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How useful ESCO can be for Japan

Japan lacks significant domestic sources of energy and must import substantial amounts of crude oil, natural gas, and other energy resources, including uranium for its nuclear power plants. In 1999, the country's dependence on imports for primary energy stood at more than 79%. Oil provided Japan with 52% of its total energy needs, coal 15%, nuclear power 15%, natural gas 13%, hydroelectric power 4%, and renewable sources 1.3%.Japan is the third largest energy consumer in the world that consumes approximately 6% of the totalprimary energy generated in the world, but depends on imports for about 80% of the energy resourcesit needs to meet its energy demand. TEPCO is supplying electricity to approximately 42.8 million people in its service area that coversmost of the Kanto region including the Tokyo metropolitan area. The total area of the service area isapproximately 39,500km2. The total amount of electricity sales and the peak demand in fiscal year2001 were 275.5 billion kWh and 64.3 million kW, respectively. The annual total amount of electricitysales in TEPCO has increased by approximately 50% in the last 10 years.The balance of energy mix should be adopted and will lead to a proper mix of renewable and available energy at the internal and external scale. The Kyoto Protocol emphases the prevention scheme for Global Warming internationally, in 2008. In this Protocol, Japan is required to eliminate 6% of the emission of CO2, target a 25% reduction until 2020 and this goal is difficult to attain.Against this background, ESCO (Energy Service Company), enforce the clients to cutdown energy consumption and cost, is much concerned from companies and ownersof building as effective mean to save energy.On top of the fact of global warming, it is indispensable to cut down energyconsumption to reduce the amount of Green House Gases emission. On the other hand, there aresome arguments that reduction of energy consumption cause economic stagnation.ESCOs service is consistent with this concern, because it cuts down the amount of theenergy consumption by management of energy use, leaving production activity untouched. ESCO offers the comprehensive service about energy saving, which cuts down theamount of the energy consumption by managing the energy used, and introducing the concept of energy-saving.Additionally, the charge system of ESCO service is based on the owner of building who paysinitial investment expense and fee of ESCO service from saving cost that ESCO service brings, and who receives the remainder of saving cost as profits. After termination of contract, all of saving cost of energy will become owner's profits. y ESCO Forecast1

In Japan, JAESCO (Japan Association of Energy Service Company (URL http: //www.jaesco.gr.jp/))was established in1999. JAESCO promotes development of energy conservation technology, finance system and ESCOs market. According to JAESCOs research, the number of cases of introduction ESCO service was about 420, and the amount of sales was about $83million in 2000. And, the amount of sales of 2001 is likely to be $260million; this figure means about 3 times the growth of the preceding year. There is a trial forecast of JAESCO, in 2010; the amount of sales will get to $1,300million. Moreover, in another forecast, potential market ofESCO service is $24,715million ($4,240million in Industry field and Business, $20,475million in Household field).
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www.jaesco.gr.jp 1

Market drivers and barriers of successful implementation of ESCO business model in Japan

The market drivers are:  A large market. A very large market of commercial, institutional and industrial companies exits in Japan which can significantly improve their energy utilization through adoption of energy-efficient technologies and practices.  A highly educated workforce. In Japan, there is a ready supply of highly educated technical (e.g., engineering, financial, marketing, and managerial) expertise needed by ESCOs to implement energy-saving technologies and processes on behalf of customers.  Stable and supportive political system supportive of improvements in energyefficiency;  Legal and financial systems are stable;  Availability of efficient equipment;  Environmentally concerned government to reduce its C02 emissions. The barriers to entry are:  The misunderstanding of ESCOs and energy performance contracting concept. ESCO is nearly not well understood bymost the third parties: financiers, attorneys, contractors, insurers, utilities, government agencies, and customers.  Government policies regarding energy performance contracting are uncertain.  Legal and contractual issues specific to performance contracting are unclear.  Economic conditions for investments in energy efficiency.  There is a lack of capital (equity financing or equity investments) for establishing ESCOs. y Financing ESCO

May 31 2011 BruceJenkyn-Jones, managing director (listed equities) at Impax Asset Managment says it is time to diversify into renewable energy and energy efficiency investments, which are now good value. He says while nuclear energy will recover from the shock of Fukushima, the disaster in Japan should remind investors to look across the whole sector. After the March 11 events, several actions were taken by the government in order to enhance the implementation of balance mix energy. Since 1999 the Economic Planning Agency (EPA) set forth the Law regarding to Promote Provision of Public Facilities and other related Services by use of Private Capital and other Resources, commonly known as the Law for Private Finance Initiative (LPFI). The EPA prepared the LPFI with reference to the Private Finance Initiative (PFI) of England. The PFI is categorized as third party finance, and there are many points in common with ESCO business. Promoting energy efficiency retrofits is not a goal of the LPFI of Japan, but the law provides policies for the government and local authorities to apply private sector funding when managing public facilities.Several decrees were taken to finance renewable energy and solution providers companies, and an interesting project of floating wind plant starts finding its paths to the realization. Even if the government is now in the mood to strengthen the renewable energy sector, still it might take time before its realization. ESCO projects are becoming more expensive due to increases in ESCO labor andmaterial costs and customers demand for more comprehensive mixes oftechnologies. A majority of ESCO project 2

installation costs have increased over the past decade even after accounting for inflation, due in part to increased labor and material costs. If these trends continue, ESCOs need to continue to demonstrate the economic case for comprehensive retrofits by delivering additional savings and value to customers, but particularly to rare investors. Financing is often considered the main barrier to the development of ESCO projects. For example, with respect to Japan, are there financial institutions that willprovide long-term debt financing to facility owners for amounts under, e.g., $1 million. Local banks are not that ready to finance performance-based energy efficiency projects; and if they are, the interest rate might be high for ESCO and repayment terms might be too short to structure loans around repayment from energy cost savings.On top of that there is no existing data about credit history of prospective customers in order to help in credit analysis.Moreover the bank officers typically dont have a standard measure to evaluate loans for energy efficiency projects backed by performance guarantees; and the lack of existing collateral assets to cover their investments make it hard for them to give their approval. In Japan, financing is done by asset coverage and corporate financing. The maximum financing limit is set individually for each corporation, and financing of the core business has priority. Since many energy efficiency retrofits have long payback periods from 4 to 10 years, the corporation has little incentive to obtain financing for investment in energy efficiency projects. When a large-scale construction project needs project Deregulation of the Utility Industry and Role of Energy Services Companies (ESCOs), a Special Purpose Company (SPC) is set up to provide a risk hedge for the lender, but for small scale projects such as ESCO business, the costs of establishing an SPC are expensive. Instead, performance contract could become the risk hedge for investors. The risk hedge which is a function of performance contracting will become more appreciated, it may become possible to apply project financing in Japan. y Importance of PE

Several possible funding sources can be investigated: private banks and lending institutions in Japan; U.S. financial institutions that are already familiar with energy performance contracting; venture capital firms; equity funds; strategic partners (e.g., utilities and engineering firms); leasing companies; and equipment manufacturers.A revolving fund to finance energy efficiency measures could also be set up. In many countries with undeveloped or developed financial markets, private equity is the sole source of capital available toenterprises to grow their businessesdebt or public equity generally being otherwise unavailable orprohibitively expensive. In addition to filling a crucial financing gap, private equity investors also provide longtermstewardship that enables companies to achieve their strategic goals and build valuefrom guiding agrowing companys national or international expansion plans, or turning around a poorly performing firm byfocusing on operational or governance improvements, to prepare a company for a public listing. If project financing is applied to the ESCO model, we can expect a good return of investment and reach the interest of Private Equity funds. Since big scale firm is difficult to implement in Japan, if we lower the scale we can expect to get investors interest. The ESCO business is also impeded by a long term payback and risk of no energy savings for households depending on certain market conditions. However, the Private Equity sector in Japan is not performing well due to cultural considerations, government policies, significantly risk aversion of managers. In fact the sector is considered as the non3

profit sector as we can see on the Dealogic chart. The private equity firms in Japan face the lack of deal flow. For the worlds third-largest economy, it is an incredible situation. Permira, a major international fund, has done one deal since it came to Japan in 2005. Kohlberg Kravis Roberts (KKR), which opened a Tokyo office the same year, is in a similar situation. Carlyle has done numerous good deals, but on March 12th 2010 it saw a $330million investment in Willcom wiped out in a refinancing because of the bankrupt of the wireless operator. On top of that, the ability for Japanese firm to raise fund easily because of low interest rate, is an obstacle for private equity. However, Japanese firms are not taking profit of this situation because, in Japanese culture, the idea of turning to a third party is considered an admission of failure. This same reason also applies to PE, Japanese businessmen generally regard outside investors as greedy speculators rather than partners. Some Japanese firms insist on maintaining jobs as a condition for a sale, undermining the rationale of a deal to restructure the business.Another matter for private equity is the Japanese policy. In 2010, a new policy allowed companies to delay the payment of their debts for three years, thus expanding the private equity waiting time to get back their funds. All rate of return measures suffer from the flaw that they conflate rewards to risk with rewards to patient waiting two quite distinct things writes John Kay in a Financial Times article. We think that private equity investors in Japan should take this statement into account. Therefore, we think for private equity to enter this market; we need strong actions from the government to support their investments. We also think that the private equity success in ESCO industry should be adapted to the reality of Japanese mind-set which structured on rigid and centralized decision making, low incentive to changes in business behavior and really risk aversion. As a private equity, it will important to review the time frame of their investments, change their exit option (highly recommended), show less engagement on management and act as external advisors, show more interest on the business growth and build strong relationship with their partners. The exit of PE before the end of the project The exit policy is a major issue for Japanese medium sized companies. They will not accept to lose their business. It is a critical situation for PE who receive funds from other partners and which contractually obliged to return the fund with return to the investors. In this case, what solution can be apply to Japanese PE? As we see the ESCO business is investment demanding and need time to have returns on investment; therefore we think pension fund investment is more appropriate to adress the long term need of financing of ESCO business model. We mean that a direct investment of pension fund in Japanese ESCO can be one the solution. Although private equity has its disadvantage on business owner view point, it still strongly needed in Japanese economy. We based our statement on the fact that, in most sector, Japanese firms are not reacting strongly to overtake their competitors in national or international basis. Nearly most the business in Japan are based on a traditional financing and business model. The need of change seems not attracting to them but catastrophe such as the nuclear power plant may take off the country from its lethargy. Most companies maintain a deadly business and dont want to receive fund from private equity. 4

Exhibit 1: An Example Installation of Household Photovoltaics module

Exhibit 2 Daily electricity consumption at TEPCOi

Source: http://www.ieahydro.org/reports/Annex_VIII_CaseStudy1102_LargeScalePS_Japan.pdf Exhibit 3 Daily consumption pattern with the solar energyiicombined with energy consumption

Source: http://www.geni.org/globalenergy/library/energytrends/currentusage/renewable/solar/japan/solarenergy/ Photovoltaics.shtml Exhibit 5- TEPCO electricity cost using oil and pumping water

Exhibit 6- Private Equity deal flow in Japan

Source: Dealogic, http://www.economist.com/node/15721549

References E. Vine, C. Murakoshi& H. Nakagami,1998. International ESCO Business Opportunities and Challenges: A Japanese Case Study. Energy Vol.23,No.6,1998 World Business Council for Sustainable Development, 2008. Case Study TEPCO & JFS Energy service companies (ESCO) Hidetoshi Nakagami Ph.D. &Jyukankyo Research Institute, Japan Association of Energy Service Companies, January 2010, Asia ESCO Conference 2010 Recent activity of the ESCO Industry in Japan & Asian countries. Chiharu Murakoshi, Jyukankyo Research Institute, Hidetoshi Nakagami, Jyukankyo Research Institute, Tsuyoshi Sumizawa, Shin Nippon Air Technologies Co., Ltd., 2008, Exploring the Feasibility of ESCO Business in Japan: Demonstration by Experimental Study 6

Websites
http://www.wholesalesolar.com/solar-panels.html http://www.economist.com http://www.ft.com/cms/s/0/6e069e1a-1441-11e0-a21b-00144feabdc0.html#axzz1OUNfs7AU http://www.guardian.co.uk/environment/2011/mar/15/japan-nuclear-explosion-energy-renewables http://greenworldinvestor.com/2011/04/04/pros-and-cons-of-renewable-energy-a-detailed-explanation/ http://www.doe.gov.ph/EE/ESCOs.htm http://3countryee.org/public/FinancingEEBrazil.pdf http://ourworld.unu.edu/en/japans-next-generation-of-renewable-energy/