from the GEF Trust Fund into the EMC Guarantee Program Special Fund. The upfront disbursement into the Fund, although in tranches, is not for goods, works or services, but rather as a contingent capital reserve held in the event of guarantee defaults. Such disbursement is essential for this project to proceed, in order for the Guarantee Program to have credibility in the market, capacity to underwrite credit risk of participating banks, and to meet subrogation claims in full when they arise. Similar waivers have been grated for a series of GEF biodiversity project, also involving the capitalization of funds with GEF resources. Robert I M. Farhandi Yuk ng Team Leader Acting Sector Director Co6Ary Manager/Dire oor 27  Annex 1: Project Design Summary CHINA: Second Energy Conservation Project Key Performance Indicators Data Collection Strategy Hierarchy of Objectives Critical Assumptions Sector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Mission) 1. Alleviate infrastructure constraints Quantified energy savings Guarantee Program CAS and GEF Objectives to 2. Promote enterprise competitiveness Quantified C02 emission Implementation Agency and Bank Mission: Promotion of and efficiency reductions from EE investments EMC Service Association environmentally sustainable 3. Safeguard the environment reports and commercial energy I services and development GEF Operational Program: Removal of barriers to EE (OP 5) Global Objective: Outcome / Impact Indicators: Project reports: (from Objective to Goal) Development Objective: Total investments of EMC PMO, EMC Service Association Development and Global Achieve cost-effective improvements in industry and project management Objectives to CAS EE on a commercially sustainable basis Number of profitable EMCs in reports; Supervision missions Stable macroeconom'ic Global Objective: operation and reports conditions Sustainable removal of commercial Energy savings and CO2 Ongoing reforms in state- barriers to EE investments emission reductions from EMC owned enterprises projects Output from each Component: Output Indicators: Project reports: (from Outputs to Objective) 1. Increased commercial investments in 1. I Total investment of EMC Guarantee Program Increasing lending of EMC projects supported by guarantee Implementation Agency, EMC commercial banks to EMCs projects facility Service Association and project Sufficient creditworthy 1.2 Number of EMC projects management reports; enterprises to sustain EMC supported by guarantee facility Supervision missions and industry 1.3 Number of participating reports EMC access to quality EE banks technologies and know-how 2. Increased capacity for EMC industry 2.1 Number of EMCs to identify and implement EE projects implementing projects 2.2 Number of EMCs and staff trained Project Components / Sub-components: Inputs: (budget for each Project reports: (from Components to component) Outputs) 1. EMC loan guarantee program I. Capital grant of US$22 Guarantee Program Commercial banks willing to million equivalent; final grant of Implementation Agency, EMC accept partial guarantees for US$3-7 million expected Service Association and project EMC projects management reports; Investors willing to establish Supervision missions and new EMCs reports Ability of new EMCs to operate successfully 2. EMC Service Association 2. US$1.6 million equivalent grant 3. Project Monitoring, Reporting and 3. US$600,000 equivalent Evaluation 28  Key Performance Indicators and Monitoring Methods The key indicators of success in achieving the stated project development objectives are the total annual energy efficiency investments generated by EMCs, and associated annual energy savings and reductions in carbon dioxide emissions. The project performance indicators on total annual energy efficiency investments generated by EMCs are based on the business plans developed for the EMC loan guarantee program and the EMC Association. These investment targets also were used for the incremental cost analysis and environmental benefits. In the project team's "best estimate" business plan, coefficients for energy savings (12.71 tce/US$'000/yr) and carbon reductions (8.46 tc/US$'000/yr) as well as the average life of equipment (9.2 years) were derived from detailed analysis of the more than 141 EMC subprojects commissioned under the first Energy Conservation Project. For the key performance indicators, however, somewhat more conservative estimates were used, given major uncertainties conceming the fuel mix saved, fuel prices, and the electricity generation source mix. For example, based on the subprojects commissioned under the first Energy Conservation Project by mid-2002, electricity savings projects save an average of 5.27 tce/US$'000/year compared with coal-saving projects with 22.96 tce/US$'000/year. Therefore, a coefficient of 10 tce/US$'000/yr has been used. Performance Indicators for Energy-efficiency Investments, Energy Savings and Reductions of Carbon Dioxide Emissions Generated by EMCs Project Year 1 2 3 4 5 6 7 Total Total Investments 14.4 22.2 38.0 62.4 80.2 82.4 84.8 384 (million USD) Energy savings 1.3 2.0 3.5 5.7 7.4 7.6 7.8 35.3 (million tce) Carbon reduction 0.9 1.4 2.3 3.8 4.9 5.0 5.2 23.5 (million t) Note: Investments are investments during the project period only. Energy savings and carbon reductions are the total amounts which will be directly generated by the investments, over the estimated life of the equipment installed. Total actual energy savings and associated carbon dioxide reductions achieved from all EMC subprojects will be reported by the guarantee program and EMC association in their biannual reports. Actual energy savings for each EMC and each subproject are relatively easy to monitor, since stipulated and confirmed energy savings are a key aspect of the energy performance contracts to be used. In addition to these key project performance indicators, a number of other quantitative and qualitative indicators will be monitored by the Guarantee Program Implementation Agency, EMC Association and PMO, and reported in all regular project reports. For the Guarantee Program Implementation Agency, the indicators to be monitored and reported include, at a minimum: (a) number and total value of guarantee commitments, guaranteed loans, and associated energy efficiency investments generated, together with information on the terms, duration, cumulative balances, etc. of these transactions; (b) number and amounts of 29  defaults, and net subrogation losses; (c) total Fund revenue (e.g., including both fee and interest income); (d) total operating costs and average operating costs per transaction; (e) net income from the Program; (f) number and types of beneficiaries; and (g) number and description of participating banks, including infonnation on related loans and guarantee commitments. For the EMC Association, indicators to be monitored and reported include, at a minimum: (a) total number of EMCs operating in China, and their basic characteristics, including equity holdings; (b) number and characteristics of EMC Association members; (c) EMC Association costs and revenues; and (d) number of EMCs participating in training events. 30  Annex 2: Detailed Project Description ClH[lNA: Second Energy Conservation Project The proposed project includes three components: (a) an EMC Service Component, designed primarily to provide in-depth, practical technical assistance to new and emerging EMCs on development of their businesses, (b) the Project Management and Monitoring Component, to support central coordination, monitoring and reporting of project activities, and (c) an EMC Loan Guarantee Program, designed to provide new and emerging EMCs with enhance opportunities to receive loans from domestic banks, and to engage the banks in the development of a sustainable EMC industry. EMC SERVICE COMPONENT This component consists of a large capacity building and technical assistance program to raise broad awareness of the EMC mechanism, assist new EMC to develop into established businesses, and help develop policy support. EMC service activities have already begun, with about $2.5 million of support through an associated technical assistance projects executed by the Bank's Asia Alternative Energy Programme (ASTAE) and financed by the Department for Intemational Development (DflD) of the United Kingdom. Under the five-year implementation period, this component includes GEF financing of $1.6 million equivalent. Although some international technical assistance will also be involved, the primary focus will be to rely on Chinese experts and business people who are well versed in the development of Chinese EMCs and their potential to assist new, emerging companies. The component includes the development of the EMC Service Group into a permanent, self-sustaining institution, to implement this function over the short and long term. The Bank reviewed and appraised the general project implementation plan and its five-year budget during project appraisal. Additional work program details are being prepared by the Group, and will be completed satisfactory to the Bank by then end of December 2002. The EMC Service Group/Association and Steering Committee The SETC formed the EMC Development and Service Group (EMC Service Group) in March 2001, operating under the umbrella of the State Economic and Trade Commission's (SETC) Project Management Office (PMO) of the World Bank/GEF China Energy Conservation Project. As of project appraisal in April 2002, the EMC Service Group included 6 full-time employees. Prior to the end of 2003, and following the expansion and further development of its EMC members, the EMC Service Group will be transformed into a permanent entity, independent from the PMO and govemment, dedicated to providing service to its EMC members. The permanent service institution will act as a service oriented trade association, and should be financially self- sustaining after project completion. Although described in this report as the "EMC Service Association", the new institution may or may not be formed as an Association under Chinese law, given that Associations in China operate differently than in many other countries. The function of the EMC Service Group/Association is to provide service to new and emerging EMCs, including: o Developing and implementing a massive and detailed training program for new and developing EMCs, in line with needs expressed by them, including assistance in EMC establishment, corporate structuring and identification of types of corporate partners, 31  assistance in project identification and development, assistance in overcoming operational problems, etc. Training will include customized technical assistance to specific EMCs, in addition to training courses, workshops and seminars; * Acting as an advocate of the EMC industry in China, and recommending policy and support activities to the Govemment, international institutions, and other key groups, which will foster healthy industry growth; * Preparing and disseminating basic information conceming the EMC business throughout China; * Recruiting new Association Members, and developing feedback mechanisms for improving member services and developing new services; and * Meeting and coordinating with financial institutions to introduce the EMC business, to explain perfommance contracting, and to discuss potential roles and benefits of financial institution participation. Measures of the EMC Association's effectiveness will include the number of commercial EMCs operating successfully, volume of energy efficiency investments implemented through EMC activities, number of EMC members and revenues generated by the EMC Association to ensure its sustainability. Qualitative performance assessments of the EMC Association and its products will be conducted through EMC member/participant surveys and interviews. In addition to SETC, the EMC Service Group is operating with the advisory assistance of the EMC Development Steering Committee, also formed in March 2001. The Steering Committee is a high-level group, established to guide the overall development of China's EMC industry. The group includes highly-respected active or former senior officials concemed with energy policy and energy conservation, bank managers, authorities form the electricity utility industry, officials involved in taxation and auditing, a legal representative, and business people from the energy conservation industry. The Steering Committee meets at least four times a year, and its Vice- Chairman is working about half-time on Steering Committee tasks. The Steering Committee's work program includes a number of site visits every year, and a research of specific operational topics confronting the EMC industry from time to time. The responsibilities of the Steering Committee include: * To direct the operation of the EMC Service Group; * To guide the accomplishment of a strategic development plan for EMCs industry; * To scrutinize, monitor, and assess the business operation of the three demonstration EMCs, and to summarize and comment on their accumulated experience; * To evaluate the training course plans and implementation by the EMC Service Group, and assess actual results achieved; * To coordinate with relative govemment policy-makers, with the objective to create a harmonious environment for EMCs development; and * To boost and attract potential EMCs, and to seek potential EMCs partnership, in part through support of individual Committee members. Near-term Work Plrogram The EMC Association's work program during March 2001-December 2003 focuses particularly on the establishment of its large-scale training program and some other services, and definition of its institutional future. The Group's work during this period is supported in large part by ASTAE's DflD supported technical assistance, but also with a portion of the GEF resources. This is a critical time period for the Group/Association, in terms of its institutional establishment 32  and identity, development of relationships with its members, and investment in customized materials, curricula and training personnel for a series of EMC training course and workshops. The work program includes: EMC Service Association Development. Working together with SETC, the EMC Service Group, the EMC Steering Committee, and the member EMCs must decide on and build the institutional future of the Group/Association, including legal establishment of the permanent institution, governance arrangements, membership criteria, organization of service provision, specifics of annual revenue development and financial plans, etc. An international workshop was held in Beijing in September 2001 to review the experience of national ESCO Associations in other countries, and lessons learned relevant to the Chinese situation. The Group is now enlarging its international contacts, and developing its institutional plans, beginning with the completion of a more detailed Project Implementation Plan for this project. EMC Training Program. With over 200 Chinese firms registering interest in training already, and more expected, training of prospective EMC staff is an urgent and massive task. During 2001, the design for a series of customized courses and workshops was completed, including an introductory course, and three advanced workshops-one for EMC General Managers on corporate development and business planning, one for EMC Project Managers, on the development and implementation of energy performance contracting projects, and one for EMC Financial Directors, on EMC portfolio risk management and EMC financial planning and accounting. The courses and workshops are being developed basically from scratch, with highly customized materials for the Chinese market based largely on EMC experience in China to date. The advanced courses, in particular, utilize some case study and business school presentational methods. Once the specific curricula and training materials have been developed and tested, it is planned to hold each course and workshop several times each year for the foreseeable future. By the end of June, 2002, the introductory course had been successfully delivered four times. Initial materials and curricula for the three advanced workshops also had been completed and each of these three courses had been successfully delivered. EMC Financial Technical Assistance. Working together with the Implementing Agency for the EMC Loan Guarantee Program, the EMC Service Group also will pursue a series of activities to raise awareness concerning the EMC industry in local banks, to help bank officials to understand the details of the business, and to provide EMCs with customized technical assistance in their preparation of applications or loan finance.. During 2002 and early 2003, workshops will be held with financial industry representatives to introduce the EMC industry and its business opportunities. Customized technical assistance and training will also be provided to banking officials concerning how to review EMC business plans, and loan restructuring options. On the EMC side, the EMC Service Group will organize assistance on the preparation of business plans for specific credit applications, on means to meet bank loan criteria and the criteria of this project's EMC Loan Guarantee Program, and on the processing of such applications. This technical assistance is also essential for the development of the EMC Loan Guarantee Program pipeline. Additional Activities. Additional planned activities of the EMC Service Group during 2002-3 include (a) activities to provide EMCs with information on new business opportunities, including state-of-the art-technologies abroad which offer good potential for EMC applications in China, and means to develop new, integrated and full-service EMC project concepts; (b) organization of workshops and other "match-making" mechanisms to facilitate foreign-local ESCO joint ventures, bank-EMC partnerships, and EMC-equipment supplier alliances which can capitalize on the comparative advantages in developing new EMCs; and (c) initiation of an EMC 33  marketing effort to all sectors in China, to further sensitize potential customers and to increase awareness among local government entities. Medium-term Work Program Whereas the 2001-2003 near-term work program involves investment in developing the basic capacity of the EMC Service Group/Association, the medium-term work program (continuing until late 2007) involves steady delivery of EMC services, and transformation of the EMC Association into a self-sustaining, permanent entity. Key tasks include the "regularization" of the EMC Association's work, development and expansion of the Association's revenue, and expansion of EMC membership and the Association's market presence. The Association's expenditures will decline, as the upfront capacity-building investments of the ASTAE-DflD projects will have concluded. The primary sources of financial support will be GEF support and the Association's own revenues (see Figure 1). The principal activities comprising the medium-term work program include: * Continued delivery of training courses and workshops, including both the introductory training course and the advanced workshops, based on demand in the market and demand from EMC members; * Continued offering of customized technical assistance and advisory assistance to EMC members, especially on access to credit financing; * EMC membership meetings and expositions, to enable EMC members to exchange experiences, to disseminate information on new business opportunities and business models, and to disseminate information about the EMC industry to society as a whole; * Publication and dissemination of newsletter and specific information pieces of interest to EMC members, utilizing website and hard copy dissemination practices; * Provision of EMC certification services, as requested and developed together with the EMC membership; * Development of a sophisticated member service request and response function, including a database for member use; * Policy research and advocacy with relevant Government agencies, in the interest of the growing EMC industry; and * Monitoring of EMC industry development, and reporting on EMC industry growth and trends to the Government, World Bank and GEF, based on mnarket surveys, database compilation and field investigations. EMC Service Component Costs and Financing The total estimated costs of the EMC Service Component, including pre-project costs supported by ASTAE-DflD financing, are about $4.96 million equivalent, as shown in Table 1. ASTAE-DfID financing comprises about $2.5 million, GEF financing $1.6 million equivalent, and Association revenue about $0.86 million. As shown in Figure 1, the ASTAE-DflID financing supports mainly upfront capacity building costs and investments, including, in particular, the development of the customized training program for continued use in future years. The GEF financing provides support for some continued investment in capacity building, and assists the EMC Service Association to make the transition to a permanent entity, which can be self-sustained through its own revenues. 34  Table 1: Preliminary EMC Service Group/Association GEF Budget GEF Budget Total Cost Component (UJSD million (USD million) equivalent) EMC Services EMC training courses 0.15 1.38 Customized EMC TA and advisory services 0.13 0.95 EMC membership meetings/expos 0.16 0.47 Policy research/advocacy 0.06 0.10 EMC partnerships, business development 0.06 0.49 EMC publications, certification services 0.07 0.15 Sub-total 0.63 3.53 Institutional Development Core costs 0.55 0.87 Business plan development, marketing, 0.16 0.25 website Staff Training/Twinning 0.06 0.10 Sub-total 0.77 1.21 Monitoring and Reporting EMC market surveys, database 0.12 0.14 Project inspections, monitoring, reporting 0.08 0.08 Sub-total 0.20 0.22 TOTAL 1.60 4.96 Revenue generation. Development of EMC Service Association revenue will take time, and the Association's revenues are expected to grow only gradually. The ASTAE-DfID and GEF support will allow the Association to gain a jump-start, and provide a mechanism for the delivery of the massive EMC training and technical assistance required for the industry to develop. Association revenue development requires both further development of the EMC industry into a true membership base, and establishment of the Association's credibility within the market as a true service-oriented entity, providing services which are worth paying for. Increasingly over the project implementation period, the Association will develop revenues, from its membership and other sources, to sustain its costs, including the costs of engaging outside expertise. It is a clear project requirement that the Group/Association must be fully self-sustaining from these revenue sources by the end of the five-year period. Revenue development is expected to be only gradual in the Chinese environment, where many "associations" developed in the past have provided little if any real service to membership. Thus, the Association must demonstrate that it can provide high quality and relevant services to its members and clearly demonstrate its value added to their businesses. The Association's advanced training courses, for example, must first gain a high reputation before many participants will be willing to pay substantial fees for the privilege of attending. Association revenue sources may include member dues, revenues from member meetings and exposition fees, fees for at least the advanced training courses, advisory service fees, fees for EMC certification, publication and exposition advertising, certain consulting fees, and Government or international agency or company financing for specific activities or research tasks. GEF financing. Details of GEF financed aspects are also included in Table 1. GEF grant would support about 32% of the total costs of the EMC Service Component (including pre-project 35  costs supported by ASTAE-DfID). GEF financing levels estimated in Table 1 assume allocation of $200,000 equivalent from the project's unallocated disbursement category. (Allocation of the $200,000 equivalent is contingent upon needs and results, relative to other project components.) GEF support would include: * $770,000 equivalent to support long-term consultants and the incremental operating costs of the EMC Group/Association, including a portion of fixed-temn personnel costs, office and travel costs for the Association, staff training and twinning arrangements, and support for the development of the Association's business plans, marketing efforts and website information dissemination. This represents about 64% of the estimated institutional costs of the Association, with the balance coming from Association revenues. The share of GEF-supported incremental operating cost financing will decline each year over the five- year project implementation period, in favor of Association revenues, until reaching zero after Year 5 (see Figure 1). * $630,000 equivalent to support about 18% of the costs of providing specific EMC Association services, including, in particular, the delivery of the training courses and workshops, customized technical assistance and advisory services, and membership meetings and expositions. * $200,000 equivalent for monitoring and reporting on the development of the EMC industry in China, as a ciitical input into this project's overall Monitoring and Evaluation reporting, as required by the Govemment, World Bank, and GEF. Figure 1 EMC Group Funding Arrangements $1,200- $1,000 $800- 0 060 {,3 $600 X - 8 : ~~UK- ~> : _ $200 GEF I . -2 -1 0 1 2 3 4 5 6 7 Project Year PROJECT MONITORING, REPORTING AND EVALUATION COMPONENT 36  The SETC's PMO will assume responsibility for coordinating and monitoring the overall Project, including both the EMC Service Component and the EMC Loan Guarantee Program. The key functions of the PMO, which will be supported with GEF financing of $600,000 equivalent to engage necessary expert services, include: * Coordinating, compiling and preparing project reports, including biannual project progress reports need for the supervision of the project by the Government and the Bank, and mid- term project reports. The PMO should review and compile progress reports from both the EMC Service Association and the Guarantee Program Implementing Agency, perform periodic inspections and audits as required, prepare full reports on the energy and carbon savings from the project as well as other project performance indicators, address implementation issues with SETC and the implementing agencies, and other project oversight activities as required. Based on, and including detailed information from the transactions of the Guarantee Program Implementing Agency and from the databases and surveys of the EMC Service Association (based on separate and specific monitoring and reporting procedures and budgets of those entities), the PMO will have oversight and reporting responsibility for the major project monitoring and evaluation aspects of the project These reports will include aggregate investment figures, number of EMCs and EMC projects supported, total energy saved, and total carbon emissions reduced from EMC projects through EMC and customer surveys, project inspections, and reporting This reporting will be a key input for the Bank's project supervision work. * Maintaining the project's Special Account, oversight of project disbursements, monitoring of financial management under the project, and preparation (or compilation from the inputs of other project entities) of all required financial reporting to the Bank. The PMO also will be responsible for oversight of the procurement of services under all components of the project, and direct liaison with the Bank on these procurement matters. * Engaging sufficient expertise to assist the Government in the supervision of the EMC Loan Guarantee Program. The PMO will operate the bank account for the EMC Guarantee Program Special Fund, for SETC. By engaging suitable expertise, the PMO will need to assist SETC in most of the detailed supervision responsibilities of the Program and account, including review of annual plans and budgets. EMC LOAN GUARANTEE PROGRAM Background China's Banking System and its Reform. China's banking system currently includes (a) several large policy banks (e.g., the State Development Bank), (b) four very large state-owned commercial banks (China Industrial and Commercial Bank, Bank of China, China construction Bank, and China Agricultural Bank), (c) a series of relatively new joint-stock commercial banks (e.g, the Bank of Communications, CITIC Industrial Bank, China Everbright Bank, Huaxia Bank, China Minsheng Banking Corporation, Shanghai Pudong Development Bank, Merchant's Bank etc.), and (d) a series of local municipal banks. A number of foreign banks have begun operations in China, but with limited scope. The financial system also includes a large number of Trust and Investment Corporations (TICs), who have provided a series of financial services, especially at local levels. Many of the TICs, however, are being restructured or are suspending operations, as regulation of these entities has increased in recent years. 37  China's banking sector is in the midst of a critical transition from operation under the planned economy to true commercial, market-based banking. This transition will still require years to complete. The legacy of the past era where the Government directed lending policies through the banks, and maintained a key role in lending decisions, still leaves an imprint on the sector-the four large state-owned banks in particular retain high ratios of non-performing loans in their portfolios, and prospects for repayment from heavily debt ridden state-owned enterprises are often dim. In addition, the interest rates which banks are allowed to charge are regulated within a fairly narrow band by the People's Bank of China. Thus, banks are not allowed to vary the price of loans substantially, based on variations in risk. Therefore, the combination of a history of relatively poor loan repayment and inability to charge for risk have caused the banks to now be exceptionally conservative in their lending policies. Loan collateral and guarantee requirements are exceptionally stringent; as interest returns are similar regardless of risk, Chinese banks currently tend to focus on maximizing loan security. With China's entry into the World Trade Organization (WTO), and the pressure and momentum of financial sector reform building, substantial progress in reform of the sector is expected during the life of the proposed project. Interest rate regulations are expected to be loosened for small and medium-sized enterprise loans in particular, but the timing of these reforms remains uncertain. WTO entry will bring an increased presence and expanded business scope for foreign banks in China over the next 3-5 years, and associated competitive pressures. Chinese banks are becoming keenly interested in customer relations and other measures to maintain or increase market share among creditworthy customers. Developments in these areas will be important for this project. China's Emerging Credit Guarantee Systems. China's first specialized guarantee institution, China National Investment and Guaranty Co., Ltd. (I&G) was established in 1993. As it began operations, the Guarantee Law of China was promulgated, as the basic law governing the guarantee business. However, the guarantee business has begun to develop commercially on a substantial basis only during the last few years. I&G's guarantee business grew sharply in 2000. Additional guarantee companies also have formed recently, although not at national levels, and most of the new guarantee companies are quite small and have small geographic scope. Although still a very new addition in China's financial sector, the business has grown recently, with government encouragement, especially as a means of assisting small and medium-sized enterprises to gain access to credit in the current conservative credit environment. Rationale for a Loan Guarantee Program. As described in the main text, China's new and emerging EMCs face major difficulties in securing credit for growth in China's conservative credit market, given that they are operating under a new business model with little track record, and most are small enterprises with few assets. Especially under the current financial system, a specialized partial credit guarantee is the most appropriate way to overcome this barrier to growth, given (a) the existence of credit risk barriers, (b) the current conservative credit and lending practices; and (ii) the fact that funds are available in the capital market which are not being deployed. The guarantee mechanism is intended to induce banks to enter this market and deploy their own resources to finance EMC projects, and, generally, to overcome the credit risk barriers and demonstrate the viability of these types of projects. Guarantees are appropriate to use when financial resources are available in the market, but need an incentive to be deployed. Energy efficiency markets are often plagued by a mismatch between what constitutes a technically and financially sound energy efficiency project versus what constitutes a creditworthy bankable project. Further, in developing financial markets, gaps often exist between perceived credit risks, as reflected in credit underwriting practices, and actual credit risks. These may arise due to financial 38  conditions within the banking system and/or within the universe of prospective borrowers. Commercially oriented guarantees can help bridge these gaps. Suitable loan guarantee facilities for EMC projects are not available in China. China's loan guarantee industry is relatively new, underdeveloped, regionally focused and largely directed towards promoting other specific public policy objectives. Many of the existing companies guarantee 100% of loan amounts, removing any real risk from the banks involved. Guarantee fees charged to date are often quite low (often 1% of the guarantee exposure per year), but counter- guarantee requirements (collateral and/or third party suretyships) are often very stringent, and similar to those of the commercial banks (perhaps undermining the rationale for the guarantee programs in the first place). The proposed loan guarantee program aims to develop the EMC market while eventually earning a market return (as opposed to making purely development-oriented investments.) Additional requirements include national coverage, and a mechanism which increasingly involves the domestic banking industry as the primary source of credit for the EMC industry. EMC Loan Guarantee Program Objectives and Scope The goal of the EMC Loan Guarantee Program is to facilitate access to domestic commercial credit for the broad, strong and sustained development of China's new EMC industry. The objective is to achieve maximum EMC investment in energy efficiency over the long term. To achieve this, the program must seek to (a) maximize guarantee transactions, leveraging capital resources as much as possible, to facilitate as much lending to EMCs as possible; (b) preserve its capital base, through commercially-oriented operation, in order to maintain resources for revolving, long-term use; and (c) engage and strengthen the involvement of domestic banks in the program as much as possible, so that the banks become increasingly familiar and comfortable with lending to the EMC industry, and are increasingly willing to undertake EMC credit risks themselves. The Guarantee Program will support a wider range of EMC business models than under the first China Energy Conservation Project, supporting loans for a wide variety of energy efficiency projects. To qualify for Guarantee Program support, however, projects supported by loans guaranteed by the Program must be structured so that: (a) more than one-half of the project cashflow benefits are derived from reductions in host enterprise energy bills; and (b) host enterprises maintain positive cash flow in respect to the project. The Guarantee Program will provide partial credit risk guarantees to applying banks and EMCs for up to 80-90% of the loan principal amount initially, and declining amounts over time. The Program will be open to any potential applicants operating EMCs in China. A variety of loan and guarantee structures are possible, with types of security potentially involving EMC assets, collateral and diversified portfolio security; third-party partial counter-guarantees; and various methods for using specific EMC contracts with host enterprises as security. EMC Loan Guarantee Program Structure Key design criteria for the Guarantee Program included (a) maximum flexibility to adjust and adapt to both the uncertainties of the new and evolving EMC market and the uncertainties of the pace and depth of China's banking sector reforms, (b) needs for national coverage, (c) needs for maximum guarantee credibility in the Chinese financial market, and (d) needs to maximize the breadth and depth of the involvement of the banks in extending credit to EMCs over time. 39  The Guarantee Program will be operated by a Guarantee Program Implementing Agency (IA), according to a Guarantee Program Implementation Agreement between the IA and the Government, which must be approved by the Bank. It is expected that one IA will be appointed at the outset of the project, and, if operations proceed satisfactorily, this IA would be expected to continue operations throughout the project. However, Program lAs could change over the tenure of the project if necessary, and it is possible in principle that more than one IA could operate the Program at the same time. In order to allow proper flexibility to adjust to evolution of the EMC industry, evolving banking sector reformn, and the gradual strengthening of capacity in the IA, local financing institutions and EMCs, the Guarantee Program will be implemented step-by-step, through a process of implementation, review, adjustment, and further implementation. The IA will prepare annual plans and budgets every year, which will be reviewed by SETC and its PMO, together with the Bank, and adjusted where necessary. The initial 2-3 year implementation phase will involve intensive, customized work to implement the first guarantee transactions of the Program, through intensive cooperation between the Bank team, SETC's PMO, the EMC Service Group, participating banks, interested EMCs and the Program IA. A first Mid-term Review is schedule for this project after the first two years. At this point, the Program experiences will be fully reviewed, and following this review, adjustments to IA arrangements, specific Program rules, targets, management methods, etc., can be made. If the arrangements with the IA are considered satisfactory, the Implementation Agreement with that IA will continue. A second Mid-term Review also is scheduled to take place after four and one half years of project implementation, involving a similar scope. Chinese Government counterparts and the Bank team have considered a variety of possible options for Implementing Agencies, involving review over many months, and proposals and discussions with many parties. In addition to the option of establishing an independent Foundation to operate the Program, which was rejected early on due to legal complexities in the Chinese system, options considered for Program operation included: (a) formation of a new guarantee company; (b) appointment of an existing guarantee company to operate the program under supervision of the Government and the Bank; and (c) deposit of the funds with one or several participating banks to supportlguarantee the extension of credit to EMCs. Following systematic review of these options, the China National Investment and Guaranty Co. (I&G) was selected to complete detailed preparations for assignment as IA for the Start-up Phase. All parties concluded that assignment of an existing guarantee company, if possible, would be the best option for the program, allowing wide bank involvement and coverage, and avoiding the complexities and needs to develop market credibility which would accompany the establishment of a new company. I&G is the only national. guarantee company with a long track record and experience, and its credibility in the market is well established. I&G has a keen interest in developing this new, specialized business. Preparations are underway so that a Guarantee Program Implementation Agreement can executed by the parties and approved by the Bank prior to execution of the GEF Grant Agreement for this project. GEF support for the EMC Loan Guarantee Program will be provided through the World Bank as a grant to the Government of China. The Government of China, represented by the Ministry of Finance (MOF) and State Economic and Trade Commission (SETC), will-use the grant funds to support the Guarantee Program through (a) the establishment and operation of an EMC Guarantee Program Special Fund ($22.0 million equivalent of GEF funds), and (b) provision of grant funds to the IA. for incremental operating costs and technical assistance services ($1.8 million 40  equivalent of GEF funds). The structure of the program and low of funds are depicted in Figure 2 below. Figure 2: Structural Overview of the EMC Loan Guarantee Program IGEF I Withdrawals and ank deposits based on Implementaflon $ Agreement Ministry of Finance Guarantee Program EMC Guarantee GEF funds Implementing Program Special 1 State Economic & Agency Fund Trade CoImission Grant for Incremental Operating Cost & TA Loan Guarantees GEF grant ...................................... ... .......................... ............... .-. . fu n d s Participating v V . technical assistance Banks ............. EM C Service Loans Association Rm V Rrb technical assistance EMCs & Host Enterprises EMC Guarantee Special Fund The EMC Program Guarantee Special Fund is the fund against which guarantee commitments under the EMC Loan Guarantee Program will be made. GEF funds of $22 million equivalent will be deposited into this reserve to support the program. (If more than one Implementation Agency participates in the program, then additional similar Funds will be created.) The IA also will share in the risks and upsides of the program, by making contributions to the reserve fund, by assuming a portion of default risk relating to the leveraging of the reserve with guarantee commitments over and above the reserve balance, and/or a combination of these. Fund resources will be place in a first-loss position for the program's guarantees. The capital reserve will be set up as a "special fund" (zhuanxiang zijin), according to the Guarantee Program Implementation Agreement. A maximum of 50% of the total amount allocated under a Guarantee Program Implementation Agreement will be disbursed when the Agreement is executed, followed with disbursement of additional tranches of up to 25% each once guarantee commitments total at least the level of previous disbursements. The funds remain the property of the Government of China, represented by MOF, but are managed by the IA according to the regulations specified in the Implementation Agreement, developed specifically for the needs of this project. Program guarantees can be made for applications from (a) EMCs which are members of the EMC Service Association, or (b) other qualifying companies submitting sound energy performance contract projects. Eligible energy efficiency projects are projects where (i) over 50 41  percent of the project's cash flow benefits are derived from reductions in the host enterprise energy bills; and (ii) financing is structured so that the host enterprise maintains a positive cash flow throughout the project. SETC's PMO will (i) ensure compliance with obligations under the Implementation Agreement; (ii) review and monitor accounts, management reports, audits, management performance, annual plan and budget, and all other relevant activities; (iii) establish and monitor performance targets on the number and level of guarantee transactions, levels of default; (iv) approve the IA's annual plan and budget; (v) approve individual guarantee transactions, to the extent specified in the Implementation Agreement; (vi) review, implement, and verify the compensation system for the IA, as revised from time to time during the annual process of budget approval; (vii) conduct post reviews and enforce appropriate recovery action in respect of guarantee payments; (viii) review and approve recommendations of Implementing Agency to write off irrecoverable amounts in respect of subrogation. World Bank supervision or approvals will also be required for aspects of (ii), (iii), (iv), (v) and (vi) above. At the end of the seven-year project implementation period, the fund balance in the capital reserve will remain in the capital reserve for continued use to backstop EMC loan guarantees developed by the IA, unless agreed by the Bank and the Government that these remaining funds should be deployed for other, specifically agreed greenhouse gas reduction activities and projects. The Guarantee Program Implementation Agreement The Guarantee Program Implementation Agreement is a critical element of the overall project framework, as it defines the operating framework for the EMC loan guarantee program, supervision mechanisms, and the incentives framework for the IA. The basic terms and conditions required in the Guarantee Program Implementation Agreement are set forth in Schedule 6 of the Grant Agreement between China (the Recipient of the Grant) and the Bank. In addition to standard clauses requiring proper use of funds and establishing regular contractual relations, Schedule 6 requires that the Agreement(s) shall include the following specific key terms and conditions, satisfactory to the Bank: * The obligations of the Recipient to: (a) establish the EMC Guarantee Program Special Fund in a commercial bank account in the name of the Recipient and for the purpose of implementing the EMC Loan Guarantee Program of the project; and (b) assign to the Guarantee Program Implementing Agency the management of the respective Special Fund. * The obligations of the Guarantee Program Implementing Agency (among other things) to: (a) prudently invest the proceeds of the respective Special Fund, in a manner satisfactory to the Bank; (b) deposit all income, including guarantee fees, subrogation recoveries, interest and investment income, capital receipts or other contributions derived from the Special Fund directly into the Special Fund account; (c) make withdrawals from the respective Special Fund only for: (i) payments for call of guarantees supported by the Special Fund; (ii) eligible operating costs of the Guarantee Program Implementing Agency; and 42  (iii) investments consistent with the purposes and objectives of the Guarantee Program Implementation Agreement; (d) annual provision to the Bank of certified copies of financial statements, and audit reports by independent auditors acceptable to the Bank, together with maintenance of required records and accounts, following standard Bank requirements; (e) submission of a Financial Management System Manual, setting forth financial management operations, control and procedures, to the Bank for the Bank's approval prior to the execution of the Guarantee Program Implementation Agreement; (f) within 30 days of a guarantee call payment, provide to the Recipient a written report indicating the reasons for the default, its recovery plan, and the Implementation Agency's assessment of the probability of recovery of the amounts in default; and thereafter implement the recovery plan as so approved by the Recipient and, if any amounts are determined to be irrecoverable, obtain the approval of the Recipient to write off such amounts; and (g) remit payment into the Special Fund account if a guarantee call payment id deemed by the Recipient to be unwarranted, for the amount of said payment; o A provision that requires the Guarantee Program Implementing Agency to obtain the approval of the Bank for the first 4 guarantees of each type of guarantee it proposes to underwrite in connection with the Special Fund, prior to entering into these guarantee agreements; o A provision that sets the compensation of the Guarantee Program Implementing Agency including: (a) a basic fee, which takes into account the operating costs of the Implementing Agency solely and directly attributable to fulfillment of its obligations under the Guarantee Program Implementation Agreement; and (b) an incentive-based fee, the amount of which is calculated on a cumulative basis by taking into account the Implementing Agency's performance which includes, but is not limited to, a consideration of: (A) the number and volume of guarantee transactions supported by the Special Fund; and (B) the guarantee fees generated less net subrogation losses. o A provision that sets forth the immediate termination of the Guarantee Program Implementation Agreement in various events, including if: (a) the Implementing Agency becomes insolvent, (b) the Implementing Agency fails to fulfill its obligations under the Guarantee Program Implementation Agreement, and (c) the charter of the Implementing Agency is amended, abrogated, repealed or waived in a manner which, in the opinion of the Bank, would materially and adversely affect the ability of the Recipient or the Implementing Agency to carry out their obligations. 43  Guarantee Program Incremental Operation Costs and Technical Assistance The EMC Loan Guarantee Program also includes $1.6-1.8 million equivalent of GEF grant financing for the IA, for $1.1-1.3 million equivalent of incremental operating costs associated with Program start-up, and for $0.5 million equivalent for technical assistance services also associated with Program start-up. Final allocations of GEF proceeds for incremental operating costs will be made based on emerging needs and results of the different project components. The transaction costs of the Guarantee Program are expected to be especially high during the initial years of its operation for two reasons. First, it is a new business. The EMC industry itself is new in China, and this industry is largely unknown to the banks and guarantee institutions. The EMCs are also just developing, and have little or no experience in preparing business plans and financing applications suitable for the banking industry. The financial structuring of loans, loan guarantees, and energy performance contracts as package which can yield the best returns with the least risks is a new topic-while this area brings great opportunity, it also will require time and energy to develop. Second, the Guarantee Program IA is not likely to be successful in generating sufficient transactions if it merely waits for sound applications-successful implementation will require a major marketing and transaction origination effort by the IA during the early years. This also will add further and substantially to initial transaction costs. The incremental operating costs supported by the GEF grant will include increased IA costs associated with Program marketing, upstream consultations and investigations with EMCs and their associated banking institutions, development of creative and new loan and guarantee structures suitable for the EMC industry, above average application review and guarantee transaction appraisal costs, etc. The technical assistance services support will include support to engage consultants and experts from abroad and within China to assist in the marketing efforts, development of the new loan and guarantee structures for the EMC industry and the Program, and review of EMC business plans and EMC subprojects. Both of these efforts also provide a major, hand-on and learning-by-doing opportunity for the IA staff, which will be critical for the successful implementation of the Program. Disbursements of these subcomponents of the EMC Loan Guarantee Program are expected to take place primarily during the first three years of the Program. Development of the EMC Loan Guarantee Pipeline Given the goals of the Program to maximize EMC energy efficiency investments, and the fact that the EMC industry is so new, it is important to build mechanisms that will ensure steady and robust developnment of loan applications and guarantee transactions. The incremental operating cost and technical assistance subcomponents of the Program are designed to help the IA to meet this need. In addition, the EMC Service Component includes substantial support for the EMC Service Association to also help the EMCs develop their corporate and business plans on a financially strong footing, and to raise awareness within the banking community about the EMC industry. These efforts must combine, through joint cooperation between the EMC Service Association and the IA, to provide for the most efficient development of the market and the Guarantee Program pipeline. With ASTAE-DfID support on EMC Financial Technical Assistance (described above), as well as aspects of both the EMC Service Component and the grant assistance provided to the IA, the target is to deliver at least 20-30 guarantee transactions during the first two years of the project. As of March 2002, an EMC Loan Guarantee Development Small Group was formed and beginning operations, as a joint effort between the EMC Service Group and I&G, who 44  has been requested to make detailed preparations for IA assignment for the Start-up Phase. This Small Group includes 6 staff, and has embarked on a work program to prepare at least 5-10 guarantee transactions, including negotiated documentation ready for signature, which can be executed as soon as the GEF Grant Agreement and a Guarantee Program Implementation Agreement are effective. 45  Annex 3: Estimated Project Costs CHINA: Second Energy Conservation Project Local Foreign Total Project Cost By Component US $million US $million US $million EMC Guarantee Programs 238.5 0.3 238.8 EMC Services 2.5 0.6 3.1 Project Monitoring, Reporting and Evaluation 0.5 0.1 0.6 Total Baseline Cost 241.5 1.0 242.5 Physical Contingencies 0.0 0.0 0.0 Price Contingencies 0.0 0.0 0.0 Total Project Costs 241.5 1.0 242.5 Local Foreign Total Project Cost By Category US $million US $million US $million Goods 199.8 0.0 199.8 Works 0.0 0.0 0.0 Services 1.69 1.0 2.69 Training 0.0 0.0 0.0 Miscellaneous Incremental Operating Costs 18.0 0.0 18.0 Guarantee Program Capital Reserve 22.0 0.0 22.0 Total Project Costs 241.5 1.0 242.5 46  Annex 4: Incremental Cost Analysis CIIUNA: Second Energy Conservation Project CONCEPT AND BARRIER REMOVAL STRATEGY Energy conservation in China over the coming decades remains critical for the country's development and for the global environment. Conservation efforts continue to be necessary to limit the otherwise huge increase in primary energy supply required to sustain the growth of China's economy and to mitigate the serious environmental consequences of expanded energy consumption. The Government has been particularly keen to develop the mechanism of energy performance contracting, which it considers to be a financing and technology dissemination instrument of great potential for China's evolving market economy. Efforts under the ongoing Energy Conservation Project have been successful so far in introducing and adapting energy performance contracting to Chinese conditions, developing a viable model in the three pilot EMCs, and establishing an initial market among client enterprises. However, despite the success of these three EMCs, parallel market activity has been slow to develop. Efforts are thus required to expand the three pilot EMCs to a national industry and seek participation of the third key player needed for a sustainable EMC market: banks and other financing institutions. As described in the main text, Section B3, the main barriers constraining rapid new EMC development today include: o Lack of sufficient awareness of the energy performance contracting and EMC concepts; o Lack of knowledge and skills to operate EMC businesses; o Lack of credit financing for EMC business development; and o Difficulties in securing sufficient equity financing. The proposed second project is designed to help overcome these barriers to rapid development of China's EMC industry as efficiently as possible. Furtherrnore, in order to foster development of an EMC industry which is sustainable in the market on commercial terms, two additional objectives were set as requirement for project design: (a) direct grants to new or emerging EMCs should be avoided, and (b) the Chinese banking industry must be engaged as the key source of credit financing, replacing the donor financing in the demonstration phase. As described in the main text, Section Cl and Annex 2, the project seeks to remove the main barriers to further EMC industry development outlined above by: o Increasing nationwide awareness of the concepts, and provision of customized, intensive training and technical assistance for new and emerging EMCs on how to set up and develop their businesses, through the implementation of an EMC Service Component; and o Establishment and implementation of an EMC Loan Guarantee Program, designed to provide new and emerging EMCs with enhanced opportunities to receive loans from domestic banks, and to engage the banks in the development of a sustainable EMC industry. 47  Contingent Finance Modality About 85% of the proposed GEF financing will be used in a contingent finance modality. GEF financing proposed for this project includes (a) $4.0 million equivalent in grant funds, including $1.6 million equivalent in support of the EMC Service Group/Association's activities, $0.6 million equivalent to support central coordination, monitoring and reporting or project activities, and $1.8 million equivalent to provide training and technical assistance to participating banks, and to partially defray the high start-up and initial transaction costs of the EMC Loan Guarantee Program, and (b) $22.0 million equivalent as a "contingent grant" to be used as a capital reserve for the EMC Loan Guarantee Program. The concept of contingent grant financing is employed in this project to use GEF funds to backstop commercial bank loans to EMCs through provision of partial credit guarantees, rather than to provide direct grants to EMCs in need of financial support. In the first phase of the project, direct grants were provided to the demonstration EMCs to help support their first demonstration projects, as there was absolutely no experience with the investment mechanism in China, and no entities were willing to either form EMCs or accept commercial loan financing without some additional incentive, given the very high risks of trying this new mechanism out for the first time. As the concept has been successfully demonstrated in the three EMCs now, however, the Bank and SETC teams believe, based on market soundings, that the combination of customized technical assistance and credit enhancement through the guarantee program will provide sufficient support for the strong development of the EMC industry in the next few years, and additional direct grants to end users can be avoided. GEF involvement in the establishment of the guarantee facility is necessary, however, as no commercial investor is willing to undertake the perceived risks of financing the facility alone. This is because the EMC industry is still very new, with such a limited track record, and also because of the limited experience of guarantee funds in China to date. However, use of a contingent grant mechanism for GEF's involvement is appropriate in this case, as there are excellent chances that the perceived risks in running the guarantee fund can be overcome over time. The contingent financing modality for this project introduces several concepts, also used in the case of the Bank's GEF Romania Energy Efficiency Project: * Concept of Gross Contingent Grant. The initial GEF grant to support the capital reserve of the proposed EMC loan guarantee program is a gross grant ($22 million equivalent proposed). The distinction between a conventional grant and this contingent grant is that the latter will be partially or fully returned to the initial beneficiary (e.g., MOF), or otherwise redeployed (e.g. perhaps for other types of guarantees), at the end of the project, for other uses in greenhouse gas reduction agreed with the Bank and GEF. (If agreement is not reached on alternative uses, however, funds developed will remain in support of the EMC Loan Guarantee Program.) * Final or Net Grant. At the end of the project, as much of the contingent grant as possible will be redeployed for use in other agreed GHG mitigation projects. If the return is lower than expected because of factors directly linked to the performance of the Guarantee Company, it will be partially or fully converted into a conventional grant. (Sufficient incentives for maximum capital preservation by the Guarantee Company management will be a key part of the agreement establishing the capital reserve fund.) The amount which is not returned for redeployment will be regarded as the Final Grant. While estimates have been prepared on the basis of reasonable assumptions and expected performance of the 48  facility, the size of the Final Grant cannot be known with any precision until the project closes. * Incremental cost. The incremental cost associated with the provision of the contingent grant for the capital reserve is equal to the difference between the future value of the Gross Grant and the money that is returned at the end of the project. Since the Final Grant will not be known until project closure, the incremental cost also will not be known until the project closing date. The advantage of the contingent finance approach is its inherent capacity to match the net GEF grant with the actual incremental costs stemming from project risk. The incremental cost payments of the Final Grant will be limited to the amount required to actually overcome the barriers to sustainable commercial financing of the EMC sector and energy efficiency investments, as borne out during actual market conditions and project implementation. Overpayment of grant resources are thereby avoided for uncertain activities that are and initially considered to be risky, but ultimately able to yield commercial returns. THE GEF ALTERNATIVE: GRANT AMOUNTS AND INCREMENTAL COSTS Baseline Scenario As described in Annex 11, some 6-8 new EMCs have been formed in China, in addition to the three demonstration EMCs. Based on the market reviews completed by the PMO to date, the project team estimates that some $53 million of investments might be undertaken by these and other new EMCs over the seven year proposed project implementation period, if no additional support measures are provided. These initial estimates are based on the current investment patterns of these companies, and assume that each EMC is able to complete about RMB 10 million of new business each year, with no growth over the first three years and 3 percent growth thereafter. Although not insignificant, these estimates of possible new EMC investment levels under a without project scenario would be a very disappointing result given the market potential. Without a large-scale effort to provide additional financial security and industry know-how, local banks will continue to ignore the EMC business potential and, thus, starve prospective EMCs of required project financing to grow their businesses. There are few reasons for the local banks to undertake the major risks involved in lending to this largely unique business alone, unless good track records are first demonstrated. As can be seen today, despite the initial successes with the three pilot EMCs, new EMCs are extremely few in number and remain unable to access meaningful financing for large-scale operations. Thus, the baseline scenario would include very limited EMC market entrants and activity, and participation by commercial lending institutions in this market would remain extremely low over the near- to medium-term. With the exception of a few financially strong investors, the EMC market would suffer from poor expertise and access to financing and thus the vast Chinese EMC market would remain largely untapped and unserved. In addition, in the absence of a dedicated Association to market the EMC concept, help address ongoing policy issues (e.g., legal, taxation, verification), and train new EMC managers and staff, new EMCs are likely to run into considerable business development hurdles, which would further constrain their growth. Also, should new and inexperienced EMCs develop projects that fail or are poorly designed, it could have significant negative repercussions on the ability for the EMC industry as a whole to further develop. 49  Technical Assistance Components EMC Service Component. GEF grant resources of $1.6 million equivalent are proposed to support about one-third of the costs of the EMC Service Group/Association's activities. This support will enable the EMC Service Group to continue its customized support of the EMC industry begun with UK DffD support, and enable the Group to develop into a permanent EMC Association. By the end of the project period, the EMC Association will be self-supporting from its own revenue sources, gradually built up over time, such as member dues, service fees, and public support for special programs. This component is a necessary companion to the EMC Loan Guarantee Program, as it builds and strengthens the market for EMC loans. In some cases, however, some EMCs may have access to sufficient project financing (e.g., some power utilities or equipment suppliers), but require assistance to develop their EMC businesses. In many cases as well, the involvement in a major national program, supported by SETC, MOF the World Bank and GEF, provides a source of business legitimacy which is critical for gaining market credibility. Project Monitoring, Reporting and Evaluation Component. The critical Project Monitoring, Evaluation and Reporting Component will require $0.6 million equivalent of GEF support, and will be implemented by SETC's PMO. The PMO will maintain the Special Account for the GEF financing of incremental operating costs and consulting services and will oversee GEF disbursements. The PMO will be responsible for compiling reports on project status, on progress meeting performance indicators (especially energy savings levels), and on financial management, based in large part on information provided by the other two implementing entities (the EMC Service Association and Guarantee Program Implementing Agency). The PMO will be responsible for all project procurement work (consisting of consulting services only), although details may prepared by the other two implementing entities. As the PMO also will operate the bank account for the Guarantee P'rogram Capital Reserve Specialized Fund, for SETC, the PMO also will need to engage qualified experts to assist the Government in the supervision of the Guarantee Program and its account. An especially important part of this component will be the monitoring and completion of detailed surveys of the EMC industry's development, maintenance of a database on this, monitoring of EMC investment levels, calculations of actual resulting energy savings and GHG reduction, and detailed reporting to the government and Bank/GEF on these aspects. Support for EMC Loan Guarantee Start-up. GEF grant resources of $1.8 million equivalent will help to defray the high initial start-up costs associated with the EMC loan guarantee program. These costs include development of initial products and in-depth marketing, staff training, use of international expertise on commercially oriented guarantee facilities, and the development and processing of the program's first few transactions, which will be particularly labor-intensive. l.hese costs also include a major program of technical assistance and training for the participating banks, to provide training and international expertise for the participating banks, and to sensitize the many branch officers who will be involved. EMC Loan Program Contingent Grant Gross Grant: The minimum level of GEF contingent grant support to be used for the Guarantee Company's capital reserve is estimated at US$ 22 million equivalent. This level of support is considered the minimum level based on estimates of both minimum market penetration and facility economies of scale. Given the size of the market, the guarantee program must have some size in order to make a noticeable impact. The financing package developed by the project team will enable the Program to back-stop loan financing for an average of about 5 energy conservation projects per year for about 20 EMCs. (For reference, the pilot EMCs have undertaken 50  an average of about 20 projects per year each during 1999-2001.) Secondly, the Guarantee Program must have sufficient business volume to defray its fixed costs, such as overhead, core staffing, strategic partnership development with participating banks, etc. Based on the initial business model for the Program, GEF financing of at least $22 million is necessary for the Program to achieve breakeven. Final Grant. The main factors determining the size of the final grant are those that determine the profitability of the Guarantee Program. Key factors include (a) ability to minimize transaction costs; (b) ability to minimize defaults; (c) the willingness of the market to accept guarantees fees which cover different risk profiles, and can properly defray evolving transaction and default costs; (d) the willingness of the market to accept guarantee commitments at multiples of the capital reserve; and (e) interest gained from the Guarantee Program's reserves. The final grant will be equal to the contingent grant of US$22 million equivalent less the final book value of the portfolio of investments made by the guarantee company (cash balance plus investments less trade creditors and the amounts attributable to the equity shareholders). While the exact amount of the final grant will not be known until project closure, preliminary and conservative analysis shows that under reasonable assumptions and continued reforms of the Chinese financial system, it may be on the order of US$4.2 million (in addition to the technical assistance grant for start-up of $1.8 million). Preliminary sensitivity analysis in Annex 5 shows that the level of the final grant show assumptions which lead to estimates of final grant amounts ranging from zero to about US$5 million. The Guarantee Program Implementation Agreement between the government and the Guarantee Program Implementing Agency must include provisions which align Company returns from the program to achievement of two key objectives: (a) the back-stopping of a maximum amount of EMC investments through provision of loan guarantees, and (b) maximum preservation (and even growth, if possible) of the capital reserves provided with GEF resources. Incremental Cost of the GEF Alternative The incremental cost of the project is equal to the cost of the grant technical assistance of $4.0 million, plus the final grant amount resulting from the contingent grant for the capital reserve of the EMC Loan Guarantee Program, which will not be known until project closure (see Table 1). If the final grant amount of the contingent grant were $4.2 million, then the total incremental cost of the project would be $8.2 million (excluding the time-value of the capital reserve funds). 51  Table 1. Incremental Cost Matrix (Seven-year project implementation period) Baseline GEF Alternative Increment Domestic Benefits * Limited project * Major increases in * Removal of EMC investment by a EMC activity from informational and few new EMCs Association and financing barriers * Limited banks training programs * Additional energy engaged in EMC * Provision of loan savings of 39 million financing guarantees from GF tce * Some EMC * Large-scale * Significant business failures awareness of EMC development of EMC business and industry framework potential GLOBAL ENVIRONMENT'AL Reductions in GHG Reductions in GHG 26 million tons of carbon BENEFITS based on low level of based on high level of reduced. EMC investment. EMC investment. Costs by Component (IIS$M) New EMC Investment without 53 53 0 Project " EMC Guarantee Programs 0 238.8 238.8 EMC Services 0 3.1 3.1 Project Monitoring, Reporting 0 0.6 0.6 and Evaluation Total Costs 53 295.5 242.5 UK DFID Contribution 2.5 2.5 2.5 GEF Incremental Costs (US$m)2' 4.0+ Note: l/ Excludes investment by three demonstration EMCs supported in first project phase. 2/ The minimum incremental cost, assuming redeployment of all of the $22 million equivalent of contingent grant funds and no accounting for the time value of these resources is $4.0 million. The maximum theoretical incremental cost is $26.0 million, which assumes no redeployment of any contingent grant resources. THE GEF ALTERNATIVE: LEVERAGING, ENERGY SAVINGS AND GHG REDUCTION BENEFITS Project Benefits: Energy Savings & Carbon Dioxide Emission Abatement The direct benefits of this project are the energy savings from the expanded EMC energy efficiency investments, and the associated carbon dioxide emission reduction (as well as reduction of local pollutants). Energy savings actually achieved in this project can and will be closely monitored and reported, because (a) actual energy savings are central to the energy performance contracting mechanism of the EMCs, (b) EMC investment levels can be closely tracked by the EMC Service Group, as a direct result of the Guarantee Program and other reporting from the Group's members. 52  Based on data from the first 141 projects commissioned by the three demonstration EMCs, the average total energy savings gained per $1000 invested in energy efficiency projects using energy performance contracting equates to 117 tons of coal equivalent (tce). This results from an average of 12.71 tce saved per year per $1000 invested, and an average estimated equipment lifetime for the types of equipment used of 9.2 years. The associated carbon emissions reduction equates to 78 tons of carbon per $1000 invested for the average fuel mix saved in these 141 projects. Direct energy efficiency investments resulting from the EMC Loan Guarantee Program are estimated at about $309 million over the seven-year project implementation period, based on very conservative estimates of the willingness of the market to accept guarantee commitments in excess of the Guarantee Company's capital reserve (see Annex 5). With commercial success, however, it is expected that the Guarantee Program may continue after the end of the project, with a GEF exit strategy whereby other investors buy-out the GEF share of the Guarantee Company's dedicated capital. Over a ten-year time slice, the illustrative projections in Annex 5 show that the Guarantee Program can support a total of $501 million in EMC energy efficiency investments, using similar conservative assumptions. This level of investment equates to 59 million tce of energy savings, and 39 million tc of reduced carbon emissions from the ten-year investment period. This does not include additional, most likely large, investments and benefits from companies which use the guarantee program initially but are later able to access credit without the Program once they have grown. The EMC Service Component is necessary for the Guarantee Program to be effective, and it therefore also contributes to the above benefits. In addition, however, the EMC Service Component will result in substantial additional energy efficiency investments by EMCs which do not need to use the Guarantee Program, but have expressed strong needs for technical assistance and programmatic support. The project team estimates that such investments may reach some $75 million over the projects 7-year implementation period, and some $120 million over a time-slice of ten years. This equates to an additional 14 million tce of energy savings and 9 million tc of reduced carbon emissions over the ten year period. Subtracting energy savings and carbon dioxide emissions reductions resulting from the estimated $53 million of EMC investment that may take place over the seven-year period in the absence of the project (perhaps also some $70 million of investment over the ten year period), the total net project benefits equate as follows: (a) $331 million of new energy efficiency investment, resulting in 39 million tce of energy savings and 26 million tc of carbon emissions reduction over the seven years of project implementation; and (b) $551 million of new energy efficiency investment, resulting in 64 million tce of energy savings and 43 million tc of carbon emissions reduction over ten years. Leveraging of GEF Funds As a second phase operation designed to reap the benefits of the initial demonstration operation, and a project designed for maximum leveraging of GEF resources through contingent financing, the leverage of GEF funds in this Phase II operation will be extremely high. The following calculations are demonstrative: (a) Based on the conservative assumptions described briefly in Annex 5, the Guarantee Program should be able to support energy efficiency investments by EMCs at a ratio 53  of at least 14:1 over the seven year project life, especially due to 1-3 year tenure of the guarantees and the revolving nature of the fund. Over ten years, this ratio is forecast to rise to about 23:1. (b) Adding in projected additional investments resulting from the EMC Service Component's activities, but subtracting investments from the baseline scenario, energy efficiency investments per unit of GEF gross grant resources, including grants in. addition to the contingent grant, are 13:1 over the seven-year project implementation period and 21:1 over ten years. (c) Considering the return of contingent grant resources at the end of the project, to be redeployed for additional, other GHG reduction activities, the ratio of net or final GEF grant investment by the end of the project to energy efficiency investment levels are very high. Assuming a final GEF grant of $4 million-the minimum level-the ratio of energy efficiency investments to GEF final grant investment is 83:1 over seven years, and 138:1 over ten years. Assuming a final GEF grant of $9 million (e.g. capital reserve losses of $5 million), the ratio of energy efficiency investment to GEF final grant investment is 37:1 over seven years and 61:1 over ten years. Grant cost eflectiveness. The net cost of carbon abatement of this Phase II project is a direct corollary of the leverage figures presented above. Assuming ten years of benefits, the gross grant cost of carbon abatement is about 60 US cents/ton of carbon, but the net grant cost of carbon abatement is projected at some 9-21 US cents/ton of carbon, assuming final grant amounts of between $4 million and $9 million as in (c) above. 54  Annex 5: Financial Summary CHINA: Second Energy Conservation Project Introduction The project will establish a new EMC Loan Guarantee Program in China to help EMCs to obtain commercial loan financing from domestic banks. The central objective of the Program is to achieve maximum EMC investment in energy efficiency projects over the long tern. To achieve this, the program will seek to: (a) maximize the number and volume of guarantee transactions, leveraging capital resources as much as possible within prudent limits, to facilitate as much lending to EMCs as possible; (b) preserve the guarantee fund's capital base, to the extent feasible while meeting the project's objectives, through commercially-oriented operation, in order to maintain financial resources for revolving, long-term use; and (c) promote, engage and strengthen the active involvement of domestic banks in the program as much as possible, so that they become increasingly familiar and comfortable with lending to the EMC industry, and are progressively willing to underwrite a greater proportion of the EMC credit risks themselves. As described in the main text and especially Annex 2, the Guarantee Program will be operated by one (or possibly more) Guarantee Program Implementing Agency (IA), according to a Guarantee Program Implementation Agreement between the LA and the Govemrnment. The project will provide GEF financing of $22 million equivalent to establish the EMC Guarantee Program Special Fund, which is the fund against which guarantee commitments will be made by the IA. The project will also provide GEF grants of up to $1.8 million equivalent to the IA, for incremental operating costs and technical assistance/training. The project implementation period is seven years, but the Program may well continue after the project closes, utilizing remaining funds in the capital reserve. For the purposes of this Annex, the Program is modeled for a ten year period. The purpose of the analysis in this Annex is to provide an overview of the key parameters and risks which define and drive the performance of the Guarantee Program, in terms of the support for EMC energy efficiency investments, the Program's financial performance and expected cash bum-rate, the trade-offs involved, key elements needed in the incentive schemes for the lAs, and an assessment of potential outcomes, given different assumptions. The analysis will be further refined during the 2-3 year initial pilot phase and in on-going discussions with the China National Investment and Guaranty CO. (I&G), with whom the Bank and the Government will enter into the first Implementation Agreement. Key Parameters Key parameters defining the investment and financial performance of the Program include: (a) the size and disbursement schedule for the capital reserve; (b) the volumes of guarantee commitments achieved, including the extent of leveraging of the Program's capital reserve; (c) Program costs, including both operating costs and losses due to unrecoverable subrogation losses; and (d) revenue accruing to the Program, including revenue from guarantee fees and interest income from conservative investment of the capital reserve. The objective of the Program is to maximize the guarantee commitments it makes, and hence EMC energy efficiency investments. However, to best achieve this objective over the long tem, it is critical to minimize loan defaults, control operating costs and maximize revenues, in order to avoid rapid erosion of the capital reserve equity, and hence undermine the ability of the Program to continue revolving guarantee commitments. Key parameters of the guarantee fund include: 55  1. Guarantee Capital Reserve. A level of $22 million equivalent of GEF investment into the capital reserve is considered the minimum capitalization required, in order to ensure a minimum level of credibility in the national market, to achieve a noticeable impact in terms of market penetration, and to provide for economies of scale in Program operation to sufficiently defray the fixed costs of the Program, such as overheads, core staffing, strategic partnership development with commercial banks, etc. Disbursement Schedule. GEF grants for the capital reserve are planned to be disbursed up front in a limited number of separate tranches. Disbursement prior to execution of guarantee commitments is necessary in order to establish credibility in the market, and is mandatory for any leveraging of guarantee commitment levels above reserve amounts. The first tranch will need to be at least $11 million equivalent, to attract a competent and credible manager and give the Program a meaningful presence in the market. Subsequent disbursements, in two tranches of US$5.5 million equivalent, are planned only after the outstanding amount of guarantee exceeds the capital reserve amount, which, on the basis of the projections, is expected in years two and three of the project. Specific disbursement triggers will be negotiated and approved by the Bank and recorded in the Implementation Agreement/s. Tranched disbursements have a detrimental impact on the fund operation due to a decrease in a possible leverage amount and a reduction in fee/investment income at a time when the costs are expected to be disproportionately high. However, tranched disbursements provides some flexibility in development and fine tuning of the Program, and establishes a firm linkage between disbursements and demonstrated performance. 2. Maximizing Support for EMC Investments. Maximizing loan volumes to EMCs, largely by maximizing guarantee commitments, is the reason for the Program's existence, and of paramount concern. Obviously, a most important variable is the rate of development of the EMC industry, and hence the market for loans and loan guarantees of this specific type. However, the project will play a very active role in market development-both through the operation of the EMC Service Component, and through a strong market and transaction development focus in the Guarantee Program itself. The World Bank Group's first pilot ESCO loan guarantee program, which was supported by the GEF and implemented by IFC in Hungary, experienced slow transaction development and it took over three years for guarantee commitments to approach the levels of the available capital reserves. Based on this experience, market and transaction development is already underway under this project, with the goal to develop the deal-flow or a pipeline of transactions prior to project effectiveness (see Annex 2). Leveraged Guarantee Capacity. Guarantee capacity is the fund's ability to deploy its capital reserves in terms of the magnitude of credit risk it is able to underwrite on behalf of the EMC sector. In legal terms, there is little statutory restriction on the level of guarantee commitments that can be made on the capital reserve-commitments are allowed to reach as high as 10:1 by the Bank of China. The key practical restriction, aside from demand from credit-worthy clients, is the perceived credit rating of the guarantee fund and the willingness of local banks to accept the guarantee-all things being equal, as leverage amounts increase, the fund's credit rating and credibility to the banks will decline. However, credibility among the banks is also a function of the financial structure, track record, management structure, and investment policy of both the IA and this specific program. Market penetration and leveraging by I&G, as the best known guarantee company in China, and an IA which is willing to assume the default risk obligations over and above the level of the capital reserve, is likely to be more rapid and greater than it would be for a new, or small guarantee company. With I&G or other strong lAs, the Program may well be able to eventually achieve a guarantee commitment leverage of 3-5 times the capital reserve. 56  Balancing transaction volume and other factors. Overly aggressive efforts to maximize Program guarantee commitments, however, are counter-productive, and could undermine the Program's results over the longer term, by incurring excessive losses to the capital reserve. Some of the trade- offs include: o Trade-offs between market development efforts and transaction costs. Intensive, customized efforts to help EMCs and local banks to develop loan and guarantee transactions are expensive. While the project has made a significant provision to cover these costs in the early years of the Program, there are limitations on how much cost can be incurred. o Trade-offs between average transaction size and transaction costs. The most profitable transactions for the Program are large guarantees, spanning several years with the most credit-worthy customers. However, much of the EMC industry potential is in small companies, who can support only small loans. Overly conservative control of transaction costs will cause the EMC industry development goals of the Program to be compromised, but too aggressive development of too many small transactions will cause excessive losses to the capital reserve. o Particularly important, pressure to maximize guarantee volume must be tempered by need to strictly control risks and avoid excessive defaults. Rapid development of guarantee commitments, without adequate attention to loan quality and credit enhancements, could rapidly undermine the Program through excessive default payments from the capital reserve. o Rapid market development and the volume of business will also need to be tempered initially to limit the losses that will occur while the credit markets mature and the fund is progressively able to price and charge for risk correctly, attain breakeven and cover the direct costs of undertaking new business. o Demand for loan guarantees will be to a substantial extent related to the terms of the guarantees. Higher guarantee fees and stricter counter-guarantee requirements may increase the profitability of the Program, but may excessively constrain guarantee commitment volume, and hence undermine the achievement of the Program's main objective. Excessively low guarantee pricing, however, may cause excessive losses to the reserve, and undermine future guarantee commitment capacity. Additional leveraging factors. Further leveraging can be expected from (a) risk sharing between the Guarantee Program and the banks-e.g. provision of guarantees for only a portion of loan amounts, (b) risk sharing between the banks and the EMCs-e.g. partial finance of the EMC's total investment amounts, and, especially, (c) revolving the guarantee capital reserve to underwrite further loan commitments over time. Although the guarantee program may need to guarantee up to 80-90% of loan amounts initially, this is expected to decline as financial reforms and experience in EMC lending proceed. Loans granted by the banks under this program are expected to be about 70% of the EMC's investment in energy efficiency projects. With the proportion of the bank loans guaranteed of around 90% planned for the first 3 years (and some 85% of the total planned for the next 2 years), the revolving effect of the Program, provided that the capital reserve is not reduced at the outset of the Program, is by far the most important of these factors in terms of leveraging. 3. Operating Costs. The Program LA/s will incur two types of operating costs: (a) recurrent or regular operating costs and (b) start-up, extraordinary operating costs. Regular operating costs are mainly general administration expenses, including costs for credit assessment, supervision, and marketing. The LA/s will be allowed to receive compensation for these costs from the capital reserve, based on specific criteria and procedures set out in the Implementation Agreements. Start- 57  up or extraordinary operating costs include the increased initial high operating costs associated with the start-up of the program, initial market development efforts, origination of the first transactions, initial and upstream coordination with the banks, and training for concerned parties. Specific provisions are included in the Program of $ 1.8 million equivalent to cover the incremental operating costs and procurement of services by the IA, especially during the first 2-3 years. Since the Program is new, and given the various trade-offs involved, determination of optimal operating cost levels will require both further review and experience over time. Operating cost compensation formula will be established in the Implementation Agreement for a short, initial phase, and then can be adjusted and fine-tuned thereafter as further operating experience is gained. The Program requires superior performance on the part of the IW/s in the origination of guarantee transactions, cost consciousness and sound management, and prudent fund management with minimum withdrawal fiom the capital reserve. The WAIs role to improve the coordination with banks is also critical, since EMC business is an emerging area and the project creates a new inter- action between EMCs and commercial banks. Thus, the program requires sufficient IA compensation so that the Program will be operated by motivated, experienced, and skilled managers and staff. On the other hand, operating costs levels are one of the most critical levels determining the financial performance of the Program, and excessive, non-performance related compensation can quickly result in excessive losses and erosion of the capital reserve. 4. Default levels. Default losses reflect the portfolio's credit quality, maturity structure and risk distribution across regions and client categories. The default level of the loan portfolio is one of the most important parameters for the guarantee fund operation. However, there is little market data available in terms of an accurate benchmark with which to assess the expected or probable default rates for this new asset class and loan guarantee program, especially given the unique nature of the EMC clients and the project's various levels of involvement with them. The default rate of recent small and medium enterprise guarantee projects with relatively high creditworthy clients in the relatively developed areas are in the range of 5 to 10 % per annum. However, since the EMC loan guarantee under the project will have unique characteristics, credit assessment of EMC loan portfolio requires an in-depth understanding of the underlying asset category and structure. EMC investments are repaid from host enterprises' positive cashflow resulting from energy savings. The existing EMCs have undertaken a variety of risk mitigation measures with the result that the repayment rate of host enterprises to the three EMCs in the first phase of the Energy Conservation Project has been excellent, with a default rate of less than 2% of all transactions undertaken to date. The EMCs have tended to do business with financially strong enterprises, and/or have required strict counter-guarantees from their clients. For relatively newly established EMCs, portfolio diversification is another key risk mitigation measure. The IA and the banks can also ensure maximum incentives for EMC to meet their loan obligations and repayment schedules by structuring these EMC loans to ensure that loan defaults are prohibitively costly to the EMCs. Finally, the umbrella of the national EMC development program, particularly during the early years of its formation, is especially important to the development of the emerging EMCs, and discouraging defaults and delays in payment through the consequences of withdrawal of national program support and adverse market publicity. Given the uncertainties, it is critical to build significant incentives into the Implementation Agreement for the lAs to minimize defaults and maximize loss recoveries, and to allow flexibility in the Program to make any needed adjustments. 5. Guarantee pricing. In principle, pricing of guarantee fees should aim to cover both operating costs and net default losses after recoveries, thereby allowing income growth and capital 58  preservation. EMCs should be offered differentiated products, with different guarantee fees for different credit risk and levels of security or collateral, from the outset. For example, an EMC which is able to provide strong comfort and supported by a robust balance sheet and strong contracts with credit-worthy customers could be offered a commensurately low guarantee fee. On the other hand, pricing of credit that is based on its inherent risk is a new concept in China, where both loan interest levels and guarantee fees tend to be relatively flat, regardless of credit risk. In addition guarantee fee levels in the Chinese credit markets are currently quite low-ranging from 0.8-2.0% in most cases involving established enterprises. The Program should aim to achieve risk-differentiated pricing, and pitched at an average level that is designed to cover all transaction costs, overheads and net default risks, to the maximum extent. This will however take time. In addition, the Program cannot set prices beyond the levels that will undermine demand, and compromise the principle objective of the Program of supporting growth in the EMC industry and promoting energy efficiency investments. 6. Capital Reserve Investment Income. The capital reserve fund must be invested in conservative, liquid and secure financial products. Given the returns of such investments in China today, interest income on the capital reserve balance, less prudent on-hand cash reserves to meet any and all eligible claims against the fund as they arise, and is estimated to be about 4% of the capital reserve. Incentives to Implementing Agencies Design of an appropriate and comprehensive incentive scheme for the LA/s is a major challenge in the project. The compensation and incentive arrangements which will be set out in the Implementation Agreement(s) for the LA/s must provide the right incentives to maximize guarantee commitments, and minimize capital reserve losses by maximizing capital reserve income and minimizing operating costs and subrogation losses. An initial compensation and incentive scheme for the first 2-3 years will be prepared in the first Implementation Agreement. After a review of results and experiences, the scheme can be adjusted, if necessary. Financial compensation of the IA will include (i) a basic fee, calculated by taking into account the IA's operating costs that are specifically attributable to meeting IA's obligations under the Entrustment Agreement; and (ii) an incentive-based fee, determined on a cumulative basis based on the IA's performance, including the number and volume of Program guarantee transactions and resultant income generated, less net subrogation losses. One possible incentive-based fee would be a two-tiered scheme involving the following: (a) Guarantee Commitment Incentive. Specific incentives could be provided to the IA, for each successful guarantee transaction booked and closed. The incentive could represent a portion of the guarantee fee obtained from the transaction, minus deductions for any unrecoverable losses. The incentive could be paid in two parts-with a smaller part when the guarantee is originated and a larger part when the transaction is successfully concluded. Such a scheme would encourage the IA to maximize the number of quality transactions, maximize guarantee fee income, and minimize net subrogation losses. (b) Cost Control Provisions. The Implementation Agreement also could provide incentives for the IA to minimize costs, so that the IA/s will benefit directly from superior cost control, and will stand to lose financially if costs become excessive. One possibility would be to set up a normative or standard for operating costs and the difference between the 59  normative level and actual costs will be shared with LA/s. Excessive operating costs would penalize the LA/s. In addition, it also is important for the LA/s to either provide a small equity contribution to the capital reserve, assume a portion of the default risk relating to the leveraging of the reserve with guarantee commitments over and above the reserve balance, or a combination of both. This also provides incentives for efficient Program management. Illustrative Program Scenarios Financial Model and Assumptions. A detailed financial model for the Guarantee Program was constructed to provide a proforna income statement, cashflow statement, and balance sheet in real terms for the operation of the Program for a period of 10 years. No specific assumptions were made concerning assignment of an IA/s. The projection is consistent with hiternational Accounting Standards (LAS) and the requirements of the Chinese authorities. A comprehensive, illustrative case is presented in Table 3 at the end of this Annex, which follows the assumptions presented in Table 1. Assumptions are then varied in Table 2, which also shows the resulting effect in the value of the capital reserve at the end of 10 years and the total energy efficiency investment level supported. A basic value at risk (VAR) analysis was also undertaken on the basis of traditional variations in the default risk, recoveries and operating cost assumptions. The model, basic assumption, sensitivity analysis and VAR will be revised further during the course of project implementation, based on on-going discussions and experience with the LA. Table 1: Financial Model Assumptions for an Illustrative Guarantee Program Case Possible Scenario' Short- Medium- Long-term Basic VAR term term Assumptions Loan Tenor (yrs) 1 2 3 Average Loan size ($) 300,000 500,000 800,000 Loan Interest Rate2 6.59% 6.59% 6.59% Proportion of the number of new 40% 50% 10% guarantees written Proportion of Guarantees Portfolio A 3 40% 40% 40% B 30% 30% 30% C 30% 30% 30% Annual Guarantee Fee4 (at year 7) A 1.5% 1.7% 1.9% B 2.1% 2.4% 2.65% C 2.7% 3.0% 3.3% Cumulative Default Rate (at year 7) A 2.0% 4.0% 6.0% Poisson Distributions B 3.0% 6.0% 10.0% C 4.0% 8.0% 14.0% Recovery Rate6 40% Normally distributed with std. dev. of 26% Recovery Expenses 5% Normative Unit Operating. Cost US$ 9,200/transaction Equal probability in a range of +/- 10% Tax Revenue tax of 5.5%, income tax of 33% Exchange rate RMB8.3 per lUS dollar I. Other key assumptions for the possible scenario which are independent of the tenor of the loan are: initial GEF seed capital equals US$22 million equivalent which is disbursed in three tranches, US$1 1 million equivalent at year I 60  and US$ 5.5 million equivalent in year 2 and 3, respectively; the facility can implement a maximum of 1 00 loans per year; Technical Assistance and initial set-up costs of US$1.8 million equivalent over the first three years. 2. Based on interest rates by the People's Bank of China for small enterprises. 3. Portfolio is categorized by I&G depending on its credit risk. 4. It is assumed that guarantee fees reach the above level by year 7. 5. Recovery rate refers to the expected recovery of claims made against the IA by the participating in respect of defaults on covered bank loans and will vary depending on the amounts of collateral and/or counter guarantees that are available to the EMCs. Conclusions of the Analysis. The illustrative case, sensitivity and VAR analysis show that even with wide variation in key assumptions the Guarantee Program can succeed in leveraging very large levels of loans to EMCs and EMC energy efficiency investments. In the illustrative case in Table 3, financial break-even is attained at the end of year 9 and the capital reserve of $ 22 million is able to generate an average of about US$30 million per annum of new bank credits to EMCs over a relatively short period of time. This in turn would achieve leverage ratio of outstanding guarantee to GEF grant approaching about 2.5:1 by year five, generate outstanding guarantee commitments of US$53 million in year 6, and mobilize cumulative commercial loans to the EMC sector by the participating banks of US$351 million over the 10 year period. Total direct energy efficiency investment of some 23 times of the initial GEF contingent grant of US$ 22 million equivalent could be achieved as a direct consequence of this program over the period, totaling $501 million, assuming that loans supported by the Guarantee Program account for 70% of investment amounts. It also is likely that the capital reserve will lose significant value over the period. In the illustrative case the capital reserve value at the end of ten years is expected to be about $4.2 million less than at the beginning of the project. It is further apparent from the basic VAR analysis illustrated in Fig. 1 that there is a small probability of the fund declining by US$ 5 million or more over this period. However, since the initial capital reserve is some four times this amount, there is little likelihood that the fund will be unable to meet all expected claims as they arise and should therefore establish a reasonable rating in the market and achieve the leveraging targets expected from the program. Figure 1. Decline in Capital Reserve (Contingent Grant) Forecast: Contingent Grant 3,000 Trials Frequency Chart 41 Outliers .026 - 79 .020 ...... .... ................. ...-.... ............ .. 59.25 .013 ..................... ....... ..... .. 39.5 _ _0 7 ......................... .............................E........ .9.7 5 1,556 2,612 3,668 4,724 5,780 Certairty is 97.50% fram -Infinity to 4,936 USS 000 As shown in the sensitivity analysis below, it is possible to formulate scenarios whereby the capital reserve fully retains its original value. However, there also are a variety of scenarios 61  whereby the capital reserve loses significantly more value than in the illustrative case. Particularly important are the effect of sharp increases in operating costs and default rates-poor results in these areas not only cause sharply greater losses to the capital reserve, but also thereby detract from energy efficiency investment results. Although not shown in the sensitivity analysis, major default levels or excessive operating cost charges during the early years of the program will be particularly devastating, as the loss in revolving capacity is greatest. These conclusions then yield two additional conclusions: (1) The net final GEF grant amount for this project will almost certainly be greater than the $4 million of grants provided in addition to the capital reserve financing. Even so, the value achieved fronm the GEF financing in terms of leveraging energy efficiency investment by EMCs is extraordinary. Assuming a final GEF grant of $8 million (e.g. capital reserve losses of $4 million), the ratio of energy efficiency investment to GEF final grant investment is 39:1 over seven years and 63:1 over ten years. (2) Careful control of operating costs and net subrogation losses is especially important, especially through provision of proper incentives to the lAs. Table 2: Preliminary Sensitivity Analysis of Selected Parameters Estimated Total Pairameter Capital Investments Maximum Reserve l Generated2 Leverage to (US$ million) (US$ million) Equity Possible Scenario 17.8 501 2.9 Transaction Volume - increase by 48% to 15.1 742 5.0 leverage 5:1 Transaction Volume - decrease by 61% to 21.1 196 1.0 leverage 1:1 Risk sharing with banks - increase by 50% 17.8 578 2.9 Risk sharing with banks - decrease by 50% 17.8 445 2.9 Operating costs - increase by 100% 12.3 386 2.9 Operating costs -decrease by 50% 20.6 557 2.9 Default rate - increase by 100% 12.3 381 2.9 Default rate - decrease by 50% 21.0 557 2.9 Guarantee Fee - increase by 50% 20.1 537 2.9 Guarantee Fee - decrease by 50% 15.4 466 2.9 1. Value after ten years. Excluding initial start-up grant of US$1.8 million equivalent. 2. Cumulative investments made over the 10-year life of the project. 62  Table 3: Illustrative 10 Year Financial Projections. GEF n Energy EMdency Projecl Illustrative Finamciai Projection (iSS '000) FYI FY2 FY3 FY4 FY5 FY6 FY7 FYS FY9 FY10 laces.~~~~~~~~~ ~ ~ ~ ~ ~ ~ ~ .rt en Revenue RevenucfromGvarantee&ProjectReviem Fee 153 294 517 813 1,093 1,178 1,216 1,213 1,242 1,230 Revenue fram Start up Grants 900 540 360 Recovered Bad Debt 76 289 503 626 718 797 743 603 Business Tax 8 16 28 45 60 65 67 67 68 68 Total Revenue 1,045 817 925 1,057 1,535 1,740 1,867 1,943 1,917 1,765 Operating Expenses Start up Expenses 900 540 360 Operating Expenses & G&A 444 540 768 866 806 820 741 728 720 719 Indemnity Payout 162 528 1,265 1,729 1,924 1,940 2,062 1,597 1,354 1,290 Additional ServiceExpenses I5 15 tO Annual Mgmt Fee 166 119 45 116 214 192 178 346 437 402 Total Operating Expenses 1,687 1,741 2,448 2,711 2,944 2,953 2,981 2,671 2,511 2,410 Non-Operating Income Guaranty Fund Financial Income 425 524 696 740 694 656 620 617 641 652 Income Pre Tax (218) (399) (827) (915) (715) (557) (494) (111) 47 7 Income Tax 1 5 2 Ne Income (218) (399) (827) (915) (715) (557) (494) (111) 31 5 Cash Fltw Stamen., Sources orCash K Cuab or Cuab Equivalt ReceRved from Operations GuarmnteeFeeReceived 153 294 517 813 1,093 1,178 1,216 1,213 1,242 1,230 Start-up Grants received 900 540 360 Recovered Bad Debt 76 289 503 626 718 797 743 603 IncreaseAccountsPayable 169 5 71 26 23 1 3 (31) (16) (10) Total Cah from Operaion 1,222 839 1,024 1,128 1,619 1,805 1,937 1,979 1,969 1,823 B. Csh Rec d from Financial ServIes 425 524 696 740 694 656 620 617 641 652 C. Guaranty Fund Grant; 11,000 5,500 5,500 Total Cash Flo.e In 12,647 6,863 7,220 1,867 2,313 2,461 2,557 2,595 2,610 2,475 Application oCCash A Start up Expenses 900 540 360 B. Subrogauon 382 1,062 1,453 1,679 1,912 2,071 1,645 1,372 1,338 C OtherOpeextingEnpenses 610 658 813 982 1.020 1,013 919 1,073 1,157 1,120 D. Taxation 8 16 28 45 60 65 67 67 84 70 E. Addional Service Expenses 15 15 10 F. Others Total Cash Application 1,534 1,612 2,273 2,480 2,760 2,989 3,057 2,785 2,612 2,528 Net Cash Changes 11,113 5,251 4,947 (612) (447) (528) (500) (190) (2) (53) Cash Balance (yer end) 11,113 16,365 21,312 20,700 20,252 19,724 19,224 19,034 19,031 18,978 Badorsre Sheet Assxts Cash or Cash Equivalent 500 765 2,123 2,905 3,358 3,824 4,142 3,290 2,743 2,675 Fixed and Intangible Assets Shon-term Investmenl 10,613 15,600 19,189 17,794 16,894 15,900 15,082 15,744 16,288 16,303 Total Assets 11,113 16,365 21,312 20,700 20,252 19,724 19,224 19,034 19,031 18,970 Liabilities and Equity Accounts Payable 169 174 245 271 294 295 298 267 251 241 Contingence Liabilides 162 307 511 787 1.032 1,059 1,051 1,003 985 938 Equity GEF/WB Grants 11,000 16,500 22,000 22,000 22,000 22,000 22,000 22,000 22,000 22,000 Other Equity Retained earnings (218) (617) (1,444) (2,358) (3,074) (3,630) (4,125) (4,236) (4,205) (4,200) Total Equity 10,782 15,883 20,556 19,642 18,926 18,370 17,875 17,764 17,795 17,800 Total Equlty and LiablUdn 11,113 16,365 21,312 20,700 28,252 19,724 19,224 19,034 19,031 18,978 Outstanding Guarantees 8,100 15,360 25,545 39,345 51,577 - 52,972 52,533 50,150 49,258 46,875 63  Annex 6(A): Procurement Arrangements CHINA: Second Energy Conservation Project Assessment of Agency's Capacity to Implement Procurement An assessment of the capacity of the agency responsible for all procurement under this project-the GEF/World Bank China Energy Conservation Project Management Office of the SETC (PMO)-was completed through interviews with the Agency during project appraisal. The summary report of the assessment is available in the project file. The assessment also incorporated the findings of the latest post review of contracts not subject to prior review awarded under the first China Energy Conservation Project, including consulting contracts procured by the PMO. The Assessment concluded that procurement risks for this project are low. However, prior review thresholds, the frequency of post review and the sample size of post review evaluations were customized at somewhat more stringent levels than normal for low-risk procurement ratings, to meet the particular needs of this project (see details below). Procurement Methods Summaries of the procurement methods to be used for the project are presented in Tables A, Al and B, below. The only procurement activities under this project are the procurement of services. Financing of the Guarantee Program Capital Reserve (Category 3 in Table C of this Annex), which will be held by the Guarantee Program Implementation Agency (IA) as a reserve to back the EMC loan guarantees which it issues, involves no procurement activities. Financing of Incremental Operating Costs under the EMC Service Component and EMC Loan Guarantee Program (Category 1 in Table C) also involves no procurement activities, as the only eligible expenses for this financing will be incremental travel and subsistence, and staff office and administration costs of the project beneficiaries, based on statements of expenditure (see Disbursements below). Financing of services involves procurement of services with a total value of $2.69 million, split between three components (Category 2 of Table C). (This amount is based on the cost estimates agreed at project appraisal, and includes sums in the unallocated disbursement category). All procurement of consultants will be according to the Bank's "Guidelines for Selection and Employment of Consultants by World Bank Borrowers" of January 1997, revised in September 1997, January 1999 and May 2002. 64  Table A: Project Costs by Procurement Arrangements (US$ million equivalent) Procurement Method I Expenditure Category ICB NCB Other N.B.F. Total Cost 1. Works 2. Goods 199.8 199.8 3. Services 2.69 2.69 (2.45)2 (2.45) 4. Miscellaneous Incremental Operating Costs 18.0 18.0 (1.55) 3 (1.55) Guarantee Program Capital 22.0 .22.0 Reserve (22.0)4 (22.0) Total 42.7 199.8 242.5 (26.0) (26.0) Note: N.B.F.- Not Bank-financed (includes elements procured under parallel cofmancing procedures, consultancies under trust funds, any reserved procurement, and any other miscellaneous items). 1/ Figures in parenthesis are the amounts to be financed by the GEF Grant. All costs include contingencies. 2/ Procurement according to the Bank Guidelines for Use of Consultants. 3/ No procurement. EMC Service Group/Association and Guarantee Program Implementing Agency annual operating budget will be subject to the Bank's prior review. 4/ No procurement. Consultant selection arrangements for the project (which includes services only) are presented in Table Al, and further detailed in the Project Procurement Plan in the project file. Procurement of services with a total value of $2.69 million will take place over the seven years of project implementation. The consultants' services procurement plan in based on the successful experiences achieved during the first phase of the China Energy Conservation Project (under implementation since 1998). All contracts with firms are expected to be very small (under $100,000), utilizing Consultants' Qualifications selection procedures. Selection of individual consultants will be in accordance with Section 5 of the Bank guidelines. Development of larger packages is not possible in this case, as there are three beneficiaries, a seven-year implementation horizon, many different topics, and very different types of required contractors. As also required in the legal agreements for the first phase of the China Energy Conservation Project, all terms of reference for all consulting assignments under the project will be subject to the Bank's prior review. 65  Table Al: Consultant Selection Arrangements and Draft Procurement Plan (US$ million equivalent) Consultant Services Selection Method Total Expenditure Category QCBS QBS SFB LCS CQ Other NBF Costl PROJECT COMPONENT EMC Service Component 0.89 0.59 1.48 Project Monitoring, Reporting and Evaluation Component 0.35 0.31 0.66 EMC Loan Guarantee Program 0.39 0.16 0.55 Total Firms 1.63 1.63 Total Individuals 1.06 1.06 Total 1.63 1.06 2.69 l\ Including contingencies. Note: QCBS = Quality- and Cost-Based Selection QBS = Quality-based Selection SFB = Selection under a Fixed Budget LCS = Least-Cost Selection CQ = Selection Based on Consultants' Qualifications Other = Selection of individual consultants (per Section V of Consultants Guidelines), Commercial Practices, etc. N.B.F. = Not Bank-financed Figures in parenthesis are the amounts to be financed by the Bank Grant. All consultant contract Terms of Reference will be subject to the Bank's prior review. Prior review is required for contracts with firms valued at $100,000 or more, and for contracts with individuals valued at $50,000 or more. Table B: Thresholds for Procurement Methods and Prior Review Contract Value Contracts Subject to Threshold Procurement Prior Review Expenditure Category (US$ thousands) Method (US$ millions) 1. Works 2. Goods 3. Services 100,000 CQ for firms 0 50,000 Individuals 0.20 4. Miscellaneous No procurement 0 Total value of contracts subject to prior review: 0.20 66  Implementation Arrangements All procurement work will be the responsibility of the Project Management Office (PMO) of the SETC. As the beneficiary of the Project Monitoring, Reporting and Evaluation Component, the PMO will conduct its own procurement for this component. The other two beneficiaries-the EMC Association and the Guarantee Program Implementing Agency-will complete TORs for consulting assignments and prepare short-lists of potential firms/individuals, but the PMO will oversee, and have responsibility for, all final evaluations and contract awards. The PMO will have overall responsibility for ensuring the adequacy of all procurement work and filing, including responsibilities for ensuring that the Bank's no objection to TORs has been obtained, and that all procurement is in strict adherence to the Bank's Guidelines for Use of Consultants. Frequency of procurement supervision missions proposed: Procurement supervision will be conducted as part of the regular biannual project supervision missions, planned once every six months. Post review of procurement will be conducted at least once every 12 months for the first two years of project implementation, and at least once every 18 months thereafter. At least one in every 8 contracts will be randomly selected for post review. Overall Procurement Risk Assessment Overall procurement risks are rated as low, because the procurement processing for this operation is not complex, and the PMO has conducted similar procurement services satisfactorily under the ongoing China Energy Conservation Project. PMO staff received training at the outset of the ongoing project, and has adhered to the basic requirements of Bank procurement well. As in this proposed project, the Bank's prior review of all Terms of Reference (TORs) for all consulting assignments has been required for this proposed Phase H project, and the PMO has carefully adhered to this requirement. The review of TORs has proved to be a good supervision tool, and vehicle for the Bank supervision team to provide guidance on these assignments. As identified in the Assessment of the PMO's capacity to implement procurement, a workshop will be convened at the launching of the project, involving the PMO, the Guarantee Program Implementing Agency, and the EMC Association, to assist in the smooth coordination of procurement processing involving the two units other than the PMO. The workshop will review (a) the overall procedures and Bank's guidelines for procurement of consultant services using the methods selected for this project, and (b) the responsibilities and interaction mechanisms between the two implementing agencies and the PMO in procurement processing. 67  Annex 6(B): Financial Management and Disbursement Arrangements CHINA: Second Energy Conservation Project Financial Management Summary of the Financial Management Assessment. An assessment of the adequacy of the project financial management system was conducted and concluded that this project meets minimum Bank financial management requirements. The GEF/IBRD China Energy Conservation I project is currently being implemented by PMO and other implementing entities. No outstanding audits or audit issues exist with any of the implementing agencies involved in the proposed project. The project would produce project financial management reports in line with the format and content agreed to between the Bank and China. Traditional disbursement methods would be used as opposed to the FMR-based disbursement systems, with the exception of EMC Guarantee Program Special Fund of the project, in which disbursements will be made into a Guarantee Program Capital Reserve Specialized Fund owned by the Government, based on executed Guarantee Program Implementation Agreements, for which prior approval of the Bank is required. Financial management systems for the Guarantee Program Implementation Agency(ies) (IA), which will manage the Specialized Fund according to the Implementation Agreements, will be fully assessed and must be approved by the Bank as part of the Implementation Agreement approval process. The financial management. system (FMS) proposed by the China National Investment and Guarantee Co., which has been asked to prepare for assignment as an IA, was assessed as satisfactory as part of the financial management assessment. The FMS of this IA, and other lAs, will include maintenance of accounts and preparation of financial reports in full accordance with international acceptable accounting standards. Audit arrangement. In line with other Bank financed projects in China, the project accounts will be audited in accordance with the Government Auditing Standards of the People's Republic of China (lhe 1997 edition). Subject to further confirmation at project appraisal, the National Audit Office has-been identified as the auditor for the project. Annual audit reports will be issued in the name of the China National Audit Office. The general project accounts related to the sources and uses of the project funds, and guarantee program accounts will be audited separately. Separate audit reports for the two accounts will be issued. The Bank requires that project financial statements be audited in accordance with standards acceptable to the Bank. Audit reports of the annual financial statements will be sent to the Bank within 6 months of the end of each calendar year. The audit report on general project accounts should have a separate opinion on Statement of Expenditure and Special Accounts. The annual audit on guarantee program will cover the accounts of the specialized fund only, and not the accounts of the whole guarantee company, as the funds will remain the property of the MOF, will be legally isolated from the funds of the company, and will be protected from any unrelated claims against the company. Disbursements Special Account. One Special Account will be opened and managed by PMO in US Dollars in a bank acceptable to the Bank. The authorized allocation to the special account is equivalent to US$400,000, which represents the grant financing of average expenditures for four months. Applications for replenishment of the special account would be submitted monthly, or whenever the accounts are drawn down by 50 percent, whichever comes first. The Special Account will be used only for disbursements of categories I and 2. For category 3, the Guarantee Program Special Fund, the special account will not be used for disbursement, and the funds will be disbursed directly to Guarantee Program Special Fund account on the basis of the Guarantee Program Implementation Agreement. 68  Reimbursement procedures. All of the withdrawal applications for the World Bank including direct payments to the Guarantee Program IA(s) should be submitted by the PMO with signature by authorized persons. The expenditures may incurred in various entities, including the EMC Service Group/Association, the Guarantee Program IA(s), or the PMO. Each entity is responsible to collect original financial documents, and submit them to the PMO for reimbursement. The PMO is responsible to prepare withdrawn applications together with other required documents for the World Bank. Use of statement of expenditures (SOEs). Disbursement will be made against statements of expenditures (SOEs) for expenditures related to: (a) consultants' services under contracts awarded to consulting firms costing less than $100,000 equivalent each; (b) consultants' services under contracts awarded to individual consultants costing less than $50,000equivalent each; (c) all incremental operating costs. The supporting documents for SOEs would be retained by PMO. In case of contracts for services above these thresholds, disbursement would be made against the full documentation with contracts themselves and other supporting documents. Allocation of the Grant Proceeds (table C). The GEF funds would be allocated into the 3 categories as the following table. Eligible expenditures for the incremental operating costs of the EMC Service Group/Association and the Guarantee Program IA(s), under Category I include local staff travel and per-diem and office costs, including rental, utilities, consumable goods, maintenance and repairs. Disbursements against these categories will be subject to the Bank's prior review of the annual operating cost budgets of the entities concerned. For the EMC Service Group/Association, incremental operating costs payable with GEF grant proceeds represent 50% of the total estimated core institutional operating costs of the Group/Association (which is a new entity developed under the project) over the seven-year project implementation period, and GEF grant payments will represent a declining share of the total over the first five years, and zero percent of the total during the last two years. For the IA, incremental operating costs payable with grant proceeds represent an estimated 7% of the total estimated operating costs of implementing the Guarantee Program over the seven-year project implementation period, and GEF grant payments will represent a declining share of the total over the period. A waiver of the disbursement requirements of OP14.40 and OP12.00 has been obtained for disbursement under Category 3 as discussed in the main text of the PAD. Disbursements under this category will be made into one or more EMC Guarantee Program Special Funds, based on Guarantee Program Implementation Agreements satisfactory to the Bank. For each Fund, up to 50% of the total amount allocated in the respective Implementation Agreement will be disbursed in a First Tranche, upon the Bank's receipt of satisfactory evidence that the respective Implementation Agreement, acceptable to the Bank, has been duly authorized and executed, and is valid and enforceable. Disbursement of Second and Third Tranches, of up to 25% of the total amount allocated in the respective Implementation Agreement, will be disbursed upon the Bank's receipt of satisfactory evidence that the respective Guarantee Program Implementing Agency has made guarantee commitments, under terms and conditions set form in the project Operations Manual and the respective Implementation Agreement, in an aggregate face value at least equal to the sum of prior disbursements. As it is expected that only one Fund will probably be established, under one Implementation Agreement, it is likely that only three disbursements under this Category will be required. 69  TABLE C: ALLOCATION OF GRANT PROCEEDS Expenditure Category Amount Financial Percentage in SDR million (1) Incremental Operating Costs (a) under Part A (EMC Service 0.20 100% Component) of the Project (b) under Part C (EM.C Loan Guarantee 0.85 100% Program) of the Project (2) Consultants' services (a) under Part A of the Project 0.87 91% (b) under Part B (Project Management 0.46 91% and Monitoring Component) of the Project (c) under Part C of the Project 0.38 91% (3) EMC Guarantee Program Special 16.64 100% of the amount of the Fund allotment deposited into the Special Fund (4) Unallocated 0.30 TOTAL 19.70 Note: The GEF grant amount is converted to SDR at exchange rate of US$1.32274 per SDR. 70  Annex 7: Project Processing Schedule ClFItNA: Second Energy Conservation Project Project Schedule Planned Actual Time taken to prepare the project (months) First Bank mission (identification) 11/99 GEF Council Approval 12/15/01 12/07/01 Appraisal mission departure 04/01/02 03/25/02 Negotiations 09/01/02 09/06/02 GEF CEO Endorsement 09/25/02 Planned Date of Effectiveness 12/31/02 Prepared by: State Economic and Trade Commission (SETC) Preparation assistance: Multiple Chinese agencies, experts and intemational advisers Bank staff who worked on the project included: Name Specialty R. Taylor Task Manager C. Husband Financial Analysis J. Singh Energy Efficiency J. Chu Operations H.C. Nguyen Legal M. Png Legal M. Ogawa Financial Analysis T. Velilla Program Assistant 71  Annex 8: Documents in the Project File CHINA: Second Energy Conservation Project A. Project Implementation Plan 1. EMC Service Group (April 2002) 2. China National Investment and Guarantee Company Business Plan (January 2002) B. Project Documents for Phase I Project 1. China Energy Conservation Project Appraisal Document (February 26, 1998) 2. China Energy Conservation Mid-Term Review Aide Memoire (December 18, 2000) 3. China Energy Conservation Supervision Mission Aide Memoire (June 17, 2002) 4. Minutes of SETC Meeting on EMC Legal Status (May 8, 2001) C. Other 1. EMC Market Survey 2. List of Seminars/Meetings with Chinese Financial Institutions on EMC Financing 3. Environmental Reviews and Impacts 4. Project P'rocurement Plan 5. Assessment of Agency's Capacity to Implement Procurement: Summary Report 6. Financial Management Assessment 72  Annex 9: Statement of Loans and Credits CHINA: Second Energy Conservation Project 09-Aug-2002 Difference between expected and actual Original Amount in US$ Millions disbursementsa Project ID FY Purpose IBRD IDA GEF Cancel. Undisb. Orig Fm,n Rev'd P06.4729 2002 SUSTAINABLE FORESTRY DEVELOPMENT PRO 93.90 0.00 0.00 0.00 93.90 0.16 0.00 P058846 2002 National Railway Project 160.00 0.00 0.00 0.00 136.09 30.26 0.00 P068049 2002 Hubei Hydropower Developnrrent in Poor Are 105.00 0.00 0.00 0.00 105.00 0.00 0.00 P070459 2002 Inner Mongolia Highway Project 100.00 0.00 0.00 0.00 100.00 0.00 0.00 P071147 2002 Tuberojilosis Control Project 104.00 0.00 0.00 0.00 103.33 -0.67 0.00 P058645 2001 Jiangxir II Hwy 200.00 0.00 0.00 0.00 188.22 3.89 0.00 P056516 2001 WATER CONSERVATION 74.00 0.00 0.00 0.00 62.52 5.07 0.00 P056596 2001 Shijiazhtuanig Urban Transport 100.00 0.00 0.00 0.00 99.00 32.57 0.00 P056199 2001 Third Inland Waterways 100.00 0.00 0.00 0.00 96.00 -0.83 0.00 P047345 2001 CN-HUAI RIVER POLLUTION CONTROL 105.50 0.00 0.00 0.00 102.05 -3.45 0.00 P051859 2001 CN-LIAO RIVER BASIN 100.00 0.00 0.00 0.00 93.00 3.21 0.00 P045915 2001 Urumqi Urban Transport 100.00 0.00 0.00 0.00 71.22 16.67 0.00 P056424 2000 TONGBAI PUMPED STORA 320.00 0.00 0.00 0.00 304.94 47.34 0.00 P049436 2000 CN-CHONGOING URBAN ENVIRONMENT 200,00 0.00 0.00 0.00 189.53 22.43 0.00 P045910 2000 CN-HEBEI URBAN ENVIRONMENT 150.00 0.00 0.00 0.00 140.03 24.11 0.00 P045264 2000 SMALLHLDR CATTLE DEV 93.50 0.00 0.00 0.00 51.23 24.78 0.00 P042109 2000 CH-BEIJING ENVIRONMENT 11 349.00 0.00 25.00 0.00 352.24 102.20 0.00 P064730 2000 Yangtze Dike Strengthening Project 210.00 0.00 0.00 0.00 164.56 86.89 0.00 P058844 2000 3rd Henan Prov Hwy 150.00 0.00 0.00 0.00 123.54 21.21 0.00 P058843 2000 Guangxi Highway 200.00 0.00 0.00 0.00 167.60 41.76 0.00 P046829 1999 RENEWABLE ENERGY DEVELOPMENT 100.00 0.00 0.00 0.00 12.87 87.37 0.00 P046564 1999 Gansu &Inner Mongolia Poverty Reduction 60.00 100.00 0.00 0.00 99.09 38.34 1.11 P046051 1999 CN-HIGHER EDUC. REFORM 20.00 50.00 0.00 0.00 31.31 28.86 0.00 P003653 1999 ContainerTransport 71.00 0,00 0.00 3.13 26.33 29.18 0.00 P043933 1999 CN-SICHUAN URBAN ENVIRONMENT 150.00 2.00 0.00 0.00 98.09 34.76 5.60 P042299 1999 TEC COOP CREDIT IV 10.00 35.00 0.00 0.00 40.41 -3.58 0.00 P041890 1999 Liaonring Urban Transport 150.00 0.00 0.00 0.00 74.15 49.95 0.00 P036953 1999 CN-HEALTH-IIX 10.00 50.00 0.00 0.00 43.55 10.31 0.00 P049665 1999 ANNING VALLEY AG.DEV 90.00 30.00 0.00 0.00 49.77 7.40 0.00 P0516888 1999 GUANZHONG IRRIGATION 80.00 20.00 0.00 0.00 62.22 28.77 0.00 P056216 1999 LOESS PLATEAU It 100.00 50.00 0.00 0.00 87.11 54.83 0.00 P057352 1999 CN-RURAL WATER SUPPLY IV 16.00 30.00 0.00 0.00 32.16 13.60 -2.93 P058308 1999 CN-PENSION REFORM PJT 0.00 5.00 0.00 0.00 2.53 2.61 0.00 P060270 1999 CN-ENTERPRISE REFORM LN 0.00 5.00 0.00 0.00 4.39 6.16 1.22 P038121 1999 RENEWABLE ENERGY DEVELOPMENT 0.00 0.00 35.00 0,00 26.67 14.34 0.00 P041268 1999 Nat Hwy4ffHubei-Hunan 350.00 0.00 0.00 0.00 181.48 55.73 0.00 P051856 1999 ACCOUNTING REFORM & DEVELOPMENT 27.40 5.60 0.00 0.00 21.82 21.23 0.00 P050036 1999 Anhui Provincial Hwy 200.00 0.00 0.00 0.00 96.60 27.55 0.00 P051705 1999 Fujian 11 Highway 200.00 0.00 0.00 0.00 133.66 90.83 0.00 P040185 1998 CN-SHANDONG ENVIRONMENT 95.00 0.00 0.00 0.00 30.29 24.38 0.00 P049700 1998 IAIL-2 300,00 0.00 0.00 0.00 49.46 12.43 0.00 P036949 1998 Nat Hwy3-Hubel 250.00 0.00 0.00 0.00 47.29 -8.54 0.00 P037859 1998 EGY CONSERVATION PRO 0.00 0.00 22.00 0.00 5.06 21.73 0.00 P046952 1998 FOREST. DEV. POOR AR 100.00 100.00 0.00 0.00 84.35 -30.29 51.71 P045788 1998 Tri-Provincial Hwy 230.00 0.00 0.00 0.00 79.75 42.95 0.00 P051736 1998 E. CHINAIJIANGSU PWR 250.00 0.00 0.00 86.00 76.04 162.04 2.11 P046563 1998 TARIM BASIN 11 90.00 60.00 0.00 2.67 72.39 54.99 0.00 P003566 1998 CN-BASIC HEALTH IHLTH8) 0.00 85,00 0.00 0.00 42.12 22.78 0.00 P003591 1998 STATE FARMS COMMERCI 150.00 0.00 0.00 60.91 8.45 81.38 1.46 P003619 1996 2nd Inland Waterways 123.00 0.00 0.00 0.00 80.34 64.34 0.00 P03S698 1998 HUNAN POWER DEVELOP. 300.00 0.00 0.00 100.00 176.67 234.67 20.61 P003614 1998 Guangzhou City Transport 200.00 0.00 0.00 0.00 130.81 126.78 0.00 P003539 1998 SUSTAINABLE COASTAL RESOURCES DEV. 100.00 0.00 0.00 2.31 49.48 32.63 0.00 73  Difference between expected Original Amount in US$ Millions and actual disbursementsa Project ID FY Purpose IBRD IDA GEF Cancel. Undisb. Orig Frm Rev'd P036414 1998 CN-GUANGXI URBAN ENVIRONMENT 72.00 20.00 0.00 0.00 79.69 50.19 1.10 P003606 1998 ENERGY CONSERVATION 63.00 0.00 22.00 0.00 48.12 13.44 0.00 P003637 1997 CN-NATIONAL RURAL WATER III 0.00 70.00 0.00 0.00 11.76 10.93 10.03 P003635 1997 CN-VOC. ED. REFORM PFROJ 10.00 20.00 0.00 0.00 0.29 1.42 0.00 P003643 1997 Xinjiang Hwy 11 300.00 0.00 0.00 60.00 26.77 86.77 15.10 P003650 1997 TUOKETUO POWER/INNER 400.00 0.00 0.00 102.50 96.09 1172.41 -6.81 P038988 1997 HEILONGJIANG ADP 120.00 0.00 0.00 0.00 23.52 21.27 0.00 P036952 1997 CN-BASIC ED. IV 0.00 85.00 0.00 0.00 2.26 5.04 0.00 P036405 1997 WANJIAZHAI WATER TRA 400.00 0.00 0.00 75.00 52.22 124.72 -12.78 P003590 1997 QINBA MOUNTAINS POVERTY REDUCTION 30.00 150.00 0.00 0.00 70.38 73.09 0.00 P035693 1997 FUEL EFFICIENT IND. 0.00 0.00 32.80 0.00 9.33 32.81 0.00 P044485 1997 SHANGHAI WAIGAOQIACO 400.00 0.00 0.00 0.00 190.95 '102.10 15.50 P034081 1997 XIAOLANGDI MULTI. 11 430.00 0.00 0.00 0.00 92.63 123.49 118.85 P003654 1997 Nat Hwy2fHunan-Guangdong 400.00 0.00 0.00 0.00 109.73 109.73 0,00 P003589 1996 CN-DISEASE PREVENTION (HLTH7) 0.00 100.00 0.00 0.00 15.31 25.40 0.00 P003594 1996 GANSU HEXI CORRIDOR 60.00 00.00 0.00 0.00 93.90 63.52 0.00 P040513 1996 2nd Henan Prov Hwy 210.00 0.00 0.00 0.00 61.97 61.97 -3.02 P003599 1996 CN-YUNNAN ENVIRONMENT PROJECT 125.00 25.00 0.00 0.00 88.16 81 53 49.05 P003602 11996 CN-HUBEI URBAN ENVIRONMENT 125.00 25.00 0.00 28.32 54.30 84.75 39.60 P003646 1996 CN-CHONGOING IND PCLCT 170.00 0.00 0.00 1 64.82 2.72 167.54 2.72 P003648 1996 CN-SH-ANGHAI SEWERAGE 11 250.00 0.00 0.00 0.00 9`1.13 91.13 3.38 P003649 1996 SHANXI POVERTY ALLEV 0.00 100.00 0.00 0.00 6.57 15.89 0.00 P003638 1996 SEEDS SECTOR COMMER. 80.00 20.00 0.00 9.40 17.77 28.22 0.00 P034618 1996 CN-LABOR MARKET DE/. 10,00 20.00 0.00 0.00 6.45 8.68 0.00 P036947 1995 SICHUAN TRANSMISSION 270.00 0.00 0.00 95.00 12.17 107.17 -0.12 P003598 1995 CN-LiAONING ENVIRONMENT 1110.00 0.00 0.00 0.00 15.07 15.07 7.66 P003596 1995 YANGTZE BASIN WATER 100.00 110.00 0.00 0.00 2.67 5.20 5.20 P003647 1995 China Econonic Law Reform -LEGEA 0.00 10.00 0.00 0.00 4.24 4.86 0.00 P036041 1995 FISCAL &TAX REF. & 25.00 25.00 0.00 0.00 0.64 3.15 3.15 P003585 1995 SHENYANG IND.REFOFRM 175.00 0,00 0.00 0.00 41.52 41.52 0.00 P003639 1995 SOUTHWEST POVERTY REDUCTION PROJECT 47.50 200.00 0.00 0.00 14.87 39.43 39.43 P003571 1995 R.AILWAYS VI] 400.00 0.00 0.00 109.00 75.18 181.16 20.21 P003642 1995 ZHEJIANG POWER DE\(7 400.00 0.00 0.00 0.00 62.15 67.77 0.00 P003603 1995 CN-ENTERPRISE HOUSING & SOC SEC REF 275.00 75.00 0.00 20.00 102.21 120.69 56.64 P003600 1995 CN-TECHNOLOGY DEVELOPMENT 200.00 0.00 0.00 3.02 20.97 23.99 0.00 P003540 11994 LOESS PLATEAU 0.00 150.00 0.00 0.00 2.22 -0.43 0.00 P003586 1994 CN-SHANGHAI ENVIRONMEN4T PROJECT 160.00 0.00 0.00 0.00 29.65 29.65 8.91 P003404 1994 SICHUAN GAS DEV. COIN 0.00 0.00 10.00 0.00 0.02 0.78 0.00 P003644 1994 XIAOLANGDI RESETTLEMENT 0.00 110.00 0.00 0.00 2.04 0.15 -3.34 P003641 1994 YANGZHOU THERMAL POW 350.00 0.00 0.00 11.50 3.32 14.82 1.43 P003626 11994 Fujian Pfov Highway 140.00 0.00 0.00 18.11i 12.29 30.40 30.38 P003609 1994 SICHUAN GAS DEV & CONSERVATION 255.00 0.00 10.00 0.00 52.16 52.16 0.00 P003595 1994 RED SOILSII1AREA DEVELOPMENT PROJECT 0.00 150.00 0.00 0.00 5.85 1.19 -0.51 P003592 1993 REF. INSTlL-A PREINV 0.00 50.00 0.00 0.00 2.64 3.15 1.75 P003473 1993 CN-ZHEJIANG MULTICITIES DEVELOPMENT 0.00 110.00 0.00 0.00 2.20 2.38 -2.53 P003632 1993 CN-ENVIRONMENT TECH ASS 0.00 50.00 0.00 0.00 4.855 5.46 5.14 P003627 11993 GRAIN DISTRIBUTION P 325.00 165.00 0.00 0.00 33.19 34.02 20.89 P003623 1993 FINANCIAL SECTOR T.A 0.00 60.00 0.00 0.00 2.03 -3.52 -3.52 Total: 13724.80 2617.60 156.80 971.66 6576.84 4236.38 504.18 74  CHINA STATEMENT OF IFC's Held and Disbursed Portfolio Jun 30 - 2002 In Millions US Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1997 Orient Finance 9.52 0.00 0.00 11.90 9.52 0.00 0.00 11.90 1997/00 PTP Holdings 0.00 0.03 0.00 0.00 0.00 0.03 0.00 0.00 1997 PTP Hubei 11.72 0.00 0.00 23.29 11.72 0.00 0.00 23.29 1996 Pacific Ports 0.00 2.54 0.00 0.00 0.00 2.54 0.00 0.00 2001 Peak Pacific 0.00 0.00 25.00 0.00 0.00 0.00 0.00 0.00 1998 Rabobank SHFC 0.90 0.00 0.00 0.90 0.90 0.00 0.00 0.90 2000 SSIF 0.00 6.00 0.00 0.00 0.00 0.45 0.00 0.00 1998 Shanghai Krupp 30.00 0.00 0.00 68.80 19.74 0.00 0.00 45.26 1999 Shanxi 17.87 0.00 0.00 0.00 15.32 0.00 0.00 0.00 1993 Shenzhen PCCP 3.76 0.99 0.00 0.00 3.76 0.99 0.00 0.00 2001 Sino-Forest 25.00 0.00 0.00 0.00 20.00 0.00 0.00 0.00 1995 Suzhou PVC 0.00 2.48 0.00 0.00 0.00 2.48 0.00 0.00 1998 WIT 5.00 0.00 0.00 5.00 0.00 0.00 0.00 0.00 2000 Wanjie Hospital 15.00 0.00 0.00 0.00 15.00 0.00 0.00 0.00 1996 Weihai Weidongri 1.92 0.00 0.00 0.00 1.92 0.00 0.00 0.00 1993 Yantai Cement 11.13 1.95 0.00 0.00 11.13 1.95 0.00 0.00 1998 Zhen Jing 0.00 2.00 0.00 0.00 0.00 2.00 0.00 0.00 2002 Advantage 0.00 0.25 0.00 0.00 0.00 0.00 0.00 0.00 1999/00/02 Bank of Shanghai 0.00 24.67 0.00 0.00 0.00 24.67 0.00 0.00 1996 Beijing Hormel 2.50 0.50 0.00 1.65 2.50 0.50 0.00 1.65 1998/00 CIG Holdings PLC 0.00 3.00 0.00 0.00 0.00 0.00 0.00 0.00 2002 CPEF 0.00 20.00 0.00 0.00 0.00 0.00 0.00 0.00 1996 Caltex Ocean 18.53 0.00 0.00 28.64 18.53 0.00 0.00 28.64 1998 Chengdu Huarong 7.40 3.20 0.00 8.60 3.70 3.20 0.00 4.30 1998 Chengxin-IBCA 0.00 0.36 0.00 0.00 0.00 0.36 0.00 0.00 1987/92/94 China Bicycles 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1994 China Walden Mgt 0.00 0.01 0.00 0.00 0.00 0.01 0.00 0.00 1994 China Walden Ven 0.00 0.21 0.00 0.00 0.00 0.21 0.00 0.00 1994 Dalian Glass 0.00 2.40 0.00 0.00 0.00 2.40 0.00 0.00 1999 Dujiangyan 25.59 0.00 0.00 30.00 16.11 0.00 0.00 18.89 1995 Dupont Suzhou 12.46 4.15 0.00 10.40 12.46 4.15 0.00 10.40 1994 Dynamic Fund 0.00 9.75 0.00 0.00 0.00 8.09 0.00 0.00 1999 Hansom 0.00 16.10 0.00 0.00 0.00 16.10 0.00 0.00 2002 Huarong AMC 31.50 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2002 IEC 20.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1996 Jingyang 32.50 0.00 0.00 69.23 32.50 0.00 0.00 69.23 1998 Leshan Scana 6.10 1.35 0.00 0.00 4.50 1.35 0.00 0.00 2001 Maanshan Carbon 9.00 2.00 0.00 0.00 0.00 0.00 0.00 0.00 2002 NCCB 0.00 26.58 0.00 0.00 0.00 26.46 0.00 0.00 1996 Nanjing Kumho 6.82 3.81 0.00 19.38 6.82 3.81 0.00 19.38 2001 New China Life 0.00 30.70 0.00 0.00 0.00 23.32 0.00 0.00 1995 Newbridge Inv. 0.00 1.95 0.00 0.00 0.00 1.95 0.00 0.00 Total Portfolio: 304.22 166.98 25.00 277.79 206.13 127.02 0.00 233.84 75  Approvals Pending Commitment FY Approval Company Loan Equity Quasi Partic 2002 Darong 10.00 0.00 1.50 8.00 2002 Narada Battery 6.60 0.00 0.00 0.00 2002 Zhong Chen 25.00 0.00 0.00 32.00 2002 ASIMCO 0.00 13.50 1.50 0.00 2002 Sino Mining 5.00 0.00 0.00 5.00 2002 Shuang Deng 12.50 0.00 2.80 0.00 2002 KHIT 0.00 .0.00 3.00 0.00 2002 SML 0.00 0.00 6.00 0.00 1996 Jingyang 4.00 0.00 0.00 0.00 1998 PTP Hubei BLINC 0.00 0.00 0.00 1.50 2000 CIG Zhapu 6.00 5.00 0.00 0.00 2000 Meijing 9.00 0.00 0.00 7.30 2000 CIMIC Tile 15.00 5.00 0.00 15.00 2001 Daning Coal 0.00 0.00 2.00 15.00 2001 AACI 0.00 0.00 2.00 0.00 2001 Minsheng 0.00 23.50 0.00 0.00 2002 Huarong AMC 15.00 0.00 3.00 0.00 2002 IEC 0.00 5.00 0.00 0.00 Total Pending Commitment: 108.10 52.00 21.80 83.80 76  Annex 10: Country at a Glance CHINA: Second Energy Conservation East Lower- POVERTY and SOCIAL Asia & middle- China Pacific Income Development diamond' 2000 Population, mid-year (millions) 1,262.5 1,853 2,046 Life expectancy GNI per capita (Atlas method, US$) 840 1,060 1,140 GNI (Atlas method, US$ billions) 1,061.2 1,964 2,327 Average annual growth, 1994-00 Population (%) 1.0 1.1 1.0 ,G Laborforce(%) 1.2 1.4 1.3 GNI 7 Gross per primary Most recent estimate (latest year available, 199400) capita enrollment Poverty (% of population below national poverty line) 5 -. Urban population (% of total population) 36 35 42 Life expectancy at birth (years) 70 69 69 Infant mortality (per 1,000 live births) 30 35 32 Child malnutribon (% of children under 5) 9 13 11 Access to improved water source Access to an improved water source (% of population) 75 75 80 Illiteracy (% ofpopulation age 15+) 16 14 15 China Gross primary enrollment (% ofschool-age population) 123 119 114 Male 123 121 116 -- Lower-middle-income group Female 123 121 114 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1980 1990 1999 2000 Economic ratios' GDP (US$ billions) 216.2 363.0 997.5 1,076.9 Gross domestic investmentGDP 35.2 34.7 37.2 37.3 Trade Exports of goods and services/GDP 7.6 17.5 22.0 25.9 T Gross domestic savingstGDP 34.9 37.9 40.1 39.9 Gross national savingslGDP 34.9 38.3 38.7 39.2 Current account balance/GDP -0.4 3.8 1.6 1.9 Domestic Investment Interest payments/GDP 0.2 0.7 0.6 0.7 savings Total debVGDP .. 15.2 15.5 13.9 Total debt servicelexports 8.0 9.9 9.0 7,4 Present value of debUGDP .. .. 13.5 Present value of debVexports .. .. 58.7 Indebtedness 1980-90 1990-00 1999 2000 200044 (average annual growth) GDP 10.1 10.3 7.1 7.9 7.4 China GDP per capita 8.5 9.2 6.1 7.2 6.7 Lower-middle-income group Exportsofgoodsandservices 11.0 16.5 13.9 32.0 11.1 STRUCTURE of the ECONOMY 1980 1990 1999 2000 Growth of lnvestnent and GDP(%) (% of GDP) 20 Agriculture 30.1 27.0 17.6 15.9 Industry 48.5 41.6 49.4 50.9 Manufactunng 40.5 32.9 33.6 34.5 :l Services 21.4 31.3 32.9 33.2 c Private consumption 50.5 49.9 47.4 47.0 95 9e 97 98 99 00 Generalgovemmentconsumption 14.6 12.1 12.5 13.1 - GDI -;* GDP Imports of goods and services 7.9 14.3 19.1 23.2 1980-90 1990-00 1999 2000 Growth of exports and Imports (%/) (average annual growth) Agriculture 5.9 4.1 2.8 2.4 40 Industry 11.1 13.7 8.1 9.6 30 Manufacturing 11.1 13.4 8.3 9.7 20 Services 13.5 9.0 7.5 7.8 1s' Private consumption 9.4 8.8 2.6 6.0 . General govemment consumpton 9.8 9.4 8.4 12.0 -10' 95 96 97 o 99 Gross domestic investment 10.8 11.6 3.2 7.9 Exports -mVports Imports of goods and services 9.1 16.1 22.3 24.8 Note: 2000 data are preliminary estimates. The diamonds show four key indicators in the country (in bold) compared wfth its income-group average. If data are missing, the diamond will be incomplete, 77  China PRICES and GOVERNMENT FINANCE 1981 1991 2000 2001 Inflation (%) Diomesdc prices 20 (% change)2- Consumer prices 25.7 3.4 0.4 0.7 15 Implicit GDP deflator 2.3 6.7 0.9 0.0 10 Govemment finance (% of GDP, includes current grants) 0 - Current revenue 24.2 16.9 15.3 17.2 -5 s 97 U0 01 Current budget balance 2.3 0.6 1.0 GDP deflator -CPI Overall surplus/deficit 0.8 -1.1 -3.6 -3.2 TRADE (USS millions) 1981 1991 2000 2001 Export and Import levels (USS mill.) Total exports (fob) 22,007 71,843 249,210 266,155 300,000 Food 2,924 7,226 12,282 12,780 Fuel 5,228 4,754 7,851 8,420 2 Manufactures 11.759 55,698 23,752 239,800 2ooo000 Total imports (cif) 22,015 63,791 225,097 243.610 Food 3,622 2,799 4,758 4,980 100.000 Fuel and energy 83 2.113 20,637 17,490 Capital goods 5,866 19,601 91,934 107,040 0 1 I, ss 90 57 98 w0 oD o0 Export price index (1995=100) 16 51 67 65 Import pceindex(1995=100) 13 49 75 73 *Exporls Elmports Ternmsoftrade(1995=100) 118 103 90 90 BALANCE of PAYMENTS (USS millions) 1981 1991 2000 2001 Current account balance to GDP (%) Exports of goods and services 24,410 78,909 279,561 299,410 5- Imports of goods and services 23,426 65,339 250,688 271,324 Resource balance 984 13,570 28,873 28,086 Net Income -124 840 -14,666 -19,173 3- Net current transfers 830 6,311 8,492 2 - Currentaccountbalance 860 15,240 20,519 17,405 1 1 1 . . Financing items (net) -4,149 -9,971 29,920 o Changes in net reserves -11,091 -10,548 -47,325 00 go 97 9D 99 00 01 Memo: Reserves including gold (USS millions) 48,154 171,753 219,970 Conversion rate (DEC, loca/IUS$) 2.1 5.4 8.3 8.3 EXTERNAL DEBT and RESOURCE FLOWS 1981 1991 2000 2001 (USS millions) CompositIon of 2001 debt (USS mill.) Total debt outstanding and disbursed 5,798 60,259 149,800 170.000 IBRD 0 3,494 11,118 11,479 IDA 0 3,672 8,771 8.550 G: 17,682 A 11,479 Totail debt service 1,744 8,305 21,728 20,900 B: 8,550 IBRD 0 357 1,291 1,716 IDA 0 23 131 164 D, 0: 23,217 Composition of net resource flows Official grants 19 406 147 \, 27,510 Official creditors 506 2,044 1,927 Private creditors 89 2,493 -2,302 F:81 ;E.5F2 Foreign direct investment 0 4,366 42,096 47,052 Portfolio equity 0 565 7,814 2,404 World Bank program Commitments 196 2,622 1.536 1,230 A - ilRD E - Bilateral Disbursements 0 1,280 1,907 1,947 B-IDA D-Otherrulblateral F- Private Prtncipal repayments 0 131 644 999 C-iMF G - Short-teIm Netflows 0 1,149 1,263 948 Interest payments 0 250 778 881 Net transfers 0 899 485 67 Development Economics 9/14/02 78  Annex 11: China's EMC Industry CHINA: Second Energy Conservation Project This annex provides further details on the results of various evaluation of the implementation results of the EMC Demonstration Component of the first phase of the China Energy Conservation Project, an assessment of lessons learned and issues and their solutions resulting from these evaluations, the results of consultations with the Chinese financial community, and the results of market soundings on new and emerging EMCs. EXPERIENCE OF THIUE THIIREE DEMONSTRATION EMCs The results of the demonstration EMCs in Beijing, Liaoning and Shandong supported under the first phase China Energy Conservation Project have been very closely monitored from the beginning. The Bank and SETC have conducted in-depth, formal reviews together with the three EMCs at least twice per year since the EMCs were founded in 1997, as part of the project supervision process. The reviews include evaluation of each EMC's project portfolio, financial results, energy savings and carbon reduction results, management and institutional building efforts, project procurement, business plans for the future, and outstanding issues and options for their resolution. Findings are reported in PMO and EMC biannual reports, and the biannual Bank project supervision mission aide memoire reports. A major Project Mid-term Review was conducted by the Bank, SETC and MOF in November 2000, in accordance with original plans, and the mid-term review aide memoire report is available in the project file. The PMO commissioned an outside, independent review of the status and work of the three EMC in 2000, which was completed by the China Energy Conservation Investment Corporation's consulting department, and used as an input for the project mid-term review. GEF Secretariat staff also conducted independent site investigations of this project in 2000, and this and other information was utilized by the Secretariat's consultants in their preparation of a 2000/2001 review of the results of GEF-supported projects involving ESCOs. Overall progress has been fully satisfactory, with each of the three pilot EMCs developing their respective businesses. Given that their business is entirely new in the Chinese market, the progress of the three EMCs has been exceptionally good by international standards. As of April 2002, the three EMCs had entered into 209 energy perfornance contracts with aggregate investment of US$45.5 million (RMB 377 million). Of this total, $3.3 million was supported by the European Commission (EC) grant, $9.4 by the GEF grant, $20.2 million by the IBRD loan and $12.6 million from internal and other financing. An additional $6.2 million in projects had been approved and contracts were under negotiation. Average annual financial rates of return of the subprojects have exceeded 20% per year. Repayments from EMC customers (referred to as host enterprises) has been good-with very few exceptions, payments have been made according to contract. All three EMCs declared net profits in 2001, and plan to continue to expand their businesses. As of April 2002, EMC investments had already delivered aggregate energy savings of 867 thousand tons of coal equivalent (tce) and associated carbon dioxide emission reductions of 577 thousand tons of carbon (t-c). Energy savings and carbon dioxide emission reductions from the direct investments of the three companies are certain to continue to grow substantially, from both additional future savings from the equipment already put in place, and from expected further major increases in investment. 79  Special Characteristics of the Chinese EMCs While EMCs in China are, in many respects, similar to ESCOs in the West, they have developed a number of unique features in their business strategies and operations over the past five years, including the following: * The three EMCs have provided all of the financing for their projects (although host enterprises may finance and complete additional related renovation works themselves). The EMCs borrow funds for their operations based on the strength of their balance sheet. Host enterprises are not a party to loan obligations from the lender to the EMCs. * The projects of the EMCs typically incorporate project design, equipment financing, equipment procurement, equipment installation, commissioning and testing, and limited maintenance. The core ingredients of all projects include financing, procurement, installation and testing/commissioning. Design work usually also involves host enterprise staff. * Projects do not proceed from completed detailed facility audits, but rather are designed to focus on one technology or system ("project lines"). Thus the constraint of audit costs or project development costs are not as critical an issue with Chinese EMCs as with Westem ESCOs, but the scope of projects is usually narrower. * Projects are truly energy conservation projects-cash flows resulting from energy savings are the main benefits. Probably well over one-half of the projects are in the $200,000- 500,000 range. Contract terms are generally 2-3 years. Coal-saving projects are at least as common as electricity-saving projects. * Technology and equipment is primarily domestic-for the fairly common types of equipment involved, foreign companies generally cannot compete on price with Chinese manufacturers. Also, many of the projects are too small to attract serious interest from intemational suppliers. * Energy performance contracts between EMCs and clients have been significantly simpler than typical ESCO contracts in the West. Project design and energy savings estimates are reviewed and agreed by both parties. Payment schedules are negotiated and fixed in the contracts, based on a percentage share of the estimated energy cost savings of the project which will accrue to the EMC (generally 60-100%). Energy savings guarantee clauses are included, stipulating how payments would change if actual savings per unit of output or time period are determined through testing to be substantially (e.g. 5-10%) higher or lower than estimated. Testing is simple, and much of the energy savings are, in fact, stipulated after commissioning. There have been virtually no disagreements about savings and payment levels-as long as the equipment performs as planned, the payment schedules established in the contracts are retained. There has been no demand from host enterprises for in-depth or complex energy savings monitoririg and verification. * For the EMCs, the most important single criterion for project selection is the financial assessment of the host enterprise, and the EMC's evaluation of the enterprises' willingness and ability to make payments. Some form of financial guarantee/definition of collateral is often included in the energy performance contracts. * Financial management of their project portfolio and associated risks is a major part of the EMC business. EMC Markets and Project Lines The potential for financially attractive energy efficiency projects in China remains substantial. Given the enormous size of China, the sheer number of industrial and commercial energy users, the 80  age of equipment and technologies employed and relative energy intensities, it is clear that new and existing EMCs will have a robust pipeline of energy efficiency projects to pursue in the foreseeable future. The resounding success of the three pilot EMCs has clearly demonstrated that the EMC model can work in China and represents an attractive service option and alternative project financing source for domestic enterprises. The experiences of the three pilot EMCs to date, while not an exact representation of the full Chinese EMC market, offers valuable data about the market for EMC project investments in China. Initial business experiences among the three EMCs, with critical EC and GEF support, allowed each EMC to test a range of technologies and applications and identify markets to replicate successful project lines. While all three EMCs continue to offer a number of similar project lines, their project portfolios and markets have begun to develop along distinctive paths based on differences among each of the EMCs' service territories and company expertise: Beijing, which has a lighter industrial base, has focused more on heating and cooling systems in hotels and office and residential buildings (electric heaters, heat pumps); Liaoning has a high concentration of industry, particularly iron/steel and chemical plants, and has found a good market for boiler and kiln/furnace renovations; Shandong has been able to replicate motor system improvements in a diverse range of host enterprises, developed a strong boiler renovation and heat recovery business, and found a few large, creditworthy enterprises in which to develop a pipeline of different technical renovations. About 14 different technical project lines have been developed by the three companies, taken together. The main key product lines include boiler renovations (layered industrial combustion systems, boiler replacements, deployment of FBC technology), kilns/furnaces/cement and ceramic kilns, electric arc furnaces, glass furnaces, waste heat (waste heat recovery, ground source heat pumps, condensed water recovery) industrial cogeneration, steam hammer renovations, motor drive systems, power supply (electrical distribution systems, transformers), automatic control systems and lighting systems (CFLs, ballasts). A breakdown of the total EMC investments by technical project line, as of March 2002, is shown in Figure 1. In terms of host enterprises, industrial projects clearly have been the largest market for the three EMCs and will likely continue to be a major market for new EMC projects. Within the industrial sector, major subsectors have included iron and steel, chemical, rubber, and textile, although many of the technical renovations (e.g., kilns, boilers, motors) are not industry specific. The three EMCs have also found a strong market for energy efficiency projects with utilities (power, heat and water). Each of the pilot EMCs has sought to balance their portfolios with some non-industrial projects, such as heating and cooling renovations in government/commercial buildings, lighting projects in hotels/tourist resorts, and projects in shopping centers, hospitals, and farms. Figure 2 contains a full breakdown of EMC customers. 81  Figure 1: EMC Project Line Breakdown Cogenurion P y 2% Lighting 4% Oontrob, s 4% 25% 2rE<__2 F ~~~~23% ...z.... .. While project lines have not changed vastly from initial plans, each EMC has found elements of competition from equipment suppliers as project lines are developed and actively marketed. Once newer technologies have been demonstrated and simpler renovations implemented, the initial financial returns tend to diminish over time for replication of the same simple projects. Thus a key aspect of the EMC business has been to maintain a step ahead of the market and build simpler renovations into broader, multi-project relationships with the same customer, or into more complex project lines with great:er value added. As the larger EMC industry develops in the future, it is certain that the market will become yet more sophisticated and diverse. Figure 2: EMC Host Enterprises FbWls/ Residenbial P Bldg 3 Off,ceComm 4% I InduStry * - 7056 82  Issues and their Resolution The main issues identified and discussed during the November 2000 Mid-Term Project Review on the Demonstration EMC Component included: (a) urgent needs to clarify the nature, legal standing and tax treatment of the EMC's energy performance contracts, as these instruments are new and were being interpreted in different ways by different entities; (b) difficulties experienced by some EMCs in developing markets for a high volume of business without excessive risks, and needs to continually develop new product lines and expand the service content of projects; and (c) the need to consider adjusting the procurement plans of the project. As the business of the three EMCs grew over late 1999 and 2000, confusion mounted among authorities at various government levels as to how to classify the EMC business for purposes of economic regulation, taxation and financial auditing. Some local authorities even stated beliefs that the business did not conform with existing regulations. As practiced by the three EMCs, the EMC business defies easy classification into traditional categories, as it combines elements of technical service, equipment sale with deferred payments, construction and installation contracting, and project management and equipment maintenance into one contract package. Although it was not known initially what specific problems would be encountered, the surfacing of these types of problems was expected at the outset of the project-indeed a key goal of the demonstration project was to adapt the ESCO model to Chinese conditions, solving various implementation issues as they arose. During 2000, the issue of classification of the EMC business was debated many times at different levels. Finally, in a comprehensive meeting with various relevant authorities on April 26-27, 2001, organized and chaired by SETC, it was concluded and officially documented that "...the business operation of energy performance contracting conforms to Chinese existing laws, and legal status problem for EMCs referred to by some persons does not exist." Financial auditing and economic regulation issues have thus been satisfactorily resolved. Tax treatment of EMCs, however, remains under investigation. SETC's PMO and the EMC Industry Development Steering Committee are completing their research of this issue, after which the central government's Bureau of Taxation is expected to make a ruling on taxation of energy performance contracts. With respect to market development, the three EMC managers will be the first to admit, despite their success, that the EMC business is not simple and easy. The business requires striking a difficult balance between financial risk and returns, between investment and service, between technical value-added and minimal technical risk, and between new business models and traditional methods of doing business. EMCs must maintain a balance between high quality technical staff with constantly evolving project lines and markets, seek out new technologies and practices to maintain a competitive edge, achieve corporate growth without sacrificing quality and customer service, replicate and expand promising project lines while maintaining high financial returns and repayments, and develop innovate ways to isolate project cash flows in less creditworthy enterprises. The three pilot EMCs in particular are already seeking ways to address many of these issues by establishing strategic partnerships with technical institutes and local banks, improving their financial appraisal and management systems, conducting market and technology reviews, etc. and will continue to explore altematives as their businesses and markets evolve. Greater EMC value-added for clients (preserving comparative advantage and resulting in strong project financial retums) can be achieved through new technical concepts, or use of technologies still relatively new in the Chinese market. In addition, greater value-added can also be achieve through better integration of service aspects in project packages-this has been the key to ESCO business 83  successes abroad. While service aspects may be of less interest to some clients in the Chinese market, the EMCs may find significant opportunities by placing additional emphasis on marketing "full service" packages, whereby the EMCs would offer to review industrial facilities and processes and design customized projects which could optimize energy use using a series of improvements/projects. With respect to procurement, difficulties have been experienced in project implementation to adapt EMC procurement to World Bank guidelines. Means to allow increased flexibility are under discussion. For the Phase II project, however, similar issues are not anticipated, as the Bank will not be directly involved in the financing of any EMC subprojects. EMERGING EMC INDUSTRY MARKET New EMCs Based on the successful business development of the three pilot EMCs, there has been substantial interest from other companies in creating new EMCs in China. A market study completed during the latter half of 2001 for the PMO identified 6 newly formed EMCs, operating with company staff of 20-30 persons each. Three of the companies had registered capital of RMvIB 10 million ($1.2 million), while the other three had registered capital of RMB 1.5-3.8 million ($180,000-460,000). with registered capital of under 5 million yuan (about US$600,000) and 20- 30 staff. However, given the complex nature of the business and general unfamiliarity of energy performance contracting in China, investments made by these companies have been limited to date. The survey also identified an additional 10-15 groups who established EMC subsidiaries but have suffered from very limited equity, business know-how and EMC operational experience. Aside from these companies which are made clear moves to establish EMC businesses, there also are at least 200 firms who have registered an interest in the concept during mid-2000 to mid-2002, and have begun to explore possibilities for creating EMC. businesses. In August 2000, the PMO organized a seminar on the potential of the EMC business in China. Over 90 firms attended the seminar and/or formally expressed their interest to the PMO in the EMC business at this initial stage. During 2001 and the first quarter of 2002, the PMO and EMC Service Group organized three additional introductory training sessions and one advanced course to better familiarize firms with energy performance contracting. The introductory sessions, held in Beijing and Kunming, Yunnan Province, have been over-subscribed, with 40-50 participants attending each session. In all, nearly 100 companies, from all over the country, have participated in the training. Thus far, about 2/3 of the firms have come from northern provinces, while around 40% are based in the interior. Sixteen companies completed the first advanced training course In March 2002. Delivery of both introductory and advanced training courses are further continuing, with expanding coverage. Many of the training course attendees to date have come from China's local energy conservation centers. Totaling around 180, these centers were established in the 1980s to provide technical support to industries in areas of energy conservation. With China's transition from a centrally planned to market-based economy, these centers are looking for opportunities to market their services on more commercial terms in order to remain in operation. The EMC business model represents an attractive option for their sustainability. Most of the other companies involved in training so far are firms focusing on equipment sales or energy-saving technology companies, although a few broader energy sector companies and energy investment companies also have been 84  involved. In the future, expanded efforts will be made to engage firms with financing, investment packaging, and/or strong and comprehensive engineering services skills as well. Although interest in the EMC model is clearly high, and a good start has been made in developing and training potential new EMCs, many challenges exist for the EMC Association and others to foster the strong development of healthy new EMCs. Few firms possess the mix of expertise ultimately required-including technical, marketing and financing/financial risk management skills and background. Most of the prospective companies have very limited equity holdings, which can seriously constrain growth if not addressed. In addition to helping the firms to become more familiar with the EMC business concepts, challenges exist to help companies to structure favorable mergers and develop strategic alliances and partnerships. As noted previously, the three pilot EMCs provide project financing as an integral part of their overall service. This model has allowed the EMCs to package the entire project together and thus offer complete project service to their customers. It has also proven very attractive to host enterprises, offering a clear alternative to on-balance sheet debt, especially since payments to the EMCs in some cases can be accounted for as operating costs. Many Chinese government and enterprise officials also believe that EMCs that do not offer financing as part of their overall service package, but provide only technical service and only help arrange project financing from others, will not attract sufficient business to survive in today's Chinese market. Thus the existing model, where the EMC provides financing as part of their overall packaging service, is still expected to the best means to meet the market demand and probably has the greatest business potential. However, as the EMC industry and market develops and banking reforms progress, it is expected that the EMC industry will become more diversified in its financial modalities and levels of sophistication. While it is expected that EMCs will continue to provide project financing over the near to medium-term, a wider range of EMC business models are likely to develop and the project will seek to encourage these new models. While efforts under the Phase 2 GEF Project will focus on EMC investments, it should be noted that activities initiated under the Bank/GEF Phase 1 Project under the information dissemination component are actively addressing technical information and best practices/case studies to end-users on potential efficiency gains, including investment-oriented and non- investment improvements. This work will continue. Under the Phase 2 Project, a wide range of EMCs, from technical consulting firms to full service EMCs (that provide service and financing), would be fostered and supported. These technical consulting firms may be better positioned to provide technical information on non-investment oriented energy efficiency improvements and, based on market demand, the EMC Service Group could provide additional assistance to these firms through their technical assistance and training programs to EMC members. Consultations with Financial Institutions The success of the three EMCs so far has generated intense interest among many other Chinese parties in developing EMC businesses of various types. During 2000 and 2001, the PMO and existing/new EMCs participated in over three workshops and numerous individual meetings with Chinese financial institutions to discuss the potential for energy performance contracting in China and gauge interest in EMC project financing. The Bank team and PMO also met with guarantee companies, potential EMC equity investors, and potential GC equity investors to discuss interest and participation in the Phase II program. (A full list of seminars and meetings with Chinese banks and a list of participating banks is included in the Project file.) 85  Many domestic banks expressed interest in the EMC concept, especially as this may provide a useful tool for them to enter into the energy efficiency investment business. The ability of EMCs to bundle projects together, and shoulder the technical and performance risks of projects, are attractive to bank officials. However, concems were raised about the newness of the concept, the lack of sufficient track records in most EMCs, and guarantee or loan collateral issues. These comments and concerns, raised on a number of occasions, in different settings and with different banks, have been a key input for the design of the proposed project. 86  Annex 12: Flow Chart for Environmental Clearance of Subprojects CBINA: Second Energy Conservation Project EMC's screen proposed subprojects using the Environment Review Checklist, rejecting subprojects with enterprises on the negative list, and determining if negative environment impacts exist. Negative impacts? YES EMC asks host enterprise to request Local Environmental Protection Bureau to review proposal mitigation plan NO EMC provides own certification and proceeds with loan guarantee , application Local EPB conducts review applicato and determines clearance NO YES /X , - Subproject terminated EMC and local bank submit loan guarantee application to IA with its own certification or EPB clearance. IA ensures that proper paperwork is provided NO YES |A reviews and approval determined NO YES /L)bproject| Subproject is implemented Subproject < > .I terminated ,| Randomly sampled post-project reviews conducted by PMO. World Bank may request or further reviews, during supervision missions, as required 87     IMAGING Report No.: 24883 CHA Type. PAD