FOR OFFICIAL USE ONLY AND A

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$200 MILLION AND A PROPOSED GRANT FROM THE GLOBAL ENVIRONMENT FACILITY TRUST FUND Transport, Energy and Mining Sector Unit Sustainable Development Department East Asia and Pacific Region ln THE AMOUNT OF US$13.5 MILLION TO THE PEOPLE S REPUBLIC OF CHINA IN SUPPORT OF THE ENERGY EFFICIENCY FINANCING PROJECT April 21, 2008 Report No.: CN This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 _I CURRENCY EQUIVALENTS (Exchange rate effective February 26, 2008) Currency Unit = Renminbi (RMB) Yuan (Y) Y 1.0 = US$0.14 USSl.0 = Y 7.15 FISCAL YEAR January 1 - December 31 ACRONYMS AND ABBREVIATIONS ABC Agricultural Bank of China IAS International Accounting Standards AFD French Development Agency IBRD International Bank for Reconstruction and Development BOC Bank of China ICB International Competitive Bidding BP Business Procedure ICBC Industrial and Commercial Bank of China CAR Capital adequacy ratio IFC International Finance Corporation CAS Chinese Accounting Standards IFRS International Financial Reporting Standards CBRC China Bank Regulatory Commission IOC Incremental Operating Cost CCB China Construction Bank IPO Initial Public Offering CDM Clean Development Mechanism ISA International Standards for Auditing CHUEE IFCiGEF China Utility-Based Energy MOF Ministry of Finance Efficiency Project CNAO China National Audit Office Mtce Million tons of coal equivalent co2 Carbon dioxide NDRC National Development and Reform Comssion CPR Country procurement review NECC National Energy Conservation Center CQS Selection Based on Consultants NPL Non-performing loans Qualifications DA Designated account OECD Organization for Econormc Co-operation and Development EA Environmental Assessment O&M Operation and Maintenance EIA Environmental Impact Assessment OP Operations Procedure EIRR Economic Internal Rate of Return PBOC People s Bank of China EMC Energy Management Company PBP Pay back period EMP Environmental Management Plan PFI Participating financial intermediary ESCO Energy Service Company PIP Project Impleme-ntation Plan ESMAP Energy Sector Management Assistance PMO Project management office Programme EUEEP China End-Use Energv Efficiencv Proiect OBS Oualitv-Based Selection EXIM The Export - Import Bank of China QCBS Quality- and Cost-Based Selection FDI Foreign direct investment RCC Rural Credit Cooperative FI Financial intermediary ROE Return on equity FIRR Financial internal rate of return SCB State-owned commercial banks FYP Five-Year Plan SO2 Sulfur dioxide GDP Gross domestic product UNDP United Nations Development Programme GEF Global Environment Facility UNEP United Nations Environment Programme GHG Greenhouse gas VSL Variable spread loan GOC Government of China WTO World Trade Organization Vice President: Country Director: Sector Manager: Task Team Leader: James W. Adams David R. Dollar Junhui Wu Leiping Wang

3 FOR OFFICIAL USE ONLY CHINA ENERGY EFFICIENCY FINANCING PROJECT I CONTENTS Page. STRATEGIC CONTEXT AND RATIONALE... 1 I1. A. Country and Sector Issues... 1 B. Rationale for Bank Involvement... 3 C. Higher Level Objectives to Which the Project Contributes... 4 PROJECT DESCRIPTION... 4 A. Lending Instrument... 4 B. Project Development Objective and Key Indicators... 4 C. Project Components... 5 D. Lessons Learned and Reflected in the Project Design... 7 E. Alternatives Considered and Reasons for Rejection... 9 I11. IMPLEMENTATION... 9 IV. A. Partnership Arrangements... 9 B. Institutional and Implementation Arrangements C. Monitoring and Evaluation of Outcomes and Results D. Sustainability and Replicability E. Critical Risks and Possible Controversial Aspects F. Loadcredit Conditions and Covenants APPRAISAL SUMMARY A. Economic and Financial Analyses B. Technical C. Fiduciary D. Social E. Environment., F. Safeguard Policies G. Policy Exceptions and Readiness: This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

4 Annex 1: Country and Sector or Program Background Annex 2: Major Related Projects Financed by the Bank andor other Agencies Annex 3: Results Framework and Monitoring Annex 4: Detailed Project Description Annex 5: Project Costs Annex 6: Implementation Arrangements Annex 7: Financial Management and Disbursement Arrangements Annex 8 : Procurement Arrangements Annex 9: Economic and Financial Analysis Annex 10: Environmental and Social Safeguard Policy Issues Annex 11 : Project Preparation and Supervision Annex 12: Documents in the Project File Annex 13: Statement of Loans and Credits Annex 14: Country at a Glance Annex 15 : Incremental Cost Analysis Annex 16: STAP Roster Review Annex17: Map... 97

5 CHINA ENERGY EFFICIENCY FINANCING PROJECT PROJECT APPRAISAL DOCUMENT EAST ASIA AND PACIFIC EASTE Date: April 21, 2008 Country Director: David R. Dollar Sector ManagedDirector: Junhui Wu Project ID: PO84874 Lending Instrument: Financial Intermediary Loan Global Supplemental ID: PO98916 Lending Instrument: Financial Intermediary Loan Focal Area: C-Climate change Supplement Fully Blended?: Yes Team Leader: Leiping Wang Sectors: District heating and energy efficiency services (90%); Banking (10%) Themes: Climate change (P) Environmental screening category: Financial Intermediary Assessment Team Leader: Leiping Wang Sectors: District heating and energy efficiency services (1 00%) Themes: Climate change (P) For Loans/Credits/Others: Total Bank financin Local Sources of Borrowing Country Total: Local Sources of Borrowing Country=380.1; and Associated IBRD Fund=200.0 These amounts are not additional to the amounts shown in the Financial Plan table above. Borrower: the People s Republic of China Responsible Agency: The Export-Import Bank of China (EXIM), the Huaxia Bank (Huaxia) and the National Develoument and Reform Commission (NDRC)

6 FY Annual Cumulative Project implementation period: Start: August 1, End: December 31,2013 Expected effectiveness date: August 1, 2008 Expected closing date: December 3 1,201 3 Does the project depart from the CAS in content or other significant respects? Re$ PAD LC Does the project require any exceptions from Bank policies? Re$ PAD IKG Have these been approved by Bank management? Is approval for any policy exception sought from the Board? Does the project include any critical risks rated substantial or high? Re$ PAD IILE Does the project meet the Regional criteria for readiness for implementation? Re$ PAD IKG [ ]Yes [XINO [ ]Yes [XINO [ ]Yes [ IN0 [ ]Yes [~INo [ ]Yes [XINO [XIYes [ ]No Project development objective Re$ PAD II.B, Technical Annex 3 Improve energy efficiency of medium and large-sized industrial enterprises in China. Global Environment objective Re$ PAD II.B, Technical Annex 3 Reduce adverse environmental impact of Chinese medium and large-sized industrial enterprises on climate. Project description [one-sentence summary of each component] Re$ PAD II. C, Technical Annex 4 The proposed project has four components: Component A: Promotion of Energy Efficiency Financing (estimated cost: US$18.7 million; US$ 9.9 million of GEF co-financing); Component B: Energy Conservation Investment Lending (estimated cost: US$571 million; US$O.O million of GEF co-financing); Component C: National Policy Support and Capacity Building (estimated cost: US$2.8 million; US$2.8 million of GEF financing); and Component D: Project Implementation Support, Monitoring and Reporting (estimated cost: US$l. 1 million: USs0.8 million of GEF co-financing).

7 Which safeguard policies are triggered, if any? Re$ PAD IV. F, Technical Annex 10 Only the Environmental Assessment Policy is triggered. In accordance with World Bank environmental safeguard policies (OP/BP/GP 4.01), the project has been assigned Category FI since individual subprojects to be financed by the PFIs will be identified after project implementation. Significant, non-standard conditions, if any, for: Re$ PAD III.F Board presentation: None Loadcredit effectiveness: None Condition of Disbursement under the GEF Trust Fund Grant Agreement: The adoption by the PMO of the NDRC of the financial management manual satisfactory to the Bank and applicable to the portion of the GEF grant allocated to the NDRC will be a disbursement condition against the disbursement of the grant allocated to the NDRC. Conditions Applicable to Project Implementation: EXIM and Huaxia shall maintain the energy conservation lending unit or team with adequate staff and resources during the entire project implementation period and apply their respective operational manuals and financial management manuals satisfactory to the Bank. EXIM shall implement the action plan agreed with the Bank to address its accounting and management weaknesses.

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9 I. STRATEGIC CONTEXT AND RATIONALE A. Country and Sector Issues 1. China is the second largest energy user and emitter of greenhouse gases (GHGs) in the world. Energy consumption in China has increased 6.0 percent annually between 1990 and more than three times faster than the world s average annual growth, rising from 990 million tons of coal equivalent (Mtce) in 1990 to 2,650 Mtce in Despite the high growth, China s per capita energy consumption is still less than one fifth of the average for the Organization for Economic Cooperation and Development (OECD). If left unchecked, China s energy consumption, primarily met by coal, will accelerate the country s significant contribution to the deterioration of local air quality and the increase of GHG emissions. Improving energy efficiency holds one of the keys to sustaining China s economic growth with reduced energy needs and lessened local and global environmental impacts. 2. China s energy efficiency lags far behind the world s most efficient economies, especially in manufacturing industries. Its energy-intensive manufacturing industries, accounting for about 50 percent of total final energy consumption, operate at significantly higher levels of energy intensity (energy use per unit of physical output) than international best practices. The significant potential for improving energy efficiency and reducing GHG emissions is largely untapped in these industries. 3. The Government of China (GOC) has stepped up its efforts to improve energy efficiency. In November 2004, the National Development and Reform Commission (NDRC) issued the nation s first Medium and Long Term Energy Conservation Plan (2005 to 2010 and 2020) which highlighted 10 energy conservation programs targeting the country s major energyconsuming sectors. In the nation s Eleventh Five-Year Plan (FYP) ( ) for Economic and Social Development, endorsed by the People s Congress in March 2006, the GOC pledged to reduce the energy intensity of gross domestic product (GDP) by 20 percent from 2005 to 2010, which is estimated to result in avoided energy consumption of over 560 Mtce annually by The NDRC launched the Large Industrial Enterprises Energy Conservation Action Plan in April 2006, targeting the top 1,008 largest industrial energy consumers, which account for approximately 30 percent of China s total primary energy consumption. The government efforts also include policy initiatives to foster technology development and deployment, and various fiscal incentives to improve energy efficiency. 4. The estimated energy conservation investments needed to achieve the 20 percent energy efficiency target surpass US$50 billion-most of them in the industrial sectors. Although Chinese experts agree that the majority of the identified industrial energy conservation investments are financially viable, most of the concerned enterprises would rather invest in business expansion than energy conservation. The domestic banking sector has not stepped in to provide the required financing either, especially for medium and large-sized energy conservation investment projects. In 2006, the first year of the 1 lth FYP, the energy intensity of GDP did not decline as planned. This has increased the urgency to accelerate government efforts to promote industrial energy conservation investments. Chen Hongwei, November 23,2006. Economic Daily. -1-

10 5. The existing industrial energy conservation financing mechanisms in China have mainly benefited relatively small projects. The Bank s First and Second China Energy Conservation Projects, funded by International Bank for Reconstruction and Development (IBRD) and the Global Environment Facility (GEF), have been credited for the development of China s energy services industry. The energy management companies (EMCS)~ supported by the two projects made US$280 million worth of energy conservation investments in 2006, many of them in the industrial sector. However, few of the EMC investments exceeded US$5 million. Another ongoing project, the International Finance Corporation (IFC)/GEF China Utility-Based Energy Efficiency Project (CHUEE), also supports small-scale industrial energy conservation investments. It promotes the installation of more energy-efficient equipments with commercial bank financing backed by a guarantee facility. 6. There is a large financing gap for medium and large-sized energy conservation investments in the industrial sector, which normally cost US$5-25 million per project. Given the economic and financial attractiveness of such projects, the GOC has gradually eliminated public funds earmarked for industrial energy conservation project financing since late 1990s, expecting Chinese enterprises to invest their own resources and banks to build energy conservation lending business lines. This expectation has not materialized. There are three key barriers which have impeded the development of the lending market for medium and large-sized industrial energy conservation investments, despite its large potential. They include: (a) Perceived high technical andfinancial risks of energy conservation investments among industrial enterprises. Compared with small industrial energy conservation projects, which often involve simple replacements or upgrades of equipment and have very short payback periods (one to two years), medium and large-sized projects typically are technically more complex and require longer payback periods. In addition, larger energy conservation projects generally impose business interruptions, resulting in losses of production and revenues, which in turn increase overall project cost. These characteristics lead to the perception that energy conservation projects are technically risky and financially unattractive, especially when compared with capacity expansion investments. The high risk perception among industrial enterprises is primarily caused by a lack of familiarity with the range of energy conservation technologies and processes, and energy conservation investment best practices, as well as the under-appreciation of financial benefits from energy conservation investments. (b) Perceived high financial risks of industrial energy conservation lending among Chinese banks. Interest in developing and implementing industrial energy conservation projects has been further dampened by the lack of available debt financing for such projects. Chinese banks have considered lending for energy conservation projects to be risky, in part, for the reasons mentioned above. Additionally, compared to production expansion projects, energy conservation projects usually do not directly generate additional revenues as usually expected by lending agencies, but rather contribute to a reduction in energy expenditures. The risk perception among Chinese banks has been EMCs are the Chinese equivalent of energy service companies (ESCOs) in North America. These companies finance energy efficiency projects of the clients and share the benefits of the energy savings with the clients based on the performance of the energy efficiency project. This mechanism is also referred as performance contracting. -2-

11 compounded by their unfamiliarity with industrial energy conservation practices, and their weak capacity to properly assess the risks and benefits of energy efficiency investments. The perceived high risk along with the initial cost of developing the internal capacity for proper evaluation and processing of energy conservation lending have resulted in a lack of institutional focus on developing energy conservation business lines by Chinese banks. (c) Insufficient institutional capacity, especially at the national level, to address the pressing needs of scaling up energy efficiency investments. In the wake of the rapid expansion of energy-intensive industries in the last decade and the increased decentralization of decision making, the Government s capability to effectively implement its energy efficiency policies and programs has declined considerably. Given the size and large share of energy-intensive industries in China s economy, as well as the widespread inefficient practices in place at most industrial facilities, policy and regulatory interventions need to be strengthened to encourage industrial enterprises to undertake energy efficiency investments. B. Rationale for Bank Involvement 7. The proposed project is requested by the NDRC and the Ministry of Finance (MOF). The GOC considers the project as an important follow-up to the GEF/IBRD-funded First and Second China Energy Conservation Projects which successfully introduced the energy perfonnance contracting mechanism through EMCs to support small commercially viable energy conservation projects. The IFC/GEF CHUEE Project, currently under implementation, is also focused on promoting small-scale energy conservation investments through a credit enhancing facility. The proposed project complements and reinforces the on-going Bank/IFC projects. It focuses on promoting energy conservation activities in China, through development of a market for investments in medium and large-sized industrial energy conservation projects, often referred to as a goldmine of energy savings by Chinese energy conservation experts because of the significant potential for energy savings. 8. The sharp increase in coal consumption since 2001, driven by a surge in demand for power generation and energy-intensive commodities, such as steel and cement, has increased the energy intensity of the economy, reversing the downward trend of the period from 1980 to This has heightened the urgency for government intervention to scale up energy efficiency investments, and led to intensified government focus on energy conservation during the 1 lth Five-Year Plan ( ). Tapping the energy efficiency potential in existing industrial stock is essential to meet the ambitious energy efficiency objectives of the 1 lth Five-Year Plan and it requires a two-pronged approach, focusing on: (a) the development and implementation of viable business models through the domestic banking sector for industrial energy conservation financing; and (b) strengthening the implementation of existing policies and regulations for promoting energy conservation investments. The Bank is uniquely positioned to provide the GOC with this support, given the Bank s close working relationship with the GOC during the last two decades, the Bank s successful experience in integrating technical assistance and lending operations with the GOC s policy agenda, and its successful support to innovative energy efficiency financing in several countries in recent years. -3-

12 C. Higher Level Objectives to Which the Project Contributes 9. The objectives of the proposed project are fully consistent with the Country Partnership Strategy for (Report No CN), approved by the Board on May 23, It directly supports a major pillar of the Country Partnership Strategy for China: managing resource scarcity and environmental challenges. It is also consistent with the Bank s recent efforts to develop a new investment framework to promote clean energy and energy efficiency by exploring effective ways of incorporating carbon finance and GEF technical assistance into the Bank s lending operations in China. In addition, the proposed project would support the World Bank Group corporate commitments of increasing renewable energy and energy efficiency lending support to clients by at least 20 percent per year during The proposed project will significantly increase commercial financing for medium and large-sized industrial energy conservation projects in China. This will strongly support the GOC s strategy to improve the energy efficiency of the energy-intensive industries. Such an improvement in industrial energy efficiency would contribute to the avoidance of additional GHG emissions and help mitigate global climate change impacts. 11. PROJECT DESCRIPTION A. Lending Instrument 11. The project is a financial intermediary lending operation. The Export-Import Bank of China (EXIM) and Huaxia Bank (Huaxia) are selected as the participating financial intermediaries (PFIs). The Bank loan product chosen by MOF for EXIM is a LIBOR-based US Dollar denominated single currency fixed-spread loan (FSL) at US$ 100 million. MOF has selected LIBOR-based US Dollar denominated single currency variable-spread loan (VSL) at US$ 100 million for Huaxia. The Bank loan will be on-lent by the MOF to the two PFIs at the same financial terms and conditions; and MOF will not provide any interest rate subsidy to the PFIs. The PFIs will be fully responsible for debt service and will bear all financial risks associated with the Bank loan allocated to them. B. Project Development Objective and Key Indicators 12. The project development objective i s to improve the energy efficiency of medium and large-sized industrial enterprises3 in China, and thereby reduce their adverse environmental impacts on climate. The project development objective will be achieved through: (a) an IBRD Loan to support energy conservation investments in medium and large-sized industrial enterprises through the selected PFIs; and (b) a GEF Grant for technical assistance to strengthen the government s capacity to enforce related laws, regulations, and standards; and assist the PFIs to develop and sustain energy conservation lending business lines. 3 The size of an industrial enterprise is defined by its annual revenues. According to the China State Statistical Bureau (2003 guideline), enterprises are defined as medium-sized if their annual revenues are in the range o f FWB30 to 300 million yuan (about US$3.9 to 39 million), and large-sized if in excess of RMB300 million (over US$39 million). The project aims to promote financing of medium and large-sized energy conservation investments in the energy-intensive, medium and large-sized industrial sector. -4-

13 13. Key performance indicators include: (a) the amount of incremental energy efficiency investments supported by the project; (b) the amount of energy saved by medium and large-sized enterprises in energy-intensive industries through investments financed and leveraged by the project, and (c) associated reduction of carbon dioxide (CO2) emissions (details in Annex 3). C. Project Components 14. This is an integrated IBRD/GEF-funded project designed to help remove the three principal barriers impeding investments in medium and large-sized industrial energy conservation projects. The technical assistance activities financed by the GEF Grant will address the knowledge, institutional and capacity building needs of the banking sector, mitigate the risk concerns of enterprises, and strengthen governmental supervision of industrial energy conservation. These efforts will be accompanied by an energy conservation financial intermediary lending program, which will demonstrate viable mechanisms for financing medium and large-sized industrial energy conservation investments, and provide direct support to the government s energy conservation priorities during the 1 lth FYP period. A detailed project description is given in Annex Both the GOC s Medium and Long Term Energy Conservation Plan and a technical study4 carried out as part of project preparation, have identified key energy-intensive industrial sub-sectors and energy conservation project types with significant potential for energy efficiency improvements and attractive financial returns. Energy intensive industrial sectors include iron and steel, chemicals and petrochemicals, and construction materials (mainly cement). The types of energy conservation projects reviewed and recommended include: (a) adoption of energy saving industrial technologies such as more efficient industrial boilers, kilns, and heat exchange systems; (b) recovery and utilization of by-product gas, waste heat and pressure; (c) installation of highly efficient mechanical and electrical equipments, including motors, pumps, heating and ventilation equipments; and (d) industrial system optimization to reduce energy use. While the PFIs will decide which particular energy conservation subprojects they will finance, subject to the eligibility criteria detailed in the project operational manuals developed jointly with the Bank, they are expected to focus on the industrial sub-sectors and energy conservation subproject types mentioned above. Some of the potential subprojects identified by the PFIs are listed in the Annex Component A: Promotion of Energy Efficiency Financing (estimated cost: US$l8.7 million; US$9.9 million of GEF co-financing). The proposed activities will address key barriers to developing energy conservation financing businesses in the domestic banking sector, primarily for medium and large-sized industrial energy conservation investments. They comprise: (1) Assistance to the PFIs to support: (i) business startup, including creation, organization, staffing, and initial business plan of the energy conservation lending business unit (or team); (ii) capacity building and training, including support for the development of necessary financial instruments, procedures, and the creation of an adequate knowledge base to evaluate and extend energy efficiency loans; (iii) marketing and development of 4 China Energy Efficiency Financing Project: Report for World Bank, Tokyo Energy December 31, The report is included in the project files. Efficiency Group, -5-

14 an energy conservation subproject pipeline; (iv) support to due diligence of eligible energy efficiency sub-loans, including financial, technical, social and environmental assessments; and (v) development of energy conservation-related financing instruments and risk management tools. Under this component, a performance-based GEF Grant of US$2.55 million will be allocated to the PFIs, at 0.43 percent of the volume of their eligible energy conservation lending under the project. This grant can be used to finance eligible technical assistance mentioned above. Assistance to other banks in: (i) business startup; (ii) capacity building; and (iii) due diligence on energy efficiency sub-projects. This assistance will be extended to two additional commercial banks, to be selected in the second year of project implementation. These two banks will lend their own funds to eligible industrial energy conservation subprojects, amplifying the impact of the proposed project and demonstrating the commercial attractiveness of energy efficiency lending. Assistance to the overall banking sector. This will include a series of national workshops to present successful case studies of subprojects carried out by the PFIs in the first one or two years, and introduce energy conservation technologies and new financial products. Assistance to energy consewation investment project demonstration, This will support the preparation and implementation of two to three industrial energy conservation projects in sectors with large replication potential, but with significant project development difficulties. The objective is to demonstrate effective business models and institutional arrangements for the preparation and financing of energy conservation projects. It will focus primarily on pre-investment activities, such as feasibility studies, due diligence, development of new financing mechanisms, and institutional arrangements. Component B: Energy Conservation Investment Lending (estimated cost: US$571.0 million). This component consists of an energy conservation lending program of US$571 million over five years: US$400 million in debt financing and US$ 171 of equity financing by beneficiary enterprises. 18. A US$200 million IBRD loan will be on-lent by the GOC to two PFIs: US$lOO million to EXIM and US$lOO million to Huaxia. The PFIs in turn will lend the funds to industrial enterprises and/or energy service companies for energy conservation investment subproject^.^ Their lending rates will be determined based on market conditions and will adequately cover the financial and operating costs and provide for a reasonable profit margin for the PFIs. The PFIs will lend in the same currency denomination in which they borrow their allocation of the IBRD loan and thus pass all the foreign exchange risk to borrowing enterprises. The PFIs have also agreed to lend, from their own resources, an additional amount equivalent to their respective IBRD loan allocation for energy efficiency investments. The subproject beneficiary enterprises The working definition of an energy conservation subproject as adopted in the PFI operational manuals is that the energy cost savings resulting from the subprojects will yield a simple payback period of less than 10 years for the total investment, with the subproject limited to renovation and rehabilitation within the confines of the beneficiary enterprise s existing facility. The overall single payback periods for the projects will be substantially shorter if other benefits of the projects are considered. -6-

15 are expected to contribute about 30 percent of project costs, a requirement by EXIM and Huaxia, amounting to US$17 1 million. 19. The staff of the PFIs energy conservation business teamhit will be trained to identify potential carbon financing candidates from their subproject pipelines. However, no GEF assistance will be provided to support the preparation of subprojects which are going to benefit from the sale of COZ emission reduction credits. For eligible subprojects that will apply for carbon financing from carbon funds managed by the Bank, the Bank will review the duediligence documentation to ensure the conformity with the agreed procedures detailed in the operation manuals before the completion of the transaction. 20. Component C: National Policy Support and Capacity Building (estimated cost: US$2.8 million; US$2.8 million of GEFJinancing6): This component will strengthen the government s capabilities to implement industrial energy efficiency policies and programs, through: (1) Assistance to ensure that the National Energy Conservation Center (NECC) is operational and fully functional, through support for organizational start-up and strategic planning. The main responsibility of NECC, approved for establishment by the State Council in August 2006, is to support the implementation of national energy conservation policies and programs; and (2) Support to the implementation of priority national energy conservation programs under the llt Five-Year Plan. This will mainly include a midterm review (2008) of implementation activities to identify problems, make recommendations and assist in implementing remedial measures. 21. Component D: Project Implementation Support, Monitoring and Reporting (estimated cost: US$I.I million; US$0.8 million of GEF co--naming): Because of the innovative character, complexity, and scale of the project, consultants will be recruited to provide project implementation support, which will include: (1) Assistance in the coordination of technical assistance activities to the banks and the government, as well as organizing project monitoring, evaluation, and reporting activities; and (2) Assistance to support the independent verification of energy conservation lending for the allocation of the perfonnance-based GEF grant and to monitor energy savings performance of subprojects financed by the PFIs. D. Lessons Learned and Reflected in the Project Design 22. Energy Efficiency Financing. A 2005 study under a World Bank/UN Foundation- United Nations Environment Programme (UNEP) Technical Assistance7 reviewed energy efficiency financing experience in Brazil, China and India. It identified three principal causes of GOC has also committed to co-finance this activity with the input of staff time and office facilities of the National Energy Conservation Center to be established under the project. 7 World Bank/U.N. Foundation-UNEP Technical Assistance Project, Development of Financial Intermediation Mechanisms for Energy Efficiency Investments in Developing Countries, September

16 operational failures in energy efficiency financing: (a) ineffective local institutional delivery mechanisms; (b) inadequate focus on building the technical capacity for assessing energy efficiency projects; and (c) lack of sustained effort and follow through, especially for adjusting institutional mechanisms and approaches during implementation, in response to market changes or operational inefficiencies. 23. The concerns and lessons identified in the study, as well as the recommendations from the study were fully incorporated in the project, through several key steps taken during project preparation. Firstly, a thorough assessment of the PFIs and their business practices was conducted. This was complemented with, a comprehensive study on market potential of major energy efficiency technologies in China s energy intensive sectors. Moreover, the project comprises carefully designed technical assistance and knowledge management programs to strengthen the PFIs capacity in selecting and evaluating energy conservation projects. Furthermore, the selection of energy conservation subprojects will be based on well-defined criteria to meet the project development objective, while in the meantime, the project pipelines are to be developed by PFIs and can be adjusted to adapt to the specific circumstances and changing needs of their clients, thereby ensuring flexibility and ease of implementation. Finally, the project builds on a decade-long experience of the World Bank Group/GEF energy efficiency studies and operations in China. 24. Financial intermediary lending. Lessons learned from lines of credit in China and other countries indicate that: 25. Lack of borrower accountability and weak management capacity of financial intermediaries hampered project implementation and jeopardized successful achievement of project development objectives. In the past, most of the failed financial intermediation operations in China were implemented by government agencies that lacked appropriate institutional and operational capacity and were compensated through a management fee. The selected PFIs under the proposed project are, in contrast, large policy and commercial banks with established sound institutional and financial operational capacity. Under the project, they will fully bear the financial risks and benefits from the lending operation. In addition, each PFI has agreed to establish a separate energy efficiency business teamhit with a clear mandate and accountability for developing their energy conservation financing business line. Moreover, the proposed project will build on the extensive industrial investment financing knowledge and skills of the PFIs which will be complemented by GEF technical assistance to build the necessary expertise and capacity for proper evaluation and processing of lending for energy conservation subprojects. Part of the GEF support is linked to the PFIs performance in building and developing their energy efficiency lending portfolios, which ensures that the intermediaries are held accountable for their activities and are rewarded for good performance, in the form of further support for strengthening their capacity. 26. Failure to assess demand appropriately and to develop bankable subprojects at early stages of project reparation slowed and even stalled project implementation. As confirmed by a technical study $? carried out during project preparation, there is a large and growing number of 8 China Energy Efficiency Financing Project: Report for World Bank, Tokyo Energy Efficiency Group, December 3 1, The report is included in the project files. -8-

17 energy-intensive industrial enterprises in China, for which energy efficiency investments present a financially viable opportunity. The surge in energy prices in recent years has further improved their financial attractiveness. The proposed project will help each PFI develop a robust pipeline of subprojects and work with government counterparts to launch programs to bring industry, banks, and service providers together to enhance interest in energy efficiency investments and develop bankable subprojects. The PFIs, in fact, have already begun identifying potential subprojects. A list of subprojects identified by the PFIs is presented in Annex 4. E. Alternatives Considered and Reasons for Rejection 27. During the preparation of the proposed project, two options were considered for the provision of financing for industrial energy conservation: (a) direct lending to industrial enterprises (direct lending operation); and (b) lending through domestic banks to industrial enterprises (line of credit operation). The first option, which would have focused on a specific industry and/or a few large energy conservation subprojects, could have generated significant project-level energy savings, but given the small size of the Bank loan compared to the financing needs, it would have had very limited impact on scaling up and mainstreaming industrial energy conservation financing. The second option was retained because it starts-up energy conservation business lending through the Bank loan and assists the PFIs in developing and sustaining the business lines by building upon their existing industrial sector knowledge and client base. The direct involvement of the banks in energy conservation investment financing and targeted technical assistance provided by the project will significantly shorten the banks learning curve and speed up their energy conservation lending business development. Compared to the first option, the second one would contribute significantly more to the scaling up and sustenance of industrial energy conservation investment financing, a key to the achievement of the project development objective. 28. The proposed project is selective and targets a well-defined subset of the energy conservation financing market. It focuses on renovation and rehabilitation of existing industrial facilities rather than on financing new projects and capacity expansions for which commercial financing is widely available in China. IV. IMPLEMENTATION A. Partnership Arrangements 29. As part of the project design process, other multilateral and bilateral energy efficiency projects in China were reviewed. The China End-Use Energy Efficiency Project (EUEEP) financed by GEF, and being implemented by the United Nations Development Programme (UNDP) and NDRC, is the most relevant to the proposed project. Component C.1 of the proposed project (Assistance to the Establishment of the National Energy Conservation Center) will complement and reinforce one of the main technical assistance activities of the EUEEP project, namely Capacity Building and Training for Provincial Energy Conservation Centers. The EUEEP also will provide substantive energy audit trainings to selected provincial energy conservation centers. The PFIs will build on the energy audit work of the provincial centers to identify and assess potential energy conservation financing opportunities. In addition, the project -9-

18 will coordinate with the IFC/GEF CHUEE Project and projects financed by other agencies, such as the French Development Agency (AFD). B. Institutional and Implementation Arrangements 30. The proposed project will be implemented over five years. A Steering Committee will be established to provide overall strategic and policy guidance to the implementation of the project activities. The Steering Committee will be chaired by NDRC, and will comprise representatives from both MOF and NDRC. A Project Management Office (PMO) has been established by NDRC and will function as the executive office of the Steering Committee. On behalf of NDRC, the PMO will be responsible for overall coordination, monitoring and reporting during project implementation. In addition, it will implement the capacity building and technical assistance activities (Component A(2), A(3), A(4) and Component C, and D) not directly implemented by the PFIs. The PFIs will be responsible for the implementation of energy conservation lending (Component B) and PFI-related technical assistance activities (Component A [ 11). If requested by the PFIs, the PMO will provide procurement and other technical services to the PFIs for the GEF financed technical assistance activities to be implemented by PFIs. The PMO has been established building upon the expertise and experience of the existing PMO for the on-going WB/GEF-funded Second China Energy Conservation Project. This existing PMO had also been effectively conducting project coordination activities for the Bank-financed First China Energy Conservation Project. 31. The MOF will represent the People s Republic of China in signing the Loan Agreement. It will on-lend the funds to each PFI, in accordance with a subsidiary loan agreement to be signed between the MOF and each of the PFIs. The PFIs have full responsibility over the energy efficiency lending and related technical assistance activities. Within each PFI, a project teamhit has been set up to coordinate or implement the sub-lending activities. The PFIs have prepared operational manuals for project implementation. They cover financial management, procurement arrangements, detailed institutional arrangements, and economic, financial, technical, environmental, and social due diligence procedures and methodology. The manuals were reviewed and approved by the Bank during appraisal. 32. Huaxia has selected the reimbursement-based method for Bank loan disbursement. EXIM has chosen advance method. Quarterly financial reports will be used as supporting documentation for loan reimbursement, advances and use of advances. The GEF Grant will be disbursed using Statement of Expenditure (SOE). C. Monitoring and Evaluation of Outcomes and Results 33. Monitoring of the implementation of the proposed project would involve: (a) the monitoring of performance indicators, as included in Annex 3; (b) annual progress reports; and (c) a midterm review of implementation progresses. The PMO will be responsible for overall monitoring and evaluation of implementation progresses, including the collection of project performance information and reporting on the impact and results of the project. It will develop a monitoring and evaluation plan during the first year of implementation, and a member of the PMO will be assigned to collect information and maintain databases to monitor the implementation performance of all the project components. For activities to be implemented by the PFIs, the project team within each PFI will be responsible for collecting information with the - 10-

19 assistance of the PMO and reporting to the Bank through the PMO. An independent third party will be contracted to monitor and validate energy conservation-related lending disbursements by the PFIs. D. Sustainability and Replicability 34. Sustainability. Evaluations by GOC and independent parties have confirmed that: (a) there is a large untapped bankable energy conservation investment potential in energy-intensive industries; and (b) the PFIs are willing and able to develop and sustain viable commercial energy conservation lending businesses that would substantially increase investments in industrial energy conservation. Sustainability will most likely be achieved through the integrated, twopronged approach of the project: (a) operational engagement of financial institutions by making available special loan funds dedicated to start-up industrial energy conservation lending; and (b) provision of technical assistance for capacity and market development to support energy Conservation lending activities of PFIs and demonstrate their viability at the early stage of project implementation. 35. Replicability. The development of a robust subproject pipeline and the financing of subprojects which are financially highly attractive in the initial years of project implementation will be important to demonstrate project viability and ensure project replication. The replication of sound energy conservation lending business model(s) among domestic banks will be promoted by providing hands-on assistance at a later phase of the project to two additional banks willing to use their own resources to finance industrial energy conservation investments. Additionally, the dissemination of the early experiences of the PFIs throughout the banking and industrial sector, to be implemented as part of the project, should result in replication of successful initiatives. It is expected that the PFIs will build expertise in energy conservation lending to specific industries and project types, based on their project portfolios and targeted markets. Through such specialization and replication, the PFIs should be able to quickly build a strong knowledge base to target financially sound energy conservation subprojects, lower transaction costs significantly as evaluation and appraisal processes are streamlined, and thereby gain business confidence to further scale up their energy conservation business line. Overall, the replication potential is backed by the large size of industrial energy conservation market in China, especially in energy intensive manufacturing industries, such as steel, cement, synthetic ammonia, and petrochemicals

20 E. Critical Risks and Possible Controversial Aspects Risks Risk mitigation measures Risk rating with mitigation Weakened government commitment to promote industrial energy conservation as a major way to meet the 20 percent target for the reduction in energy intensity of GDP under the 1 lth FYP ( ). Commitment to im rove energy efficiency is one of the highest tr priorities of the 11 FYP and this has been reaffirmed by officials at the highest level of the government. The GOC has set up a series of stringent technical guidelines and standards to prevent the expansion of inefficient industrial facilities. Low Weak implementation capability of the government To component results Slow subproject pipeline development Slow buildup of PFIs capacity to appraise and process subproject loans. Slow pace in establishing the NECC due to budget and staffing difficulties. Overall risk rating The NECC to be established under the project will further strengthen the government s capability of enforcing related energy conservation policies, laws, regulations and standards. PFIs already developed solid subproject pipelines. Technical assistance will be provided to the PFIs for business development. The disbursement o f part of the GEF grant will be linked to the disbursement o f energy conservation loans by the PFIs. Technical assistance will be provided to all the PFIs for business startup, new product development and capacity building at very early stages of the project implementation. Strong leadership assumed by the NDRC in creating NECC and the pressing need of the government to strengthen its implementation capacity for the priority energy conservation Drograms endorsed bv the 1 lth FYP. I Modest Modest Low Modest Modest F. Loadcredit Conditions and Covenants 36. Condition of Disbursement under the GEF Trust Fund Gvant Agreement: The adoption by the PMO of the NDRC of the financial management manual satisfactory to the Bank and applicable to the portion of the GEF grant allocated to the NDRC will be a disbursement condition against the disbursement of the grant allocated to the NDRC. 37. Conditions Applicable to Project Implementation: EXIM and Huaxia shall maintain the energy conservation lending unit or team with adequate staff and resources during the entire project implementation period and apply their respective operational manuals and financial management manuals satisfactory to the Bank. EXIM shall implement the action plan agreed with the Bank to address its accounting and management weaknesses

21 IV. APPRAISAL SUMMARY A. Economic and Financial Analyses Economic and Financial Due Diligence of the PFIs 38. EXIM and Huaxia were selected as potential PFIs from among six Chinese banks screened at the early stages of project preparation. Subsequently, the Bank performed its financial due diligence of Huaxia in accordance with the established eligibility criteria set by Bank Operational Policy 8.30 and confirmed its selection as a PFI. In the absence of financial statements prepared and audited in accordance with accounting and auditing principles acceptable to the Bank, EXIM undertook agreed-upon interim measures to assist the Bank in evaluating its financial performance for the year ending December 31, EXIM has also developed a time-bound action plan to address accounting and management weaknesses identified by the Bank due diligence team. This plan has been reviewed by the Bank and regarded as satisfactory and EXIM has agreed to implement the plan. Consequently, EXIM s participation in the project was confirmed during appraisal. 39. EXIM is one of the three state-owned policy banks in China, while Huaxia is a commercial bank established in October At the end of 2006, Huaxia had a capital adequacy ratio (CAR) of 8.2 percent, and its ratio of non-performing loans (NPLs) stood at 2.7 percent based on audits in accordance with International Accounting Standards (IAS), while EXIM had a CAR of 2.19 percent and NPL ratio of 3.47 percent. However, EXIM has the same international credit rating as Chinese sovereign debt due to the explicit and implicit credit supports from the Government. Economic and Financial Analysis of the Pvoject 40. The selection of subprojects for energy efficiency financing will be the responsibility of the PFIs. The financing will focus on renovation and rehabilitation activities whose primary financial benefits will be derived from energy savings. 41. It is widely recognized that most energy efficiency investments are economically justified, especially at current high energy prices which are expected to prevail in the medium term. In China, where coal is the dominant primary energy resource, the economic justification is even stronger, because of the significant environmental benefits expected from energy efficiency investments, resulting in economic internal rates of return (EIRRs) that are higher than the financial internal rates of return (FIRRs). This project is built on the premise that the proposed energy efficiency subprojects are economically justified if they are financially viable. The PFIs are only requested to analyze and confirm that the selected subprojects are financially viable. 42. To confirm the validity of the above premise, economic and financial analyses were carried out on four representative subprojects, which were part of the first batch of subprojects envisaged for financing under the proposed project. The four subprojects include two waste heat recovery subprojects, a subproject to replace outdated fans and pumps with more efficient ones, and a subproject to revamp a production line in a petrochemical complex. A more detailed -13-

22 description of these four subprojects is provided in Annex 9. The subproject investments ranged from US$5 million to US23 million. The financial impacts of the subprojects were analyzed based on the financial benefits, derived mainly from energy savings of the subprojects, and the costs, mainly investment and incremental operating costs due to the subprojects. The economic analysis also took account of the environmental benefits from reduced C02,,902, and particulate emissions. The FIRRs were calculated with and without assuming the benefit of carbon financing for a 10-year period. The resulting FIRRs ranged from 11.2 to 48.2 percent (before income tax) without carbon finance and 12.4 percent to 59.2 percent with carbon finance benefits, demonstrating the financial attractiveness of these subprojects. The corresponding payback-periods ranged from 1.5 to 6.6 years without carbon finance and 1.2 to 5.9 years with carbon finance benefits. The analyses showed that the ERR for the representative subprojects ranged from 13.1 percent to a high of 62.8 percent, exceeding the 12.0 percent economic discount rate that is normally applied to Bank projects in China. Details of the financial and economic analysis are provided in Annex 9. B. Technical 43. A technology screening and review was undertaken by international consultants for all the major energy conservation technologies in China s major energy-intensive industries. The review finds that all the established technologies are technically sound and commercially available. The results have been provided to the PFIs for their reference. Furthermore, the operational manuals, prepared by the PFIs and approved by the Bank, stipulate that industry specialists and energy audit experts will be included in the subproject due diligence teams, and that they will ensure that the subprojects are in compliance with Chinese industrial and technical policies and regulations; fully satisfy the technical eligibility criteria; and are technically feasible. Technical assistance to build capacity for project technical due diligence will be also provided to the PFIs during project implementation. This will ensure that the design of the subprojects will be technically sound. C. Fiduciary 44. The proposed project meets the minimum Bank financial management requirements, as stipulated in BP/OP The project recipients of the IBRD loan and GEF grant assistance have agreed to maintain financial management arrangements that are acceptable to the Bank. Taking into account the risk mitigation measures proposed under the project, the FM risk rating proposed for this project i s moderate. The details of the financial management arrangements are available in Annex The procurement capacity assessment of the NDRC concluded that it has adequate experience and capacity to carry out the procurement activities related to technical assistance to be funded by GEF. The procurement assessments of the two PFIs have also been completed with satisfactory results. In this respect, the procurement risk is rated as average. A brief summary of the procurement capacity assessment and more details on the procurement arrangements are provided in Annex

23 D. Social 46. The energy conservation subprojects to be financed under the proposed loan will be within the existing premises of industrial facilities and will not require additional land acquisition. In addition, subprojects which result in workforce redundancy will not be eligible for project financing. Hence, the proposed project will not trigger any social safeguard policies. E. Environment 47. In accordance with World Bank environmental safeguard policies (OP/BP/GP 4.01), the project has been assigned Category FI since individual subprojects to be financed by the PFIs will be identified after project implementation. As is the requirement for FI projects, the PFIs prepared a Framework Environmental Impact Assessment (EIA) Document (Framework Document) acceptable to the World Bank. This Framework Document is presented in Annex The Framework Document describes procedures to be followed by any Sub-borrowers and PFIs to satisfy both Chinese and World Bank EIA regulations and policies. Chief features of the Framework Document include procedures to be followed for screening, Environmental Assessment documentation, public consultation, EIA review and approval, disclosure, supervision, and reporting. The Framework Document specifies that any subproject that Chinese environmental authorities determine as requiring a full EIA during screening (equivalent to World Bank Category A) or as requiring land acquisition will be rejected from further consideration under the World Bank loan. The overwhelming majority of energy efficiency subprojects are anticipated to have either minor or no environmental impacts. Therefore, this criterion is not expected in anyway to limit the subproject pipeline. 49. A primary requirement of the Framework Document is the requirement that the Subborrowers provide the PFI an Information Package that includes the Sub-borrower EIA approval letter or certificate, the EIA document, and documentation that consultation and disclosure were performed in accordance with Chinese and World Bank requirements. Furthermore, since energy efficiency subprojects are almost always associated with an existing operatiordprocess, the Information Package will also include documentation that the connected project had all the necessary Chinese EIA approvals prior to construction and/or operation of the connected facilities. 50. All PFIs will contract with Chinese environmental consultants for any technical reviews or activities that are their responsibility. Since the potential environmental impacts likely to be associated with the anticipated subprojects are either minor or negligible, this arrangement is considered acceptable. 9 For a Financial Intermediary (FI) operation, the Bank requires that each FI screen proposed subprojects and ensure that sub-borrowers carry out appropriate EA for each subproject. Before approving a subproject, the FI verifies (through its own staff, outside experts, or existing environmental institutions) that the subproject meets the environmental requirements of appropriate national and local authorities and is consistent with the applicable environmental policies of the Bank. -15-

24 F. Safeguard Policies Safeguard Policies Triggered by the Project Environmental Assessment (OPIBPIGP 4.01) Natural Habitats (OPIBP 4.04) Pest Management (OP 4.09) Cultural Property (OPN 11.03, being revised as OP 4.11) Involuntary Resettlement (OPIBP 4.12) Indigenous Peoples (OD 4.20, being revised as OP 4.10) Forests (OPIBP 4.36) Safety of Dams (OPIBP 4.37) Projects in Disputed Areas (OPIBPIGP 7.60) Projects on International Waterways (OPIBPIGP 7.50) G. Policy Exceptions and Readiness: 5 1. The project does not require any policy exceptions. Yes [XI No [I [XI [XI [XI [XI [XI [XI [XI [XI [XI 52. The project is ready for implementation: (a) EXIM and Huaxai have identified subprojects for lending amounting to over 50 percent of the Bank loan amount; (b) both banks have established project teams to implement the project; and (c) NDRC has established a PMO for project implementation

25 Annex 1: Country and Sector or Program Background CHINA: ENERGY EFFICIENCY FINANCING PROJECT MACROECONOMIC OVERVIEW 1. Recent macroeconomic developments. In 2006, China enjoyed GDP growth in excess of 10 percent for the fourth year in a row. This sustained high level of economic growth can be attributed to four principal drivers. First, continued economic reforms have made China s labor and capital resources more productive. World Trade Organization (WTO) accession in 2001, with increased entry and competition in domestic markets and improved access to foreign markets, has propelled trade, investment and competition, factors that are associated with productivity increases around the world. China has also been reaping the full benefits of the state-owned enterprises (SOE) reforms initiated in the mid- 1990s. Second, increased business profitability and a recovery in government revenues have boosted already high savings and investment. China s high saving and investment allowed more capital deepening and infrastructure construction, which in turn increased labor productivity and potential GDP. Third, better macroeconomic management has reduced economic volatility and risk. Fourth, the global environment has been very favorable. Global growth in the last five years has been remarkably resilient, and averaged around 4 percent, levels not seen since the late 1980s. This has created a favorable environment for China s exports, which grew an average of almost 30 percent per year. Real GDP growth rate (production side) Consumer price inflation Current account balance (USD billions) As share of GDP Foreign exchange reserves (USD billions) * 10.0% 10.1% 10.4% 10.7% 9.6% 1.2% 3.9% 1.8% 1.5% 2.5% % 3.6% 7.1% 8.7% 6.3% ,066 1, As exports continued to outpace imports by a wide margin, China s trade surplus reached new record highs in the second half of 2006, and the contribution of net trade to GDP growth increased from almost 2 percentage points in the first half to 3.3 percentage points in the second half of Rapid increases in trade surplus and foreign direct investment (FDI) flows have led to China s foreign exchange reserves increasing at a rate of 38 percent annually during , with reserves of over US$1 trillion at the end of The trade surplus may flatten out eventually because the expansion of manufacturing capacity that underlies much of it is likely to moderate. Nevertheless, imports have been growing more slowly than would be expected based on historical patterns for a few years now, in part because of continued deepening of supply chains within China. China s investment and export based growth model has come under increasing global scrutiny because of its implications for trade, and environmental and resource use sustainability. 3. With regard to inflation, consumer price inflation has picked up recently, mainly due to higher food prices, especially grain prices. Since WTO accession, grain prices in China have been moving more in line with international prices. In December 2006, consumer prices rose by - 17-

26 2.8 percent (year on year based). Non-food consumer price inflation remained modest at around 1 percent. Despite the increase in consumer price inflation, medium-term inflationary pressures remain moderate, given relatively good credibility of monetary policy, a strong currency, and excess labor force in the economy. 4. China s trade in goods is already very open, and further opening up, while desirable, is likely to generate less efficiency gains than in the past. Moreover, if driven by accumulation of capital alone, growth will be subject to diminishing marginal returns. However, long-term prospects for economic growth in China remain good. It is expected that increases in both labor and capital productivity, where China lags behind significantly compared to more advanced countries, will be an important source of future growth. Forty percent of China s labor force is still tied up in low productivity agriculture, where labor productivity is only around one-sixth of that in the rest of the economy. On the demand side, growth in consumption is expected to play a more important role in the future, both to sustain economic growth and to mitigate trade imbalances. Most of the decline in the consumption to GDP ratio since the late 1990s can be explained by the decline in the share of wage income in the total economy rather than a change in household savings behavior. The share of wages in GDP declined from 53 percent in 1998 to 41.4 percent in 2005 compared to 57 percent in the United States. BANKING SECTOR OVERVIEW 5. The third national financial work conference concluded on January 20, 2007 set out directions for improving China s financial sector. This high level meeting, held every 5 years, has charted major new policies in the past. This year s meeting discussed a wide range of reforms including in rural finance, policy banks, and foreign exchange management. The meeting decided on broad direction of reforms, which over the coming months and years will become more detailed. 6. Restructuring of the ownership of the state-owned commercials banks (SCBs) has sped up in 2005 while China is required to honor the WTO stipulation to open up its banking sector fully to foreign investors by the end of Among the four largest state owned banks (SCBs), the China Construction Bank (CCB) completed its high-profile public offering on Hong Kong Stock Exchange in October 2005, the Industrial and Commercial Bank of China (ICBC) and the Bank of China (BOC) had received approval for their selection of international strategic investors and are preparing for initial public offerings (IPOs) in 2006 or The foreign strategic investors have promised to contribute to improvement of corporate governance, risk management, new product development and asset management of the banks they have invested in, through nomination of board directors. Full time directors have been assigned to the board of each SCB by the central government through Central Huijin Corporation, a quasi bank restructuring agency whose stake in financial institutions is rapidly rising as its equity investment covers both banks and securities houses. 7. Equity participation by foreign banks is seen as a vote of confidence in the Chinese banks as well as the Chinese economy in the long run. Nonetheless, it remains unclear whether the foreign investors have enough incentives to monitor the bank, since their shares are only 510%

27 to begin with. To enable the 3 SCBs to prepare for IPOs, the government has invested heavily, through both injection of capital and purchase of NPLs. 8. Total reported NPLs of commercial banks accounted for 8.6% of the total loans at the end of 2005, reduced from 13.2% in The reported NPL ratio of the Big-Four State-owned Commercial Banks also decreased to 10.5% in 2005 from 15.6% in The rate of return on asset and on equity remains low industry-wide. According to the new series of Indicators for Risk-based Supervision of Commercial Banks issued by the China Bank Regulatory Commission (CBRC) in January 2006, the minimum rate of return on asset of commercial banks should be 0.6% and return on equity 11%. This new rule is currently applicable to the Big-4 SCBs under restructuring, and will be officially enforced in Foreign participation in second-tier banks. By the end of 2005, 173 foreign banks from 40 countries and regions had established 240 representative offices in 23 cities in China, and 71 foreign banks from 20 countries and regions have established 238 operational entities (including 181 branches and 14 legal entities) in 23 cities in China. Total assets of these foreign banks in China reached US$84.5 billion, accounting for about 2% of the total banking asset of China. 19 foreign financial institutions have invested about US$20 billion as of the end of 2005 in Chinese banks. In response to CBRC regulations on capital adequacy and risk management, the second-tier banks, including both joint-equity national banks (14) and city commercial banks (1 14), have intensified efforts to replenish capital. The increased appetite for foreign and private capital has provided a window of opportunity for foreign banks to take equity positions in banks that would not have opened up in the past. Up to now more about 15 second-tier banks have received foreign investment, and several more are in the process of doing so. 10. On rural finance, January 20, 2007 conference decided to reduce the access threshold for financial institutions into the rural market and to continue the shareholding reforms of the Agricultural Bank of China (ABC). Before the conference, the CBRC had already announced more detailed measures regarding increased access. They are a major step towards a more open and diverse rural financial market, which for decades has lagged behind developments in other parts of the financial sector. This is particularly true on the lending side. Other financial services such as depositing money and payments services are abundantly available. The net withdrawal of funds from the countryside, which is common around the world, is accentuated in China by insufficiently developed rural finance. Key factors hindering lending are constraints on entry, limits on lending rates, weak existing rural financial institutions, and an inadequate legal environment. These issues have taken central stage as better rural finance is an important building block for the new socialist countryside and harmonious society. Looking ahead: (a) for rural finance to be sustainable it needs to be commercially viable, with interest rate caps removed; (b) rural economies and finance would benefit from a more diversified field of providers; (c) a more differentiated rural financial sector will require adjustments to the regulation and supervision framework; (d) the government rightly is putting renewed emphasis on reforming the ABC; and (e) consolidation of reform of the Rural Credit Cooperatives (RCCs) is important. -19-

28 ENERGY EFFICIENCY CHALLENGES 11. China is the second largest GHG emitter in the world, mainly due to its enormous fossil fuel (primarily coal) consumption. During , energy consumption in China grew at a rapid pace of 6.0 percent annually, more than three times faster than the world s average annual growth. The total energy consumption and total GHG emissions from energy consumption surged to about 2.7 billion tons coal equivalent (tce) and around 920 million tons of C02 emissions, respectively, in Despite the high growth, China s per capita energy consumption is still at less than one fifth of the OECD average, with significant room to grow as the economy continues to expand rapidly. Supplying China s ever growing energy needs with fossil fuels, especially coal, will most likely result in unacceptable environmental damages, both locally and globally, and escalate energy security concerns. Low Energy Efficiency and Improvement Barriers 12. Despite China s achievements in improving energy efficiency in the Os, its level of energy efficiency still remains significantly lower than that of the most efficient economies in the world. The large and growing contribution of the energy-intensive industrial sector in China s economy has been a primary reason for the rapid increase in energy consumption in recent years. This sector accounts for about 50 percent of total final energy consumption in China. The energy-intensive manufacturing industries in China operate at significantly lower levels of energy efficiency when compared to international best practices, with energy use per unit of production higher in China by, for example: 22% in iron & steel, 19% for coal-fired power plants, 37% for nitrogen fertilizer, 15% for coal-fired boilers, and 40% for cement The significant potential and technical options for energy efficiency improvement and GHG emission reduction in these sectors is largely untapped in China even though the opportunity to gamer high financial returns through the application of many internationally well-proven energy efficiency technologies and techniques are currently available. The consensus among Chinese experts is that most of the existing fixed assets in China s energy intensive industries, especially those in medium and large enterprises, will still remain in production until at least Hence, there is a large window of opportunity in the next five years to rehabilitate and upgrade these existing industrial assets to improve their energy efficiency significantly. 13. The estimated energy conservation investments needed to achieve the 20 percent energy efficiency target surpass US$.50 billion-most of them in industries12. Although Chinese experts agree that the majority of the identified industrial energy conservation investments are financially viable, most of the concerned enterprises would rather invest in business expansion than energy conservation projects from internal resources. The domestic banking sector has also not stepped in to provide the required financing, especially for medium and large-sized energy conservation investment projects. In 2006, the first year of the 11 th FYP ( ), the energy intensity of GDP did not decline as planned, partly because of the continued heavy bias toward 10 II I2 Assuming a carbon intensity of 2.3 ton C02elton raw steel production based on the analysis in China Sustainable Energy Scenarios in Energy Research Institute of China, State Development and Reform Commission, Mid and Long-term Energy Conservation Plan, Shen Hongwei, November 23,2006. Economic Daily

29 energy-intensive, expansion-oriented investments in the industrial sector. This has increased the urgency to accelerate government efforts to promote industrial energy conservation investments. 14. The existing industrial energy conservation financing mechanisms in China have mainly benefited relatively small projects. The Bank's First and Second China Energy Conservation Projects, funded by the World Bank/GEF, have been credited for the development of China's energy services industry. The EMCs13 supported by the two projects made US$245 million worth of investments in 2005, many of them in the industrial sector. However, few of the EMC investments exceeded US$l million. Another ongoing project, the IFC/GEF CHUEE Project, also supports small-scale industrial energy conservation investments. It promotes the installation of more energy-efficient equipments with commercial bank financing backed by a guarantee facility. 15. There is a large financing gap for medium and large-sized energy conservation investments in the industrial sector,14 which normally costs US$5-25 million per project. Before the late 1990s, public funds were the primary financing source for medium and large-sized industrial energy conservation projects, including the central government's dedicated energy conservation funds channeled through state-owned banks, and local government counterpart financing. Since then, the GOC has gradually eliminated public funds earmarked for industrial energy conservation project financing, expecting that Chinese enterprises to invest their own resources and banks to build energy conservation lending business lines, given the economic and financial attractiveness of such projects. This expectation has not materialized. There are three key barriers which have impeded the development of the lending market for medium and largesized industrial energy conservation investments, compared to its large potential. They include: Perceived high technical and financial risks of energy conservation investments among industrial enterprises. Perceived high financial risks of industrial energy conservation lending among Chinese banks. Insufficient institutional capacity, especially at the national level, to address the pressing needs of scaling up energy efficiency investments. 16. Perceived high technical andfinancial risks of energy conservation investments among industrial enterprises. Compared with small industrial energy conservation projects, which often involve simple replacements or upgrades of equipment and have very short payback periods (one to two years), medium and large-sized projects typically are technically more complex and require longer payback periods. In addition, larger energy conservation projects EMCs are the Chinese equivalent of energy service companies (ESCOs) in North America. These companies finance energy conservation projects of the clients and share the benefits o f energy savings with the clients based on the performance of the energy conservation projects. The size of an energy efficiency investment is defined by the estimated investment cost o f a single energyefficiency technology intervention. The targeted energy efficiency investments o f the proposed project range from about US$5 to 25 million, compared with small sized investments o f about US$1 million or less. The size of an industrial enterprise is defined by its annual revenues. According to the China State Statistical Bureau (2003 guideline), enterprises are defined as medium-sized if their annual revenues are in the range o f RMB30 to 300 million yuan (about US$4 to 39 million), and large-sized if in excess of RMB300 million (over US$39 million)

30 generally impose business interruptions, resulting in lost production and revenues which increase overall project cost. These characteristics usually lead to the perception that energy conservation projects are technically risky and yield low financial returns, making energy conservation investments unattractive, especially when compared with capacity expansion investments. Lack of familiarity with the range of energy conservation technologies and processes, and energy conservation investment best practices as well as the under-appreciation of financial benefits from energy conservation investments are primarily responsible for the high risk perception among industrial enterprises. In recent years, the rapid increase in energy prices have improved the prospects for higher financial return from energy conservation investments and raised the interest o f industrial enterprises to undertake such investments. 17. Perceived high financial risks of industrial energy conservation lending among Chinese banks. Interest in developing and implementing industrial energy conservation projects have been further dampened by the unavailability of debt financing for such projects. Chinese banks have considered lending for energy conservation projects to be risky, in part, for the reasons mentioned in paragraph 16. Additionally, compared to production expansion projects, energy conservation projects usually do not directly generate additional revenues, but rather contribute to a reduction in energy expenditures. This makes it difficult for banks to assess the positive cash flow contribution from energy conservation investments, and attribute sufficient market value to the energy conservation project assets to justify significant lending. The risk perception among Chinese banks has been compounded by their unfamiliarity with industrial energy conservation practices, and their weak capacity to properly assess their risks and benefits. The perceived high risk along with the significant initial cost o f developing the internal capacity for proper evaluation and processing o f energy conservation lending have resulted in a lack of institutional focus on developing energy conservation business lines by Chinese banks 18. Insufficient institutional capacity, especially at the national level, to address the pressing needs of scaling up energy efficiency investments. In the wake of the rapid expansion of energy-intensive industries in the last decade and the increased decentralization of decision making, the govemment s capability to effectively implement its energy efficiency policies and programs has declined considerably. Given the size and large weight of the energy-intensive industries in China s economy, as well as the widespread inefficient practices among their major facilities, policy and regulatory interventions need to be strengthened significantly to encourage industrial enterprise to undertake energy efficiency investments. Government Programs in Energy Efficiency 19. The GOC has placed high priority to promoting energy conservation and considers improvements in energy efficiency as an important pillar in its efforts to shaping a more environment and resource-conscious, sustainable economic growth path. Aided by the implementation of an Energy Conservation Law passed in 1997, the Government has been endeavoring to develop and implement various energy efficiency standards and labeling programs for energy-intensive equipment, codes for new buildings, and some unit energy consumption benchmarks for new industrial plants. A revised Energy Consewation Law is in preparation and planned to be submitted to the National People s Congress (NPC) for approval in

31 20. Recently, the GOC has stepped up its efforts to address China s energy conservation challenges. In November 2004, the NDRC issued the nation s first Medium and Long Term Energy Conservation Plan (2005 to 2010 and 2020) which highlighted ten energy efficiency programs mainly targeting the country s major energy intensive sectors for energy efficiency improvements. The 1 lt FYP for Economic and Social Development ( ) endorsed by the People s Congress in March 2006 incorporates major objectives of energy conservation, including: (a) significant increase in overall energy efficiency, in major industries and for the major products, for which the unit output energy use will reach or be close to the leading level in the world at the time of early 21St century; (b) build robust energy conservation systems including supportive law and standards, policy, technical service, inspection and management, which are compatible and consistent with the socialist market economy; and (c) emphasize a new, market-oriented growth model that also is much more energy efficient and environmentally friendly. More importantly, the GOC made an important pledge in its 1 lth FYP to reduce energy intensity of GDP by 20% from 2005 to While GOC expects structural changes in the economy with an increased role for the service sector to contribute to roughly two-thirds of the energy intensity reduction target, it has emphasized that a significant part will need to come from technical improvements, especially in energy-intensive industrial sectors. As a result, NDRC launched the I 000 Large Industrial Enterprises Energy Conservation Program in April 2006, targeting the top 1008 largest industrial energy consumers in China who account for approximately 33 percent of China s total primary energy consumption. These enterprises are from nine energy intensive industries: steel, non-ferrous metallurgical, coal-mining, electricity, petrochemical, chemical, construction materials, paper, and textile industries. The government efforts also include a series of policy initiatives to foster technology development and dissemination, and to provide various fiscal incentives. However, without measures to overcome the financial barriers and a proactive development of the energy efficiency financing market, the large window of opportunity to improve energy efficiency in existing industrial facilities will go largely untapped. Bank s Involvement in Energy Efficiency 22. The proposed project is requested by the NDRC and the MOF. The GOC considers the project as an important follow-up to the GEF-funded First and Second China Energy Conservation Projects which support commercially viable energy conservation projects by introducing an energy performance contract mechanism through EMCs. The EMCs have been especially successful in arranging financing for small energy conservation projects, but are not positioned to serve the medium and large-sized industrial energy conservation projects market segment. The IFC/GEF CHUEE Project, currently under implementation, is also focused on promoting small-sized energy conservation investments. The proposed project complements and reinforces the on-going BanWIFC projects focused on promoting energy conservation activities in China, by addressing the financing gap in the medium and large-sized industrial energy conservation investment market, often referred to as a goldmine of energy savings by Chinese energy conservation experts because of the potential for significant energy savings from each project in this market

32 23. China s rapid ascendance to world manufacturing powerhouse has not been accompanied by a transition of its industrial sector to world-class energy efficiency. The sharp increase in coal consumption since 2001, driven by surging demand in power generation and energy-intensive industries, has increased the energy intensity of the economy, reversing a descending trend achieved during the period. This has heightened the urgency for Government intervention to scale up energy efficiency investments, and led to intensified government focus on energy conservation during the 11th FYP ( ). The combination of government priority to enhance industrial energy efficiency and the large stock of energy-inefficient industrial equipments and processes presents a significant window of opportunity to scale up energy efficiency investments with attractive investment returns in medium and large-sized manufacturing facilities. Seizing this window of opportunity requires a two-pronged approach, focusing on: (a) the development and implementation of viable business models for industrial energy conservation financing for demonstration purposes; and (b) strengthening the implementation of existing policies and regulations for promoting energy conservation investments. The Bank is uniquely positioned to provide the GOC with this support, given its close working relationship with the GOC during the last two decades, its successful experience in integrating technical assistance and lending operations with the GOC s policy agenda, and its successful support to innovative energy efficiency financing in several countries during recent years

33 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies CHINA: ENERGY EFFICIENCY FINANCING PROJECT Sector Issue Bank-GEF-financed Energy-efficiency and environmental improvements Energy-efficiency and environmental improvements Energy-efficiency and Project OED Latest Supervision (PSR) Ratings rating (Bank-financed project only) Implementation Development Progress (IP) Objective (DO) Heat Reform and Building Energy Efficiency Energy Conservation Project S S Second Energy Conservation NA S S Energy-efficiency and I Efficient Industrial Boilers I NA I S S environmental improvements Energy-efficiency and Shandong Environment NA S S environmental immovements Proiect Energy-efficiency and I UNDP China: End-Use I NA I NA environmental improvements Energy Efficiency Project (EUEEP) NA 1. The project has been developed and will be implemented in close coordination with the on-going energy efficiency related international assistance program in China, thereby maximizing knowledge-sharing and incorporating lessons learned into project design. The First and Second China Energy Conservation projects focus on promoting energy efficiency through the development of ESCO industry in China. The PMO which managed these two projects will also provide implementation support for the project, ensuring real coordination and complementarities to take place between these two projects and the proposed project. The UNEP and Energy Sector Management Assistance Programme (ESMAP) financed Three Country Energy Efficiency Project study on energy efficiency financing mechanism in China, India, and Brazil has been instrumental in the preparation and design of the proposed project. 2. The project will coordinate with and take advantage of the findings from the UNDP GEF China EUEEP. Component C(1) of the proposed project (Assistance to the Establishment of the National Energy Conservation Center) will complement and reinforce one of the main technical assistance activities of the EUEEP project, Capacity Building and Training for Provincial Energy Conservation Centers. The EUEEP also will provide substantive energy audit trainings to selected provincial energy conservation centers. The PFIs will build on the energy audit work of the provincial centers to identify and assess potential energy conservation financing opportunities. In addition, the project will coordinate with the IFUGEF CHUEE Project and projects financed by other agencies, such as the AFD

34 I PDO Improve energy efficiency in medium and large-sized enterprises of energyintensive industries. Reduce adverse environmental impact of medium and large-sized enterprises of energy-intensive industries on Annex 3: Results Framework and Monitoring CHINA: ENERGY EFFICIENCY FINANCING PROJECT Table A3.1 Results Framework Project Outcome Indicators Amount of incremental energy efficiency investments supported by the project. Associated annual energy savings capacity. Associated COz emissions reduction capacity. Use of Project Outcome Information YR2-YR3: determine if project assistanc strategiesiactivities need to be adjusted. YR5: provide strategic advices for GOC to sustain energy efficiency improvemei in medium and large-sized enterprises. Intermediate Outcomes Component A: Promotion of Energy Efficiency Financing Energy efficiency lending business line established and sustained at PFIs Government EE-financing programs strengthened Component B: Energy Conservation In Increased energy efficiency investment in energy-intensive manufacturing industries Intermediate Outcome Indicators EE financing amount demanded by projects in the pipeline EE investment preparation procedures and financing modalities piloted EE investment monitoring and Use of Intermediate Outcome Monitoring YR1-YR2: low levels may flag weak business development capacity at PFIs YR3: introduce necessary adjustments i: assistance strategy and activities YR5: feed into strategy for sustaining ai scaling UP EE lending to energy-intensi. I evaluation procedures developed 1 manufacturing industries kstment Lending Cumulative amount of energy efficiency lending of participating banks Annual energy consumption avoided from the EE lending of participating banks Annual avoided C02 emissions resulted from the EE lending of participating banks Y Same as above Increased national energy efficiency NECC business plan and initial management and policy implementation work program developed capacity NECC established and becomes Accelerated implementation of fully operational priority EC programs of the 11 th FYP Mid-term review of programs conducted and recommendations made. Necessary actions taken to enhance results Component D: Project Implementation Support and Reporting Efficient implementation of China Energy Efficiency Financing Project Project targets and delivery schedule met YR1-YR5: monitor implementation progress to determine whether assistanc is effective and approaches are realistic. Necessary adjustments made to meet policy and institutional development objectives. YR1-YR5: monitoring overall project progress and specific deliverables to determine efficiency of project coordination. Adjustment made to ensu project targets and milestones are met

35 0 E a k2 a i: a 0 E: a k2 a 0 In 3 $ 0 * W v, 3 5 'o \o r- 0 0

36 v) E a a 5 5 a a 2 E B d d 5 a i2 B d E a E 3 B d 0 00 '? d 3 I 0 o\ d d 'c! 7 hl 0 w v) i- u e, I 0 0 W 2 2 x 0 d Y m 6 9 x 3 e, Ld.-.d i-.- E a s a v).d 8 Y D u Y z IP I C

37 Annex 4: Detailed Project Description CHINA: ENERGY EFFICIENCY FINANCING PROJECT Component A: Promotion of Energy Efficiency Financing (estimated cost: US$18.70 million; proposed financing: GEF US$9.9 million). The proposed activities will remove key barriers to developing energy conservation financing businesses in the domestic banking sector primarily for medium and large-sized industrial energy conservation investments. They comprise: 1. Assistance to PFIs (estimated cost of US$8.3 million, includinn GEF $6.3 million and PFIs $2.0 million) in: (i) EE lending business unit start-up; (ii) capacity building and training; (iii) marketing and pipeline development; (iv) due diligence for eligible sub-loans; and (v) financial products development. Each of the PFIs (EXIM and Huaxia) will be allocated US1.875 million of GEF Grant to finance the project activities managed by each of them. US$2.55 million of GEF grant will also be allocated to the PFIs as 0.43% of the volumes of their eligible energy conservation lending under the project. In addition, each of the PFIs will cofinance the project activities at around USl.0 million in the form of staff time, office space, and other expenses to ensure a successful implementation of the project. i) Assistance in business start-up will include international and local consultant services to the PFIs for the creation, organization, staffing and initial business plan of the energyefficiency business units (or teams) and its lending strategy and systems. ii) Assistance in capacity building and training, including development of necessary internal mechanisms, procedures and knowledge base, through training for PFIs to facilitate: 0 0 familiarization with energy, energy efficiency, Clean Development Mechanism (CDM) and related markets and businesses; appraisal of energy efficiency projects and familiarization with government guidelines; risk management, financial instruments and hedging instruments; focus on specific sectors of interest; and visit to one or two countries with successful EE financing institutions. iii) Marketing and energy conservation subproject pipeline development assistance will support dissemination and replication of successful activities, awareness programs targeting clients with large potential energy savings, as well as pilot energy auditing for EE pipeline. iv) Support to due diligence of eligible energy conservation sub-loans, including financial, technical, social and environmental assessment: 0 0 staffing or hiring o f technical experts, including industry specialists, energy audit experts and environmental and social specialists; and costs associated with on-site visits, third-party review of the due diligence reports

38 v) Development of energy conservation-related financing products and risk management tools. 2. Assistance to other banks (estimated cost US$ 1.6 million. to be financed bv GEF grant of $0.8 million, and other banks of $0.8 million). The proposed project will also provide technical assistance to two additional commercial banks, which will lend their own funds to eligible industrial energy conservation subprojects, amplifying the impact of the proposed project and demonstrating the commercial attractiveness of lending for industrial energy conservation investments. The two banks will be selected in the second year of the project implementation and assistance will be provided for: (i) EE lending business start-up; (ii) capacity building; and (iii) due-diligence. These activities will learn from and build on the successful experience of the PFIs in the first two years of project preparation. i) Business start-up support will include international and local consultant services for the creation, organization, staffing, and initial business plan for energy-efficiency lending; and marketing and pipeline development. ii) Capacity building support will assist with familiarization of energy, EE and CDM markets and businesses; appraisal of EE projects and familiarization with government guidelines; and risk management, financial instruments and hedging instruments. iii) Due-diligence support will focus on helping the banks meet the due-diligence requirements for the subprojects (up to four) through hiring of technical experts (industry, energy audit, environmental experts) for subproject appraisal and on-the-job training for relevant staff. 3. Assistance to overall banking sector (estimated cost of US$0.3 million to be financed bv GEF). This will include a series of national workshops to present successful case studies of subprojects financed by the PFIs in the first two years and to disseminate information on EE business financing products and technologies. The workshops will also have sessions to disseminate guidelines for assessing and developing EE sub-projects. 4. Assistance to enerm consewation investment project demonstration (estimated cost US$8.5 million, to be-financed bv GEF grant of $2.50 million, and GOC of US$6.0 million). This subcomponent will support the implementation of the 10 priority national energy conservation programs. Preparation work for two or three pilot projects included in the 10 priority national energy conservation 8 programs, providing assistance in feasibility studies, including technical, institutional, financial and environmental aspects, and in securing financing for implementation. The objective is to demonstrate effective business model(s) for preparation and implementation of projects in sector(s) with large replication potentials but with significant project development difficulties. Is The 10 priority national energy conservation programs were highlighted in the National Medium and Long Term Energy Conservation Plan (2005 to 2010 and 2020) issued by NDRC in November,

39 ii) Development of an assessment, supervision and monitoring system of government supported/co-financed industrial energy conservation projects, including: Development of methodology for assessment and supervision of industrial energy conservation projects, including definition of baseline and performance indicators; 0 Development of an "energy conservation investment handbook" to facilitate and improve the quality of proj ect preparation at industrial enterprises; and 0 Training programs. Component B: Energy Conservation Investment Lending (estimated cost US$571 million; proposed financing: IBRD US$20 million, PFIs US$200 million, beneficiary enterprises US$171 million). This component includes a total of US$400 million energy conservation investment lending over five years, and a corresponding US$171 million equity investment by beneficiary enterprises. 5. The proposed IBRD loan will be on-lent by the GOC to two PFIs: US$lOO million for EXIM and US$lOO million for Huaxia. These two banks in turn will lend the funds to industrial enterprises (regardless of ownership) for energy conservation investment subprojects. They will be responsible for repayment of the IBRD loan and will assume all financial risks. Their lending rates will be determined by the market and adequately cover the financial and operating costs and provide for a reasonable profit margin. They have also agreed to lend, from their own resources, an additional amount equivalent to their respective IBRD loan allocation for energy efficiency investments. The subproject beneficiary enterprises are also expected to contribute 30 percent of project costs in equity investment, a standard requirement by Chinese banks, totaling US$17 1 million. 6. The eligible subprojects will include medium and large-scale energy conservation investments in which the primary incremental benefits are cost savings associated with reduced energy consumption. PFI financing will target energy efficiency enhancing rehabilitation and renovation subprojects in energy-intensive industries such as, but not limited to, iron and steel, petrochemicals and chemicals, and construction materials. It is expected that the energy conservation subproject investments will be in the range of US$5-25 million with the subproject sponsor contributing no less than 30% of the investment cost. Subprojects whose incremental benefits are primarily derived from capacity expansions or non-energy related cost savings will not be eligible for financing. The PFIs will follow procedures, guidelines and conditions outlined in the operational manuals developed by each PFI, reviewed and agreed by the Bank. 7. Both the GOC's Medium and Long Term Energy Conservation Plan and a technical study19, carried out as part of project preparation, have identified key energy-intensive industrial sub-sectors and energy conservation projects types which present sound financial opportunity and significant potential for energy efficiency improvements. Industrial sectors identified as energy-intensive include iron and steel, chemical and petrochemicals, and construction material 19 "China Energy Efficiency Financing Project: Report for World Bank", Tokyo Energy Efficiency Group, December 3 1, The report is included in the project files

40 (mainly cement). The types of energy efficiency projects analyzed and recommended include: (a) adoption of energy saving industrial technologies such as more efficient industrial boilers, kilns, and heat exchange systems; (b) recovery and utilization of by-product gas, waste heat and pressure; (c) installation of highly efficient mechanical and electrical equipments, including motors, pumps, heating and ventilation equipments; and (d) industrial system optimization to reduce energy use. While the PFIs have discretion with regard to the particular energy conservation subprojects to finance, subject to the eligibility criteria detailed in their project operational manual, the project will mostly focus on the industrial sub-sectors and energy conservation subproject types mentioned above. Some subprojects have already been identified and they are listed in following tables2': Table A4.1. HUA XIA BASK SUB-PROJECTS PROFILE so Equity & Project Same Project Description Loan Other Investment Sources Copper Flash Furnace Smelting System Comprehensive EC Renovation Sulfate Production (800,000 toda) Process Surplus Heat Power Generation Efficient Fans, Pumps, and Frequency Inverters Renovation of Power Supply and Distribution System ;ight Alloy Manufacturing C Power System Renovation Terrous Metallurgical ManuJ Renovation of in-plant power distribution Melting Furnace Surplus Heat Recoverv 1) Addition of surplus heat pipe boiler; 2) Renewal of flash furnace surplus heat boiler; 3) Addition of steam drying system; 4) Addition of 2.5 MW surplus heat power generation. Addition of 2 sets of surplus heat boilers (3.82 MPa, 450 ") and 2 sets of condensing steam turbines (2Xl8MW). 1) Replace the existing fans, pumps with efficient ones; 2) Renovate water supply system to cut efficiency loss in fans and pumps; 3) Adopt VVVF to control the operation of fans and pumps. 1) Using efficient transformer to cut distribution loss; 2) Reactive compensation; 3) Adoption of Harmonic filters; 4) Addition of load monitoring system. 1) Addition of efficient transformers; 2) Renovation of substation oil switches; 3) Replacement of power cables; 4) Installation of Silicon Controlled Rectifiers; 5) Renovation of water and air pump stations with high voltage VVVF. nturing Co. 21,507 9,626 5,005 2,268 19,608 6,536 11,765 14,971 6,750 2,503 1,135 6,536 2,876 2,502 1,133 13,725 5, As requested by the PFIs, the names of the potential sub-borrowers are deleted to protect their commercial interests

41 recovery Total No. Project Name Project Description Loan Investment Equity & Other Sources I ~ storage; 2)Renovation of heating furnace in rolling I 9 Hydrogen recovery 10 Calcium carbide furnace heat recovery 11 Power System Renovation 1,307 1,961 3,268 Table A4.2. EXIM BANK SUB-PROJECTS PROFILE Equity and No. Project Name Project Description Total Loan Other Investment Sources XXXIron & Steel Co. 1 Comprehensive EC Renovation 1) CCGT; 2) Surplus heat recovery; 392, ,438 3) BT heat recovery; 4) Coking Plant EC renovation; XXXAluminum Manufacturing Co. 2 Large-sized Aluminum Electrolyzer EC Renovation 3 4 Surplus Heat Recovery Efficient Fans and Motors, Frequency Control XXXAluminum Manufacturing Co. 5 Comprehensive 1) Monitoring and control system upgrade; 4,575 3,203 Electricity Saving 2) Distribution system optimization; Renovation 3) Installation of Harmonic Filters; 4) Installation of integrated control system. 6 Comprehensive Power system Renovation XXX Paper Manufacturing Co. 1) Installation of Inverters; 2) Insulation of steam pipeline; 3) Installation of CFB boilers. 8. The staff of the PFIs energy conservation business teamhit will be trained to identify potential carbon financing candidates from their subproject pipelines. However, no GEF assistance will be provided to support the preparation of subprojects which are going to benefit from the sale of COz emission reduction credits. For any eligible subprojects that have applied for carbon financing from carbon funds managed by the Bank, the Bank will review the duediligence documentation to ensure the conformity with the agreed due diligence procedures before the completion of the transaction

42 Component C: National Policy and Institutional Support (estimated cost: US$2.80; proposed financing: GEF US$2.80 million21). This component will strengthen national government capabilities to implement national energy-efficiency policies and programs in the following ways: 9. Assistance to the National Enerm Consewation Center (GEF $2.05 million). The State council approved the creation of NECC in August The main responsibility of NECC is to support the implementation of national energy conservation policies and programs. NECC is expected to be established and staffed in the next two years, with GOC budget support. This subcomponent will provide organizational and strategic planning assistance to the establishment of NECC, as well as help develop initial work programs of NECC. The proposed activities include: NECC Start-up - development of vision, organizational structure, functional responsibilities and procedures based on international best practices, including coordination of provincial energy conservation centers, and three-year work program ( ). Capacity Development - design and implementation of a capacity building/training program and three-year twining cooperation with comparable institutions of other countries. Development of Consumer/Civil Society Awareness Programs. Assessment of Energy Auditing Industry and recommendations for promoting and strengthening it. 10. Supporting the implementation of priority national energy consewation prosyams of the 11 th FYP (GEF US$O. 75 million). This subcomponent will assist the government in addressing issues arising during the implementation of the 11 th FYP, including: 0 Mid-tern review (2008) of the llth FYP of implementation activities on energy conservation to identify problems, offer recommendations and assist in implementing remedial measures; Special studies to address specific needs that will arise; and 0 Adoption of international best practices in national priority energy conservation programs. This will involve specific country studies and high-level dialogues. It is proposed to select four countries, preferably with differing policies and institutional frameworks. International consultants will prepare country visits for three-day training and two-day field trip and policy dialogues. This learning will be applied to mid-plan review and adjustment of national energy efficiency policy framework. 21 GOC has committed to co-finance this activity with the inputs of staff time and office facilities of the National Energy Conservation Center to be established under the project

43 Component D: Project Implementation Support, Monitoring and Reporting (estimated cost: US$1.1 million; proposed financing GEF US$0.8 million, and GOC US$0.3 million). Due to the innovative character, scale and complexity of the project, GEF support is proposed to assist the government in project implementation support, monitoring and evaluation. This will mostly involve the recruitment of consultants and limited incremental operating cost, such as office rental, basic equipment, utilities and travel, etc. 11. Assisting in coordinating technical assistance activities with the banks and the government, as well as organizing project monitoring, evaluation, and reporting activities; and 12. Assistance to support the independent verification of energy conservation lending for the allocation of the output-based GEF grant and to monitor energy savings performance of subprojects financed by the PFIs

44 Annex 5: Project Costs CHINA: ENERGY EFFICIENCY FINANCING PROJECT Project Costs by Component (us$ ooo,ooo) Component Local Foreign Total Component A: Promotion of EE Financing A1 : Assistance to PFIs A2: Assistance to other banks A3: Assistance to the overall banking sector A4: Assistance to EC project demonstration Component B: Energy Conservation Investment Lending OO EC lending by PFIs Matching equity investment by enterprises Component C: National Policy and Capacity Building C1: Establishment of National Energy Conservation Center C2: Implementation of priority EC programs Component D: Project Implementation Support, Monitoring and Reporting D1: Project management, evaluation and reporting D2: Monitoring and verification of EE lending Total Project Costs Total Financing Required Project Financing by Component (US $ 000,000) PFIs or Benefi ciary Component IBRD GEF Other enterp GOC Total Banks rises Component A: Promotion of EE Financing A1 : Assistance to PFIs A2: Assistance to other banks A3: Assistance to the overall banking sector A4: Assistance to EC project demonstration Component B: Energy Conservation Investment Lending EC leiding by PFIs Matching equity investment by enterprises Component C: National Policy and Capacity Building C1: Establishment of National Energy Conservation Center C2: Implementation of priority EC programs Component D: Project Management and Reporting D 1 : Project management, evaluation and reporting D2: Monitoring and verification of EC lending Total Financing Required

45 Annex 6: Implementation Arrangements CHINA: ENERGY EFFICIENCY FINANCING PROJECT Overview 1. The proposed project will be implemented over five years. 2. A Steering Committee will be established to provide overall strategic and policy guidance and facilitate coordination among different agencies on project implementation. The Steering Committee will be chaired by NDRC, and will comprise representatives from both MOF and NDRC. 3. A PMO will be established by NDRC and will function as the executive office of the Steering Committee. The PMO will be responsible for overall coordination, monitoring and reporting during project implementation. In addition, on behalf of NDRC, it will directly implement the capacity building and technical assistance activities for NDRC and financial intermediaries other than the PFIs (Component A(2), A(3), A(4), Component C and D, using the GEF grant). The PMO will consist of a director, project officers, procurement officer, financial officer and administration staff. The PMO will be established based on the expertise of the existing PMO of NDRC which has been effectively conducting project coordination activities for the first and the second China Energy Conservation Projects financed by the World Bank/GEF. 4. The PFIs will be responsible for the implementation of energy conservation lending (Component B), using the IBRD loan, and PFI-related technical assistance activities (Component A[ l]), using the GEF Grant. If requested, the PMO may also provide procurement and other technical services to the PFIs The organizational structure for project implementation and the detailed institutional arrangements are described below. MOF NDRC r I Steering L Committee Component A( 1) and B PMO - I. 0 I 0 I Exim I Huaxia Assistance to Assistance to I 1 1 I I 1 Government OtherBanks Mz:zent Sub-borrowers

46 6. The MOF will represent the People s Republic of China in signing both the Bank loan agreement and GEF grant agreement with the Bank. It will pass on the Bank loan to PFIs, in accordance with subsidiary loan agreements to be signed between the MOF and PFIs and GEF grant to NDRC and PFIs according to the grant agreement. The MOF has indicated that the loan will be passed on to PFIs on the same terms and conditions as the Bank loan. 7. The PFIs have the full responsibility on the energy efficiency lending and related technical assistance activities, and bear all the financial risks. To a large extent, the lending activities will be implemented within the existing institutional framework and under their existing business procedures and regulations. But, it has been agreed that within each PFI, a project teamhit will be formed to coordinate or implement the sub-lending activities and to act as the focal point of the PFI to interact with the Bank, the PMO of NDRC, and other stakeholders. The Commercial Division of the On-Lending Department at EXIM, and a newly established Energy Conservation Program Office at Huaxia s Banking Department will have the primary responsibility in marketing and pipeline development of energy conservation lending opportunities, preliminary assessment of potential subprojects for eligibility screening and in coordinating with the Bank, the PMO and other project stakeholders. These units/teams will be also responsible for the implementation of the technical assistance activities to be financed by GEF. 8. The PFIs have prepared operational manuals (PM) for the project implementation. The operational manuals cover the operation of the energy conservation lending under the project, such as procurement arrangements, detailed institutional arrangements, and economic, financial, technical, environmental, and social due diligence procedures and methodology for energy conservation subproject financing. The manuals were provided to the Bank for review and found acceptable, and will be adopted by the PFIs during the project implementation. 9. The operational manuals also describe the subproject eligibility criteria which the PFIs will apply to screen potential subprojects which would be eligible for project sub-loan financing. These criteria have been agreed with the Bank and are listed below. Sub-borrower Eligibility The sub-borrower s beneficiary enterprise22 which will own and implement the subproject shall be an industrial enterprise whose total annual revenues shall be at least RMB 30 million.23 The annual revenues of the beneficiary enterprise shall be confirmed by the income statement from the latest financial statements Subproject Technical Eligibility Sub-project investment shall be limited to renovation and rehabilitation (adjustment, replacement or extension) of existing physical component(s) and system(s) with the objective of achieving higher energy efficiency. Such renovation and rehabilitation will be confined within the sub-borrower s existing premises such that no new land acquisition will be made for the purposes of the subproject; If the sub-borrower is a holding company, the relevant beneficiary enterprise will be the subsidiary enterprise which is implementing the subproject and which directly benefits from the energy savings expected to result from the subproject. According to China State Statistical Bureau (2003 guideline), the annual revenue o f a medium-sized enterprise should be in the range of RMB30 (about US$3.9) to 300 (about US$39) million, and that of a large-sized enterprise should be RMB300 million or more

47 The cash flow benefit arising only from energy savings24 associated with the sub-project, as estimated using the sub-project financial projections prepared by the sub-borrower and reviewed by the PFI, shall be adequate to repay the total investment cost o f the sub-project within a period of ten (IO) yearsz5. Subproject Social and Environmental Eligibility The sub-borrower shall have obtained environmental approval from the appropriate Chinese environmental authorities and shall make available to the PFI documents with respect to such approvals; Proposed sub-projects that the Chinese environmental authorities decide require a complete EIA, equivalent to World Bank Category A sub-projects shall not be eligible; Sub-projects which the Chinese environmental authorities decide require an EIA Table (equivalent to World Bank Category B sub-projects) shall have their EIA Table reviewed and approved by the relevant environmental authorities; and Subprojects which directly cause workforce redundancy and thereby result in involuntary dismissal of the affected work personnel by the sub-borrower shall not be eligible. 10. For the GEF financed project subcomponents for which NDRC is responsible, on behalf of NDRC, the PMO of NDRC will undertake the selection of consultants, including preparation of terms of reference, advertising, short-listing, issuing requests for proposals, evaluation of proposals, negotiating with selected consultants and contracting with those who have been selected. The PMO will also be responsible for maintaining accounting and management information systems, progress reporting to both GOC and the Bank, conducting outreach and liaison and monitoring and evaluation. The PMO staff will consists of a Director, Executive Director, Financial Manager, technical experts and 2-3 assistants. The Director could be one government officer from NDRC who will lead the project management activities. The Executive Director will be a full time supervisor of PMO who will conduct specific management work with the Director s guidance Annual cash flow benefit from the energy efficiency improvements associated with the sub-project will be calculated as the expected amount of energy saved due to the sub-project in any given year multiplied by the expected average energy sale or purchase price for the sub-borrower during that year for all forms of energy saved (electricity, coal use, etc.). The payback period will be calculated simply as total investment cost (including interest during construction) divided by the average annual cash flow benefit derived from energy savings associated with the sub-project, with the average taken over a period not to exceed the first ten years of the sub-project operations

48 Annex 7: Financial Management and Disbursement Arrangements CHINA: ENERGY EFFICIENCY FINANCING PROJECT Introduction 1. The Financial Management Specialist (FMS) has conducted an assessment of the adequacy of the project financial management system of the China Energy Efficiency Financing Project. The assessment, based on guidelines issued by the Financial Management Sector Board on November 3, 2005, has concluded that the project meets the minimum Bank financial management requirements, as stipulated in BP/OP In the FMS opinion, the project will maintain adequate financial management arrangement acceptable to the Bank and, as part of the overall arrangements that the borrower has in place for implementing the operation, provide reasonable assurance that the proceeds of the loan and GEF grant will be used for the purposes for which the loan and GEF grant are provided. Financial management risk, defined as the risk that World Bank loan proceeds will not be used for the purposes intended, is a combination of country, sector and project specific risk factors. Taking into account the risk mitigation measures proposed under the project, the FM risk rating proposed for this project during the appraisal stage is modest. 2. Funding sources for the project include Bank loan, GEF grant and counterpart funds. The Bank loan proceeds will directly flow from the Bank into eligible PFIs using reimbursement or advance and report-based disbursement method, and finally to the borrowers from the PFIs. The GEF grant executed by the PMO will flow from the Bank into a project designated account (DA) for the GEF grant to be set up at and managed by the Financial and Statistics Division (FSD) of International Department of MOF and finally to contractors or suppliers. The GEF grant executed by the PFIs will flow from the Bank to the PFIs and finally to contractors and suppliers using reimbursement method. The Bank loan agreement will be signed between the Bank and MOF, and on-lending agreements for the Bank loan will be signed between MOF and the eligible PFIs. The GEF grant agreement will be signed between the Bank and MOF. Counterpart funds will be government appropriation and PFIs own funding sources. 3. No outstanding audits or audit issues exist with any of the implementing entities involved in the proposed project. However, the task team will continue to be attentive to financial management matters during project supervisions. Audit Arrangements 4. The Bank requires that project financial statements be audited in accordance with standards acceptable to the Bank. In line with other Bank financed projects in China, the project will be audited in accordance with International Auditing Standards and the Government Auditing Standards of the People s Republic of China. The Audit Service Center for Foreign Loan and Assistance Projects of China National Audit Office (CNAO) has been identified as auditors for the project. Annual audit reports will be issued by above audit center. The Bank currently accepts audit reports issued by CNAO or provincial/regional audit bureaus/offices for which CNAO is ultimately responsible

49 5. The annual audit report of project financial statements will be due to the Bank within six months after the end of each calendar year, as stipulated in the loan and grant agreements. The responsible agency and timing for each report is summarized as follows: Audit Report Project financial statements for GEF Project financial statements for lending and GEF Project financial statements for lending and GEF Submitted by PMO EXIM Huaxia Due date June 30 of each calendar year June 30 o f each calendar year June 30 o f each calendar year 6. In addition, annual audit reports on financial position and operating results of the two PFIs will be due to the Bank within six months of the end of each calendar year. The financial statements for the two PFIs are not fiduciary requirements, but are rather required for monitoring the sustainability of these entities. The requirements for these audits will not be included as part of the loan covenant but rather included in the Project Agreement. Disbursement Arrangements 7. Disbursement arrangementsfor IBRD Loan. The PFIs (Huaxia and EXIM) will manage disbursement for their own portions of the loan respectively. For Huaxia, reimbursement method will be used, and applications for reimbursement will be supported by interim un-audited financial reports submitted on a quarterly basis. 8. For EXIM, advance method will be used. One pooled DA will be opened in a commercial bank acceptable to the Bank and managed by EXIM. As agreed between EXIM and the Bank, the DA will be an EXIM general foreign currency account. Advances will be provided in USD and deposited into this EXIM general foreign currency account but a separate ledger account that tracks receiving and uses of World Bank loan will be maintained. The ceiling of DA is US$20,000,000, and EXIM may claim for advances at any times as long as the outstanding advance in the DA does not exceed the ceiling. Applications for reporting of uses of advances will be supported by interim un-audited financial reports submitted on a quarterly basis. The format and content of interim financial reports has been agreed between the Bank and the PFIs, which will be specified in the Disbursement Letter issued by the Bank. 9. The flow of funds and withdrawal applications (WAS) for the Bank loan are as follows: PFIs _----_ 4 World Bank

50 10. The Bank loan would be disbursed against eligible expenditures (inclusive of taxes) as in the following table: Category (1) Sub-loans (b) Huaxia (c) EXIM Amount of the Loan Allocated (expressed in USD) 99,750, ,000,000 Percentage of Expenditures to be financed (inclusive of Taxes) 100% Sub-loan amount disbursed (2) Front-end Fee 250,000 Amount payable pursuant to Section 2.03 of Loan Agreement for Huaxia in accordance with Section 2.07 (b) of the General Conditions TOTAL AMOUNT 200,000, Disbursement arrangements for the GEF Grant. For the GEF grant executed by the PMO, two disbursement methods of advance and direct payment are applicable. One segregated DA denominated in US dollar will be opened for the GEF grant executed by the PMO at a commercial bank acceptable to the Bank and managed by MOF FSD. The ceiling of DA for the Bank loan will be US$0.7 million. For the GEF grant executed by Huaxia and EXIM, the reimbursement and direct payment methods will be used. 12. Applications for reimbursement and reporting for uses of advances will be supported by: (a) The list of payments against the contracts, and records evidencing eligible expenditures, e.g., copies of receipts, supplier invoices, for the contracts subject to the Bank prior review indicated in the table below: Goods Firm Consultant Individual Consultant Equivalent 200, ,000 50,000 (b) Statement o f Expenditures (SOEs) for any other expenditures. 13. MOF FSD will be directly responsible for the management, maintenance and reconciliation of the DA activities of the grant executed by the PMO. Supporting documents required for Bank disbursements will be prepared and submitted by the PMO through MOF FSD for final verification and consolidation before being sent to the Bank for further disbursement processing

51 14. The flow of withdrawal applications for the GEF grant is as follows: b World Bank FSD 4 EE PMO DA at MOF The GEF grant would be disbursed against eligible expenditures (inclusive of taxes) as in the following table (pending on finalization by legal agreement): Allocated Amount

52 Financial Management and Reporting Arrangements 16. Risk Assessment and Mitigation. The following risks with corresponding mitigating measures have been identified during the assessment: r Risk /Inherent Risk Rating Incorporated Risk Mitigating Measures Conditions of Negotiations, Board or Effectiveness Entity Level c Project Level Control Risk Accounting I-- Internal Control I * FundsF1ow Financial Reporting Modest Modest Modest Modest Modest Low Low Modest r Auditing Low See the following mitigating measures utilized in the project. The financial staff of PFIs is new to Bank financed projects. A well designed training session should be provided to them during launch workshop. Detail financial management and disbursement procedures have been documented in the project financial management manual (FMM), which is part of the operation manual. The project structure and activities are relatively straightforward and do not involve many project implementing units. The funds flow arrangement is fairly simple. The team will work with the PFIs and China Energy Efficiency PMO to improve their budgeting, execution and monitoring. Accounting policies and procedures for Bank loan and GEF grant are already in place. Verification by the task team at the initial implementation stage to ensure the accounting system has been correctly set up. This should be followed up by regular supervision missions. There are some existing internal controls at PFIs, which will also serve for the project activities. Proper segregation o f duties has been set up in each PFI. Also, the disbursement documents for GEF grant will be reviewed by MOF to ensure compliance. For Huaxia, the Bank loan will be disbursed directly from World Bank to Huaxia using the report-based reimbursement method. For EXIM, the Bank loan will be disbursed directly from World Bank to EXIM under the advance method using report-based disbursement. The GEF grant executed by the PMO will go through MOF. The GEF grant executed by the Huaxia and EXIM will be disbursed from the Bank to each PFI using reimbursement method. The format and contents o f financial statements have been stipulated by MOF. A set o f customized interim financial reports will be developed and agreed with the PFIs being used for report-based disbursement of Bank loans. The project financial management manual will also establish such financial reporting requirements. The external auditor, Audit Service Center for Foreign Loan and Assistance Projects o f China National Audit Office (CNAO), has extensive experience with previous Bank projects. Adoption of the FMM is a condition of disbursement exclusively for GEF grant executed by the PMO

53 17. Therefore, the overall FM risk-rating of this project at the appraisal stage is modest. The FMS will monitor the project FM risk during project implementation. 18. Strengths. NDRC has been implementing several World Bank/GEF projects, such as the First and Second Energy Conservation Projects. It has extensive experience in project financial management and disbursement, which will benefit the implementation of this project. The FSD of MOF has experience with managing designated accounts and is familiar with the disbursement requirements and procedures for Bank financed projects. 19. Weaknesses and Action Plan. Since all the PFIs do not have experience in Bankfinanced projects, a training course will be conducted during the launch workshop on project disbursement and financial management. In addition, existing financial management internal controls at PFIs are not specifically related to the project activities. Thus, a financial management manual, as a part of operation manual, have been prepared to uniformly align the project financial management policies at all PFIs. The following action plan for addressing this weakness has been identified: Significant weaknesses No uniform project financial management arrangement in place at the EE PMO. Actions Responsible Completion Person Date Financial management manual EE PMO Before to be drafted, reviewed by the Bank and finalized by EE PMO. disbursement of GEF grant allocated to the EE PMO Implementing Agencies 20. A project steering committee will be established to provide overall policy guidance and facilitate coordination among different agencies on project implementation. The committee will consist of representatives from the MOF and NDRC. 21. The two PFIs, China Huaxia Bank and China EXIM Bank will be responsible for the implementation of Component B, using the Bank loan, and component A (l), using GEF grant, which links to their lending programs. At each PFJ, a project team (or unit) has been established. The project accounting and withdrawal applications for the intermediary lending and their allocated GEF grant portion will be managed by each respective PFI. 22. NDRC is responsible for implementation of components A (2), A (3), A (4), C and D using GEF grant. The PMO will consist of a director, project officers, procurement officer, financial officer and administration staffs. 23. Budgeting. Although the cost table has been prepared for the project, project still needs to prepare its annual implementing plan, which will identify the detailed project activities to be undertaken. The FMS will work with the related entities to enhance their budgeting work during project implementation. 24. Accounting. The administration, accounting and reporting of the project will be set up in accordance with the Circular #13: Accounting Regulations for World Bank Financed Projects

54 issued in January 2000 by MOF. The circular provides in-depth instructions of accounting treatment of proj ect activities and covers the following: 0 Chart of account Detailed accounting instructions for each project account Standard set of project financial statements 0 Instructions on the preparation of project financial statements 25. The standard set of project financial statements mentioned above has been agreed between the Bank and MOF and applies to all Bank projects appraised after July 1, 1998 and includes the following: Balance sheet of the project Statement of sources and uses of fund by project components 0 Statement of implementation of loan agreement Statement of implementation of GEF grant agreement 0 Statement of designated accounts 0 Notes to the financial statements 26. The PMO and each of the two PFIs will be managing, monitoring and maintaining their respective project accounting records for the components they execute. Original supporting documents for project activities will be retained by the PMO and each PFI. In addition, the PMO and each PFI will be responsible for the preparation their own financial statements and submission to the Bank for review and comment on a regular basis. 27. The presence of adequate project accounting staff with relevant educational background and work experience commensurate with the tasks they are expected to perform is a critical factor for successful implementation of project financial management. Based on discussions, observation and review of educational background and work experience of the staff identified for financial and accounting positions in implementing entities, the task team concluded that the financial staff are qualified and appropriate to the work they are expected to assume. 28. To strengthen financial management capacity and achieve consistent quality of accounting work, the task team has suggested that a project financial management manual (the Manual) be prepared. The Manual will provide detailed guidelines on financial management including internal controls, accounting procedures, fund and asset management, withdrawal application procedures, financial reporting and auditing arrangement. The first draft of the Manual has been prepared and submitted to the Bank and the FMS has already reviewed this draft and provided feedback. The Manual will be finalized before disbursement and distributed to all the relevant financial staff. 29. EXIM Bank will utilize computerized financial management information software while Huaxia Bank will manually record and maintain the project accounting books. The task team will monitor the accounting process especially during the initial stage to ensure complete and accurate financial information will be provided in a timely manner

55 30. The related accounting policy, procedures and regulations were issued by MOF and a financial management manual will be prepared and issued to uniformly align the financial management and disbursement requirements of the two PFIs Internal Control and Internal Auditing. There is no fomial independent Internal Audit department for the project. However, this will not impact on the project s financial management as the PMO and each PFI s management and monitoring and annual external audit will serve as the mechanism to ensure that financial management controls are functioning appropriately. 32. Financial Reporting. The format and content of interim financial reports being used for report-based disbursement for Bank loan have been agreed between the Bank and the PFIs. As agreed with EXIM and Huaxia, the interim financial reports used for lending disbursement will be on quarterly basis. 33. The PMO and each PFI will prepare the project financial statements on the components they are implementing and submit to the Bank for review and comment on a regular basis. The interim unaudited project financial statements should be prepared and furnished to the Bank as part of the project progress reports not later than one month after the end of each calendar semester, covering the semester, in form and substance satisfactory to the Bank. 34. Financial Covenants. No specific financial covenants are applicable to the project except for those standard financial covenants like project audit and interim financial reports. Supervision Plan 35. The supervision strategy for this project is based on its FM risk rating, which will be evaluated on regular basis by the FMS and in consultation with relevant task team leader

56 Annex 8: Procurement Arrangements CHINA: ENERGY EFFICIENCY FINANCING PROJECT A. General 1. Procurement for the proposed project would be carried out in accordance with the World Bank's "Guidelines: Procurement under IBRD Loans and IDA Credits" dated May 2004; and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" dated May 2004, and the provisions stipulated in the Legal Agreements. The various items under different expenditure categories are described in general below. Procurement of goods and services under the IBRD loan will normally be based on predominant commercial practices in China. For GEF grant, the different procurement and consultant selection methods, the estimated costs, prior review requirements, and the implementation schedule have been discussed and agreed between the implementation agencies and the Bank. They are documented in the Procurement Plan which will be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. IBRD Loan: US$200 million 2. The loan will be on-lent to large and medium sized enterprises (sub-borrowers) to finance eligible energy conservation projects through participating financial intermediaries (PFIs). The PFIs will lend at commercial rates to sub-borrowers in accordance with their own lending practices and the operation manual agreed with the Bank. The PFIs will be responsible for loan repayment to the GOC, and will assume all the financial risks. The potential targeted subborrowers are medium and large autonomous commercial entities in the energy-intensive sectors such as, but not limited to, iron & steel, petrochemical and chemical, construction materials. 3. Based on the assessment of potential sub-borrowers and their procurement practices, it is decided that established commercial practices in China will be followed for the procurements financed by the Bank loan in accordance with paragraph 3.12 of the Procurement Guidelines. However, an International Competitive Bidding (ICB) threshold for procurement of goods financed by the proposed project will be set at US$7.0 million equivalent. For goods (supply only) contracts, estimated to cost US$7.0 million each or more, ICB procedure will be followed. In case of supply and installation contracts, estimated to cost US$7.0 million each or more, subject to the Bank's prior review of the procurement plan, related technical specifications and approval, the ICB threshold can be up to US$lO million equivalent. All the contracts, estimated to cost US$lO million each or more, ICB procedure will be followed. The Bank's ICB procedure of Section 2 of Procurement Guidelines will be applied to all ICB contracts. GEF Grant: US$13.5 million 4. The proposed GEF Grant will finance technical assistant activities to be implemented by the NDRC and the PFIs. Under this component, consulting services and small goods will be procured

57 5. Goods: A total of about US$50,000 of goods would be procured under the project, including office equipment such as computers and peripherals, communication facilities and training devices. Contracts estimated to cost less than $100,000 each will be awarded following shopping procedures. 6. Consulting services, trainings and workshop: A total of about US$13,150,000 of consulting services, trainings and workshops would be required under the proposed project. International and local consultant services will be procured to provide: (a) assistance to the PFIs and additional participating banks to start-up and build adequate capacity to scale-up their energy conservation financing business lines; (b) assistance to the banking sector through dissemination of information on successful energy conservation financing experiences and assistance for assessing and developing energy conservation subprojects; (c) assistance for detailed preparation of 2 or 3 pilot projects for energy conservation project demonstration; (d) assistance to the Government to provide organizational and strategic planning assistance to establish the National Energy Conservation Center, and to identify and address issues pertaining to the 20 percent reduction of energy intensity during the 1 lth FYP; and (e) assistance to project monitoring and evaluation, including development of an assessment, supervision and monitoring system for government supported/co-financed energy conservation projects and the independent validation of bank lending to finance energy conservation sub-projects. All consultant services financed by the GEF grant will be procured according to the Bank s guidelines on the selection and employment of consultants. Quality- and Cost-Based Selection (QCBS) would be used for contracts estimate at more than $200,000 each; Selection Based on Consultants Qualifications (CQS) would be used for the contracts less than $200,000 each; Quality-Based Selection (QBS) would be used for assignments of complex or higher quality requirements; SSS would be used for specific assignments with prior agreement by the Bank. Individual consultant would be procured in line with the Section 5 of the Procurement Guidelines. The Standard Request for Proposals shall be used for QCBS and QBS procured contracts. For trainings and workshops planned, detailed programs will be developed by the PMO of NDRC and the PFIs during the project implementation and included in the project annual work plans for the Bank s review. Actual expenditures incurred in according to the approved detailed programs will be used as the basis for reimbursement. 7. Incremental Operating Cost (IOC): A total of about US$300,000 would be required to fund a small portion of the incremental operation costs of the implementing agencies: NDRC PMO and PFIs. The IOC would cover their incremental project management costs including expenditures for office supplies and operation of office equipment, communication, and operational travel allowances of the project staff etc., which the project implementing agencies would not have incurred absent the project. 8. The above budget allocation for goods, consultants, IOC and training and workshops does not include counterpart funding

58 B. Assessment of the Agency s Capacity to Implement Procurement and Procurement Practice in China 9. Procurement Capacity Assessment was conducted in March 2007 after meeting with the PMO and PFIs. The conclusions are summarized as follows: IBRD Loan 10. In case of procurement under sub-loans, Participating Financial Intermediaries (PFIs) will be responsible for ensuring that the procurement rules for sub-loans specified in their project management manual are followed by the sub-borrowers. The Export-Import Bank of China and China Huaxia Bank has been selected as PFIs under this project. A division or a team has been established in each PFI to be responsible for lending of the Bank fund, including reviewing and monitoring the compliance with the agreed procurement rules. A specialist will be assigned within the division or team to be responsible for all procurement activities. The Sub-borrowers will be requested to have at least one full-time staff to be in charge of the procurement under its sub-project. The designated procurement staff will also be responsible for record keeping and facilitating the PFIs and Bank s reviews as appropriate. The World Bank will conduct regular post reviews of the sample sub-projects not requiring a prior review for procurement if the estimated cost of the package is lower than ICB thresholds. 11. Commercial Practices: The Bank conducted a review of potential sub-borrowers of the Bank loan to understand their legal and financial state, procurement procedures and control system. The findings and conclusion were covered by a Special Procurement Assessment on Sectors Common Practices. Based on the review, it was concluded that private sector enterprises and autonomous public commercial enterprises have already established commercially sound practices for the procurement of goods, works and services. The details are provided below: (a) Potential sub-borrowers legal and financial aspect: In the country procurement review (CPR) dated February 17,2003, it was indicated that the enterprises in public sector, even Chinese SOEs are independent and sufficiently autonomous from a legal, financial and managerial perspective. (b) Potential sub-borrowers procurement procedures: There is a highly competitive market among local contractors and suppliers for goods and works procured under Bank and government financed projects. Detailed description of the market situation is presented in the Procurement Practice Assessment Report. (c) Potential sub-borrowers procurement control: the general rule is to procure the least cost goods, works and services meeting minimum quality requirements. The review shows that usually procurement management departments are responsible for procurement on behalf of the enterprises and the departments are subject to corporate internal control. Audit and supervision departments in the enterprises conduct monitoring and control of the procurement activities and provide support as needed to ensure the procurement -50-

59 activities are conducted properly. In general, the procurement in such enterprises is carried out based market situation and according to applicable rules and procedures. The risk is well controlled. 12. Based on the assessment above, it is concluded that commercial practices can be considered to be consistent with the World Bank s criteria relating to economy and efficiency of procurement processes. GEF Grant 13. The NDRC is the government agency responsible for overall project coordination of the technical assistant components to be funded by GEF grant. It will also directly implement and supervise over 50 percent of the technical assistant activities (Component A (2), A(3), A(4), C and D). A PMO will be established by NDRC based on the existing organization and expertise of NDRC s existing PMO for the World BanWGEF China Energy Conservation Project I and 11. This PMO will work on behalf of NDRC for project coordination and management. In each PFI, a sub-project management team or division (hereby called PFI team) will be established for its TA sub-project implementation (Component A [l]). As requested by PFIs, the PMO will provide procurement and other technical services to the PFIs for the GEF financed technical assistant activities to be implemented by PFIs. 14. An assessment of the capacity of NDRC to carry out procurement activities for the project was carried out in January 2007 and followed by assessment of the EXIM Bank and Huaxia Bank in March The assessment reviewed the past experience, organizational structure in implementing the project and staffing of NDRC s existing PMO on which the new PMO will be established. Based on NDRC s previous performance of implementing two previous Bank s projects, and institutional and staff arrangement for this proposed project. The conclusion is that: (a) NDRC has required experience to adequately carry out activities under the proposed project; and (b) the two PFIs, have the experience and capacity to implement projects financed by multilateral or bilateral financial institutions. The overall project risk for procurement is average. C. Procurement Plan and General Procurement Notice 15. As the proposed project is a financial intermediary lending operation, it is impossible for the PFIs to develop Procurement Plans and to prepare and publish General Procurement Notices before project implementation. During the project implementation, sub-borrowers will provide a list of procurements planned under the sub-loans, which shall be subject to the prior review by the PFIs. In case any sub-project includes ICB procurement, special procurement notices will be published in accordance with the Procurement Guidelines. 16. For the GEF Grant, NDRC and the PFIs submitted procurement plans for the first 18 months of project implementation for review and comments. The plans have been finalized. According to the procurement plan of NDRC, some consulting services may need to be procured and implemented before the signing of the Grant Agreement. During the negotiations, it was agreed that retroactive financing upto US$1 m will be applied

60 D. Frequency of Procurement Supervision and Review Procedures 17. The Bank will review the procurement arrangements proposed/performed by the PMO and PFIs every year, including contract packaging, applicable procedures, and the scheduling of the procurement processes, for their conformity with Bank Procurement Guidelines and PFIs operational manuals agreed with the Bank during project preparation. Prior Review 18. IBRD Loan. All ICB contracts, if any, will be submitted to the Bank for Prior Review in accordance with the procedures set forth in paragraphs 2 and 3 of Appendix 1 to the Procurement Guidelines. Contracts awarded through Commercial Practices will not be subject to prior review. 19. GEF Grant. (a) Goods contracts: the first shopping contract will be subject to prior review; (b) All firm consultant contracts 2$100,000 will be subject to prior review; (c) only individual consultant contract S50,OOO each will be subject to prior review; and (d) all the terms of reference for consultant contracts with consultant firms and individuals, and training, workshop and study tours will be subject to prior review. 20. The following prior review thresholds have been recommended following the procurement capacity assessment: Expenditure Category 1. Works 2. Goods under TA component 3. Goods for Lending Component 4. Consultant services Contract Value Threshold Procurement Method Contracts Subject to (US$) Prior Review (US$) NA <$100,000 Shopping First shopping contract <$7 million for normal goods Commercial practice NA <$lo million for supply and installation 87 million for normal goods 810 million for Supply and ICB Installation contract All ICB Contract 8200,000 QCBS, >=100,000 (firms) <$200,000 CQ >=50,000 QBS, SSS and IC (individuals) All SSS 21. Short lists composed entirely of national consultants: Short lists of consultants for services estimated to cost less than $300,000 equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines

61 Post Review 22. The procurement documents for all other contracts under technical assistance (TA) component shall be subject to the Bank s post review on a random basis, one in five contracts. Post review of the procurement documents will normally be undertaken during the Bank supervision mission or as the Bank may request to review any particular contracts at any time

62 Annex 9: Economic and Financial Analysis CHINA: ENERGY EFFICIENCY FINANCING PROJECT A. PARTICIPATING FINANCIAL INSTITUTIONS (PFIS) 1. Two banks, the Export-Import Bank of China (EXIM), and the China Huaxia Bank (Huaxia), were selected as potential PFIs from six Chinese banks screened at the early stage of project preparation. Subsequently, the Bank performed its financial due diligence of Huaxia in accordance with the established eligibility criteria set by Bank Operational Policy 8.30 and confirmed its pre-selection as the PFI. In the absence of financial statements prepared and audited in accordance with accounting and auditing principles acceptable to the Bank, EXIM undertook agreed-upon interim measures to assist the Bank in evaluating its financial performance for the year ended December 31, EXIM has also agreed to develop and implement a time-bound action plan to address accounting and management weaknesses identified by the Bank due diligence team. This is an eligibility condition for EXIM s participation in the project. EXIM is one of the three state-owned policy banks in China, while Huaxia is a commercial bank established in October Detailed findings from the due diligence of the PFIs are included below. B. ELIGIBILITY CRITERIA FOR SELECTION OF PFIS 2. The Bank Operational Policy (OP8.30) requires that all financial intermediaries, which participate in a Bank financed credit line operation, are viable financial institutions at time of project appraisal and throughout the project implementation. The PFIs should be able to meet the established eligibility criteria in order to become a PFI. The due diligence is carried out in accordance with the established eligibility criteria. The eligibility criteria for the PFIs in the China Energy Efficiency Financing Project were developed based on best practices in the Bank line of credit operations. The criteria set out standard financial performance benchmarks for PFIs to meet in order to participate in the project. These benchmarks are structured to reflect the core areas of a financial institution - capital adequacy, asset quality, management and governance, liquidity, profitability, and efficiency - and are primarily aimed at setting a basic standard of financial health and soundness for eligible PFIs. General Criteria w Be in substantial compliance with all the prudential and regulatory requirements of CBRC, acceptable to the Bank. Be duly licensed in China to undertake banking operations and at least two years in operations. Have an appropriate corporate governance structure that complies with the appropriate regulations, with independence and capacity to provide adequate supervision to management and control over the bank s lending decisions. Have financial reports for the past two years, audited by a reputable auditing firm that is acceptable to the Bank, in accordance with International Accounting Standards (IAS) and International Standards for Auditing (ISA)

63 Financial Criteria. Be in full compliance with CBRC regulations, including: o Have and maintain an IAS calculated risk weighted capital adequacy ratio >=8% o Non-performing loans to total outstanding loans <= 5% o Single borrower limit: <lo% of net capital o Related/connected borrower limit: 45% of net capital as defined by CBRC and in. line with international best practice Profitable for the current and previous two years as reflected in the IAS audited financial statements. c. PFI DUE DILIGENCE SUMMARY*~ Huaxia 3. Huaxia is a commercial bank founded by Shougang Group General Corporation on October In April 1996, Huaxia transformed itself into a joint stock company upon approval from the People s Bank of China (PBOC). 4. As of December 3 1, 2006, 1,560 million shares representing 37.1% of Huaxia s capital was listed in the Shanghai Stock Exchange (SSE). The remaining 62.9% block of 2,640 million shares is scheduled for future listing in the SSE in several annual tranches beginning June As of June 30, 2006, out of the non-listed 62.9% of shares, Deutsche Bank (DB) owned a combined stake of million shares or 14.0% of Huaxia s capital, making DB its biggest individual shareholder. Among domestic shareholders, ten state owned companies led by the Shougang Group Corporation hold a combined stake of 44.4% of share capital. The remaining shares are held by several minority international shareholders. 5. Huaxia is running its business profitably generating positive return on equity (ROE) of 13% in 2006; its net profit amounted to RMB 1,482 billion in 2006, an increase of 5.8% over financial year Huaxia s annual financial statements for the years 2003 to 2006 were audited by Beijing Jing Du Certified Public Accountants Co., Ltd. and Ernst & Young (Hong Kong) Ltd., respectively, in accordance with Chinese Accounting Standards (CAS) and International Financial Reporting Standards (IFRS). The Auditors issued cleadunqualified opinion under both IFRS and CAS, with respect to the financial statements prepared by Huaxia. Huaxia is in compliance with the prudential and regulatory requirement of CBRC. EXIM 6. EXIM was founded in 1994 as a wholly state owned bank with the purpose of executing policies determined by the State Council. The bank s business focus is on four areas: (a) financing of exports and imports by priority sectors of the economy; (b) providing credit to support the development of priority sectors; (c) providing policy-based credit to other nations 26 The complete financial due diligence reports for each o f the PFI are included in the project files

64 and foreign firms; and (d) administering and distributing credit provided by foreign governments (chiefly foreign export credit agencies and bilateral and multilateral development institutions). 7. EXIM is not subject to normal commercial banking regulation by the CBRC. The bank s activities are subject to the 1994 Ordinance 20 of the State Council and the 1993 Accounting System on Financial Institutions which determine the governance and structure of the bank and its accounting policies, neither of which conform to CBRC regulations for commercial banks or to IFRS. In October, 2007, EXIM hired one of the big four accounting firms to prepare its financial statement of 2007 in accordance with 2006 Chinese accounting standards which are consistent with international accounting standards. The bank is directly supervised by the State Council, which maintains a staff of full time supervisors at the bank who may comment and independently report on EXIM s activities to the State Council. 8. EXIM enjoys the explicit and implicit support of the state and as a consequence has the same international credit rating as Chinese sovereign debt. 9. Issues Relating to OP The following draws attention to certain issues relevant to the application of Bank Operations Policy 8.30 with respect to EXIM s qualification as a PFI: 0 0 EXIM is not subject to regulation for commercial banks by the CBRC; and EXIM fulfils all requirements of its governing law and regulations. However, these law and regulations do not set standards or requirements (particularly with reference to the adequacy of provisioning for potential losses, capital adequacy, liquidity, and governance and controls) which meet the equivalent CBRC standards and requirements. 10. EXIM has developed a time-bound action plan to address these issues. been reviewed by the Bank and regarded as satisfactory. This plan has D. SUB-PROJECT ECONOMIC AND FINANCIAL ANALYSIS 11. The selection of subprojects for energy efficiency financing will be the responsibility of onlending banks. Such financing will focus on renovation and rehabilitation activities whose primary financial benefits will be derived from energy savings. 12. It is widely recognized that most energy efficiency investments are economically justified, especially at current high energy prices which are expected to prevail in the mediumtern. In China, where coal is the dominant fuel, the economic justification is even stronger because of the significant environmental benefits expected from energy efficiency investments, resulting in EIRRs that are higher than the FIRRs. This project is built on the premise that the proposed energy efficiency subprojects are economically justified if they are financially viable. The on-lending banks are only requested to analyze and confirm that the selected subprojects are financially viable. 13. To confirm the validity of the above premise, a study was conducted during project preparation to survey major energy saving technologies requiring investments between US$5 and US$25 million to reduce energy consumption and improve energy efficiency in three energy

65 20 intensive industries in China, specifically, iron and steel, chemical and petrochemical and cement2'. The study reviewed 17 technologies for the iron and steel industry, 30 technologies for the chemical and petrochemical industry, and 9 technologies for the cement industry. The study also assessed the payback period for most of the technologies based on actual projects carried out in China during the 1990s and early 2000s, and in Japan. The payback periods, calculated on very conservative assumptions, are as follows: - Iron and Steel Chemical and Petrochemical Cement Total PBP 55 yrs 5 yrs QBP 5 8 yrs QBP Total 8 yrs Of the 56 energy saving technologies surveyed by the abovementioned study, 42 of them (that is, 75 percent of the total) had cash flows that investment payback periods (PBP) of less than 8 years. An analysis of the relationship between the simple payback period and the FIRR was conducted to estimate the FIRR associated with each of the payback periods. The relationship between PBP and FIRR based on the assumptions of a typical energy efficiency subproject is presented below in Figure A9.1. A PBP of 8 years translates to an FIRR of 10.2 percent, higher than the weighted average cost of capital of 8 percent that is assumed for a typical medium to large scale enterprise in China, implying that 75 percent of the energy saving technologies which were covered by the survey had financial returns which would exceed the weighted average cost of capital of project owners. The median PBP for the 56 technologies was 3.3 years, which is equivalent to a FIRR of 26.5 percent, far in excess of 8 percent. FIGURE A9.1: RELATIONSHIP BETWEEN FIRR AND PBP 70% - Basic Assumptions: - I 2 years' construction period, _--I 60% ~ years' operation period I 50% - Constant cash flow during the project period % - Ct 30% - 20% - 10% li Pay Back Period (Year) 21 "China Energy Efficiency Financing Project: Report for World Bank", Tokyo Energy Efficiency Group, December 3 1, The report is included in the project files

66 15, In addition, economic and financial analyses were performed on four representative subprojects of the first batch of subprojects envisaged for financing under the proposed project. The four subprojects are located in Anhui province, and include: (a) a waste heat recovery in a copper making process; (b) a waste heat recovery in a vitriol production process; (c) a rehabilitation of fans and pumps; and (d) a rehabilitation of Polyvinyl Alcohol (PVA) production line. Cost-benefit analyses were carried out to estimate the EIRRs, the FIRRs and the PBP of these sub-proj ects. The subproject investments ranged from US$5 million to US$23 million. 16. The estimation of the incremental financial and economic benefits of the sub-projects has been estimated based on conservative assumptions about the expected energy savings and environmental benefits. Costs considered in the calculation include investment costs and incremental operation costs. Benefits considered for the analyses include energy savings, valued at market energy price, and for EIRR, the environmental benefits, valued at 4,978 $/ton for particulate, 218 $ /ton for SO2, and 10 $/ton for CO2 emission. 17. Since it is likely that these sub-projects could qualify for carbon financing, the financial benefits have been considered with and without carbon financing revenues.28 Energy saving financial benefits for the sample sub-projects are derived from two sources: a reduction in the amount of energy consumed (such as a reduction in the intake of oil, coal, electricity), and in selected cases, from own generation of electricity using recovered waste heat which helps the enterprise reduce its purchase of electricity. The sub-project environmental benefits are derived from the avoidance of emission resulting from the improvement in energy efficiency. The avoided emission of SO2 and total suspended particulate (TSP) from the burning of heavy oil and coal (either for steam production or electricity generation) are assumed to provide local environmental benefits whereas the associated avoidance in CO2 emission is expected to result in global environmental benefits. 18. The key common assumptions in estimating the economic and financial benefits of the four sub-projects are summarized below: Financial. Value added tax (VAT): 17% for electricity and heavy oil, 13% for coal. Energy prices are based on market prices of 2,800 yuardton of heavy oil, industrial electricity tariff of 0.56 yuanlkwh, electricity feed-in tariff of yuanlkwh (VAT included for above prices) and 500 yuardtce of coal (VAT excluded), and Electricity losses from generation plant use and transmission & distribution (T&D) losses assumed at 15%. Environmental: The emission factors and the value per ton of avoided emission which have been assumed for the economic analyses are as follows: 28 Although the analysis considers both cases with and without carbon-financing for the sub-projects, it is important to note that GEF grant assistance will not be provided to those that are considered for carbon finance

67 Emission TSP so2 c02 Electricity Production Heavy Oil Combustion Value for Emission (kgigwh) (kgiton) Avoided (US$/ton) ,978 3, ,989 3, The externality cost of particulate and SO2 were calculated based on the China - Environmental Cost from Pollution report, which was jointly completed by the Chinese governments (State Environmental Protection Administration, Ministry of Water Resources, Ministry of Health and its Center for Disease Control), the World Bank, Resources for the Future (USA), and CICERO and ECON (both Norway) in January The carbon emission was valued at the recent carbon trade market price 20. The following tables summarize the results from the economic and financial analysis of the four sample sub-projects. The analyses showed that the EIRR for the representative subprojects ranged from 13.1 percent to a high of 62.8 percent. These EIRRs exceed the social discount rate of 12 percent usually considered in Bank financed energy projects and previous Chinese guidelines for evaluation of projects, confirming, as expected, the economic viability of the subprojects. A lower social discount rate of 8 percent was retained in the recently revised guidelines for evaluation of projects in China. The lower discount rate of 8% increases the robustness of the conclusion that energy efficiency investments are economically sound and desirable. TABLE A9.3. RESULTS OF THE ECONOMIC ANALYSES OF REPRESENTATIVE SUB-PROJECTS 21. On a combined basis, the representative four sub-projects yield an EIRR of 33.9 percent. The annual energy saving of these four sub-projects amounts to 127,031 tons of coal equivalent and the annual carbon reduction amounts to 312,860 tons. Based on the total investment cost of the four sub-projects, the average carbon reduction cost was estimated at around 7.7 $/ton of c Extrapolation based on the analysis of the four sub-projects imply that the project will result in annual energy savings of 1.5 million tce and annual C02 emission reduction of 3.6 million tons, considering the $200 million investment together with co-financing from

68 participating banks and equity provided by enterprises themselves. The total investment on EE subprojects was estimated at $571 million, including 70 percent debt ($200 million from IBRD, and $200 million from the PFIs and participating additional banks) and 30 percent equity financing in the first five years of project implementation. 23. Similarly, the sub-projects yield attractive financial returns and hence their implementation should be of material interest to both the on-lending banks and the sub-project sponsors. The FIRRs for the four sub-projects range from 11.2 to 59.2 percent (before income tax), which indicates that the sub-projects are financially attractive against the typical weighted average cost of capital of 8 percent of medium and large-scale enterprises in China. Similarly, the payback period are relatively short, ranging from 1.2 to 6.6 years and the average payback duration is 2.3 years with carbon financing and 2.7 years without carbon financing. The table below summarizes the FIRR and PBP results for the four sub-projects. TABLE A9.4. RESULTS OF THE FINANCIAL ANALYSES Sub-project Waste Heat Utilization in Investment Cost FIRR (%) PBP (years) (million US$) With CF I W/O CF With CF I WiO CF 23.O Waste Heat Utilization in I I Rehabilitation of Fans and I I Pumps Rehabilitation of PVA production line Total Subproject 1 : Waste Heat Utilization in Cooper Making Process Description 24. XXX Nonferrous Metal Corporation plans to recover the waste heat in its copper making process to reduce energy consumption and thereby decrease its energy expenditures. The proposal includes: (a) substitution of recovered waste heat heavy oil in the cooper minerals drying process; (b) rehabilitation of the existing waste heat utilization boilers to recover more heat from its vitriol making process, and (c) use of the recovered waste heat for power generation (2.5 MW generation unit). Economic Analysis 25. Economic Costs. Economic costs considered in the analysis include: (a) the total investment cost of million yuan; and (b) the operation and maintenance (O&M) costs. All costs are net of taxes and duties, assumed at 1 percent annually of the investment cost. The conversion factor considered in the analysis is 1.0 since financial costs are determined by the market

69 26. Economic Benefits. The major economic benefits considered in the analysis include: (a) energy savings from waste heat utilization which include reduction of heavy oil consumption by 6,300 todyear, reduction of electricity consumption by 7.35 GWWyear, substitution of 15.0 GWWyear generated by heat recovery to electricity purchases from the grid, and (b) associated environmental benefits due to avoided pollutant emissions from heavy oil combustion and electricity production. The market price of heavy oil and sales price of electricity (tax excluded) are taken as the proxy of consumer willingness to pay. The value of avoided pollutants are estimated based on the report China Environmental Burdens from Air and Water Pollution, which was jointly completed by the Chinese governments, the World Bank and other international agencies in January The carbon emission was valued at the recent carbon trade market price. 27. Economic internal rate of return. The detail analysis of the EIRR estimate for this subproject is shown in Table A9.3 below. The EIRR of the sub-project is 13.1 percent, higher than the 12 percent hurdle (discount) rate applied by the Bank to provide economic justification. The estimated annual energy saving for this sub-project is 16,567 tons of coal equivalent (tce) and the annual CO2 emission reduction is 38,430 tons. - Year TABLE A9.5: COST BENEFIT ANALYSIS FOR WASTE HEAT UTILIZATION IN COOPER ~AKING PROCESS SUB-PROJECT Cost (my) Benefit (my) Energy Saving nvestmentl o&m cost I I Enviornmental Subtota Subtotal ieavy Oil I Electricity I Generation I Local I Carbon Net Benefit % EIRR % 28. Sensitivity and Risk Analysis. The sensitivity and risk analysis for this sub-project were conducted considering its relatively low EIRR. The selected variables include energy price, -61 -

70 investment cost, and the price of carbon. The sensitivity analysis showed that the EIRR will decrease to: (a) 11.8 percent if energy price decreases by 10 percent; (b) 11.8 percent if investment cost increases by 10 percent, and (c) 12.8 percent if carbon price decreases by 20 percent. The risk analysis showed that the expected ERR of this subproject will be 13.1 percent based on Monte-Carlo simulation of 1,000 times, same as the base case considering the growing energy price which benefits EE subprojects and compensates part of other adverse impacts to this sub-project. The probability of an EIRR lower than 12 percent is about 22 percent. Financial Analysis 29. The FIRR of the proposed investment is 11.2 percent. This rate would improve to 12.4 percent assuming that the reduction in C02 could benefit from receipt of carbon financing revenues, which have been assumed to trade at $10/ton, Both FIRRs are higher than the estimated investor s hurdle rate of 8.0 percent. The pay back period of this sub-project was calculated as 6.6 years without carbon financing revenues. The PBP decreases to 5.9 years if carbon financing revenues are included. Subproject 2: Waste Heat Utilization in Vitriol Production Process Description 30. The owner of this sub-project is also the XXX Nonferrous Metal Corporation who plans to recover and use the waste heat produced during the vitriol production process. Two generation units (2x18MW) will be installed to utilize the recovered waste heat for electricity production. Economic Analysis 31. The economic costs and benefits are assessed according to the methodology described above. The economic costs include: (a) total investment cost of 73.6 million yuan, and (b) annual O&M cost. The major economic benejts considered for the analysis include: (a) annual generation of 173 GWh from recovered waste heat; and (b) associated environmental benefits due to reduction in pollutants emission from the avoidance of electricity purchase. 32. The detailed estimate of EIRR for this subproject is presented in table A9.3. The ERR of the sub-project is 57.6 percent, much higher than the 12 percent threshold, indicating the robustness of the economic viability of sub-projects of similar nature. The estimated annual energy saving for this sub-project is 55,360 tons of coal equivalent (tce) and the annual C02 emissions reduction is 137,533 tons

71 TABLE A9.6. c OST BENEFIT ANALYSIS FOR WASTE UTILIZATION IN VITRIOL PRODUCTION - Year Cost f my) \ I nvestm en t I o&m cost I Subtota Ilectricity Consumption Saving Enviornmental Local I Carbon Subtotal Net Benefit % ElRR % Firtart cia1 Analysis 33. The FIRR is calculated according to the same methodology described above. The FIRR of the proposed investment is 47.5 percent and would increase to 55.2 percent if the benefits of COz emission reductions trading at $10/ton are included in the analysis. These returns clearly exceed the subproject sponsor's assumed weighted average cost of capital of 8.0 percent. The payback period of this sub-project was calculated as 1.5 years without carbon financing revenues. The PBP will decrease to 1.2 years if carbon financing revenues are included. Subproject 3: Rehabilitation of Fans and Pumps Description 34. The owner of this sub-project is also XXX Nonferrous Metal Corporation which plans to rehabilitate the 74 sets of fans and pumps in its factory by adopting frequency control technology

72 Economic Analysis 35. The economic costs considered in the analysis include: (a) the total investment cost o f 38.3 million yuan, and (b) the annual O&M cost. The major economic benefits considered in the analysis include: (a) annual electricity consumption saving of GWh; and (b) associated environmental benefits due to avoided pollutant emissions from reduced electricity generation. 36. The detailed calculation of the EIRR for this subproject is shown in the table A9.3. The EIRR of the sub-project is 35.8 percent, much higher than 12 percent discount benchmark. The estimated annual energy saving for this sub-project is 13,124 tons o f coal equivalent (tce) and the annual COz emission reduction is 32,603 tons. TABLE A9.7: COST BENEFIT ANALYSIS FOR REHABILITATION OF FANS AND PUMPS SUB-PROJECT - Year Cost (my) lnvestmen t I! g: I Subtotal Electricity Consumption Saving Benefit (my) Enviornmental Local I Carbon Subtotal Net Benefit (my) % EIRR 35.8% Financial Analysis 37. Based on the expected net financial benefit, the FIRR of the proposed investment is 31.8 percent and would increase to 34.7 percent when benefits from carbon financing are included

73 Both FIRRs are higher than the assumed weighted average cost of capital of 8.0 percent. The pay back period of this sub-project was calculated as 2.2 years without carbon financing revenues. The PBP decreases to 1.9 years if carbon financing revenues are included. Subproject 4: Rehabilitation of Polyvinyl Alcohol (PVA) Production Line Subproject Description 38. The owner of this sub-project is XXX Advanced Materials Company. It plans to improve the enterprises energy efficiency by rehabilitating its (a) PVA production line, (b) air cooling system, and (c) CHP plant to make use of waste heat for more generation and reduce its power purchase from the grid. Economic Analysis 39. The economic costs include: (a) the total investment cost of 67.4 million yuan; and (b) the annual O&M cost. The major economic benefits considered for the analysis include: (a) the resulting energy savings including the reductions of electricity consumption by 4.37 GWWyear and the reductions of steam consumption by 52 todhour; (b) the associated environmental benefits due to avoided pollutant emissions from coal burning for electricity and steam production; and (c) the reduction of water consumption. 40. The detailed calculation of the ERR for this subproject is shown in table A9.3. It shows that the ERR of the sub-project is 62.8 percent, much higher than 12 percent hurdle rate. The estimated annual energy saving for this sub-project is tons of coal equivalent (tce) and the annual C02 emission reduction is 104,293 tons

74 TABLE A9.8. COST BENEFIT ANALYSIS FOR REHABILITATION OF PVA PRODUCTION LINE SUB- - Year Cost (my) nvestmentl OLIM Cost I Subtotal Energy Saving Water Con. Enviornmental Electricitv I Coal Saving Local I Carbon Subtotal Net Benefit % ElRR 62.8% Financial Analysis 41. The financial internal rate o f return of this sub-project is 48.2 percent and would increase to 59.2 percent if benefits from emission reductions trading at $10/ton are also included. Both FIRRs are higher than the estimated investor s hurdle rate o f 8.0 percent. The payback period of this sub-project was calculated as 2.1 years without carbon financing revenues, and 1.7 years with carbon financing revenues included. Conclusions 42. The analyses o f the four sub-projects provide extended comfort that the energy efficiency investments which are likely to be considered by the on-lending banks will be economically justified and financially viable. The financial viability of these subprojects would be enhanced if COz emission reductions are traded. As the environmental benefits are usually underestimated in countries like China, where coal is dominant, the economic viability is even more robust and EIRRs are consistently higher than FIRRs

75 Annex 10: Environmental and Social Safeguard Policy Issues CHINA: ENERGY EFFICIENCY FINANCING PROJECT 1. The World Bank/GEF China Energy Efficiency Financing Project (the Project ) has been designed to address major institutional, financial and technical barriers that are constraining the development of a sustainable energy efficiency financing market in China. The Project consists of two integrated components: an IBRD loan which will be on-lent by PFIs to finance energy efficiency investment sub-projects in medium and large scale industrial enterprises, and a GEF-funded technical assistance which would assist in building institutions and institutional capacities to support the promotion of an active energy efficiency financing market. The Bank is currently preparing the Project with the following PFIs: Export and Import Bank of China and Huaxia Bank. Subprojects to be financed by IBRD loan are primarily process additions, process modifications, or process changes that either recovery waste heat or improve energy efficiency. Typical subprojects include waste heat boilers, pressure recovery turbines, and changes of inefficient equipment with efficient ones, etc., which usually have either minor or no environmental impacts. 2. The purpose of this environmental assessment (EA) framework document (Framework Document) is to be used to provide guidance to both the subproject sponsor (sub-borrower) and the PFIs for the environmental assessment process to be followed in evaluating individual subprojects that are to be considered for financial support under the Project. This Framework Document defines the contents, procedures and responsibilities for environmental assessment of the subprojects, whose purpose is to ensure the environmental assessment is in compliance with both Chinese EA laws and regulations and in accordance with World Bank EA policies and procedures as specified in OP/BP (Environmental Assessment). 3. The EA procedure covers the following six aspects of preparatiodconstruction phase and two aspects of implementation phase. Each of the aspects is described below along with the requirements and responsibilities for each aspect. A. Sub-Proiect Preparation and Construction Phase 1. Project Screening 2. EA Document Preparation 3. Public Consultation 4. Review and Approval of EA 5. Disclosure 6. Related Conditions and Responsibilities B. Implementation Phase 7. Supervision 8. Reporting

76 A. Sub-Proiect Preparation and Construction Phase General The Sub-borrower is responsible for subproject screening, EA document preparation, public consultation, and disclosure. The PFI has no involvement in these activities. After the Subborrower obtains the required Chinese environmental approvals, it will be required to submit to the PFI an information package consisting of items outlined in paragraph ix to demonstrate that the Chinese EA procedures have been followed in strict accordance with Chinese EA regulations. The PFI will review this material and if necessary, request additional supplementary information from the Sub-borrower to insure that the World Bank EA procedures are also followed. Details of these requirements are presented below. 1) Sub-project Screening The Sub-borrower will discuss the proposed sub-project with appropriate local, Provincial or State Chinese environmental authorities and provide them the necessary information which they would require to establish the EIA documentation requirement. The Chinese environmental authorities will establish the EIA documentation required for the proposed sub-project either as: (a) a full EIA (equivalent to World Bank Category A), (b) an EIA Table (equivalent to World Bank Category B) or (c) no EIA required (equivalent to World Bank Category C). Having reviewed the related Chinese regulations, it has been confirmed that (1) the Chinese full EIA Report is equivalent to World Bank Category A ; (2) the Chinese EIA Table is equivalent to World Bank Category B ; and (3) the Chinese no EIA required is equivalent to World Bank Category C. 2) EIA Document Preparation The Sub-borrower is responsible for preparing the EIA documentation requirement which has been established by the appropriate Chinese environmental authorities. Full EIA Required (World Bank equivalent of CATEGORY A) a) Proposed sub-proj ects that the Chinese environmental authorities decide require a complete EIA or involve land acquisition will not be eligible for financing under the IBRD loan. EIA Table Required (World Bank equivalent of CATEGORY B) b) Sub-projects with impacts of limited duration andor extent and that are easily mitigated through standard, readily available, widely practiced techniques

77 The PFI will provide the sub-project sponsor with the information requirements of a World Bank Category B project (Environmental Management Plan or EMP, see the Annex). The sub-project sponsor will then prepare an EIA Table that is consistent with both Chinese environmental requirements and World Bank EA Category B requirements (EMP). Nothing Required (World Bank equivalent of CATEGORY C) c) Sub-projects with little or no impacts and require no mitigating measures. Since proposed sub-projects which require a Full EIA (Category A) will not be eligible for financing under this Project and eligible sub-projects which do not require any environmental review (Category C) have no further environmental assessment requirements, the remainder of this Section, deals only with eligible sub-projects which require an EIA Table (Category B). Public Consultation The Sub-borrower is responsible for conducting the public consultation. These responsibilities include: notification to the public, conducting the consultation and recording the significant findings, conclusions, recommendations and next steps. Details of the documentation required for the public consultation are presented in Section D of Annex 10-1 (Consultation with Local NGOs and Project-Affected Groups). The purpose of public consultation is to solicit views of groups or individuals who may be affected by the sub-project regarding their environmental concerns. Affected groups or people should identify the environmental issues they believe to be significant. Any significant issues, established during the public consultation, should be incorporated into the EIA Table. Only one public consultation is required and it may be held (a) prior to preparing the draft EIA Table and incorporating the collected issues into the final draft EIA Table or (b) after a draft EIA Table is prepared which can be used as a background document to be circulated at the public consultation and then using the results of the consultation the Subborrower would add or delete issues from the EIA Table based upon the recommendations of the public consultation. Review and Approval of EA The Sub-borrower will submit the EIA Table to appropriate Chinese environmental authorities for review and approval. The energy efficiency sub-projects under this Project will be restricted to modification, renovation and rehabilitation at existing production facility(ies) of the Sub-borrower. The sub-borrower must also validate that the existing production facility which will be

78 defined as the connected project has a valid, approved EA29 if required by the Chinese environmental authorities and a verification that the existing production facility(ies) was operating with all appropriate environmental approvals, permits, licenses, etc. required by Chinese environmental regulations. This is only required if the existing production facility was constructed after Chinese EA regulations were officially adopted or Chinese environmental authorities had a retroactive EA requirement for the facility. i) The Sub-borrower will submit the following Information Package to the PFI: 0 Copy of the sub-project EIA approval letter from Chinese environmental authorities; 0 EIA Table; 0 Record of the Public Consultation (see Annex I, Section D: Consultation with Local NGOs and Project-Affected Groups); 0 Location (physical or website address) and Date of EIA Disclosure (see below); Copy of the EIA approval letter for the connected project ; 0 Documentation that all environmental laws and regulations for the connected project are in compliance; and 0 Construction start date for the connected project. The PFI will review the EIA Table to ensure that it meets both requirements of the Chinese environmental authorities and World Bank requirements for a Category B project. If the approved EIA Table does not contain all the information required by the World Bank EMP, the PFI will request the sub-borrower to provide the additional information to ensure that EMP information requirements of the World Bank are also satisfied. The PFI will then review the entire information package detailed in paragraph ix to determine that: (a) the sub-borrower has all the necessary Chinese EA approvals; (b) the information contained in the EL4 Table also satisfies World Bank EMP requirements; (c) the record of the public consultation is complete; (d) the EIA was disclosed in a timely and proper manner; and (e) the connected project met all the Chinese EIA requirements with construction starting after EIA approval had been obtained. 5) Disclosure j) The sub-borrower and the PFI will be responsible for disclosing the approved EIA Table publicly (municipal building, library etc. near the project site, and/or on their Internet websites). l9 The World Bank environmental safeguard policies require an evaluation of any activities which although not directly involved with the World Bank investment may be linked to that investment and whose operational performance is dependent upon the World Bank investment. For example, if the World Bank was financing a transmission line extending from an existing power station, the policy would require a verification that the power station was operating with all appropriate environmental approvals, permits, licenses, etc. required by the sub-borrowers country. This is only required if the existing production facility was constructed after Chinese EA regulations were officially adopted or Chinese environmental authorities had a retroactive EA requirement for the facility

79 6) Related Conditions and Responsibilities During the investment sub-project tender, it is the responsibility of the sub-borrower to assure that the requirements put forward in the EIA Table have been included in all tender documents. During sub-project implementation, the PFI has the right to check tender documents to verify this condition. Satisfying these conditions is one prerequisite to winning the bid. In addition, the PFI will ensure that an appropriate clause be included in sub-project construction contracts regarding the procedures to be followed in the event of chance finds of culturally significant artifacts or sites according to related Chinese laws and regulations. B. Implementation Phase The Sub-borrower is responsible for insuring that all the requirements of the EIA Table and any supplementary World Bank EIA requirements are properly implemented. 7) Supervision During the normal Sub-project supervision activities, the PFI will check with local environmental authorities to determine if the Sub-proj ect implementation is meeting all specified EIA requirements. Any supervision reports prepared by the PFI should include a brief environmental section. 8) Reporting The PFI will include an environmental section in any report prepared for the World Bank. As appropriate, the Section will discuss details of any environmental issue that occurred during the reporting period and the actions taken to resolve it. C. Institutional Arrangement Environmental specialist(s) who are familiar with both Chinese and the World Bank EA requirements will be hired by the PFI during the project implementation to help the PFI s project team conduct environmental due diligence

80 Environmental Management Plan CHINA: ENERGY EFFICIENCY FINANCING PROJECT Sub-project Description Present a brief description of the subproject. Include the nature of the investment, the location, and any characteristics of the area that are of particular interest, e.g. near a protected area, area o f cultural, historical, religious interest, etc. Also, very briefly describe the general land use characteristics (farming, small industry etc.), and the location(s) of the nearest population centers. Provide a brief summary of the major subproject related environmental issues, how will they be managed, who will manage them and what, if any, are the environmental risks. A. MITIGATION PLAN Phase Construction Issue Mitigating Measure cost of Mitigation (If Substantial) Responsibility * Start Date End Date Operation A. Itenis indicated to be? vesponsit ity ofthe contractor should be spec ed in the bid documents

81 UaJ e;;; w n I m b I

82 INSTITUTIONAL ARRANGEMENTS A brief narrative discussion should be prepared to indicate how monitoring data is going to be used to maintain sound environmental performance-who collects the data, who analyzes it, who prepares reports, whom the reports are sent to and how often, what he/she does with the information. D. Consultation with Local NGOs and Project Affected Groups Provide documentation of the following: 0 Manner in which notification of the consultation was announced: media(s) used, date(s), description or copy of the announcement Date(s) consultation(s) was (were) held Location(s) consultation(s) was (were) held 0 Who was invited - Name, Organization or Occupation, Telephone/Fax/ numbedaddress (home and/or office) 0 Who attended - Name, Organization or Occupation, Telephone/Fax/ number/address (home and/or office) 0 Meeting Program/Schedule What is to be presented and by whom 0 0 Summary Meeting Minutes (Comments, Questions and Response by Presenters) List of decisions reached, and any actions agreed upon with schedules and deadlines and responsibilities

83 Annex 11 : Project Preparation and Supervision CHINA: ENERGY EFFICIENCY FINANCING PROJECT Planned Actual PCN review April 04, 2006 Initial PID to PIC Initial ISDS to PIC March 14,2006 May 07,2007 Appraisal June 2007 June 2007 Negotiations March 2008 April 7, 2008 BoardiRVP approval Planned date of effectiveness Planned date of mid-term review Planned closing date May 2008 August 2008 December December 2013 Key institutions responsible for preparation of the project: Ministry of Finance, Government of China National Development and Reform Committee, Government of China The Export-Import Bank of China HuaxiaBank Bank staff and consultants who worked on the project included: Name Title Unit Leiping Wang Senior Energy Specialist/Task Team Leader EASTE Nancy Chen Senior Financial Mgmt SpecialistKO-Task Team Leader EAPFP Robert P. Taylor Lead Energy Specialist EASTE Feng Liu Consultant EASTE Nuru Lama Ximing Peng Haixia Li Xiaowei Guo Bernard Baratz Mei Wang Noureddine Berrah Ashok Sarkar Nuyi Tao Xiaoyu Shi Teri Velilla Young Professional Energy Specialist Financial Management Specialist Senior Procurement Specialist Consultant, Senior Environmental Specialist Senior Counsel Consultant Senior Energy Specialist Technical Specialist/Carbon Finance Consultant Program Assistant EASTE EASTE EAPCO EAF'CO EASTE LEGEA EASTE ESMAP ENVCF ESMAP EASTE Teresita Orterra Y Program Assistant EASTE Bank funds expended to date on project preparation: 1. Bank resources: $397, Trust funds: n/a 3. Total: $397,

84 Annex 12: Documents in the Project File CHINA: ENERGY EFFICIENCY FINANCING PROJECT 1. Technical Options of Energy Efficiency in Three Energy Intensive Sectors 2. NDRC Personnel for the Preparation of the GEF Grant 3. China Energy Conservation Financing Research Report 4. China Mid and Long Term Energy Conservation Plan 5. Due Diligence Report (Huaxia Bank) 6. Due Diligence Report (China Export Import Bank)

85 Annex 13: Statement of Loans and Credits CHINA: ENERGY EFFICIENCY FINANCING PROJECT Data as of April 4,2008 Project ID PO93963 PO88964 PO83322 PO PO77752 PO91020 PO96285 PO75613 PO PO81776 PO PO PO85333 PO PO75732 PO84742 PO86629 P PO96158 PO93906 PO PO81255 PO81346 PO81161 PO75730 PO PO86505 PO69862 PO68752 PO67828 PO57933 PO65035 PO65463 PO66955 PO69852 PO73002 Original Amount in US$ Millions FY Purpose IBRD IDA SF GEF CN-Guiyang Transport CN-Guangxi Integrated Forestry Dev CN-SICHUAN URBAN DEV CN-3rd National Railway CN-SHANDONG ENVMT 2 CN-Fijian Highway Sector Investment CN-MSE Finance CN-Shaanxi Ankang Road Development CN-W. Region Rural Water & Sanitation CN-GUANGDONG/PRDZ CN-LIAONING MED CITIES INFRAS 2 CN-Ecnomic Reform Implementation CN-5th Inland Waterways CN-Fuzhou Nantai Island Peri-Urban Dev CN-SHANGHAI URBAN APL2 CN-IAIL 111 CN-Heilongjiang Dairy CN-Liaoning Medium Cities Infrastructure CN-Renewable Energy II (CRESP 11) CN-3rd Jiaiigxi Hwy CN-HENAN TOWNS WATER CN-ChangjiangiPearl River Watershed Reha CN-LIUZHOU ENVIRONMENT MGMT CN-CHONGQING SMALL CITIES CN-HUNAN URBAN DEV CN - Poor Rural Communities Development CN-NINGBO WATER & ENVMT CN - Agricultiiral Technology Transfer CN-Inner Mongolia Highway & Trade Corrid CN-Renewable Energy Scale-up Program CN-TAI BASIN URBAN ENVMT CN-Gansu & Xinjiang Pastoral Development CN-Jiangxi Integrated Agric. Modem. CN-ZHEJIANG URBAN ENVMT CN-Wuhan Urban Transport CN-Basic Education in Westem Areas OO Difference between expected and actual disbursements Cancel. Undisb. Orig. Frm. Rev d oo oo

86 PO PO PO PO PO PO PO7019l 2003 PO PO PO PO PO PO PO PO PO PO PO PO PO PO PO CN-GUANGDONG/PRD UR ENVMT CN-Hubei Shiman Highway CN-4th Inland Waterways CN-TIANJIN URB DEV II CN-Yixing Pumped Storage Project CN-2nd Anhui Hwy CN-SHANGHAI URB ENVMT APLl CN-3rd Xinjiang Hwy Project CN-Sustainable Forestry Development CN-Hubei Hydropower Dev in Poor Areas CN-Tuberculosis Control Project CN-HUAI RIVER POLLUTION CONTROL CN-LIAO RIVER BASIN CN-Shijiazhuaiig Urban Transport CN-CHONGQING URBAN ENVMT CN-Yangtze Dike Strengthening CN-HEBEI URBAN ENVIRONMENT CN-BEIJING ENVIRONMENT II CN-Accounting Reform & Development CN-Tec Coop Credit IV CN-Health IX Ertan II Hydroelectric Project Total: 8, , , oo CHINA STATEMENT OF IFC s Held and Disbursed Portfolio In Millions of US Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 2002 ASIMCO 2006 ASIMCO 2005 BCCB 2003 BCIB 2006 BUFH 2005 Babel Babel Necktie 1999 Bank of Shanghai 2000 Bank of Shanghai 2002 Bank of Shanghai 2005 BioChina 2002 CDH China Fund 2005 CDH China II I.oo

87 CDH Venture CT Holdings CUNA Mutual Capital Today Changyu Group Chengdu Huarong China Green Ener China Re Life China Walden Mgt Chinasoft Colony China Colony China GP Conch Dagang Newspring Darong Deqingyuan Dynamic Fund Epure Fen gl in Fetiglin HJ MDF Five Star GDIH Great lnfotech 1.73 I Hangzhou RCB HiSoft Tech HiSoft Tech IB Jiangxi Chenming Launch Tech Maanshan Carbon Maanshan Carbon Minsheng Mitisheng & IB Mitisheng Bank Mitisheng Bank NCCB Nanjing Kumho Nanjing Ktimho Neophotonics New China Life New Hope Newbridge Inv. North Andre PSAM oo oo RAK China Renaissance Sec Rongde SAC HK Holding SAIC oo

88 ~ SBCVC SEAF SSlF SH Keji IT SHCT SIBFI Shanghai Krupp Shaiishui Group Shanxi SinoSpring Stora Enso Stora Enso Stora Enso TBK VeriSilicon Wanjie High-Tech Wumart XACB Xiiiao Gas Zhejiang Glass Zhengye-ADC Zhong Clieii Zhongda-Y aiij i n oo I oo Total portfolio: Approvals Pending Commitment FY Approval Company Loan Equity Quasi Partic SML 2004 NCFL Xinao CTC China Green Launch Tech MS Shipping Peak Pacific Total pending commitment

89 Annex 14: Country at a Glance CHINA: ENERGY EFFICIENCY FINANCING PROJECT POVERTY and SOCIAL 2006 Population, mid-year (miilions) GNI percapita (Atlasmethod, US$) GNI (Atlas method, US$ biliions) Average annual growth, Population (%) Laborforce (%) East Lower- Asia 8 middle- China Paclflc Income ,000 2,623 6 Most recent estimate (latest year available, ) Poverty (%of population belo wnationalpoverty iinej Urban population (%of totalpopulation) Life expectancyat birth (years) Infant rnortality(per looolive births) Childmalnutrition (%ofchiidren under5) Access to an improved watersource (%ofpopulation) Literacy (% o f populatio n age IS+ Gross primaryenrollment (%of school-age population) Male Female lq 1,900 2, ,037 3,539 4, ' t4 10 1' levelopment diamond' Life expectancy T I GNI Gross per +-- primary capita enrollment Access to ImDrOvedwatersource - -_- China Lo wr-middle-inco me gro up KEY ECONOMIC RATIOS and LONG-TERM TRENDS GDP (US$ billions) Gross capital formationlgdp Exports of goods and selvtceslgdp Gross domestic savingslgdp Gross national SavingsIGDP Current account balancelgdp Interest paymentslgdp Total debtlgdp Total debt selvicelexports Present value of debtlgdp Present value of debtlexports ' (average annual growth) GDP TI1 90 TI4 GDP percapita Exports of goods and sewices DO , , Q6 30 Q x)7 1)6 a Sconomlc ratios' Trade T Domestic,,*,<'+:;-, Capital savings formation Indebtedness China Lo wer-middle-income wouo STRUCTURE of the ECONOMY

90 (%of GDP) Agriculture Industry Manufacturing Services Household final consumption expenditure General gov t final consumption expenditure Imports of goods and services 147 BO 2005 P (average annual gro MhJ Agriculture Industry Manufacturing Services a1 P8 x) Household final consumption expenditure a9 78 General gov t final consumption expenditure Gross capital formation 119 a2 Imports of goods andsewices PI a I P5 a3 63 a 9 a2 143 Growth of exports and Imports (Oh) 4o T.- I-. 10 _* I_ I Exports -Imports Note 2006 data are preliminaryestimates This table was produced from the Development Economics LDB database Thediamonds showfourkeyindicators inthecountry(in bo1d)comparedwithits income-groupaverage If dataaremissing,thediamondwll be incomplete China PRICES and GOVERNM ENT FINANCE Domestic prices (%&angel Consumer prices Implicit GDP deflator Government finance (%of GDP. includes current grants) Current revenue Current budget balance Overall surplusideficit a TRADE (US$ rnillionsj Total exports (fob) Food Mineral fuels, lubricants, and related material! Manufactures Total imports (cif) Food Fuel and energy Capital goods ,942 4,448 3, ,904 1, , a.231 5,931 P9.P ,672 6,877 54, , ,073 22,481 25,722 ff, P , % 9,388 9,997 63, Export price index (2000-CJOJ a7 Import price index(2000=x)oj 76 a8 18 P4 Terms of trade (2000-MOJ 77 1x IExport and import levels (US$ mlll.), so I m l OS 06 mbports Imports I

91 BALANCE of PAYMENTS (US$ miilionsj Exports of goods and sewices imports of goods and Services Resource balance I986 34,952 43,453-8, ,Q7 ff, , ,681 7Q, ,769 P4, ,9Q Current account balance to GDP (%) 4" - Net income Net current transfers Q.437 2,Q9 Q ,200 Current account balance , ,867 Financing items (net) Changes in net resewes ,727 Memo: Reserves including gold (US$ mibons) Conversion rate (DEC, iocai/us$) 35 24, ,7ff , , , , EXTERNAL DEBT and RESOURCE FLOWS I986 (US$ miiiions) Total debt outstanding and disbursed 23,719 ib RD 965 IDA 774 Total debt sewice IBRD IDA 2, Compositionof net resourceflows Official grants 155 Official creditors 1,165 Private creditors 3,693 Foreign direct investment (net inflows) Portfolio equity(net inflows) Q8.8ff , , ,6Q ,741 27,361 i,d ,Q , Composition of 2005 debt (US$ mlll.) G A B E F World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers 1,QO ,900 2, , ,185 1, ,004 P Iff0 I A - IBRD E-BiIalerd B - IDA D - Other rmltilatsd F - Private C-IMF G- Short-twr Note This tablewas producedfrom the Development Economics LDB database 9/28/

92 Annex 15: Incremental Cost Analysis CHINA: ENERGY EFFICIENCY FINANCING PROJECT National Development and Global Environment Context 1. China s rapid ascendance to world manufacturing powerhouse has not been accompanied by a transition of its industrial sector to world-class energy efficiency. The sharp increase in coal consumption since 2001, driven by surging demand in power generation and energy-intensive industries, has helped drive up the energy intensity of the economy, reversing a descending trend of over 20 years. This has heightened the urgency in the government to accelerate and scale up energy efficiency policy interventions. 2. The continuing fast expansion of China s economy and the large size of its (existing) inefficient sectors require dual attentions to energy efficiency improvements. China must seize the opportunity of growth and strive for adopting state-of-the-art energy technologies in all new capital investments. It will also need to invest in energy efficiency renovation of the existing physical plants and facilities that will continue to operate in the next years, or even longer. The consensus among Chinese experts is that most of the existing capital stocks in China s energy-intensive industries, especially those in medium and large-sized enterprises, will still remain in production until at least There i s a window of opportunity to rehabilitate and upgrade the existing capital stocks to improve their energy efficiency in the next five years or so. 3. The government has adopted a comprehensive policy to increase energy efficiency investments in major energy-consuming sectors, especially in energy-intensive industries, with strong efforts during the 1 lth FYP period ( ). The proposed project, especially the GEFsupported components, will assist the implementation of national energy conservation programs with the objective of building capacity for long-term and sustained energy efficiency improvements, focusing on removing barriers to financing energy conservation investments in medium-size to large manufacturing facilities in energy-intensive industries where major energyefficiency renovations have stalled. 4. The energy-intensive manufacturing sectors, such as iron and steel, building materials, and petrochemical industries, consume approximately 50 percent of China s total primary energy and have great potential for cost-effective energy saving investments. Even the good practices in relatively modem large facilities of these industries still require percent more energy per unit physical output than international best practices (Table A1 5.1). 30 For example, China now produces 30 percent and 45 percent of the world s raw steel and cement, respectively. Most of the production capacities were added in the past 5-10 years

93 Synthetic Petroleum Raw steel Cement Plate glass ammonia Ethylene refining International best practice Large enterprises in China The government has set a target of achieving 560 Mtce annual energy savings by It is estimated that one third of the expected energy savings will come from technical improvements, and the rest from structural changes of the economy. The energy savings potential achievable through energy efficiency renovation among the existing medium and largesized manufacturing facilities of iron and steel, cement, plate glass, synthetic ammonia, ethylene, and petroleum refining are between 30 Mtce and 50 Mtce per year. Much energy savings can be realized by energy conservation investments with less than five years of simple payback time.31 These represent major opportunities for GEF intervention and will result in significant amount of reduction in carbon dioxide emissions. Main Barriers to Scaling up Investments in Industrial Energy Efficiency Renovations 6. The needs for energy efficiency renovation in medium and large-sized manufacturing facilities in energy-intensive industries are large. However, actual investments in such investment projects remain limited. For examples, coke dry quenching, a reliable technology with attractive financial returns (about four years of simple payback time), is applied in only 10 percent of the medium and large-sized coking plants. The main barriers to scaling up investments in major energy-intensive manufacturing facilities include the following: (a) Perceived high technical and financial risks by industrial enterprises. Compared with small-scale industrial energy conservation projects, which usually cost about US$ 1 million per project and have very short payback periods (one to two years), medium and large-sized projects typically are technically more complex, sometimes involving new technologies and optimization of production processes, have no solid record of reliable financial returns, and require longer payback periods. Such characteristics often lead enterprises to defer or abandon major investments in energy conservation renovations in favor of production expansions, which normally fit well with the general growth pressure in the Chinese economy. (b) Unfamiliarity with industrial energy conservation technologies and a lack of knowledge of energy efficiency business opportunities among Chinese banks. Chinese banks are accustomed to providing loans for production expansion projects and have little experience in financing energy conservation projects, in part because of the lack of demand. The lack of specialty experience and skills and the large variety of energy 31 Consultant report: Energy Efficiency Renovation Technologies in Iron and Steel, Construction Materials, and Petro-Chemical Industries of China; Tokyo Energy Efficiency Group, December

94 conservation technologies do not encourage the banks to start their own initiatives in energy efficiency lending because of perceived difficulties for repeat businesses and the high costs of project appraisal and supervision. In addition, energy conservation investments usually do not generate additional revenues, but rather contribute to profit margins through a reduction in energy expenditures. This makes it difficult for banks to identify and trap cash flows from such projects and take energy savings as assets of sufficient market value to justify a loan, often resulting in unattractive financing cost and terms. As such, Chinese banks have not developed operational capacity for direct energy-efficiency lending to industrial enterprises, nor do they have a good understanding of the major investment opportunities in industrial energy conservation. (c) Insufficient institutional capacity, especially at the national level, to address the pressing needs of scaling up energy-efficiency investments. The government has set ambitious goals for energy efficiency improvements for the 1 lth Five-Year Plan period and in the next 15 years. Achieving these goals will require a combination of marketbased policy instruments and enforcement of regulations and standards. In the wake of the great expansion of energy-intensive industries in the last 10 years or so, the government s capability to effectively implement its energy efficiency policies and programs has declined considerably in relative terms. Given the size and large weight of the energy-intensive industries in China s economy, as well as the widespread inefficient practices among their major facilities, policy and regulatory interventions need to be strengthened significantly to encourage industrial enterprise to undertake energy efficiency investments. Baseline Scenario 7. Without the proposed project, it is expected that energy efficiency financing for medium and large-sized industrial energy conservation investments through direct lending by domestic banks will remain negligible in the next five years. The participating banks will not conduct explicit marketing and pipeline development activities for energy efficiency lending, nor will they seek to establish the energy efficiency lending business lines in a systematic manner (with specialized unit and budget). 8. Under the baseline scenario the implementation of the government s energy conservation policies and programs will also be affected negatively because of a slower pace in developing the capacity of the soon-to-be-established NECC and inadequate resources for other time-sensitive activities, for example, the midterm review of the energy efficiency programs of the 11 th FYP. GEF Alternative and Barrier-Removal Activities 9. The proposed project will remove the above barriers through targeted technical assistance activities and a performance based funding allocation scheme to partially cover the incremental costs o f new energy efficiency lending business. The details are described in Table A

95 TABLE A1 5.2: EFFECTS AND OUTCOMES OF BARRIER-REMOVAL ACTIVITIES Barrier-rem oval activities Support for Promotion of Energy Efficiency Financing (Component A of the ProDosed Proiect) Al. Assistance to participating banks in business startup, capacity building, marketing and subproject pipeline development, subproject due diligence, development o f energy conservation financial products and support to cover part of the incremental cost o f maintaining the mandated new energy efficiency business unit or team. Effects and outcomes Addressing Barriers 1 and 2 while also supporting the removal of Barrier 3. Accompanied by an infusion of an IBRD on-lending loan of US$200 million IBRD, this subcomponent will help jumpstart the energy efficiency lending business o f two participating banks (alternatively referred as PFIs). With a focus on learning by doing, GEF technical assistance will help the banks develop internal capacity to identify, prepare, and appraise industrial conservation investment projects, build sector wise specialty areas and business lines, as well as manage risks. In addition to the US$200 million IBRD on-lent funds, the two participating banks are expected to lend another US$200 million from their own funds for industrial energy conservation investment over five yeas. A GEF grant will also provide support for marketing and energy conservation subproject pipeline development, which will raise awareness o f the new energy efficiency lending business lines among medium and large-sized industrial facilities and help the participating banks to develop lending pipelines. GEF assistance will provide support to the PFIs for due diligence of energy conservation subprojects, with which the banks are not familiar and thus build the expertise required to scale-up energy conservation lending. In addition, GEF grant will support PFIs to develop financial instruments and risk management tools which are tailored towards energy conservation lending. A portion of GEF assistance will be disbursed as a performancebased payment based on independent verification of energy conservation lending by the banks. Disbursing part of the incremental cost assistance through the output-based payment scheme is expected to encourage the banks to quickly scale up their energy efficiency lending business. The outcome will be significantly shortened learning curves for the participating banks, attainment o f a critical mass o f bank lending to medium and large-sized industrial energy conservation projects, and a successfully demonstrated energy efficiency lending business development model that can be replicated by other domestic banks. A2. Assistance to other banks in establishment o f energy efficiency lending business Similar GEF energy efficiency business development assistance will be extended to two nonparticipating banks (without IBRD loan) at a later phase o f the project to leverage additional energy efficiency lending

96 Barrier-rem oval activities A3. Assistance the overall banking sector Effects and outcomes This subcomponent will disseminate the early experience gained from the energy efficiency lending practices o f the participating banks and serve as a platfordforum for knowledge exchange and energy efficiency business promotion. The outcome will be a broad awareness o f the opportunities o f and financing products for industrial energy conservation, which will lead to further expansion of the energy efficiency lending business beyond the direct beneficiary banks. A4. Assistance to energy conservation project demonstration This will support the preparation and implementation of two or three industrial energy conservation projects in sectors with large replication potentials, but with significant project development difficulties, focusing primarily on pre-investment activities, such as feasibility studies, due diligence, and financing arrangements. In addition, assistance will be provided for the development of an assessment, supervision, and monitoring system for governmentsupported or co-financed industrial energy conservation projects. This will help streamline the selection and approval process o f projects, laying a foundation for scaling up government fiscal and financial support for industrial energy conservation on one hand, and helping industrial enterprises better access government energy efficiency investment incentives on the other. Monitoring and verification of PFIs' energy conservation lending (Component B2 of the proposed project) National Policy Support and Capacity Building (Component C of the Proposed Project) C1. Assistance to the establishment o f the NECC This will mainly support independent verification of energy conservation lending for the disbursement o f the performancebased incentive grant, as well as monitoring of energy conservation subproject performance. Addressing Barrier 3. To support the government's efforts to strengthen the institutional capacity o f energy efficiency interventions, the proposed project will provide major assistance to the establishment and initial operation of NECC, focusing on strategic planning, work program development, and capacity enhancement. The outcome will be a well-positioned organization able to provide critical and effective supports to the government in the implementation of major national energy conservation policies and programs. C2. Assistance to the implementation of the 11 t" FYP This subcomponent will help the government address urgent policy and institutional issues arising from the first two years o f implementing the priority energy efficiency programs of the 1 lth FYP, thus easing the impediment to achieving the target o f reducing the energy intensity of GDP by 20%

97 10. GEF co-financing for management, monitoring, and evaluation of the proposed project also is proposed (Component D). This will help ensure the efficient implementation of the proposed project and defray part of the costs of administrative and technical services for project management, monitoring, and evaluation. Incremental Costs and Global Benefits 11. The incremental costs of the GEF alternative include (a) the costs associated with the technical assistance activities; (b) the capital cost of additional energy conservation investments; (c) the costs incurred by beneficiary banks for setting up and operating new energy consewation lending businesses; and (d) the costs of administrative and technical support to project management, monitoring, and evaluation. The total estimated incremental cost is US$593.6 million. The main assumptions of the incremental cost calculation are described in the Incremental Cost and Benefit Matrix at the end of section. The detailed incremental cost estimates and proposed GEF co-financing are presented in Table A15.3. A. Promotion of Energy Efficiency Financing AI.Assistance to PFls TABLE A15.3: ESTIMATED INCREMENTAL COST AND PROPOSED GEF CO-FINANCING Ald. Subproject due diligence A 1 e. Financial products development Components and Activities A1 f. Performance-based incremental cost support I I I Incremental GEF (million Cost (million USD) ''Dl Ala. Business startup I Alb. Capacity building I 1.3 I 0.9 I 1 Alc. Marketing and pipeline development I I A2a. Business startup I I I A2b. Capacity building I I ' I A3..4ssistance to overall banking sector 1 A2c. Due diligence I 0.6 I 0.2 I A4. Assistance to energy conservation project demonstration I A4a. Preparation of pilot projects I 6.8 I A4b. Development of an assessment, supervision and monitoring system of government supportedico-financed industrial energy conservation projects EC lending by PFIs Matching equity investment by enterprises

98 ~ I C. National Policy Support and Capacity Building CI. Assistance to the establishment of NECC Cla. NECC startup I 0.3 I 0.3 I I Clb. Capacity development I 1.3 I I C 1 c. Development of awareness programs I 0.25 I 1 Cld. Assessment of energy auditing industry I I ' C2. Assistance to prioriy energy conservation programs C2a. 1 lth Five-Year Plan midterm review C2b. Special studies D. Project Implementation Support and Reporting C2c. Adoption of international best practices I : Project management, evaluation, and reporting I 0.7 I 0.4 I 02: Monitoring and verijkation of EC lending I Total project The average investment cost of industrial energy conservation investment projects is estimated to be about $290/tce-annual capacity based on studies of experts from the Energy Research Institute of NDRC. Using this estimate, the expected incremental energy efficiency investment volume of US$571 million over five years (US$200 million IBRD funds, US$200 million of additional PFI lending and US$171 million of equity contribution by beneficiary enterprises) is expected to result in about 1.97 Mtce/y of energy saving capacity by the end of the project implementation period. Assuming a 20-year life span of the subproject investment, the cumulative avoided energy consumption amount will be 39.4 Mtce, resulting in about 96.1 million tons of avoided C02 emissions. The cumulative energy savings and associated C02 emissions avoidance during the project period will be 3.2 Mtc and 7.8 million tons, respectively, assuming the investment stream indicated in Table A Table A15.4: Energy Conservation Investment and Energy Savings Resulting Without the proposed project (baseline), the total amount of energy conservation investments from the participating banks will be negligible over the next five years. Therefore, the incremental reduction of C02 emissions of the proposed project is 7.8 million tons of C02 at the completion of the project and 96.1 million tons of COz over the 20 -year life span of the energy conservation projects. The overall undiscounted unit incremental cost for the lifecycle avoided 32 Assuming that year 1 investments start to generate energy savings in year

99 COz emissions avoidance is about US$6.18 per ton of C02 (based on US$593.6 million of total incremental cost), of which GEF s contribution is aboutus$o. 14 per ton of C02. Table A15.5: Incremental Cost Matrix Domestic Benefits Global Benefits costs Baseline (without project) None None (1) Technical assistance (TA): US$O (2) Cost of capital: US$O (3) Project implementation support (PIS): usso Alternative (with project) Avoided energy consumption of 39.4 Mtce over 20 years. Avoidance of million tons of C02 emissions over 20 years. (1) US$2 1.5 million (2) US$571 million (3) PIS: US$l. 1 million Increment Avoided energy consumption of 39.4 Mtce over 20 years. Incremental reduction of 91.6 million tons of COz emissions over 20 years. (1) US$2 1.5 million (2) US$571 million (3) PIS: US$1.1 million Total baseline cost: US$O Total alternative cost: USS593.6 million Total IC: US$593.6 million Proposed GEF co-financing of IC is US$13.5 million, including US$12.7 million for technical assistance to banks, industries and government; 0 US$0.4 million for monitoring and verification of energy conservation lending at PFIs; and 0 US$0.4 million for sharing project management, evaluation and reporting

100 Annex 16: STAP Roster Review CHINA: ENERGY EFFICIENCY FINANCING PROJECT Review and Comments by Jayant S athaye 10 March 2007 Summary 1. The goal of this project is to improve energy efficiency of medium and large scale industrial enterprises, and to reduce their climate change impact. Given China s rapid industrialization and fast growth of its manufacturing sector, in this reviewer s opinion, this is precisely the type of project that the World Bank and the Global Environment Facility should be undertaking. The project is technically feasible and manageable. It reflects priorities identified in studies undertaken by leading western and Chinese laboratories and institutes, and can build on the ongoing work under the GEF China EUEEP project. 2. The technical and financial barriers identified by the World Bank in the proposal are familiar and widespread in most industrial establishments in developing countries. The project calls for development of sustainable energy efficiency lending practices for the industrial sector in private and public banks, and the strengthening of government capability to enforce standards, rules and regulations, and monitor energy savings. Both will greatly enhance the credibility of energy efficiency practices in China. 3. In summary, I find this to be an excellent project, indeed the type of project that is creative and innovative and well-targeted to produce tangible sustainable development benefits. 4. General and specific comments by paragraph are noted in the sections below. General Comments 5. The project is aimed at improving the efficiency of industrial enterprises. Industrial enterprises tend to have significantly higher hurdle rates for energy efficiency investments than indicated by the minimum attractive FIRR in the proposed project. This could be a risk factor that could lead to lower than expected demand for energy efficiency loans from prospective industries. This risk factor should be explicitly stated in the table on page The project proposal would benefit by including additional discussion of the types of incentives that would encourage enterprises to borrow for energy efficiency investment and approaches by which this project could strengthen those incentives

101 7. The proposed project focuses on supporting investments whose only benefit is derived from direct energy savings. This energy-efficiency-centric criterion may discourage investments whose main benefit is savings of material and other factor inputs. Material savings in turn yield larger savings of embodied energy. The project design should be made flexible enough to include and seek investment opportunities that capture non-energy and embodied-energy benefits. 8. The main text of the document, Le., description of Project Components on pages 5-6, makes no mention of the role of GEF. It needs to provide a clear description of the GEF role in this project. This oversight may be corrected by adding a paragraph or two to describe the GEF role. 9. The sustainability and replicability sections could be further strengthened, especially on how to involve the whole banking sector. Because most banks lack technical skills and of necessity emphasize borrowers financial credibility, it has been difficult to get them to focus on lending for energy efficiency improvements. The project s goals to introduce such plans in China are laudable. Replication and sustainability of the practices will require commitments at all levels particularly at the highest level where the main rationale for bank involvement may have little to do with energy efficiency per se. Ways to sustain non-energy-rationale will be important in order to maintain the interest in energy efficiency. 10. The technical rationale for the project is based on a consultant report. It would be very useful to provide a summary of the report in an appendix to the main report, and note its key findings in a separate section in the main text. Specific Comments 11. I would like to suggest the following specific considerations to improve various sections of the main text, and Appendix 15, Incremental Cost Analysis. Section A. Strategy Context and Rationale Para (P).2. The term energy conservation is often used to denote energy efficiency improvement through behavioral changes (turning off lights when no one is present for instance). Unless, energy conservation is a term of art that is widely accepted to mean all aspects of energy efficiency in the World Bank and affiliated institutions, it may be better to use the term energy efficiency in place of energy conservation in the document. P. 3. Please define the word Medium in the title - Medium and Long Term Energy Conservation Plan. What sizes of industry are being referred to here? P. 3 A recent article notes that China s energy efficiency gains are already lagging behind the 4% annual goal to This should provide added rationale for implementing the proposed energy efficiency loan, and reference to this document should be included in the text. P.4 At several places, the document refers to official publications or some significant events. In this paragraph, reference is made to dramatic improvements in production

102 - - capacities without significant energy efficiency improvements. It is my understanding that this is not correct. I have provided a chart to World Bank staff that illustrates the gains made by industry in this regard. It is important to either cite the document that the proposal text is based on, or rephrase the sentence in the proposal to note that despite such improvements, Chinese industry lags behind its international counterparts. P.5 This paragraph should cite the earlier experience with ADB loans, and note the lessons learned from these loans. P.7-8 Experience with industrial sector energy efficiency investments suggests that companies demand higher rates of return for investments made within the company that are primarily aimed at cost reduction. This may be due to the difference in capital and operating budgets, organizational reasons, and downtime required to install new energy efficient equipment, or perceived higher technical risks. This fact should be noted in the paragraph. Section B. Project Description - P.14 - The reasons for the World Bank to work through participating financial institutions are well articulated in the document, and it is an effective approach to reduce transaction costs and also build capacity that may be used to spur more such projects elsewhere in China. A note of caution, however, is warranted in this regard. A similar ADB project was set up with the Industrial Development Bank of India (IDBI) in order to on-lend energy efficiency loans to Indian industry for modernization and expansion purposes in the late 1990s. The response was relatively modest, and industry was reluctant to borrow funds for this purpose. In addition, IDBI staff did not set up technical capability within the bank, which precluded further replication and sustainability of this effort. In part this was caused by a recession in the industrial sector in the late 1990s, but it also revealed the reluctance on part of banks to build internal technical capacity and to take on technical challenges. The key issue here is to understand the rationale for an industry to take on debt financing for technically challenging projects, and for banks to be persuaded to take on technical tasks which will require them to retrain or hire staff with technical expertise. The project components section is missing an explanation about the role of GEF. A paragraph or more is needed to explain its role, which is articulated in Appendix 15. P Please check typos associated with loan amounts. P.18 - Please explain the incentive for PFIs to supplement the IBRD loans. As I understand it, this will be a requirement in order for PFIs to receive the IBRD loan. A sentence to this effect should be included in the text. P These paragraphs are difficult to understand. They need to be restated in plain English so that a lay reader can understand their meaning. What is diagnostic work and assistance? What were the challenges? Shaped by what study? Reference? Please reword the italicized title of P.26. What was requested by the PFIs? P.27 Please explain lending volume. Is it the total amount or per loan? What is the amount? P.30 - Typo - difference - different P.31 - How will the project assist PFIs to develop a robust pipeline of sub-projects? Has bringing together industry, banks, etc. worked before? It is a laudable goal but usually it is difficult to get stakeholders with such diverse interests to work together