China - Energy Conservation Project

Document of The World Bank Report No: 17030-CHA PROJECT APPRAISAL DOCUMENT ONA PROPOSED LOAN IN THE AMOUNT OF US$63 MILLION AND A PROPOSED GEF GRANT OF US$22 MILLION EQUIVALENT TO THE PEOPLE'S REPUBLIC OF CHINA FOR AN ENERGY CONSERVATION PROJECT February 26, 1998 Energy and Mining Development Sector Unit China Country Unit East Asia and Pacific Regional Office  CURRENCY EQUIVALENTS (As of October 1997) Currency Unit = Yuan Yuan 1.00 = US$0.12 US$1.00 = Yuan 8.3 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ABD Asian Development Bank CAS Country Assistance Strategy CO2 Carbon Dioxide DO Development Objective DSM Demand-Side Management EBRD European Bank for Reconstruction and Development EC European Communities ECIDC Energy Conservation Information Dissemination Center EMC Energy Management Company ESCO Energy Service Company GEF Global Environment Facility GHG Greenhouse Gas lAS International Accounting Standards IBRD International Bank for Reconstruction and Development IP Implementation Progress NGO Nongovernmental Organization PCR Project Completion Report PDF Project Development Funds PMO Project Management Office SETC State Economic and Trade Commission SO2 Sulfur Dioxide SPC State Planning Commission TSP Total Suspended Particulates UNDP United Nations Development Prograrn VAT Value-Added Tax Vice President Jean Michel Severino, EAP Country Director Yukon Huang, EACCF Sector Manager Yoshihiko Sumi, EASEG |Task Manager Robert Taylor, Senior Energy Economist, EASEG  CONTENTS A: Project Development and Global Objectives ................................... ..........................2 1L. Project development objective and key performance indicators ....................................2 B: Strategic Context ............................................................2 I a. Sector-related Country Assistance Strategy (CAS) goal supported by the project ............................................................2 lb. Consistency with GEF Operational Program .............................................................2 2. Main sector issues and Government strategy ............................................................. 2 3. Sector issues to be addressed by the project and strategic choices ............... .................3 C: Project Description Summary .............................................................6 la. Project components .............................................................6 lb. Phase II EMC Expansion .............................................................7 2. Key policy and institutional reforms supported by the project .................. ....................8 3. Benefits and target population .............................................................8 4. Institutional and implementation arrangements ................................... ; . 8 D: Project Rationale ........................................9 1. Project alternatives considered and reasons for rejection ................................ ..............9 2. Major related projects financed by the Bank, and/or other development agencies (completed, ongoing and planned) ....................................................... 10 3. Lessons learned and reflected in the project design ..................................................... 10 4. Indications of borrower commitment and ownership ................................................... 10 5. Value added of GEF and Bank support in this project ........................................ ......... 10 E: Summary Project Analysis .......................................................... 11 1. Economic .......................................................... 11 2. Financial analysis .......................................................... 12 3. Technical analysis .......................................................... 12 4. Institutional .......................................................... 12 5. Social .......................................................... 12 6. Environmental assessment .......................................................... 12 7. Participatory approach .......................................................... 13 F: Sustainability and Risks .......................................................... 13 1. Sustainability .......................................................... 13 2. Critical Risks .......................................................... 13 3. Possible Controversial Aspects .......................................................... 14 G: Main Loan Conditions .......................................................... 14 1. Effectiveness Conditions .......................................................... 14 2. Other .......................................................... 14  H. Readiness for Implementation .......................................................... 15 I. Compliance with Bank Policies .......................................................... 16 Annex 1: Project Design Summary .......................................................... 17 Annex 2: Energy Conservation in China: Making the Transition to the Market ........... ............. 20 Annex 3: Project Description and Costs .......................................................... 25 Annex 4: Project Justification, Incremental Costs, and Benefit-Cost Analysis .......................... 35 Annex 5: Financial Aspects of the Energy Management Companies ...................... ................... 45 Annex 6: Procurement and Disbursement Arrangements .......................................................... 56 Annex 7: Project Processing .......................................................... 61 Annex 8: Documents in the Project File .......................................................... 62 Annex 9: Statement of Loans and Credits ........................................................... 63 Annex 10: Country at a Glance .......................................................... 67  China Energy Conservation Project Appraisal Document East Asia and Pacific Regional Office China Date: 02/26/98 Task Team Leader/Task Manager: Robert Taylor Country Manager/Director: Yukon Huang Sector Manager/Director: Yoshihiko Sumi Project ID: CN-PE-3606 Sector: Energy Program Objective Category: Environmentally Sustainable Dev. Lending Instrument: Specific Investment Loan Program of Targeted Intervention: [] Yes [X] No Project Financing Data [X] Loan [] Credit [] Guarantee [] Other [Specify] For Loans/Credits/Others: Amount (US$ M/SDR M): IBRD Loan $63 million, GEF Grant $22 million Proposed terms: [ ] Multicurrency [X] Single currency, specify US dollars Grace period (years): 5 [ ] Standard Variable [ Fixed [X] LIBOR-based Years to maturity: 20 Commitment fee: 0.75% Service charge: n.a. Financing plan (US$ M): Source Local Foreign Total EC Grant /a 2.2 2.3 4.5 GEF Project Grant /b 5.3 16.7 22.0 IBRD Loan 6.5 56.5 63.0 SETC Grant 7.0 0.0 7.0 Domestic loans (through SETC) 27.8 3.1 30.9 EMC internal sources /c 23.4 0.0 23.4 Total 72.2 78.6 150.8L L/ Effective June 1997. L Total GEF grants for this project are US$22.7 million, including GEF Project Development Grants of US$0.7 million approved in 1996. L/ Internal funds for reinvestment in projects by the EMCs, derived from project revenues, are projected to total about US$620 million over 10 years. This table only includes allocation of internal funds to cover taxes due on GEF/IBRD/SETC-financed investments. Borrower: People's Republic of China Guarantor: Responsible agency(ies): State Economic and Trade Commission Estimated disbursements (Bank FY/US$M): 1999 2000 2001 2002 2003 2004 2005 2006 GEF Grant Annual 7.4 7.1 5.2 1.9 0.3 Cumulative 7.4 14.5 19.8 21.7 22.0 IBRD Loan Annual 3.8 5.7 7.8 10.1 11.0 11.3 9.5 3.8 Cumulative 3.8 9.5 17.3 27.4 38.4 49.7 59.2 63.0 Project implementation period: seven years Expected effectiveness date: 09/98 Expected closing date: 06/06  Page 2 A: Project Development and Global Objectives 1. Project development objective and key performance indicators (see Annex 1). The objective of the project is to achieve large, sustained and growing increases in energy efficiency, and associated reductions in growth of carbon dioxide emissions and other pollutants. The project will achieve this 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 and energy use quotas to a more market-oriented system, which can be sustained over time and grow with China's economy. The project would support the establishment and pilot demonstration of Energy Management Companies (EMCs) in China for the first time, followed by a program to support proliferation of the EMC concept. These commercial companies will be engaged in self-sustaining energy efficiency investments through energy performance contracting. In addition, the project also seeks to achieve increases in energy efficiency by strengthening China's national efforts to provide improved access to specific information concerning successful domestic experiences in energy efficiency measures and projects, geared in particular to financial decision makers in enterprises. Key performance indicators will include quantified energy savings and associated carbon dioxide (CO2) emissions reduction resulting from the project. B: Strategic Context la Sector-related Country Assistance Strategy (CAS) goal supported by the project (see Annex 1). CAS document number: 16321-CHA Date of latest CAS discussion: February 25, 1997 The project supports the twin CAS objectives of alleviating infrastructure constraints and safeguarding the environment, by increasing the supply of useful energy to industrial and commercial users through environmentally attractive increases in the efficiency of end-use energy-intensive equipment. lb. Consistency with GEF Operational Program: China ratified the IJN Framework Convention of Climate Change on January 5, 1993. The project is consistent with Operational Program #5 of the GEF Operational Strategy for climate change, where one of the long-term mitigation measures is to remove the barriers to energy conservation and energy efficiency. 2. Main sector issues and Government strategy: The need to improve the efficiency of energy use in parallel with development of additional energy supply has been a cornerstone of China's energy policy for over 15 years. Although substantial success has been achieved, it is widely recognized both inside and outside of China that far greater improvements in the efficiency of energy use are critical to the country's economic and environmental future. All recent macroeconomic forecasting work on China has shown that continued rapid economic growth is not physically, financially or environmentally sustainable without dramatic further improvements in energy efficiency. Improving energy efficiency is a main pillar of China's environmental protection strategy, especially as a means to abate local and regional air pollution and increases in greenhouse gas (GHG) emissions. Enormous potential for cost-effective improvements in energy efficiency remains untapped in China, especially in the industrial sector, which is expected to continue to dominate energy consumption in China for decades. The strategic importance of and remaining cost-effective potential for energy  Page 3 efficiency measures is well documented in recent sector work completed by the Bank and a wide range of other studies completed both in China and abroad.' China's existing energy conservation system is among the most extensive in the world. During the 1980s, China successfully developed a comprehensive energy conservation program, including major policy directives, procedures, regulations, technical assistance programs, and project financing initiatives. The institutional framework includes a series of specialized energy conservation units at national, provincial and county/prefecture-level government units, operating under the State Economic and Trade Commission (SETC) and its provincial and local affiliated commissions. The system was quite effective under the centrally planned economic system, taking advantage of the well-established systems of industrial enterprise energy input quotas and government investment funding mechanisms for state- owned enterprises. With the ongoing conversion of China's economic system to a market economy, however, the established system for promoting energy conservation must be transformed to operate more effectively in a new environment. Without timely change, many of the critical gains in capacity building achieved during the last decade and a half may be lost, especially the major gains achieved in development of technical expertise in energy conservation project work. The Government recognizes the need to adapt China's energy conservation system to maximize the play of market forces, and strongly supports the development of market-based energy efficiency initiatives. Major reforms in retail energy pricing pursued during the late 1980s and 1990s have brought average retail energy prices to levels at or above the cost of supply. As a result, of 16 case studies of typical energy conservation investments in manufacturing enterprises completed for the China GHG study, all exhibited financial rates of return of over 15 percent, and three quarters exhibited returns of 20 percent or higher. Many challenges, however, are involved in the conversion to market-based energy efficiency initiatives. Because many of the administrative measures previously used to promote energy conservation are now becoming inapplicable, promotion efforts must be built on the interest of enterprises themselves to undertake energy efficiency measures, as a means to increase enterprise profits and/or meet environmental regulations. New and different financing approaches and mechanisms are needed, and promotion activities must better focus on and utilize the direct self-interest of enterprises. Support for the introduction of market-oriented approaches is especially important at this phase, when market incentives for energy conservation are increasing, but knowledge among most enterprise managers of the most effective energy efficiency options is weak, and the institutional system for promoting energy conservation has little experience with the types of methods and mechanisms which can best assist enterprises in the new environment. 3. Sector issues to be addressed by the project and strategic choices: Energy conservation investments, especially in industry, can be categorized into three types. A first type includes investment in energy efficient processes and equipment in new plant, as part of new plant design. A second type includes packages of substantial investments to restructure and modernize industrial plants, focusing usually on adoption of more efficient production processes. Examples of this second type include conversion of steelmaking furnaces to modem technology, conversion of cement plants from wet to dry process, conversion of existing housing blocks to use of piped gas for cooking, etc. These restructuring projects typically involve large-scale investment, medium-level rates of return, and major benefits in expanded production or improvement in product quality, as well as substantial See, for example, China: Energy Conservation Study (Bank Report 10813-CHA, February 4, 1993), and China: Issues and Options in Greenhouse Gas Emissions Control (Summary and four major subreports on energy efficiency), a GEF-financed joint report of the Chinese Government, UNDP and the World Bank, 1994.  Page 4 energy savings. Case studies have shown that enterprise managers in China are usually keen to undertake these investments, but face major constraints arranging adequate credit and overcoming a series of enterprise efficiency problems stemming from incomplete state-owned enterprise reforms. A third type of investment includes relatively small-scale measures, usually involving replacement or addition of specific equipment, and focused primarily on energy savings alone. Examples include replacement of traditional lighting equipment with high-efficiency lamps, adoption of high-efficiency and/or variable- speed motors and associated fans and pumps, and boiler and steam system modifications to improve combustion, increase heat recovery and/or reduce steam loss. The total energy savings of each investment are fairly small, but the scope for implementation is very broad, so that the potential for aggregate energy savings through these types of projects is very high. Investment costs are relatively low, and rates of return of well conceived projects are quite high, but constraints exist in mobilizing implementation. While this project includes some support for the accelerated implementation of some of the second type of projects, e.g., in the information component, the primary focus of this project is on the third type of energy conservation investments. Detailed case studies on energy efficiency projects with wide potential across China showed that many projects would yield sound life-cycle financial returns today, but remain unimplemented. Rates of return for the third type of energy conservation investments typically exceed 20 percent, while payback period range from 1 to 5 years. Many of the barriers identified in case studies in China which constrain the implementation of these commercially-tested and financially viable projects are similar to those found in other countries: * Inadequate Information. Enterprises and individuals lack information about energy-saving investments, especially on financial aspects and the implementation experiences of others. China has developed various mechanisms for distribution of technical information on energy efficient technologies and renovation measures within the energy conservation community. The system falls far short of current needs, not only in terms of coverage, but particularly in terms of focus. Little information is available for the enterprise managers concerning how specific energy conservation projects can yield direct financial benefits to enterprises, practical implementation measures from experience, impacts on production (if any), etc. - Technology Transfer Barriers. While some state-of-the-art energy efficient technologies have been introduced in China, many have yet to be widely distributed. * Risk. Perceived technical and financial risks to enterprises in adopting innovative energy saving technologies are very high in China. Fears that a new technology may not work, could interrupt production, or may take time to perfect, all inhibit enterprise management from adopting new energy-saving technologies or practices. * Real and Perceived Insignificance of many Energy Efficiency Investments. Many worthwhile energy efficiency investments are relatively small, and while they may yield sound financial returns, the value of the savings achieved typically is only a small percentage of enterprise operating costs. Enterprise managers are most interested in expanding production and increasing market share, and, especially if there is some perceived risk involved, they often show little interest in small projects yielding relatively small savings in operating costs. * High Transactions Costs. Especially when technologies are relatively new and unfamiliar to enterprises, energy efficiency projects often carry high costs (especially high opportunity costs of key skilled enterprise personnel) for obtaining and checking information, planning and design, arranging financing (including internal arrangements), implementation scheduling, monitoring initial performance and implementing necessary adjustments, etc. Especially where the benefits are considered small, enterprises are reluctant to incur these costs.  Page 5 * Difficulties in Arranging Financing. Interested enterprises have insufficient access to project financing for upfront investment costs for projects to reduce operating costs. Credit for all types of investment projects is difficult to obtain in China today, but domestic banks are particularly reticent to lend for energy conservation projects. Financial institutions in China (and elsewhere) are generally not familiar or adept at analyzing the financial aspects of energy efficiency projects, and hence less willing to extend credit for these projects. * Institutional Constraints. China's present energy conservation system, while extensive, is not geared to provide the type of support needed by enterprises under the market system, and is currently not well placed to help enterprises overcome many of the barriers listed above. GEF Energy Efficiency Strategy for China. The overall GEF program to assist China to reduce GHG emissions through energy efficiency improvements includes a portfolio of projects that have been approved or are under preparation included are two UNDP-implemented technical assistance projects (the approved Energy Conservation in Township and Village Enterprises Project, and the proposed High- Efficiency Refrigerator Project) and two Bank-implemented investment projects (the approved Efficient Industrial Boilers Project and this proposed project). As a whole, the program seeks to alleviate the barriers listed above through a combination of mutually reinforcing measures to: (a) improve access to relevant information, (b) facilitate the transfer of advance technology, especially for production of high- efficiency equipment, and (c) develop institutions and financing mechanisms that can more effectively spur energy conservation investment under the market economy. The TVE, boilers and refrigerator projects each combine a series of efforts to alleviate barriers for a specific subsector. The TVE project focuses on the development of interventions specifically geared for this growing, collectively owned sector, where energy efficiency work has traditionally been undersupported in China. The boiler and refrigerator projects focus on technology transfer for domestic production of more efficient, new energy-using equipment, and the information dissemination, institutional development, and policy strengthening needed for interventions to be sustainable. This project, combined with a proposed Phase II follow-up effort, will address the identified barriers through introduction of energy performance contracting and an improved information dissemination program. Energy performance contracting is an energy conservation project financing and implementation method which has been successfully employed in North America and Western Europe since the late 1970s. It involves joint implementation of an energy conservation project by an Energy Service Company (ESCO)-or, as termed in China, an Energy Management Company (EMC)-together with a "host enterprise," according to an "energy performance contract." The ESCO/EMC undertakes project design, arranges financing, and installs and usually maintains the key equipment in the host enterprise. In exchange for these services and shouldering most of the project risk, the EMC is compensated from a portion of the money saved by the host enterprise on its energy bills. In China's case, the concept is being developed, at least initially, in a manner similar to equipment leasing with a buyout provision: the EMCs purchase and install more energy efficient equipment and are compensated monthly from the resulting actual savings until the investment cost and a reasonable profit have been recovered, after which equipment ownership reverts to the host enterprise. The energy performance contracting concept is most applicable for the third type of energy conservation projects mentioned above, where projects are small, easily replicated, and energy savings are relatively easy to verify. The Government is particularly keen to develop energy performance contracting, which it considers to be a financing and technology dissemination mechanism of great potential for China's evolving market economy. Compared with traditional financing mechanisms, use of the energy performance contracting mechanism as designed in this project: (a) helps to overcome host enterprise reticence due to lack of  Page 6 information and perceived risk by placing responsibility for implementation and risk burdens on the EMC developer, (b) helps to overcome enterprise reticence due to perceptions of small projects as being financially not significant enough to warrant development by placing the burden for development primarily on the EMC, (c) reduces transaction costs for small projects through development of a high volume of technically similar product lines within an EMC, and (d) eases financing constraints in host enterprises by utilizing savings in operating costs to directly pay for investment. The Government hopes that increasing use of this mechanism can make the existing energy conservation support system more relevant for today's needs. C: Project Description Summary la Project components (see Annex 2for a detailed description and Annex 3for a detailed cost breakdown): Component Category Cost Incl. % of Bank % of Contingencies Total financing Bank/GEF (US$M) (US$M) financing 1. EMC Demonstration Physical, institutional building 137/a 90 15 (GEF) 63 (IBRD) } 57 2. Information Dissemination Physical, institutional building 10 7 5 (GEF) 50 3. Program Management and Policy, institutional building, 4 3 2 (GEF) 50 Monitoring project management Total 151Lf 100 /a Figures do not include the GEF Project Development Grants, costs associated with the planned Phase 11 EMC follow-up effort, or over US$600 million of energy conservation project investment by EMCs financed through reinvestment of funds over a I 0-year period. Energy Management Company Demonstration. Under this core component, three demonstration EMCs will be developed, begin operation, and expand as commercial businesses. The three EMCs will adapt, operationalize and develop energy performance contracting, as developed by ESCOs in other countries, for the first time in China. The EMCs will undertake investment projects in other "host" enterprises. Although additional financing mechanisms may be developed over time, in this demonstration phase the EMCs will finance the investment, shoulder the technical and financial risk, and initially own the equipment installed in the host enterprises. The EMCs will be paid by the host enterprises from a share of the value of the energy savings actually achieved, according to an energy performance contract. The EMCs will receive most of the money saved by the energy efficiency investment at the beginning, until it is fully compensated for the investment, operating costs, risks undertaken and a reasonable profit. Thereafter, the equipment ownership normally would be transferred to the enterprises, and the enterprises receive all of the further financial benefits of energy savings. As developed in North America, if the EMC selects good projects and. manages them well, it should earn profits for steady growth. The host enterprises incur less risk, provide no investment capital, and eventually own more efficient equipment and enjoy accompanying reduced energy costs. Geared for provincial-level operations, the EMCs were established as shareholding companies in 1996 in Beijing Municipality, and Liaoning and Shandong Provinces. The companies have received a large amount of technical assistance financed with Global Environment Facility (GEF) Project Development Funds. Operations are being developed gradually, with opportunities to leam from practical experience.  Page 7 Execution of an ECU 4 million (about US$4.5 million) grant from the European Commission began in June 1997, supporting the implementation of the first series of energy performance contracting projects and further technical assistance. GEF financing will support further implementation of pilot projects to adapt the energy performance contracting concept for different technologies, consumer types and contract variations. IBRD funds will support replication of successful pilot projects, in a series of "project lines" in each EMC, and EMC growth. The SETC has arranged 300 million yuan (currently equivalent to about US$36 million) of domestic credit at commercial terms, for counterpart financing of pilot projects and further EMC growth. Total investments in energy conservation projects to be undertaken by the three EMCs forecast during 1997-2006 is expected to amount to about US$730 million, as host enterprise payback to the EMCs should be completed within 18-30 months for most energy performance contracts, and financing from reinvestment will grow to large levels during the middle and later years of the project. Information Dissemination Component. This component will support the development of a new system to provide practical information on energy conservation project results to Chinese enterprise managers. The system will be operated by the new Energy Conservation Information Dissemination Center (ECIDC), established on January 9, 1998, which will function under a performance contract with SETC's Project Management Office (PMO). New information products will be developed with particular emphasis on financial results actually achieved by enterprises, problems and solutions during implementation, any impacts on main enterprise production or other key risks, and contact information on enterprises with relevant experience. Dissemination work will focus on influencing enterprise decisionmakers, and ECIDC's performance will be evaluated based on how many enterprises actually use the information provided to implement energy conservation projects. The Center's regular operations will be funded by the Government, including SETC grant financing of US$5 million during the initial five years to support the core costs of ECIDC and a core level of product development and dissemination. GEF grant financing of US$5 million will support training and institutional capacity building, a portion of product development and dissemination, especially during the early, trial years, and program evaluation and monitoring. Program Management and Monitoring Component. This component will be executed over a five-year period by the Project Management Office (PMO) of SETC. The component will support the activities of two distinct units in the PMO: the EMC Development Unit and the Project Management Unit. The purpose of the EMC Development Unit is to promote and assist the creation of new EMCs in China by any interested domestic or international parties. The success of the program and the unit staff will be measured by the number of new EMCs created and the successful operation of these EMCs. Activities of this unit will include provision of information, liaison and provision of technical assistance to foreign ESCOs interested in possible China operations, to Chinese financial institutions, and to Chinese businesses interested in developing energy performance contracting. The EMC Development Unit also will assist the PMO in the preparation of the proposed Phase II effort (below). The second unit, the Project Management Unit, will provide operational support and technical assistance for the implementation of the two other project components, provide policy advice to the Government, and implement a series of training activities for staff and experts nominated by the PMO. l b. Phase II EMC Expansion. While the proposed EMC Demonstration Component will demonstrate the EMC concept in three provinces of China, full success in removing barriers to EMC development in China (and greatest cost- effectiveness) requires the expansion and dissemination of the concept to other EMCs throughout China,  Page 8 following up on the work of the EMC Development Unit of the PMO. Additional support under a Phase II will therefore be necessary to develop a variety of different types of EMCs in many parts of China, including joint ventures with foreign firms. It is therefore expected that additional incremental cost GEFsupport, the size of which will be determined during implementation of the EMC Demonstration Component, will be sought for a Phase II EMC Expansion about 18 months after effectiveness of this first Energy Conservation Project. Preparation and implementation of the Phase II project is scheduled behind the first project so that its detailed design can build upon the implementation experience of the initial demonstration EMCs. Financing for the preparation of Phase 11 is included in the Program Management and Monitoring Component of this Phase I project. Documentation for the Phase II proposal to the GEF Council will note and include: (a) completion of an evaluation of implementation results of the initial pilot project in the EMC Demonstration Component, (b) assessment of lessons learned, identification of issues requiring resolution, and proposed solutions; (c) completion and evaluation of a conference on EMC results with the domestic financial community, and (d) arrangement of suitable counterpart financing/cofinancing. 2. Key policy and institutional reforms supported by the project: The project supports major institutional reforms through the development of a new energy conservation investment financing and implementation mechanism, and a new type of information dissemination system. However, these reforms are specific to the energy conservation field. 3. Benefits and target 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). Direct benefits include (a) reduction in energy use from the operation of the three EMCs, totaling an estimated 45 million tons of coal equivalent (tce), and associated carbon dioxide emissions reduction of 34 million tons carbon, over the life of the projected investments undertaken during the next 10 years; and (b) estimated energy savings of 24 million tce, and associated carbon dioxide emissions reduction of about 18 million tons carbon, over the life of investments fostered through 10 years of operation of the new information program. Yet, if this project and Phase II efforts are successful, even larger and more important benefits can be achieved through dissemination of the new energy conservation investment financing mechanisms and institution building on a wider scale in China, based on this demonstration of the energy performance contracting concept (see also Annex 4). 4. Institutional and implementation arrangements: The SETC will be responsible for coordination of project implementation, assisted by other agencies and research units. The SETC, and the affiliated Economic and Trade Commissions at provincial, prefecture and county levels, are responsible for implementation of the country's energy conservation policies and organization of the government's efforts to renovate existing enterprises. They manage and allocate state funds provided in the national economic plans for this purpose. The SETC has established a Project Management Office (PMO) to oversee project preparation and implementation, chaired and partially staffed by the Department of Resource Savings and Comprehensive Utilization, with additional expert staff from the Energy Research Institute of the State Planning Commission, the Beijing Energy Efficiency Center, and other units. The PMO also is assisted by a variety of domestic and intemational consultants. The PMO will coordinate the implementation of the EMC Demonstration Component; implement the Information Dissemination Component, through ECIDC operating under its direct supervision; and directly implement the Project Management and Monitoring Component. The three provincial-level EMCs will be the project beneficiaries for the EMC Demonstration Component, financed by the EC and GEF and all of the IBRD loan. Government coordination in the provinces is  Page 9 managed by the provincial Economic and Trade Commissions at a high level. IBRD loan funds will be provided under subsidiary loan agreements between the Ministry of Finance and provincial Finance Bureaus, and between provincial Finance Bureaus and each EMC, with provincial government repayment guarantees. GEF funds for the EMC Demonstration Component will be provided under subsidiary grant agreements, similar to the subsidiary agreements under the EC grant. Step-by-step monitoring and evaluation are critical in this project, and will be conducted by the EMCs and PMO with support under the project. Biannual project implementation reports from each EMC must include specified monitoring data and evaluations for each of their demonstration projects, as a basis for mid-course correction, for definition of key implementation issues requiring government attention (with support under the project management and monitoring component), and for definition of the specific activities for the Phase II EMC Expansion. Following the experience of a similar UK program, ECIDC also must monitor and verify the effect of its information dissemination work, in terms of energy savings by affected enterprises, as will be specified in the performance contract between ECIDC and the SETC. The Bank has reviewed the financial management capabilities of the three EMCs. The EMCs, as new companies established in 1996, are learning the energy performance contracting business and improving project management capacity quickly with the benefit of a large amount of technical assistance and training both during project preparation and implementation (see Annexes 3 and 5). Special emphasis has been placed on the development of financial management and reporting capacity to operate and control companies of this nature; provision of training to financial personnel; development and implementation of more sophisticated financial planning and control functions; production of monthly cost and variance reports by element and process, cash budgets and proforma financial projections; and definition of financial policy and appropriate procedures. The EC Grant includes a substantial financial management and reporting technical assistance package for this purpose, to be implemented in 1998. Further follow- up assistance will be organized by SETC under the Project Management and Monitoring Component as and when necessary. D: Project Rationale 1. Project alternatives considered and reasons for rejection: The project team and Government counterparts also considered the development of a line-of-credit operation to support industrial energy conservation investments. Although such an operation might have been simpler to develop for the Government counterparts, they strongly preferred the energy performance contracting concept. Given the issues involved in financial intermediary operations for industrial renovation generally, and the mediocre experience of past Bank projects in other countries involving lines of credit for energy conservation specifically, the Bank team also opted for the new approach. The concept of promoting electricity conservation by electric power utilities through consumer rebates or subsidies, as practiced in North American demand-side management (DSM) programs, was rejected due to a desire to avoid consumer subsidies and the fact that China's current power price regulation system is not conducive to recovery of such costs through the power tariff.  Page 10 2. Major related projects financed by the Bank, and/or other development agencies (completed, ongoing and planned): Sector issue Project Latest Supervision (Form 590) Ratings (Bank-financed projects only) Implementation Development Progress (IP) Objective (DO) Bank Industrial Energy Conservation Hungary: Industrial Energy Diversification and n/a n/a Conservation (PCR, 1993) Hungary: Second Industrial Energy and n/a n/a Conservation (PCR, 1994) Bangladesh: Industrial Energy Efficiency Project n/a n/a (PCR, 1992) Indonesia: Industrial Energy Conservation n/a n/a Project (PCR, 1994) Technology Transfer China: Efficient Industrial Boilers (GEF) S S Power Development Yangzhou Thermal Power S S Ertan II Hydroelectric S S Other development agencies Asian Development Bank: China: Energy Conservation I Industrial Energy Conservation IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons learned and reflected in the project design: Energy projects in the current China portfolio (January 1998) all have highly satisfactory or satisfactory ratings. The energy conservation projects listed above (and several other additional earlier Bank projects) all involved lines of credit for industrial energy conservation. The implementation record for these types of projects has been mixed-while some success has been achieved (the first two projects in Hungary, and the ADB China project), many have had difficulty disbursing and some (Bangladesh) were canceled without disbursement. Problems have included changes in government or other institutional problems and high processing costs to potential subborrowers, but the constraints listed in Section B3 also dampened interest in borrowing. The proposed project adopts a new approach to overcome these constraints. 4. Indications of borrower commitment and ownership: Borrower commitment and ownership is high. At least 20 million yuan in equity financing already has been invested to establish each EMC, and the SETC has allocated US$43 million equivalent in loan and grant financing for the project. The SETC and provincial Economic and Trade Commissions have contributed over US$700,000 equivalent for project preparation. Project preparation has been well organized, and counterparts have completed a variety of complex tasks on time and efficiently. The SETC and EMCs have used international technical assistance effectively, and implementation of the EC grant is proceeding satisfactorily. Provincial Government support is strong and at a high level, especially in Shandong and Liaoning. 5. Value added of GEF and Bank support in this project: The different roles of the EC, GEF and IBRD financing, allowing first introduction and demonstration of the new energy performance contracting concept, followed by broader development and dissemination,  Page 11 are critical for the project as a whole. Bank leadership in introducing the new energy performance contracting concept has been and will continue to be very important. GEF support is essential for the implementation of the first phases of the project, focusing on the introduction, adaptation and demonstration of new concepts. For the EMC Demonstration Component, the lack of actual, on-the-ground experience with the energy performance contracting concept, requiring adaptation to Chinese legal, taxation, financial and institutional systems, is the major barrier that has arrested development of this concept in China so far. No commercial entity has proved willing or able to incur these upfront development costs. While the Government has expressed a strong commitment to the project, evident in its financial support, the Government also has been clear that it cannot sanction borrowing of IBRD or commercial bank funds for initial development and demonstration of the energy performance contracting concept, which is commercially unproven in China. GEF Project Development Fund (PDF) support has played a role in the necessary upfront technical assistance. The EC Grant has been critical, to allow some initial experience to be gained in implementation of a small number of pilot projects prior to GEF and IBRD project approval. GEF support, blended with Government counterpart financing, is critical for demonstration of the energy performance contracting concept in the three EMCs, development and adaptation of the new information dissemination methods and practices, and the institution building necessary to sustain these activities. Follow-up GEF support, through the proposed Phase II EMC Expansion, will also be necessary to overcome barriers to further EMC development throughout China. The IBRD loan also is an essential part of the package, as it provides much of the loan capital for the EMCs to develop and grow as commercial businesses. The loan will be onlent to the EMCs on commercial terms, and successful EMC growth under market conditions will provide the best demonstration of the concept's viability to domestic commercial banks. E: Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) 1. Economic (supported by Annex 4): [ ] Cost-Benefit Analysis: NPV=US$ million; ERR= % []Cost Effectiveness Analysis: [X] Other (Specify) Project justification and economic analysis are discussed in detail in Annex 4. The economic analysis for the demonstration phase of the EMCs, financed in part with EC and GEF grants, and the information component, were based on the global environmental incremental cost methodology of GEF. The incremental cost of the EMC component has been calculated as the difference between what would have been spent on industrial energy conservation in the three pilot provinces (the "baseline"), and the amount needed to overcome the barriers to the establishment of a market-based ESCO program in these provinces (the "GEF alternative"). The cost to GEF for direct carbon reduction under the EMC and information program components is about 40-60 US cents per ton of carbon, which compares very favorably to GEF investments in other countries. The EC and GEF pilot-phase investments are essential for commercial replicability of the EMC component, to be supported by IBRD and domestic commercial loans. No ESCOs have been developed in China, and commercial entities have been so far unwilling to undertake the risk to introduce and demonstrate the concept. Once the concept is developed and adapted to Chinese conditions, economic returns are projected to be high, which will promote replicability. The economic rate of return of the investments to be supported under the IBRD loan are estimated to be about 47 percent, shared between the EMCs and the host enterprises. Financial rates of return to the EMCs for  Page 12 the same investments are in the range of 20 to 25 percent. The present value of the total net economic benefits of the EMC Demonstration Component is estimated at about US$325 million. 2. Financial analysis: A discussion of financial issues and detailed analysis are presented in Annex 5. The Bank and PMO conducted a financial appraisal of the three EMCs, based on their I 0-year business plans. The EMCs are in many ways a unique type of business, combining aspects of an industrial enterprise with aspects of a bank or leasing company. In addition to needs to continually refine their business strategies to minimize risk and maximize profits, the EMCs must carefully control indebtedness, maintain a conservative debt- to-equity ratio, and keep strict control of accounts receivable. The Bank has obtained assurances in these areas. For all energy performance contract projects supported with EC, GEF or IBRD financing, host enterprises will be required to meet specified financial criteria (see Annex 3). In addition, further intensive technical assistance is being provided to the EMCs in corporate financial management for ESCOs under the EC Grant, and further follow-up will be undertaken under the Program Management and Monitoring Component. The project as a whole has a large positive fiscal impact, stemming from tax receipts (VAT, import duties, sales tax and EMC income tax) from the EMC businesses. 3. Technical analysis: Technical aspects of initial EMC energy performance contract projects are being reviewed by international consultants engaged by the Bank and PMO. EC-financed projects are being individually reviewed. GEF and IBRD-financed projects also will be individually reviewed until the Bank waives this prior review requirement for specified project lines in specified EMCs. Further details are presented in Annex 3. 4. Institutional: Institutional development is a core objective of this project, and the three demonstration EMCs and Energy Conservation Information Dissemination Center will be new institutions. Institutional arrangements and issues are described in Annex 3. 5. Social: The project entails no resettlement or land acquisition, and no social development issues. 6. Environmental assessment: (Category B) This project will result in substantial environmental improvements through increased energy efficiency. Negative environmental impacts are not expected. The EMCs will be involved in hundreds of small subprojects, which will be identified during project implementation. Few, if any, will involve any negative environmental or safety issues. These projects generally involve replacement of standard types of equipment (motors, fans, pumps, lamps) or addition of energy-saving devices. The Environmental Protection Bureaus of Beijing Municipality, Liaoning Province and Shandong Province have each evaluated the prospective project lines of the relevant EMCs, and formally endorsed and approved the business plans of the three EMCs for implementation. In addition, assurances were obtained from the EMCs at negotiations that they will identify any subprojects with potential negative environmental or safety impacts and, in such cases, provide the Bank with a plan for subproject implementation that will mitigate those impacts and confirmation of necessary government approvals.  Page 13 7. Participatory approach: The primary beneficiaries of the project-Chinese enterprises-have been closely involved in project development and initial implementation through the EC Grant, and will be critical partners throughout implementation. It is the nature of the business of EMCs to develop joint implementation arrangements for energy conservation projects with host enterprises. As core aspects of their business, the EMCs supported under the project have completed, and must continue, assessments of enterprise needs and demands, joint identification of investment opportunities, and negotiation of mutually beneficial implementation arrangements. Other key stakeholders include the variety of Chinese groups of which the country's energy conservation network is comprised, including agencies and public companies associated with the SETC and State Planning Commission at central, provincial and local levels; units associated with the China Energy Conservation Association; regional and local power companies; academic and research organizations; and local energy conservation technical service units. Representatives of these groups have been active as members or advisors to SETC's PMO and/or the provincial-level PMOs for this project, and the advice of these groups has been sought by the project leaders at central and provincial levels through a number of workshops and work conferences. The introduction of the EMC concept has attracted great interest in China's energy conservation community, and the combination of information dissemination and seeking of advice between the PMOs and the wider network begun during project preparation will continue with support under the Program Management and Monitoring Component. This project has generated interest in the international energy efficiency community as well. In addition to staff from the GEF and EC, the Bank and/or Chinese project teams have consulted with representatives of other multilateral institutions (e.g., UNDP, ADB and EBRD), a number of bilateral donor agencies, international research institutes and academic organizations, NGOs active in energy efficiency work, and a range of international ESCOs. These consultations have yielded useful advice for the project team, incorporated in the project design, and also helped spark interest in applying some of the concepts of this project in other countries. F: Sustainability and Risks 1. Sustainability: Project sustainability is enhanced by strong project ownership by the beneficiaries, and a focus on adaptation and revision of the new concepts by the counterparts to match Chinese circumstances. Domestic commercial bank financing for EMCs is important for sustainability after project implementation. Accordingly, the Provincial Governments have involved several domestic banks in project preparation activities, and conferences and workshops to introduce the initial results of the three demonstrations EMCs and energy performance contracting concepts to the domestic financial and banking community, once some experience has been gained, are included in the project. 2. Critical Risks (reflecting assumptions in the fourth column ofAnnex 1): This project involves high initial costs to develop and adapt the energy performance contracting concept to Chinese conditions, through a series of technical assistance, pilot demonstration, monitoring and evaluation and correction activities, begun during project preparation and accelerated during the first years of project implementation. Without separate, concessional EC and GEF financing of these costs, the proposed Bank loan would clearly be too risky and not financially prudent. Government agencies, taxation and legal authorities, the Chinese financial community, and potential client or host enterprises  Page 14 are unfamiliar with the concept. Some issues can (and are) being overcome through technical assistance in project preparation and implementation. However, initial, on-the-ground experience in energy performance contracting is required, including adaptation for different types of technologies, customer groups and contractual arrangements, as each involves significantly different issues. While there is little debate in China or abroad that the energy performnance contracting concept has great potential in China, no party has been willing to shoulder the high initial development costs. Once the initial barrier is overcome, the project is designed to capitalize and build upon the experience gained through (a) IBRD credit on commercial terms for replication of proven project packages in the three EMCs, and hence EMC growth, and (b) the Phase II EMC Expansion effort, to support the development of a variety of other types of EMCs, including joint-venture and private sector firms. Overall risks associated with the EC/GEF/SETC-financed EMC demonstration projects are rated medium. Risks of individual performance contract project failure include risks of technical failure, inability to enforce contracts, and lack of financial performance. These risks are being minimized by emphasis in project selection on (a) simple, proven technology, (b) projects where energy savings monitoring and verification are relatively simple, (c) projects with rapid payback periods, and (d) selection of host enterprises which are particularly keen and competent. The existing active involvement of the SETC and especially provincial Economic and Trade Commiissions also is critical during this trial period to coordinate adaptation to the existing legal, taxation and institutional management framework, and to assist in minimizing risks of contract defaults. Overall risks associated with the IBRD loan are rated moderate, as use of loan funds will be targeted towards technology/contract/consumer group packages which are proven to hold the greatest promise for growth. 3. Possible ControversialAspects: This project has a low controversial issues rating for all categories (social, ecological, pollution, governance). G: Main Loan Conditions 1. Effectiveness Conditions: No critical policy or institutional reforms have been sought. Execution of onlending and subgrant agreements for the EMC Demonstration Component satisfactory to the Bank are conditions of GEF Grant and IBRD loan effectiveness. 2. Other [classify according to covenant types used in the Legal Agreements.]: Assurances were obtained at negotiations in the GEF Grant, IBRD Loan and Project Agreements that the Grant Recipient, Loan Borrower and Project Beneficiaries will prepare mid-term project review reports, based on terms of reference satisfactory to the Bank, by August 31, 2000 and August 31, 2002, review them with the Bank by September 30, 2000 and September 30, 2002, and take necessary measures based on the report recommendations and the Bank's views. Assurances were obtained at negotiations in the GEF Grant and IBRD Loan Agreement that the Recipient will, through SETC:  Page 15 * enter into a performance contract satisfactory to the Bank with the Energy Conservation Information Dissemination Center by June 30, 1998, or a later date agreed with the Bank; * maintain the PMO, comprised of a project management unit and an EMC development unit, both with functions and resources acceptable to the Bank and competent staff in adequate numbers, to coordinate project implementation; and * ensure that ECIDC shall be maintained with qualified and experienced management and competent staff in adequate numbers, and that ECIDC shall implement a time-bound project implementation and staffing plan and long-term financial plan, both satisfactory to the Bank. Financial assurances obtained at negotiations in the EMC Project Agreements include assurances that each EMC will: * not incur any further indebtedness unless its net revenues exceed, and are projected to continue exceeding, its debt service obligations by at least 1.6 times; * adopt and maintain a conservative capital structure and dividend policy throughout the duration of the loan such that total long term debt will not exceed 60 percent of total capitalization (net equity + total debt); * undertaken all projects on acceptable commercial terms and ensure that the average collection period of all accounts receivable does not exceed 60 days; and * provide the Bank, by end-March of each year, with a rolling five-year financial plan containing the investment program, business plan and projected financial statements; and taking into account the Bank's comments implement the plan thereafter. Special subproject implementation assurances obtained at negotiations in the EMC Project Agreements include assurances that each EMC will: * identify six or more types of subprojects (product lines) and implement one or more pilot projects within each; * enter into energy performance contracts for these projects, which protect specified interests of the Bank, Borrower and EMCs, and which shall be on commercial terms and for subprojects that meet criteria acceptable to the Bank (as described further in Annex 3, Section A); * obtain Bank approval for all individual energy performance contracts to be financed with GEF or IBRD funds prior to execution, until and unless the PMO and Bank formally waive this prior review requirement for the relevant project line of the relevant EMC; and * identify any subprojects with potential negative environmental or safety impacts and, in such cases, provide the Bank with a plan for subproject implementation that will mitigate these impacts and confirmation of necessary government approvals. Execution of a performance contract between SETC and ECIDC satisfactory to the Bank will be a condition of disbursement of Part B (the information dissemination component) of the GEF grant. H. Readiness for Implementation [ ] The engineering design documents for the first year's activities are complete and ready for the start of project implementation. [x] Not applicable. [ ] The procurement documents for the first year's activities are complete and ready for the start of project implementation. [x] The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality.  Page 16 I. Compliance with Bank Policies [x] This project complies with all applicable Bank policies. [signature] .. R fE Task Team Leader/Task Manager: Robert P. Taylor .;- ..- --_ [signature] Sector Manager/Director: Yoshihiko Sumi rsignlattu Country Manager/Director: Yukon Huang  Page 17 ANNEX 1 ANNEX 1: PROJECT DESIGN SUMMARY Narrative Summary Key Performance Indicators /a Monitoring and Supervision Critical Assumptions and Risks (a) CAS Objective (CAS and GEF Objectives to Alleviate infrastructure con- See below See below Bank Mission) straints; safeguard the environ- Increases in energy efficiency ment provide increases in energy (b) GEF Operational services without negative Program Goal: OP#5 environmental impact. Project Development and (Development and Global Global Objectives Objectives to CAS Objective) Achieve large, sustained and Quantified energy savings per Biannual project summaries Energy efficiency gains are growing increases in energy year, and associated CO2 prepared by the PMO integrat- sustained and grow from (a) efficiency, and associated emissions reduction resulting ing and summarizing data proliferation of energy per- carbon dioxide emission reduc- from the project. described below. formance contracting concept, tions with (a) new project and (b) sustained operation of financing concepts and market- instituting developed under the oriented institutions; and (b) project (three EMCs, national improved access to information information center). on successful, financially attractive energy efficiency experiences. (Outputs to Development and Project Outputs Global Objectives) * Development, demonstration * Quantified energy savings * Project implementation and EC/GEF/SETC financing of and growth of energy and CO2 reduction from energy savings data in initial development costs is performance contracting in projects of three EMCs. project reports from three required. Without this finan- three demonstration EMCs. EMCs. cing, IBRD loan risks are unacceptably high (see PCD text for details). * Proliferation of energy * Listing of firms engaged in * Results of monitoring survey performance contracting to a energy performance continu- of SETC on energy perform- variety of companies in ity in China and estimated ance contracting in China at China. energy savings and CO2 large. reductions from their activities. * Increased adoption of key * Energy savings and CO2 * performance reports of infor- energy efficiency measures reductions from energy effi- mation center, required in due to improved access to ciency measures of enter- performance contract with high quality, financially prises verified to be a result SETC, following methodol- relevant information. of specific information ogy used in the United discussed by the energy Kingdom. efficiency information center supported by the project. Project Components * EMC Demonstration Standard project Project progress and See above. * Information Dissemination implementation indicators. supervision reports. * Technical Assistance L/ See section below.  Page 18 ANNEX I Key Performance Indicators and Monitoring Methods The key indicators of success in achieving project development objects are the energy savings achieved per year and associated reductions in the growth of carbon dioxide emissions. Performance indicators for the core EMC Demonstration Component, which accounts for 92 percent of the project investment by GEF and IBRD, are provided below. These performance indicators include only a portion of the direct energy savings expected from the investments of the three demonstration EMCs. (Total direct energy savings from the three EMCs are estimated at 45 million tons of coal equivalent, and associated total carbon dioxide emissions reduction is estimated at 34 million tons carbon.) The indicators include only savings achieved during the project implementation period, whereas large additional savings are expected after the project is completed from continued savings from investments undertaken during the project implementation period. Furthermore, the performance indicators are somewhat more conservative than the energy savings estimates corresponding with the business plans of the three EMCs, incorporating greater risk of implementation difficulties than the company targets. Energy savings figures include savings resulting from EC-supported pilot projects. Performance Indicators for Energy Savings and Reduction of Carbon Dioxide Emissions from Direct Investments of the EMCs Calendar Years Total 1998 1999 2000 2001 2002 2003 2004 2005 2006 Period Energy savings 0.04 0.2 0.5 0.8 1.3 1.7 2.1 2.8 3.6 13.0 (million tce) Carbon reduction 0.03 0.1 0.3 0.5 0.9 1.2 1.5 1.9 2.5 9.2 (million t) Total actual energy savings and associated carbon dioxide emissions reductions achieved from all subprojects will be reported by each EMC in their annual project reports (as well as more frequent project updates, as and when required). Actual energy savings for each of the energy performance contracts of the EMCs are relatively easy to monitor during the implementation of the energy performance contracts, as measurement or confirmation of stipulated energy savings are key aspects of these contracts. To assess energy savings from projects after contract periods are over, the EMCs will complete sample surveys of sufficient size and using internationally accepted scientific sampling and statistical methods to ensure the reliability of results. Final annual energy savings and associated carbon dioxide reduction indicators for the information dissemination component will be included in the performance contract between SETC and ECIDC, to be completed by June 30, 1998, following completion of ECUDC's detailed project implementation plan. Energy savings eventually resulting from this component may total 24 million tce, and associated carbon dioxide emissions reductions may total 18 million tons carbon, but as in the case of the EMC Demonstration Component, only a portion will be achieved during the project implementation period. Estimation of energy savings actually achieved in this case is complicated and difficult, but the necessary survey work is also required for ECIDC to continually monitor and adjust its marketing methods. Monitoring will need to involve at least three components: (a) compilation of data on the number of types of energy conservation investments promoted and the typical energy savings which may be achieved, largely from the number of successful case studies and technical guides prepared each year;  Page 19 ANNEX I (b) data on the number of enterprise managers contacted directly and indirectly, and the number of enterprise managers that have actually reviewed the specific information provided; and (c) the number of enterprise contacts that have resulted in implementation of the energy conservation measures being promoted. It also may be useful to survey the recorded sales of the energy efficiency technology being marketed by ECIDC as another source of information. Even though specific performance indicators are not necessary, measures of the success being achieved by the EMC Development Unit also should be monitored and reported at least biannually, and should include : (a) data on the detailed activities of the unit, including requests for assistance received and acted upon, contacts made, marketing activities conducted, etc., and (b) data on the number of enterprises utilizing energy performance contracting in China, the scale of the investment portfolio of these enterprises, and estimates of the energy savings being achieved by these firms. For each of the three EMCs, additional financial project implementation performance indicators includes: (a) maintenance of accounts receivable of 60 days or less in each year of project implementation, and (b) achievement of a return on assets of at least 6 percent in 1999, and 9 percent in 2002 and 2006.  Page 20 ANNEX 2 ANNEX 2: ENERGY CONSERVATION IN CHINA: MAKING THE TRANSITION TO THE MARKET ENERGY CONSUMPTION-INTENSITY In 1990, China's economy was among the most energy-intensive in the world, registering an energy use per unit of GDP level some 3-10 times that of major developed countries. One of the reasons for China's high energy intensity is that industry comprises about 44 percent of China's GDP (1993), a share much higher than that of other low-income countries and even higher than Japan. This drives up energy intensity because industry is far more energy-intensive than the other major sectors. Chinese industry has also been dominated by the production of basic, intermediate industrial goods, and generally low levels of product quality or specialization, while out-of-date, energy ineiFficient technology remains pervasive throughout Chinese industry. China's commercial energy intensity per unit GDP fell by over 30 percent between 1980 and 1990-a remarkable achieve by internationai standards. The elasticity of growth in commercial energy use relative to GDP growth was just 0.5 percent. Among the largest energy-intensive industries, the most impressive gains were made in the steel industry, where unit energy consumption fell by over 20 percent between 1980 and 1990. One of the factors behind the drop in industrial energy intensity since 1980 has been the increasing share of relatively less energy-intensive subsectors, such as machinery and electronics industries, and declining roles of the energy-intensive metallurgy and chemical fertilizer industries. Even more important has been a shift in the mix of products produced within industrial subsectors (e.g., within the chemical industry itself), and this trend is expected to continue. In the textile and garment industry, for example, a substantial growth in value-added is not expected to come from huge increases in square yards of cloth or numbers of shirts produced, but more from increases in product value, in terms of quality and fashion. Declines in energy use per unit of output value due to this trend will be especially important in the chemical, machinery, building materials and light industry sectors, which together accounted for over 60 percent of industrial final energy use in 1990. Although structural effects may have the greatest impact on the energy intensity of China's economy, technical efficiency levels-energy consumption per physical unit of output-can be more directly influenced by national and local policies. Unlike many other GHG reduction options, emissions reductions from technical energy efficiency improvements can be realized almost inmnediately. Because Chinese industry will undergo dramatic transformation as a result of economic growth, the opportunities for energy efficiency gains are greatest between now and the year 2010. ENERGY CONSERVATION POTENTIAL There is tremendous scope in China for further improvement in the technical efficiency of energy use (e.g., the efficiency of energy use per physical unit of output). By far the largest potential for technical efficiency improvement in China is in the industrial sector, where potential energy savings between now and 2020 are more than 500 million tons of coal equivalent (Mtce) per year, or more than half of China's current annual energy consumption. Among the industrial energy conservation projects which have been identified as having great potential in China include: waste heat, gas, and resource recovery;  Page 21 ANNEX 2 cogeneration; adoption of more electric-motor drive systems; furnace and kiln renovation; improvements in industrial boiler efficiency; improved energy management systems; and insulation and thermal/steam system renovation. A second area of energy conservation potential is in commercial and residential buildings, for lighting, water heating, and space heating and cooling. At least 100 Mtce can be saved over the next 20 years through energy conservation investments in buildings, where a large amount of new construction will take place. CHINA'S ENERGY CONSERVATION PROGRAM China's energy conservation system is among the most extensive in the world. During the 1980s, China successfully developed a comprehensive energy conservation program, including major policy directives, procedures, regulations, technical assistance programs, and project financing initiatives. Compared to programs in other developing countries, China's program is especially strong in its comprehensive coverage of enterprises, monitoring of consumption practices, promotion of awareness of energy efficiency goals among enterprise managers, and domestic technical information dissemination. Built largely around the planned economy, the system developed during the 1980s emphasizes administrative measures to prod enterprises to improve energy efficiency. A drawback with planned economy measures is that they are not automatic or built into the economic system. Administration is usual difficult and complicated. The pressure applied to enterprises is greatly uneven, and for reasons that are arbitrary from an economic point-of-view. In addition, the planned economy system encourages mediocrity, rather than promotion of optimal efficiency levels, as performance evaluation tends to be referenced against domestic averages. The institutional framework for energy conservation in China includes a number of specialized energy conservation units at national, provincial and county/municipal levels, operating under the State Economic and Trade Commission (SETC), and provincial and local Economic Committees. National plans and capital construction projects to improve energy efficiency are undertaken by the State Planning Commission (SPC) and its affiliates at provincial and local levels. The China Energy Conservation Investment Corporation handles much of the capital construction project investment, with the general guidance of SPC. The system was quite effective under the centrally planned economic system, taking advantage of the well-established framework of industrial enterprise energy input quotas and government investment funding mechanisms for investment in state-owned enterprises. Central and provincial electricity administrations coordinate conservation work at the local level through the Offices of Electricity Allocation, Conservation, and Safety. A number of provinces have established energy conservation service centers to provide enterprises with technical advice and training. Most of these centers have concentrated on measurement and monitoring of energy use, especially to check compliance with energy consumption quotas and standards. With the ongoing conversion of China's economic system to a market economy, the system for promoting energy conservation must be transformed to operate more effectively in a market economy. Many of the administrative measures which have been relied on in the past cannot be expected to work effectively or efficiently in a more market-oriented future. Nonetheless, much of the energy conservation promotion system built up through the 1980s can serve China well in the future; the institutional network, and its increasing capacity to execute serious energy conservation initiatives on a comprehensive scale, provide a critical advantage. A broad set of reforms are underway in China providing state-owned enterprises with autonomy and full accountability for profits and losses, with new fiscal and tax provisions enforcing budget constraints and accelerating corporatization. Efforts to promote energy efficiency must now be built primarily on the self-interest of enterprises, as a means to  Page 22 ANNEX 2 increase enterprise profits and/or to meet environmental regullations. New and different financing approaches and mechanisms are also needed. BARRIERS TO ENERGY CONSERVATION IN CHINA'S TRANSITIONAL ECONOMY There are a wide variety of constraints impeding implementation of attractive energy conservation projects in China. Some constraints to energy conservation projects are because of the current transition from a planned to a market economy, while others are common in (leveloped market economies as well: * Weak Cost-consciousness. "Classic" energy conservation projects involve upfront investments- to reduce future energy operating costs. Enterprise enthusiasm for such investments require strong desire by enterprise management to control operating costs as a means to increase enterprise profits. While the profit motive and market competition are rapidly increasing cost-consciousness in Chinese enterprises, it takes time for management methods and attitudes to change. * Demand for Short Payback Periods. People with experience in the promotion of "classic" energy conservation projects know that these investments are alrnost always assessed by enterprise managers or potential investors in terms of their payback period, rather than their life-cycle rate of return. Conservation investments with payback periods of more than five years are rarely undertaken by enterprises or investors, unless there are other pressures. - Risk and Uncertainty. Use of payback period calculations are usually associated with risk and uncertainty. Whereas investments in output expansion involve physical, easily perceived benefits, the benefits from energy-saving investments are future cost savings calculated by analysts. In China, a bias against cutting operating costs has been exacerbated by a management culture attuned to maximizing physical output and achieving-or surpassing-output quotas. Another category of risk is market and technical risk stemming from the current rapid change in China's economy. The increasing role of competition and the market is driving a major economic restructuring, and associated volatility in the profitability of different sectors and product lines. In China today, flexibility to respond to rapid market changes is critical. Long payback periods mean funds are tied up. Not only may future opportunities for high-return profits be foregone, but market changes may render renovated production lines, although more energy-efficient, less profitable or unprofitable as a whole. * Lack of Adequate Information. Often, viable energy conservation investments may not be undertaken because enterprise managers have limited knowledge of these opportunities. Particularly lacking is practical information on actual enterprise experiences with different technical measures, and the details of the actual cost savings and increased profits. * Low Financial Significance and Transaction Costs. Even if rates of return are high, and payback periods are considered acceptable, many energy conservation projects may not be considered priority investments by enterprises because net benefits are not large relative to the size of the enterprise. The time and effort of staff to gather information, design projects, undertake the relevant analysis, and implement the projects may not be worthwhile. In other words, there may be a number of additional, hidden costs involved in project preparation and implementation, especially for highly valued staff, which reduces the project's attractiveness. * Lack of Financing. For some energy conservation projects, enterprises lack adequate funds for investment. A more common financing problem is that domestic banks do not wish to lend for energy conservation projects as they do not directly result in increased production.  Page 23 ANNEX 2 WHAT IS ENERGY PERFORMANCE CONTRACTING? Energy performance contracting is a means to pay the entire cost of an energy conservation project out of reduced energy expenditures. The energy savings that result from the energy efficiency investment are used to finance the project. Such a mechanism allows customers to use future energy savings to upgrade plant and equipment and to cut operating costs now. Energy performance contracts, signed between enterprises undertaking energy efficiency investments (the "host" enterprise, or the "customer") and specialized profit-seeking energy management companies, can help promote energy efficiency projects. Under other, traditional arrangements, all of the risk and all of the benefits of energy efficiency projects lie with the enterprise undertaking the investment. Consequently, many promising energy efficiency investments have yet to be implemented. There are several steps in the identification and implementation of energy performance contracts by energy management companies (EMCs): * Identification and Selection. A company (usually the EMC) does an assessment of the customers' opportunities for cost-effective energy efficiency measures. The current energy use of the customer may be measured, along with the anticipated savings from various energy efficiency improvements. Typically the EMC or their contractor design the efficiency improvements. * Financing and Payments. The EMC uses their capital (or that of a third party, such as a commercial bank or equipment supplier) to finance the capital investment. The customer and the EMC negotiate a deal to allocate cost and savings from energy conservation investments over a period of time. The EMC and the customer share the energy savings on a agreed split. The usual energy performance contract provides the EMC with most of the savings during the early years of the contract to repay the capital investment, while the customer's share of the savings rises in later years. Payment is made by the customer to the EMC based upon an agreed schedule. In some countries, the EMC may take over payment of the energy bills for the term of the agreement in return for a fixed payment from the enterprise. The enterprises' payments for energy use and a portion of the conservation investment should be equal to or less than previous energy bills; the energy savings are thus used to finance the capital investment. * EMC structure. EMCs can take many forms. Some have evolved from engineering companies into energy management firms providing energy efficiency services. Others have evolved from energy management equipment manufacturers seeking greater markets for their products. In the past 10 years in the United States, EMCs associated with electric power companies have flourished. Power companies have formed subsidiary units to provide energy efficiency services to their customers initially and then to others. Other power companies have hired independent EMCs to provide energy efficiency services to their customers. A recent trend has been power companies acquiring EMCs to provide services to their customers and those of other power companies. Producers of high energy efficiency equipment also have a clear commercial incentive to establish EMCs. HOW CAN ENERGY PERFORMANCE CONTRACTING HELP OVERCOME BARRIERS TO ENERGY CONSERVATION IN CHINA? The objective of "energy performance contracting" in China is to accelerate energy conservation and efficiency investments by removing two major barriers: (1) inadequate financial incentives, and (2) a lack of capital for project financing. While high transactions costs and "insignificance" are major barriers to many energy efficiency investments in China, they reflect enormous market potential for energy performance contracting. Much  Page 24 ANNEX 2 of the potential for energy savings in China is through implementation of large numbers of individually small projects. High transaction costs to individual enterprises are also a barrier to undertaking energy efficiency investments. Energy efficiency projects often carry high costs (particularly high opportunity costs of key skilled enterprise personnel) for obtaining and checking information, planning and design, arranging financing, implementation scheduling, monitoring initial performance and implementing necessary adjustments. EMCs can reduce the high transactions costs to individual enterprises by undertaking the relatively small energy conservation investmenjts and providing a low-risk guarantee to host enterprises. Energy performance contracting can help overcome financing problems and allow host enterprises to undertake energy conservation investments with little or no investment of their own. And, because these are not loans to the host enterprise, and payments to the EMCs are typically paid from reductions in operating costs, no debt for the investment is carried on the books of the host enterprise.  Page 25 ANNEX 3 ANNEX 3: PROJECT DESCRIPTION AND COSTS A. EMC DEMONSTRATION COMPONENT Concept and Activities Under the Energy Management Company (EMC) Demonstration Component, energy performance contracting will be introduced and developed in China through the establishment, development, operation and expansion of three EMCs, in Liaoning Province, Shandong Province, and Beijing Municipality.) Including technical assistance during project preparation, the component involves four phases: (a) training and technical assistance on energy performance contracting concepts, establishment of the EMCs, and initial project preparation (GEF PDF-financed, 1996-97); (b) intensive training and technical assistance on EMC operations and implementation of the first pilot projects by the EMCs (EC- financed, 1997-98); (c) implementation of a wide variety of demonstration projects (GEF/counterpart fund-financed, 1998-2000); and (d) EMC growth, through replication of successful demonstration projects (IBRD/counterpart fund-financed, 1998-2003). Initial project preparation activities. Following introduction by international advisors of basic energy performance contracting concepts and a competitive process undertaken by SETC to select provinces to participate in the project, Liaoning, Shandong and Beijing EMCs were first established in April 1996. Subsequent major activities included (a) an assessment of international experiences in energy performance contracting by the PMO and three EMCs; (b) preparation of first-draft EMC business plans, including project development and scheduling, and corporate finance, with substantial international expert assistance; and (c) initial training in project design, verification of energy savings and development of contract models appropriate for Chinese conditions, through preparation of initial energy performance contracting pilot projects with international advisors. EC Grant. Approved by the European Commission in December 1996 and made effective in June 1997, an EC grant of ECU 4 million (about US$4.5 million) is providing funding support to begin initial EMC operations prior to GEF grant and IBRD loan approval and effectiveness. An average of US$ 1.1 million is being provided to each EMC to support some 8-12 energy performance contracting pilot projects each, and to sum up experiences. The pilot projects are being approved in three phases during 1997 and early 1998, with staggered implementation through 1997 and 1998. As the first energy performance contracting projects in China, each project is being reviewed by the PMO and Bank team together with the EMCs, and revised if necessary, prior to approval. By January 1998, the first phase of projects were under implementation with initial favorable results. Technical assistance and training during the last half of 1997 and early 1998 supported by the grant include: (a) development of customized training materials, curriculum and course delivery of a major two-part course for EMC project managers on the technical and commercial aspects of energy performance contracting; (b) technical assistance on EMC financial management and development of relevant procedures and MIS; (c) education of government policy officials and provincial government staff on energy performance contracting; (d) engagement of short- term international and domestic advisors for the PMO and EMCs on selected topics; and (e) evaluation of project progress by late 1998 by an independent, third party. l Energy performance contracting is described in Annex 2.  Page 26 ANNEX 3 GEF Pilot Projects. Each EMC has identified 6-10 potential "project lines" for their energy performance contracting businesses in the coming years. Under the EC Grant, a few pilot projects within several of the project lines will be implemented by each. Subsequent GEF financing averaging about US$5 million for each EMC would support implementation of pilot projects among all of the project lines. Moreover, several pilot projects will be developed within each project line, with substantial adjustments in the energy performance contracting mechanism to meet the requirements of different types of enterprises and to adapt different variations in savings verification or contractual arrangements. EC and GEF pilot project implementation will be undertaken over a four-year period, enabling the EMCs to develop project lines gradually, as company capabilities and expertise allow, and with sufficient flexibility to try new concepts, savings verification arrangements and contractual terms, based on the experiences previously gained. Project Replication and EMC Growth. The proposed IBRD, domestic counterpart loans, reinvested profits, and, increasingly, domestic commercial loans arranged by the EMCs will provide the capital for replication of successful pilot projects on a large scale and EMC ,growth. EMC business success will require translation of the successful experiences, expertise and market credibility gained from the pilot projects in a given project line into the development of a "mass production" project line, using tested project designs, savings verification and contractual arrangements for large numbers of projects, with declining transaction costs and risks to the EMC. Implementation of "replication" projects using loan capital within successful project lines developed in 1997 and 1998 will overlap with implementation of pilot projects in other, newer project lines during the initial years of project implementation. EMC Investments and Financing. Annex 5 provides an assessment of the investment plan, financing plan and financial position and projects of the three EMCs. EMC Institutional and Legal Structure The three EMCs are for-profit limited liability shareholding companies, established and registered in 1996 according to China's Company Law. Following a prevailing model in modern China, the company shareholders are public entities or publicly owned corporations, but the EMC are autonomous from the government, with independent accounting, independent management, and sole responsibility for their profits and losses. Company management reports to a Board of Directors, representing the company shareholders. The official names and shareholders of the EMCs are: C Liaoning Province Energy Conservation Technology Development Company, Ltd. Registered capital at inception totaled 20 million yuan, with shareholders including Liaoning Provincial Electric Power Development Company (50 percent), Fushun Aluminum Factory (25 percent), Liaoning Xinda Industry Development Company (10 percent), Liaoning Province Energy Conservation Center (5 percent), Liaoning Province Magnesium Resource Protection Office (5 percent), Shenyang Yukai Science and Technology Development Co. (5 percent). * Shandong Energy Conservation Engineering Company, Ltd. Registered capital at inception totaled 34.4 million yuan, with shareholders including Shandong Energy Conservation Technology and Service Company (wholly owned by the Shandong Provincial Economic and Trade Commission) (58 percent), Shandong Energy Savings and Technical Service Center (24 percent), Shandong Shengli Stock Corporation (15 percent), and Sanlian Group Corporation (3 percent). The EMC Board of Directors also would like to accept new shareholders, perhaps expanding the registered capital to a total of more 60 million yuan by the end of 1999, with the new shareholders, provisionally including Shengli Oil Administration Bureau, Shandong Provincial Electric Power Company and Shandong Yanzhou Coal Administration, each providing about 10 million yuan. With the addition of these  Page 27 ANNEX 3 shareholders, the largest shareholder's share (Shandong Energy Conservation Technology and Service Co.) will fall to under 50 percent. Beijing Yuanshen Energy Saving Technology Company, Ltd. Registered capital at inception totaled 20 million yuan, with shareholders including Beijing Energy Investment Company (affiliated with the North China Power Group, 75 percent), Beijing Energy Savings Monitoring Center (15 percent), and Beijing Energy Savings Technical Service Center (10 percent). The energy efficient lighting projects of the EMC are being implemented in association with Beijing Sanyuan Green Lighting Technology Development Co., in which Beijing Yuanshen Energy Saving Technology Company holds a controlling share of 60 percent of that company's registered capital of 500,000 yuan. Electric power utilities are the dominant shareholders in the Liaoning and Beijing EMCs, and a power company is expected to become a minority shareholder in the Shandong EMC in 1998. Provincial Energy Conservation Centers, established in the 1980s and supervised by the State and Provincial Economic and Trade Commissions, are small shareholders in each EMC, and a significant number of the technical staff in the EMCs has transferred from these Centers. While there are some variations in internal organization, a strong financial management department and one or several strong operational departments are common features in each EMC. As of Fall 1997, core staff in each EMC included about 8-10 professionals, plus a number of contracted advisors and senior technicians. Each EMC has established recruitment plans, criteria and procedures for steady increases in staff as the number of projects undertaken by the companies increase. Training of new EMC project managers is a high priority, and hence substantial investments are being made under the EC Grant to develop an in-depth, practical training course which can be delivered biannually for project managers. Development and installation of a financial management, reporting and billing system to meet the special needs of the EMCs also is a high priority, and will be supported with EC and GEF financing. EMC Project Lines Each EMC has planned its business to include a series of project lines, as illustrated in Table 1. These business plans will change as experience is gained and market opportunities develop or contract-the business plans presented should be revised in a flexible manner at least annually as project implementation proceeds. After the initial startup and phased growth, each EMC is expected to eventually develop and implement 80-100 new projects per year. The average project investment cost during the initial years is about 1.6 million yuan (about US$200,000), rising to about 2.6 million yuan (about US$3 10,000) in the later years. Each of the three EMCs has developed their project lines in accordance with the conditions in their provinces and their particular staff expertise, but as the three have exchanged ideas, there has been considerable cross-fertilization. Compared to ESCOs in Canada and the USA, the Chinese EMCs are adapting energy performance contracting with a greater focus on industrial applications, and have developed a number of project concepts which have big market potential in China today but would not have a significant market in the West. Each of the project lines is being reviewed as the EMCs prepare the relevant initial demonstration projects for PMO and Bank review and approval. As a result, project lines with demonstration projects financed by the EC or proposed for funding during the first year of GEF fund disbursement had been more thoroughly reviewed by the time of project appraisal, while other project concepts will be more fully reviewed during project implementation. All three of the EMCs are developing early project lines for installation of energy efficient lighting in commercial and public buildings, installation of more energy efficient electric motor systems, and renovation of small and  Page 28 ANNEX 3 TABLE 1: PLANNED PROJECT LINES OF THE THREE EMCs, OCTOBER 1997 Number of Projects Investment (Million Yuan) 1997-99 2000-06 Total 1997-99 2000-06 Total Liaoning EMC Electric furnace renovations 33 113 146 88 387 475 Efficient electric motor drives 15 131 146 42 457 499 Boiler renovations 29 140 169 24 144 168 Efficient electric lighting 20 87 107 9 55 64 Steam & air hammer replacement 5 72 77 12 227 239 Waste heat recovery 1 54 55 3 246 249 Other 0 38 38 0 424 424 Total 103 635 738 178 1,940 2,118 Shandong EMC Commercial building lighting & pumps 15 13 28 16 17 33 Autoclave insulation 11 68 79 25 205 230 Steam & air hammer replacement 12 6 18 9 4 13 Efficient electric motor drives 24 144 168 55 421 476 Boiler renovations 25 62 87 11 31 42 Electric arc furnace renovations 4 9 13 9 23 32 Waste heat recovery 4 82 86 7 187 194 Waste heat power generation 4 70 74 16 345 361 Glass furnace insulation 4 69 73 18 420 438 Improved cement grinding 4 41 45 11 151 162 Total 107 564 671 177 1,804 1,981 Beijing EMC Efficient lighting in chicken farms 7 142 149 5 133 138 Efficient commercial lighting 17 280 297 9 165 174 Boiler renovations 9 189 198 4 103 107 Steam & air hammer replacement 10 49 59 8 50 58 Condensed water recovery 25 347 372 38 681 719 Power transformer renovation 4 83 87 9 255 264 Efficient electric motor drives 6 90 96 6 121 127 District heating renovation 5 52 57 37 496 533 Others 9 97 106 24 341 365 Total 92 1,329 1,421 140 2,345 2,485 medium-size coal-fired boilers (primarily installation of one of a number of coal sorting devices developed in China for installation in fuel feed systems). Current individual company business plan characteristics are: * Liaoning EMC. Based on the special expertise and industrial relationships of company staff, this EMC is developing a strong initial business in electric arc furnace renovation work. Electric motor projects also is an area of major emphasis at this stage, complimented by a range of smaller boiler renovation and electric lighting projects. * Shandong EMC. Electric motor projects are an area of particular emphasis in Shandong. The company also has developed a line of projects to install improved insulation on industrial autoclaves. In addition to early implementation of smaller lighting projects, Shandong EMC also would like to  Page 29 ANNEX 3 initiate a somewhat wider range of project lines during the first few years than the other EMCs, especially in waste heat recovery and installation of improved insulation for glass furnaces. Beijing EMC. Beijing EMC has placed greater emphasis on lighting projects than the others, developing projects in chicken farms, hotels, shopping centers and the subway. In addition to some initial development of boiler projects and investments to replace air and steam hammers with more efficient electrically powered industrial hammers, the EMC is also developing innovative project lines for recovery of condensed water (and its latent heat) in industry and for renovation of medium- size district heating blocks. The capabilities of the three EMCs to assess the market for business opportunities and adjust plans based on actual conditions, where necessary, has greatly increased over 1997, especially with the beginning of project implementation with EC support. Host enterprises for EMC projects include a variety of types of enterprises, and not only state-owned enterprises. Project and Host Enterprise Selection Criteria. To be eligible for EC, GEF or IBRD financing, projects must (a) be energy conservation investments (e.g., more than 50 percent of total project benefits accruing to the EMC must be derived from savings in host enterprise energy costs); (b) yield an estimated net financial rate of return to the EMC of at least 15 percent per year; (c) employ the energy performance contracting mechanism; and (d) be undertaken in stable and financially sound host enterprises, as described further below. In addition, for projects to be eligible for EC or GEF financing, each project must have distinct demonstration value: each project should demonstrate application of the energy performance contracting mechanism in a new product line or technological application, in a different type of host enterprise, or with a different type of savings verification or contracting arrangement. Especially during the early years, EMCs should continue to select technical applications with minimal technical risk, relatively simple installation and implementation requirements, relatively simple energy savings verification requirements, high local replication potential, and quick financial payback periods. Although host enterprise financial requirements are different for energy performance contracting than for appraisal of loans, as payments to EMCs are treated as operating costs and not loan repayments, EMCs must still ensure that the enterprises hosting energy performance contracting projects are stable and financially sound. During at least the last year, host enterprises must have (a) shown a net profit, (b) maintained a debt to total assets ratio of less than 70 percent, and (c) show a credit rating of AAA or AA, or equivalent. In addition, EMCs should ensure that host enterprises have (a) sufficient liquidity to make payments on time, (b) demonstrated stable production and market conditions, (c) sound company management, (d) clear and stable company ownership, and (e) sufficient company size (assets). The above criteria were agreed by the Bank, SETC and the three EMCs at project appraisal and negotiations, and denote the commercial terms and subproject criteria acceptable to the Bank referred to in the Project Agreement. Project Approval Requirements PMO and Bank approval of all energy performance contracting projects of the EMCs will be required prior to implementation unless and until this approval right is formally waved for specific project lines. Project feasibility reports and draft contracts will be submitted to the Bank through the PMO. The PMO and the Bank will place special emphasis on review of the technical and economic aspects of new project lines when projects in a new project line are first proposed. Once a sufficient number of pilot projects  Page 30 ANNEX 3 have been implemented to demonstrate the technical and commercial viability of a specific project line in a specific EMC, the Bank and PMO may formally wave prior approval requirements for IBRD-supported projects for that project line for the duration of the project, although a revocation right will be retained. Table 2: EMC Demonstration Component Cost and Financing Current US$ million EC grant La 4.5 GEF project grant -15.0 Domestic loans, through SETC 30.9/b IBRD loan 63.0 EMC internal sources 23.4 Total 136.8 /a Effective June 1997. /b 300 million yuan, valued at US$36 million at the 1997 exchange rate, and US$30.9 million in current terms. B. INFORMATION DISSEMINATION COMPONENT Concept and Outputs This component will support the development of a new system to develop and provide practical information on energy conservation project results to Chinese enterprise managers. The system will be operated by the new Energy Conservation Information Dissemination Center (ECIDC), functioning under a performance contract with SETC, established on January 9, 1998. ECIDC will oversee the development of new information products, patterned after highly successful models in developed market economies, and the dissemination of these materials primarily through channels already existing in China. The new products, and function and operating framework of the Center, are to some extent patterned after the Energy Efficiency Demonstration Scheme (EED'S) and the Best Practice Program of the Government of the United Kingdom, but with major adaptations to Chinese conditions. This component includes US$10 million of support for the initial five years of the program. SETC grant financing of US$5 million will support the core costs of ECIDC, and a core level of product development and dissemination. GEF grant financing of US$5 million will support training and institutional capacity building, a portion of product development and dissemination, especially during the early, trial years, and program evaluation and monitoring. The new information products are being designed to better meet the needs of enterprise managers operating in the market economy. While there currently is a wide range of publications and newsletters in China on energy conservation measures, the information focuses virtually exclusively on technical aspects, and is geared primarily to an audience of enterprise, research institute or industrial bureau engineers responsible for energy conservation work. Production and dissemination of these technical materials is typically not very systematic, and is both geographically and institutionally highly fragmented. In contrast, the new information products will be geared towards a wider audience and especially industrial enterprise managerial and senior engineering staff responsible for investment decisions. All materials will be based on verifiable information from actual projects undertaken in  Page 31 ANNEX 3 Chinese enterprises. Particularly strong emphasis will be given to financial results actually achieved by enterprises (and the factors underlying these results), problems and solutions during implementation, any impacts on main enterprise production or other key risks, and contact information on enterprises with relevant experience. All materials will be presented in a standard, easily recognized, professional format, with the authoritative endorsement of ECIDC backed by SETC, and disseminated nationwide in a systematic fashion. The two key new products include: * Case Studies. A case study will provide independent, authoritative information on specific energy efficiency measures with high replication potential, implemented by specific industrial enterprises. The implementation of a measure at a host enterprise will be observed by an independent monitoring contractor appointed by ECIDC. Measurements and surveys will be taken before, during and after the measure is implemented. The case study documents will typically be about 4 pages, including pictures, drawings and graphs, and focusing on costs, financial results, impacts on meeting energy use or environmental regulations (if relevant), before-and-after analysis, implementation and operational experience, "tips" for others, and contact information. About 100 case studies will be completed under the project, beginning with about 10 during the first year and increasing to about 25 per year during the fourth and fifth year. - Technical Guides. The technical guides will provide enterprise senior technical and energy managers with authoritative information on a range of energy savings options within a given technical category (e.g., electricity savings in electric pump applications, or energy management systems in the cement industry). The guides will complement the case studies, which feature one measure each. They will be prepared by recognized experts on contract with ECIDC. Each guide will typically include (a) process description and energy saving opportunities; (b) technical description and advantages and disadvantages of key energy saving options; (c) possible nonenergy benefits; (d) considerations in equipment selection; (e) implementation and operational experience in various enterprises, and how to avoid common pitfalls; (f) costs, financial benefits and financial risks, base on case histories; (g) decision trees detailing circumstances in which different technologies or techniques should be used; and (h) sources and contacts for further information. It is planned to complete about 17 technical guides under the project. Dissemination will be a key activity of ECIDC. Based on the proposed performance contract, ECIDC will ultimately be judged not on how many case studies or technical guides it produces, nor the quality of these materials, but on how many industrial enterprises actually use the information to implement projects. Thus ECIDC must disseminate material of sufficient impact and content, and in an appropriate manner, to result in increased investment in energy conservation measures by enterprise decisionmakers. In addition to distribution of the case studies and technical guides, ECIDC plans to (a) produce short newsletters; (b) conduct workshops, site visits and seminars; (c) publish articles in a variety of relevant journals describing its case studies and guides; (d) operate a database of information program outputs and, possibly, equipment suppliers; and (e) operate an Inquiries Bureau. As vehicles and partners in conducting direct mailings, workshops, site visits, and seminars, ECIDC will work closely with local Economic and Trade Commission offices and affiliated institutions, energy conservation units in the industrial line ministries, local Industrial Bureaus, the China Energy Conservation Association and its local representatives, and other institutional networks. Useful fora include a full range from regular government work conferences to local trade exhibitions.  Page 32 ANNEX 3 Institutional and Implementation Arrangements ECIDC will operate under the supervision of the Resource Savings and Comprehensive Utilization Department of the SETC, based on a performance contract. At negotiations, it was agreed that the performance contract will include at least (a) a description of services to be provided, deliverables and work program targets; (b) approval procedures for annual plans; (c) key performance indicators, including energy savings targets, agreed methodology for monitoring these indicators, and any other evaluation criteria; (d) financing arrangements and financial management requirements; (e) subcontracting provisions; (f) supervision and management role of SETC's PMO; and (g) reporting requirements. The performance contract will specify required levels of proven annual energy savings stimulated by ECIDC's activities (ramped up with time). ECIDC will therefore need to closely rnonitor and survey the results of its activities, according to agreed procedures. Based on UK experience, this will provide the Government (and GEF) with a useful measure of the cost-effectiveness of use of public funds. It also is incumbent upon ECIDC to carefully target technologies, its audience, material formats, and dissemination work to achieve the maximum results in verifiable energy savings at least cost. Strategy development, market research and self-evaluation of activities to allow mid-course corrections are all important areas for ECIDC's work. ECIDC is a not-for-profit public service entity, an independent legal person with independent accounting, and is intended as a permanent entity. Although ECIDC may generate a small level of revenue, many activities must be free to users (e.g., distribution of case studies), or provided bellow full cost (e.g., technical guides), in order to meet the objectives of the program, as is the norm in other countries. Revenues might be generated through small fees for certain products or advisory services, but areas where revenue generation is allowed must be explicitly and precisely listed in the performance contract, to avoid conflicts with broader program interests. ECIDC will require some continued Government funding after the five years of project implementation. The core staff of ECIDC will be engaged as long-term employees, working full time and only for ECIDC. Three initial core staff were engaged as of January 1998. Table 3: Information Dissemination Component: Cost and Financing (Five Years) L/ (US$ million) GEF SETC Total A. Center Core Costs 0 2,400 2,400 B. Capacity building, training and technical assistance, including overseas 1,500 100 1,600 training, long-term and short-term program consultant and trainers, technical assistance for strategy, and market research and evaluation C. Products and product dissemination Case studies 1,700 1,100 2,800 Technical guides 450 200 650 Dissemination (seminars, work conferences, site visits, third-party events, newsletter, training of local energy conservation staff) 1,150 1,100 2,250 Subtotal 3,300 2,400 5,700 D. Evaluation 200 100 300 Total 5,000 5,000 10,000 La GEF-financed aspects include US$3.7 million in consultant services, and US$1.3 million for printing and measuring/monitoring equipment costs.  Page 33 ANNEX 3 Building upon the existing project implementation plan prepared by the PMO, ECIDC will submit prior to April 1, 1998 its final project implementation and staffing plan, in form and substance satisfactory to the Bank, together with a financial plan satisfactory to the Bank for ECIDC's operation for at least a 10- year period. At project negotiations, the Bank obtained assurances that the SETC will enter into a performance contract satisfactory to the Bank with ECIDC no later than June 30, 1998, or such later date agreed with the Bank. C. PROGRAM MANAGEMENT AND MONITORING COMPONENT Activities This component includes (a) activities to support the proliferation of energy performance contracting among a wide variety of possible enterprises in China, to be implemented by the EMC Development Unit of the PMO; and (b) training and technical assistance for energy efficiency program management and support and evaluation of the project's other components to be implemented by the Project Management Unit of the PMO. The component will be supported with US$2.0 million of GEF financing for incremental costs and US$2.0 million equivalent of SETC grant financing for core costs, especially staffing costs. The EMC Development Unit will promote and assist the creation of new EMCs in China by any interested domestic or international parties. The success of the program and the unit staff will be measured by the number of new EMCs created and the successful operation of these EMCs. The Unit's operations will be supported with US$1.1 million of GEF funding. The Unit should undertake the following tasks: X Provide specific information on EMC development in China for dissemination to potential EMC organizers, Chinese financial institutions, government officials and foreign ESCOs. * Provide assistance, including the help of foreign experts, to any EMC organizer beginning an EMC company, including assistance on basic concepts, product lines, model contracts, financial models, and lessons learned. * Arrange conferences and workshops for potential EMC organizers, Chinese financial institutions and government officials.