PROJECT TITLE: RENEWABLE ENERGY AND ENERGY EFFICIENCY FUND

GEF FOCAL AREA: Climate Change

COUNTRY ELIGIBILITY: All GEF-eligible countries

TOTAL PROJECT COSTS: $130 million to $230 million

GEF FINANCING: $30 million

PARALLEL FINANCING: $100 million to $200 million Fund capitalized separately by Fund investors

GEF IMPLEMENTING AGENCY: World Bank

EXECUTING AGENCY: IFC/Fund Management Company

ESTIMATED APPROVAL DATE: June 1996

PROJECT DURATION: 15 years

GEF PREPARATION COSTS: None

PROPOSED PROJECT:

1. The International Finance Corporation (IFC), the private sector affiliate of the World Bank Group, is considering the establishment of an investment fund dedicated to investing in the renewable energy (RE) and energy efficiency (EE) sectors in developing countries and economies in transition. IFC recently conducted a feasibility study for this project with support from the governments of France, Germany, The Netherlands, Norway and the United States. The proposed Renewable Energy and Energy Efficiency Fund ("the Fund") would raise a minimum of US$100 million and up to US$200 million in capital from IFC and other commercial investors, potentially leveraging US$400-800 million in total project costs. A separate pool of grant funds in the amount of US$30 million is requested from the Global Environment Facility (GEF), US$24-26 million for project co-financing and US$4-6 million for fund management costs. These resources would be used to catalyze Fund investments in important RE and EE market segments that, absent such support, are less likely to receive attention from a commercial investment fund. Key features of the Fund include the following:

2. GEF will provide US$20 million to the Fund only if US$100 million in investment is raised for the Fund (including IFC's investment). The GEF will provide a further US$10 million on a prorated basis for the next US$100 million raised in excess of US$100 million.

3. Every dollar of GEF funds will leverage three to six times as much private sector, IFC, and other investment in the Fund, and ten to twenty times the amount of the GEF funds in total project costs (assuming an average Fund investment of 25% of project costs). This formula does not take into account the strong potential for a multiplier effect from expansion or replication of successful projects.

4. Up to US$24-26 million of the GEF funds will be used for project co-financing to help defray the incremental costs and risks associated with eligible projects in which the Fund also invests its own resources. GEF support may be in the form of grants, loans, equity, or guarantees. GEF funds will be available on a stand-by basis and will only be used for a portion of the Fund's projects needing incremental cost financing--especially for smaller or more innovative projects or for projects encountering high transactions costs or market barriers. Any funds that are provided by the Fund in a non-grant form and recovered from Fund projects (e.g. interest income, loan repayments, equity divestments) will revert to the GEF Trust Fund at the end of the life of the Fund.

5. Based on the results of the feasibility study, it is probable that about one-third to one-quarter of the projects supported by GEF funds are likely to be energy efficiency projects with the balance in renewable energy (off and on grid) projects.

6. The proposed GEF support will be administered by IFC (separate from the capital of the Fund itself) through its arrangement with the World Bank in the latter's capacity as a GEF Implementing Agency. A committee housed within IFC will review projects submitted for GEF support by the fund management company (FMC) - see paragraph 7 below. IFC and the Bank's Global Environment Division will review each proposal from the FMC for use of GEF funds to ensure that GEF eligibility and incremental cost criteria are satisfied. This project selection and review approach is currently being used in the IFC/GEF Small and Medium Scale Enterprise (SME) Program. Consistent with the policy detailed in GEF/C.7/12 ("Engaging the Private Sector"), IFC will notify the country GEF focal point when a project in that particular country is selected.

7. The investors will appoint a fund management company (FMC) sponsored by a private sector group or consortium with the diverse capabilities needed to manage the Fund's operations successfully. The FMC will manage the Fund under financial and environmental guidelines and procedures established by the Fund's investors through its board of directors. Fund management costs (including personnel, administration, and travel to develop, manage, and liquidate investments) are typically supported by an annual management fee of 2-3% of a fund's equity capital and 1% of debt resources. For example, funded on a 50-50 debt-equity basis, the FMC's annual budget for a US$150 fund would range from US$2.25-3 million. A FMC investing in a diversified range of small RE and EE projects will incur higher than normal costs (see paragraph 40 for details). Thus up to US$4-6 million of GEF funds (US$500,000 to $750,000 per year) will be allocated over the first eight years of the Fund for the FMC's incremental (the higher than normal) costs of reviewing, managing, and exiting from investments in projects that present higher transactions costs than would normally be borne by commercial fund managers.

8. The projects co-financed with GEF funds will conform to the climate change operational strategy of the GEF and will only be undertaken in GEF eligible countries.

9. The operational modalities proposed for the Fund are consistent with GEF Council decisions and guidance. The GEF Instrument, the Long-Term Operational Strategy and its programs, and the GEF's draft policy papers on Engaging the Private Sector and on Incremental Costs and Financing Modalities all call for the GEF to support innovative measures to reduce greenhouse gas (GHG) emissions and to leverage additional finance from the private sector. At its May 1995 meeting, the Council agreed that Implementing Agencies should be encouraged to prepare project concepts requesting non-grant financing which the Council could consider on their merits in advance of finalization of the policy paper on Financing Modalities. The Fund may incorporate in its operations the first use or among the first uses by GEF of concessional finance, equity, or guarantees in the operational phase of the GEF. IFC will consult with the World Bank and the GEF Secretariat a) in developing operational criteria for the treatment of incremental costs in projects with GEF funding and b) the first time a new financing modality is proposed to ensure that the application of GEF funds meets GEF eligibility and incremental cost criteria. Concessional finance is being used in several GEF projects such as IFC SME Program and the India alternative energy project and is under consideration by the Brazil biodiversity project.

10. The investment fund approach not only leverages significant additional private sector resources toward GEF objectives and is one of the innovative measures encouraged by the Council in the Operational Strategy, but is an efficient approach to working with the private sector. Programmatic or "umbrella" approaches to GEF projects were endorsed by the Council for the Biodiversity Enterprise Fund for Latin America and is a feature of the SME Program and of trust funds that received GEF funding.

BACKGROUND AND PROJECT CONTEXT:

11. The combustion of fossil fuels for energy supply is a major source of greenhouse gas (GHG) emissions. The United Nations Framework Convention on Climate Change (FCCC) seeks to address this threat through broad-based international cooperation, notably through financial support from the GEF for GHG-mitigating projects in eligible developing countries and economies in transition. The energy sector investment needs of these countries include an estimated $160 billion in the power sector alone by the year 2000. The expansion of power generation capacity through construction of fossil fuel plants remains the principal solution being pursued by both public and private investors, so that GHG emissions are expected to increase significantly in the years ahead. However, there is also growing private investment activity in two sectors whose expansion is critical to achieving the FCCC's objectives: renewable energy (RE) and energy efficiency (EE).

12. Wind, hydro, solar, biomass, geothermal and other RE resources produce energy with no or low net GHG emissions, while EE projects avoid GHG emissions through energy conservation. Other benefits include reduced local air pollution, improved energy security, increased industrial production efficiency and competitiveness, and profitable use of agricultural waste. The RE and EE sectors involve relatively small, modular projects that can be implemented and expanded quickly in receptive environments and can offer competitive rates of return to private investors.

INVESTMENT OPPORTUNITIES:

13. IFC recently reviewed market conditions and a broad sample of indicative projects in the RE and EE sectors as part of its feasibility study for the proposed Fund. The study found that the most advanced sub-sector consists of grid-connected RE projects for the sale of power to electric utilities or large end users. Several hundred projects are under development, representing US$3-5 billion in investment potential over the next five years. The fastest growth has been in India and Central America, but projects are being pursued in many other markets. Favorable conditions in a growing number of countries include attractive power purchase prices, long-term (eg 10-20-year) power purchase agreements, streamlined approval procedures, and special fiscal incentives and credit facilities. Most on-grid RE projects are in the 5-30 MW range, with costs in the range of US$1-2 million per MW.

14. Off-grid RE businesses target the mass market of households, enterprises and communities in regions unlikely to be served by the grid. In many such environments, RE applications can provide higher quality energy at lower life-cycle costs than diesel generators and other alternatives. The two major sub-sectors are: small power plants serving commercial end users, municipalities and villages, in the 50 kW to 5 MW range and frequently using hybrid technologies (solar and/or wind systems backed by diesel or gas generators), and the commercial deployment of solar housing systems (SHS) using solar photovoltaic (PV) technology, in the 20-500 W range and costing several hundreds or thousands of dollars each.

15. Energy efficiency projects are undertaken directly by end users and by energy service companies (ESCOs) providing turnkey services often on a performance contract basis. Many EE projects can offer attractive rates of return, with paybacks of 1 to 5 years, using proven energy conservation technologies, such as metering systems and efficient industrial motors and boilers. The "technical" potential for EE investment is measured in the hundreds of billions of dollars, and significant EE business development is underway in Central Europe, India, Brazil, Mexico and elsewhere. Important sub-sectors include district heating, real estate, public lighting, and industrial energy efficiency. Investment opportunities fall into two categories:

(a) EE project portfolios: Most EE projects are in the US$100,000 to US$2-3 million range. In order to develop a critical mass of business and capital demand, energy service companies and third-party investors and lenders often seek to develop dedicated medium-term debt or lease finance facilities that can support the establishment and expansion of portfolios of such projects.

(b) Stand-alone projects: Larger individual EE projects (eg of US$5-50 million) are most likely to be found in energy-intensive heavy industry sectors (eg metallurgy, pulp and paper), in the establishment of combined heat and power cogeneration plants within a host firm, and in mass commercial distribution of such products as meters and controls and efficient appliances and lighting.

16. The market assessment also confirmed the investment opportunity in domestic manufacturing of RE and EE equipment (such as indicative projects involving PV modules, wind turbines, compact fluorescent lamps, capacitors) and in local financial intermediaries (eg banks, leasing companies, sector-specific funds) seeking to develop dedicated lines of business in the RE and EE sectors.

CONSTRAINTS:

17. Despite the vast opportunity and increased activity, private investment in renewables and efficiency is impeded by a number of market barriers and other constraints, including: (a) the high relative costs and risks of developing and investing in smaller projects; (b) the lack of experience of regulatory authorities, project sponsors, local financial intermediaries, and potential clients in many countries with the technologies and project structures; (c) the poor creditworthiness or unfamiliar risk profiles of clients in important market segments, such as state-owned utilities, municipalities or rural consumers; (d) the lack of suitable financing including equity capital from institutional investors, long-term debt to accommodate the cost structure of on-grid RE projects (high capital costs and low operating costs), medium-term loan and lease facilities in the off-grid RE and EE sectors, and mechanisms to mitigate credit risk and relatively high project and/or business development costs in all sectors; (e) currency convertibility, devaluation or other economic and financial risks, as well as subsidized energy prices, high taxation, administrative bottlenecks and other policy constraints. Larger, more conventional energy supply projects also face some of these problems, but can more readily absorb the transaction costs associated with overcoming regulatory, market, financing and other barriers. Also, they have readier access to financing and advisory support.

PROJECT OBJECTIVES:

Global Environment Objectives and Benefits

18. The Fund will seek to mobilize new financial resources for investments in privately-sponsored projects in the RE and EE sectors in non-OECD countries. The projects supported by the Fund will generate global environmental benefits as a result of avoided GHG emissions. The Fund will also help catalyze further private investment by helping to introduce proven technologies and project structures in new markets, supporting new types of projects, and engaging new sources of commercial financing.

Specific Project Objectives and Benefits

19. The Fund's principal objective will be to generate a competitive risk-adjusted rate of return, to be achieved by supporting highly qualified project sponsors and developing a balanced portfolio of investments in the target sectors. The Fund's management team is likely to work closely with local financial intermediaries and sources of expertise as it develops, monitors and ultimately exits its investments. It is expected that the management team will seek to raise additional financing and expand its activities on the basis of the Fund's commercial success and a continuing strong pipeline of investment opportunities.

PROJECT DESCRIPTION:

Fund and Management Structure

20. The Fund will mobilize capital from IFC as well as strategic investors such as power companies, private institutional investors such as insurance companies and social investment funds who are prepared to support these sectors on their financial merits and as a means to demonstrate their commitment to reducing global warming, and similarly motivated multilateral and bilateral investment agencies. A proposed IFC investment is under review by IFC's management.

21. The investors will appoint a fund management company (FMC) as explained in paragraph 7. An advisory board will be created to provide guidance on investment issues and on the use of concessional and grant funds.

22. The proposed structure of the Fund, summarized below, is still under review by IFC's management and potential Fund managers and lead investors.

(a) Sector and geographical coverage: The Fund would invest in the on-grid RE, off-grid RE and EE sectors. It would have a "global" scope of operations, enabling it to invest in the most active markets--such as India (RE and EE), Central America (RE) and Central Europe (EE)--while pursuing high-quality projects elsewhere on a more opportunistic basis.

(b) Financing instruments and funding: IFC and potential co-sponsors are exploring the possibility of mobilizing both equity and debt funding for the Fund, enabling it to use a wide variety of financing instruments in its investments. Grid-connected RE and major EE projects lend themselves to an equity-based investment strategy, since they typically require a conservative balance among equity, quasi-equity and senior debt. However, the equity investment opportunities are contingent on the mobilization of long-term debt, which is more difficult to secure. Companies in the EE and off-grid RE markets must also have an adequate equity base, but generally require more highly leveraged medium or long-term debt or lease financing for their clients to achieve significant business volume.

(c) Fund size and capital structure: A US$100-200 million fund would represent a conservative 2-3% of the estimated effective demand for capital in the RE and EE sectors over the next five years. Within this range, the size of the Fund will largely be a function of whether it is established as an equity investment fund only, or whether debt resources and financing capabilities are also incorporated.

Financial and Environmental Investment Guidelines

23. The Fund's investment policies and guidelines will be determined by its lead investors in consultation with the FMC. The Fund will focus on medium-sized projects and companies with total costs in the US$5-30 million range. This is where the bulk of the investment opportunity lies in the RE and EE sectors. The Fund will adopt prudent financial exposure guidelines, such as limitations on individual investment size, percentage of project costs, and sectoral and country concentration. Due consideration will be given to the objectives and operational strategy of the GEF in developing the Fund's investment guidelines. All uses of GEF funds to support the Fund's commercial investment activity will adhere to GEF criteria. The Fund's investments will also be consistent with the climate change action strategies and programs and energy sector development plans adopted by the respective host countries.

24. The Fund will apply rigorous environmental screening and monitoring procedures in its investment activities, including but not limited to the World Bank Group's environmental procedures and policies. IFC will assess the FMC's capability to carry out such reviews for each project and will periodically monitor this activity. Environmental screening will ensure that sound practices are followed, including community consultation, with respect to such issues as project siting; social soundness; selection of biomass fuels; disposal of replaced equipment; atmospheric emissions, liquid effluents and waste management practices; and other measures that can be used to mitigate potential environmental risks.

RATIONALE FOR GEF FINANCING:

25. The Fund currently under development responds to the FCCC and GEF's objectives of controlling GHG emissions and leveraging the private sector.

26. There are virtually no institutional investors focusing exclusively on the RE and EE sectors, even in developed countries. Commercial investment in these areas is pursued along with broader activities in the power or other sectors, and few of the institutions have turned their attention to opportunities in developing countries. Nevertheless, market development has reached a point where IFC and other commercial investors can readily establish a Fund dedicated to the RE and EE sectors. However, such a Fund would focus on projects (such as larger wind, biomass cogeneration or industrial energy efficiency projects) that are larger and/or have lower transaction costs and lower risk profiles than many of the RE and EE projects currently under development.

27. The GEF support will allow the Fund's scope to be expanded into promising market segments that are otherwise likely to receive little attention, because typical projects may be smaller and riskier such as smaller on-grid RE projects (eg below 5 MW), off-grid village power stations or solar housing systems, and support for ESCOs seeking to develop EE projects. By investing in a wider range of projects and markets than a conventional investor, the Fund will have a deeper impact on mobilizing private entrepreneurs, commercial financing and other market forces that must be harnessed for accelerated RE and EE sector growth.

28. GEF resources will enable the FMC to provide greater than normal advisory support to project sponsors in resolving complex commercial, legal and financial structuring issues and in mobilizing financing for their projects. With respect to project financing per se, GEF funds will be applied in innovative ways to reduce credit risks and otherwise improve marginal risk-adjusted rates of return that are preventing projects from going forward. Possible applications include: partial funding of guarantee, debt or lease finance facilities, extending the maturities of loans available from other sources, or buying down the capital costs of select projects with a strong potential for replication and expansion on a strictly commercial basis thereafter.

PARTICIPATION AND SUSTAINABILITY:

29. IFC's feasibility study and broader experience suggest that the Fund will offer many opportunities for stakeholder participation:

(a) The Fund will have access to an extensive network of organizations and individuals who are willing and able to direct the Fund's attention to specific investment opportunities and to provide ad hoc advice. These sources of "deal flow" and broader support include host country utilities, RE and EE trade associations, NGOs, foundations, development banks, government and donor agencies, IFC and others. Many such organizations were consulted during IFC's feasibility study.

(b) The Fund will bring together an investor group and management team with a commitment to RE and EE market growth through profitable private investment. The Fund will support RE and EE project sponsors who are actively engaged in client and market education as they promote cost-effective and environmentally sound approaches to meeting and managing energy demand. The Fund's investments will support national climate change action strategies by helping utilities gain firsthand experience with on-grid RE systems, and by engaging municipalities, rural populations and other EE and off-grid RE clients more deeply in selecting the best options for their energy future.

(c) Given the relatively small project sizes, the Fund's success will depend on and can be instrumental in encouraging co-investment and support from local financial institutions, community groups, and NGOs. The smaller projects can also obtain business planning and finance mobilization assistance from various SME support programs, including IFC's Africa and South Pacific Project Development Facilities.

(d) The Fund can also help finance the development of project portfolios, capital market securities and other mechanisms to aggregate capital demand from smaller projects to a scale that could attract greater interest from foreign investors and lenders and from emerging domestic capital markets.

(e) The status of the Fund's investments will be described in an annual report of the Fund available to Fund investors, the GEF and other appropriate parties.

LESSONS LEARNED AND TECHNICAL REVIEW:

30. IFC is a leading investor in the emerging private power markets in developing countries, through direct loan and equity financing, syndicated loans and participation in several infrastructure investment funds. While most of the activity concerns large conventional power plants, IFC has also financed a number of small hydro and biomass projects and is appraising potential investments in wind and geothermal power plants. IFC is also providing advisory support to project developers and considering investments in the energy conservation and off-grid renewable energy sectors. The experience confirms that well-designed projects in these areas can be commercially viable under price and other conditions prevailing in various markets. However, given the small project sizes relative to other IFC power sector investments, IFC is seeking opportunities to channel resources through financial intermediaries who can reach such projects cost-effectively: not only the proposed Fund, but also local commercial banks and leasing companies. The lessons learned from IFC's extensive participation in venture capital and investment funds and from its leadership role in private power project financing will be incorporated in the design and supervision of the Fund.

31. This project proposal was subject to an Independent Technical Review by a STAP member, whose comments are attached. The reviewer urged that particular attention be given to opportunities in the EE sector and in domestic manufacturing of EE equipment, as these sectors can offer the highest multiplier effect in terms of GHG reductions per unit of investment. IFC's feasibility study recognized this large potential, and it is expected that the Fund will be fully capable of supporting qualified projects in these areas.

PROJECT FINANCING AND BUDGET:

32. The GEF resources will be applied in the two areas presented below.

Project Co-Financing

33. The largest component of the GEF financing--estimated at US$24-26 million--will be available through a standby co-financing pool of GEF funds managed by IFC to help defray the incremental costs associated with eligible projects in which the Fund also proposes to invest its own resources. The GEF resources will be invested in projects on terms that are consistent with GEF guidelines. The financing could be extended on a grant, equity, or loan basis. Potential uses of the GEF co-financing funds are introduced below.

34. Support for project review and structuring: High project preparation costs--including their technical, commercial, legal and financial aspects--can discourage sponsors. The proposed GEF funding could be used to defray a portion of the preparation and review costs of select projects. The form of investment might include: (i) grants (e.g. when this is the only instrument that can ensure an adequate rate of return for the supported project); (ii) equity (e.g. when stronger capitalization is needed to help secure the additional debt financing required); or (iii) loans (preferably at market rates but with repayment terms that can be comfortably supported by the project's cash flow). The GEF support would normally be extended after considerable resources have already been invested by the project sponsors.

35. Partial funding of guarantee facilities: The credit risk of prospective clients can be a major deterrent to investment in important RE and EE market segments. Credit risk can result from the client's poor financial condition, low purchasing power and lack of a credit history, as well as from concerns about the enforceability of contracts in an untested environment. Short of obtaining a guarantee from a creditworthy third party, a variety of mechanisms can be and already are being used to mitigate credit risk (e.g., escrow accounts, the ability to sell power to industrial clients if a utility fails to honor its power offtake obligations, installation of prepayment meters in solar housing systems, and cross-collateralization of loans within a portfolio of projects). However, these mechanisms do not always give adequate comfort to commercial lenders. The GEF funds could be used to help fund guarantee facilities for select projects, potentially including (i) escrow accounts to back a client's payment obligations under a power purchase agreement or an energy efficiency contract; or (ii) guarantee funds to support revolving consumer finance schemes established by local financial intermediaries in the off-grid RE sector, or revolving EE portfolio finance facilities.

36. Partial funding of debt or lease finance facilities: Difficulties in obtaining medium-or-long-term financing is also a serious constraint in the RE and EE sectors. Factors include the small project sizes which make them uneconomic for international commercial lenders to support on an individual basis, the lack of experience with RE and EE projects among domestic banking institutions, and the difficulty of raising debt of sufficiently long maturities from international and domestic lenders willing to consider smaller projects, due to risk perceptions as well as the scarcity of long-term funding resources.

37. GEF funds could be used to provide a portion of the financing required by select projects, including: (i) long-term loans (eg 12-15-years) for small on-grid RE projects; (ii) medium-or-long term debt or lease financing facilities (eg 3-8-years) for off-grid RE and EE projects (e.g. revolving facilities for portfolios of consumer loans or energy efficiency performance contracts); or (iii) innovative refinancing facilities designed to extend the maturities of loans provided by other sources.

38. Capital cost buy-downs: GEF funds may be used in exceptional cases to directly reduce the capital costs of projects in promising new market segments and/or technology areas. This support would normally be provided on a grant basis, for purposes of improving marginal rates of return that would otherwise prevent the project sponsors and other commercial investors or lenders from proceeding.

FMC Costs:

39. The operating budget of the FMC has yet to be determined, as it will be a function of Fund size. Fund management costs are typically supported by an annual management fee drawn from the fund's capital base, generally in the range of 2-3% of a fund's equity capital and 1% of debt resources. Given an average Fund size of US$150 million, funded on a 50:50 equity:debt basis, the FMC's annual budget could range from US$2.25-3 million. This budget would cover all normal operating costs, including personnel, administrative, travel and other expenses of developing, managing and liquidating the investment portfolio.

40. An FMC investing in a diversified range of projects and markets in the RE and EE sectors can be expected to incur higher than normal costs for a number of reasons. With average investments likely to be under US$5 million, the Fund's portfolio may consist of 30 or more projects. Since commercial venture capital funds of any size typically invest in no more than 15-20 projects, the Fund's personnel requirements are likely to be greater than usual. The potentially wide range of markets, technologies, projects and financing techniques also calls for a broad base of skills within the FMC and extensive use of outside specialists. The pioneering nature of many RE/EE transactions may also require that the FMC provide greater than normal project structuring, technical assistance and advisory support to project sponsors.

41. GEF grant funds will help cover a portion of the FMC's incremental costs of reviewing, managing and exiting from investments in projects that are smaller, more complex and/or newer in the market and that otherwise present higher transaction costs or risks than would normally be considered by commercial fund managers. The GEF grants would cover the additional staff, consultants, travel and other costs associated with such investments. A condition of this funding will be that the FMC's staff include at least two individuals specifically focusing on EE, off-grid RE and/or smaller on-grid RE projects (eg below US$5 million total cost). It is estimated that the budget for this component will be US$4-6 million, to be allocated to the FMC over the first 8 years of operation of the Fund in annual installments, on the basis of annual budgets approved and monitored by IFC.

INCREMENTAL COSTS:

42. This project is designed to expand the market for commercial financing of RE and EE projects in developing countries and economies in transition, thereby accelerating the pace and improving the sustainability of development of these sectors.

43. Baseline: A Fund seeking to earn a risk-adjusted commercial rate of return would normally focus on projects that are larger and/or have lower transaction costs and lower risk profiles than many RE and EE projects. Indeed, two potential new "renewable energy" investment funds for Latin America are targeting larger on-grid RE projects (a minimum of US$50 million in one case), and both will invest in natural gas projects as well. Similarly, PV distribution projects relying exclusively on cash sales to higher income clients, or energy service companies engaged primarily in supply side or large industrial energy efficiency projects, are also focusing on the more profitable and less risky niches in their respective sectors. They have little impact in terms of the deeper market penetration that is necessary for the development of the EE and off-grid RE sectors.

44. GEF Alternative: The GEF funds will help (a) complete the financing required for the development and/or implementation of eligible projects that are unlikely to proceed in timely fashion without support from concessional sources, and (b) defray some of the additional costs of investing in projects that would not normally be considered by a commercial fund. As a result of the GEF financing, the Fund is likely to invest in a larger number and greater diversity of projects in a wider range of countries, to provide greater than normal advisory support to project sponsors, and to have a stronger demonstration effect with respect to the commercial investment opportunity and the documentation of environmental and economic benefits of RE and EE private sector projects. The incremental cost component of each of the uses of GEF funds is further explained in the Project Financing and Budget section above.

RISKS:

45. Mobilization Risk. The Fund may not attract significant interest from private institutional investors. The placement effort is therefore likely to focus on strategic and socially-oriented investors who are already committed to these sectors.

46. Deal Flow Risk. The number of projects in the Fund's target market segments and deal size range may be fewer than anticipated. This could put pressure on the FMC to broaden its investment focus to include larger projects in the most conventional sub-sectors.

47. Portfolio Performance: Profitability can be adversely affected by customer default, foreign exchange and conversion risks, changes in regulatory and tax regimes and other political and economic risks.

48. Competing Sources of Financing: Competing investment funds may enter the market. Multilateral and bilateral institutions are also expanding their efforts in the target sectors, although these initiatives are likely to benefit the Fund by stimulating project development activity and providing long-term debt.

INSTITUTIONAL FRAMEWORK AND IMPLEMENTATION:

Administration and Oversight

49. The proposed GEF support will be administered by IFC as described above in paragraph 6. The GEF's interests will also be represented on the Fund's board of directors and advisory board.

Monitoring and Reporting

50. The FMC will follow normal Fund management reporting procedures, presenting financial and activity reports to the Fund shareholders and to the GEF on a regular basis.

Implementation

51. IFC is currently discussing the Fund concept with potential Fund managers and investors. A detailed project document will be circulated to the GEF Secretariat and the Council following IFC management and Board review and the formation of the Fund.

TECHNICAL REVIEW

RENEWABLE ENERGY AND ENERGY EFFICIENCY FUND

1. In my terms of reference, I was asked to comment on several aspects of the proposed Fund: its importance in promoting sustainable energy use and greenhouse gas mitigation, its effectiveness through leveraging private entrepreneurship and financing, and the adequacy of its design and its prospects for success. My comments below are followed by a number of suggestions.

COMMENTS ON THE FUND CONCEPT AND DESIGN:

2. The Fund will be a cost-effective and innovative way to meet the Climate Convention's and the GEF's greenhouse gas mitigation objective and to leverage a large amount of private sector finance toward this objective. The Fund will also be tracking the GHG mitigation benefits of its investment projects, which should provide valuable lessons for the international community. The only two ways to cap our dependence on fossil fuel from a technical standpoint are first (and most affordably) to improve energy efficiency, and second to introduce renewable fuels and electricity. These must of course be supported by the right policies: to eliminate subsidized energy in developing countries ("DCs" -- in this Review, "DC" will mean all non-OECD countries), and then to introduce energy taxes (as in most developed countries). Such policies are being promoted by institutions like the IMF, and, as energy prices rise, so will the market for RE/EE technology -- and the demand for funds like the RE/EE Fund. Beyond capping carbon emissions, we must also consider the environment in general, for which energy efficiency and renewables are among the most cost-effective environmental investments available.

3. Improving energy efficiency in DCs can be done typically with investments providing 1-3 years' payback time, but they nevertheless will require hundreds of billions of dollars, which means that they must largely be funded, for profit, by the private sector. And of course hundreds of billions more are needed in the power sector, and it is only prudent to switch this investment flow to renewable technologies. This particular Fund should be very well positioned to attract private attention to these opportunities, and to support both international developers and local entrepreneurs and investors.

4. The RE/EE Fund proposal is very interesting and exciting, with a high potential not only for success, but also for sparking explosive growth in the RE/EE sectors. I have given advice to many grant programs, and also to some venture capital funds, the California "convertible loan" fund, and projects in DCs. The grant programs offered no access to private capital, while the venture capital funds weren't interested in small investments or in more innovative projects (they wanted "low-hanging fruit", or very profitable and easily understandable transactions). The uniqueness of the proposed RE/EE Fund is not only its exclusive focus on the RE/EE sectors, but also the fact that it couples $100-200 million of commercial capital from the Fund investors with $30 million of concessional and grant funds from the GEF. With these special resources, the Fund should be able to pursue projects that are already "nearly attractive" to commercial investors, but whose development and financing have stalled over some barrier. The GEF funds will improve the quality of the projects, making them suitable for a commercial investment by the Fund and for co-investment by other parties, who will then have greater confidence to invest in further projects.

SUGGESTIONS:

5. The Fund should seek out investment opportunities in select countries where project sponsors are working with one or more utilities or other parties that are already interested in energy efficiency and renewables, or better, can stand to profit from selling, buying or sponsoring the independent expansion of energy services rather than raw energy production alone. In the US, many states have "decoupled" the profits of investor-owned utilities from their sales of energy, and in a few states (California, New England, Wisconsin) utilities are actually permitted to share in the value of the energy savings achieved by rate-payers, so that they are seriously interested in promoting energy efficiency. These utilities have the largest (>$1 billion/year) and most effective "Demand Side Management" or "DSM" programs. The programs have been successful and profitable, and are bound to spread slowly outside the US.

6. The Fund's managers should therefore be alert to the development of innovative DSM programs and "Integrated Resource Plans" by utilities in DCs, because such programs tend to stimulate entrepreneurial interest in efficiency and renewables. They might also note that capacity-limited utilities in DCs are often obligated to subsidize residential prices, but allowed to charge market rates to commercial and industrial customers. Since they would benefit by switching kilowatt-hours from "home to office", they may show growing interest in supporting residential energy efficiency projects.

7. The Fund might also consider the leverage that can be achieved by investing in the production of efficient appliances and equipment. The industrialized world is full of production lines that just meet existing standards, even though there is a significant market for more energy efficient products with optimal life-cycle costs. The situation is worse in DCs, where there are no efficiency labels, few surveys of demand for more efficient products, and enormous emphasis on low first costs. A few years ago, several utilities in the US offered a $35 million grant to the winner of a design competition ("Golden Carrot") to install a production line for an energy efficient refrigerator. The runner-up in the competition soon decided to bring its own efficient refrigerator into production. The industry and resulting energy savings are growing. While the Fund will not be in the business of sponsoring competitions, and the supporting GEF grant funds will only finance a small portion of any given project, this example indicates that grant support for a breakthrough project can have a very large multiplier effect. Another product whose commercial launch could have an extremely high impact is the "cogged" V belt, which couples electrical motors to their loads. Belts have been cogged for a decade in OECD countries, but are unknown in the former Soviet Union, for example. They could save enough electricity in this region alone to avoid 3 Gigawatts of capacity, or 3 times that of each of the dangerous units at Chernobyl.

8. A last suggestion about the relative priorities for efficiency, off-grid renewables, and on-grid renewables. Energy supply is visible, easier to understand, and easier to market than efficiency. And even with efficiency, the more visible and expensive the equipment, the better the market. Many building owners see the virtue of an efficient air conditioner, but find it harder to comprehend that if they had a white roof, they could get away with a smaller air conditioner, or none at all. The Fund should give priority to financing Energy Service Companies who can take on this marketing challenge and deliver efficiency and energy services at low cost. It is urgent to help these enterprises establish a track record so that they can attract conventional capital.

CONCLUSION:

9. The Fund is a novel and exciting "one-stop shop", bridging the conventional gap between grants, concessional funds and commercial capital. It should spawn successful investments in RE and EE. There is considerable financial and management talent that the Fund can focus on this opportunity. I predict that the design of the Fund itself, or variations thereon, will have a replication effect among commercial financing institutions, and it will provide much insight on how public sector resources can have a multiplier effect on private investment.

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