Project to Support the Implementation of
PROESCO:
A Guarantee Facility to Promote ESCO Investments
Final Report for the ESMAP-funded TA project
administered by the World Bank
September 30, 2007
Contents
Introduction 3
A: The BNDES and the characteristics of PROESCO 4
BNDES Operations 4
PROESCO 5
B: The problem of guarantees and the origin of PROESCO 7
C: Startup of PROESCO 10
D: Contribution of ESMAP Technical Assistance 11
E: Current outlook and considerations for the near future 12
References 14
Annex A: Model for First Presentation of Projects 15
Annex B: Model of Contract between BNDES and Bank 19
Annex C: Seminar Series with Banks 27
Introduction
BNDES (Banco Nacional de Desenvolvimento Econômico e Social) is the most important channel of the federal government for financing development and the major source of financing for long term credit in Brazil’s financial market.
PROESCO is an innovative program of BNDES to support greater access to financing for energy efficiency retrofit projects in Brazil. Given the key role of the BNDES in the financing of medium-term investments, this program is widely seen as fundamental for the consolidation of the energy efficiency services sector with third party financing in Brazil.
Created in May 2006 by BNDES, PROESCO is formally a new version of an existing credit line offered for energy efficiency projects. In this new alternative there are several key changes relative to conventional financing:
§ Collateral is not required to obtain the credit. While personal guarantees of the borrower are required, they need bear no minimum relation to the size of the loan.
§ A report by an accepted third party must validate the technical and economic soundness of the proposed project.
§ BNDES assumes up to 80% of the credit risk.
PROESCO was conceived to be a kind of “virtual guarantee facility for credit risk. In this way it seeks to make a “project finance” approach viable for energy efficiency projects, using the future income stream of receivables under performance contracts to obtain loans. Section A below, summarizes the basic characteristics of PROESCO.
The problem of guarantees for credit risk has long been recognized as a big barrier to obtaining loans for energy efficiency investments. Its importance was confirmed and highlighted in the work of the Three Country Energy Efficiency (EE) Project,[1] which led to an analysis of the design of a possible guarantee facility. As described in Section B, PROESCO was developed within the BNDES as a result of that bank’s active participation in the Three Country EE Project. It is an innovative approach designed to introduce a guarantee mechanism with minimal institutional pre-requisites.
The startup of PROESCO has been slow. As described in Section C, the main reason has been delays in signing the necessary risk-sharing agreements with participating commercial banks.
ESMAP technical assistance has supported BNDES’ effort to dialogue with banks about adhering to PROESCO. It has also been the primary source of support for other activities needed to effectively establish the program. These activities supported by ESMAP are described in Section D.
The last section summarizes the near term outlook and some considerations about issues which should be addressed.
A: BNDES and the characteristics of PROESCO
BNDES Operations
BNDES (Banco Nacional de Desenvolvimento Econômico e Social) is the main vehicle of the federal government for financing development and is also the main source of financing for long term credit in the Brazilian financial market. It is by far the cheapest source of bank credit available for most firms. Total outstanding loans at the end of 2006 were R$147 billion. Of these, more than 80% were to the private sector.
BNDES offers resources directly or indirectly through accredited financial agents. The great majority of financial institutions incorporated in the country are accredited by BNDES including all of the largest commercial banks.
Loans below R$10 million (about US$5.3 million today) must be made through an intermediary agent (the limit is lower in the North and Northeastern regions). Almost all EE projects (except some large industrial or cogeneration projects) are relatively small in size and any loans would thus necessarily have to be obtained through an intermediary bank in an “indirect” operation.
The financial cost of a BNDES loan is given by the formula.
Financial Cost = Basic Interest (TJLP) + BNDES Spread + Agent Spread
Where:
§ The basic interest rate is the TJLP, or “Long Term Interest Rate”. It is adjusted quarterly and is currently 6.25%/yr (consumer inflation is about 4%/yr).[2]
§ The BNDES spread remunerates the operational cost of the BNDES and in indirect operations is typically 1% per annum. In direct operations it also covers the credit risk (and additional operational costs) and may reach 4% per annum.
§ The agent spread is the remuneration for credit risk and for covering the operational costs of the intermediary bank. It varies between 1 to 4% per annum.
In an indirect operation, the credit risk of the loan is entirely the responsibility of the intermediary bank.
PROESCO
Under PROESCO, BNDES will lend up to 90% of the total investment in an energy efficiency project. Investments made up to 6 months before the loan application can count as part of the required 10% counterparty. The maximum loan term is 72 months and the grace period is up to 24 months.
Virtually any project which can demonstrate energy savings (fuel or electricity) is in principle eligible. The loan may cover the costs of: engineering & project development, civil works & installation; equipment; specialized technical services; systems for information, monitoring, controls and verification of the results. It cannot include the costs of purchasing real estate or used equipment. There are no explicit limits (upper or lower) on the size of the loans.
Three kinds of operation are possible. Two are conventional “direct” and “indirect” operations, with the parameters given above. Thus, in the more typical “indirect” operation:
· The TJLP or basic long term interest rate of BNDES – currently at 6.25% p.a.
· A 1% administrative spread for BNDES.
· A 4% spread for the intermediate bank as the remuneration for credit risk and to cover administrative costs.
The third kind of operation represents the innovation and is the source of the new name. In it
BNDES, will cover up to 80% of loans which are in default (including the capitalized interest and spread of BNDES). Normally this risk is entirely with the intermediate bank and if a borrower is in default, the bank must continue to make the scheduled debt service payments to BNDES. Under PROESCO the intermediate bank need only make 20% of the scheduled debt service payments to BNDES. This means that the execution of the guarantee will be immediate and automatic, a crucial characteristic for the credibility of the guarantee.
In this option, with a partial guarantee provided by BNDES, the cost of the PROESCO loans will have four components:
· The TJLP or basic long term interest rate of BNDES – currently at 6.25% p.a.
· A 1% administrative spread for BNDES.
· A 1% administrative spread for the intermediate bank.
· A 3% “risk spread” divided between BNDES and the intermediate bank in the same proportion as the risk assumed. In the case where BNDES covers 80% of the loan it would receive 2.4% and the intermediate bank 0.6%.
To be eligible for financing with the partial BNDES guarantee the borrower must be the project developer. Project developers are considered to be ESCOs, but no formal certification as an ESCO is required. It is expected that projects will be developed as performance contracts.
The formal process begins with the submission of a first “letter of intent” (carta consulta), which includes a basic description of the project. The model format for presenting the required information is shown in Annex A and was developed in part with resources from ESMAP (see Section D).
Based on the information in this first application form, the intermediate bank can make the conventional credit check. If this is favorable, the project developer must present a document which permits the detailed identification and analysis of the actions in the project with respect to their impact on EE and the environment, as well as their subsequent verification.
The technical and economic viability of the project must then be evaluated by an entity authorized by BNDES and acceptable to the parties. The borrower and his client must also be prepared to accept technical visits to accompany the project and verify its results. This follow-up activity is also intended to stimulate exchanges about experiences with projects and to disseminate the results.
In the loan operations with this partial guarantee by BNDES, the borrower must offer to the intermediate bank the personal guarantees of the firm’s owners and pledge the performance contract of the ESCO as security (caução do contrato). These guarantees are for the loan operation as a whole – neither BNDES nor the intermediate banks would require any further guarantees. The value of the personal guarantee may be substantially less than the value of the loan, different from the normal requirements for collateral – which are usually larger than the value of the loan.
Figure 1 summarizes the relationships and payment flows envisioned in PROESCO, though as a simplification only the alternative of lending to the ESCO is shown.
Each commercial bank participating in the program must first sign a contract with BNDES regarding the terms for the risk-sharing. A model for such a contract is shown in Annex B. BNDES has also prepared a basic model for the loan contract between the commercial bank and the borrower.
Most ESCO projects have economic savings other than those from EE, but so far no criteria have been set for the minimum percentage of investment or benefits resulting from EE measures that would be needed to qualify.
There is no explicit termination date for PROESCO. There is an initial upper limit of R$100 million of coverage, but this can be increased relatively easily if the initiative is successful.
B: The problem of guarantees and the origin of PROESCO
As in other countries, the realization of a significant part of overall potential for EE involves investments to retrofit existing buildings and industrial installations. These investments often involve projects whose design and execution are not trivial and may best be undertaken by specialized developers such as ESCOs. The projects may also only be viable if there is access to credit, either by the consumer or the project developer.
The development of a substantial and sustainable EE retrofit market depends in good part on developing routine access to medium term credit for projects. This has so far been lacking in Brazil as in almost all emerging economies.
This common challenge led to the creation of an exploratory project to analyze the difficulties and possible innovations for financing EE retrofit projects in India, China and Brazil. This project, financed by the UNF and ESMAP supported small work groups in each country and periodic exchanges.[3]
In Brazil, the work group confirmed the importance of finance as a restraint on the growth of the EE retrofit market (ABESCO, 2005). It also confirmed that the guarantees required for credit are the key impediment.
Despite the importance often attributed to a guarantee mechanism for credit risk, there had been relatively little rigorous analysis of issues and parameters for the design of such a facility for the EE project market. For this reason, the Three Country Project contracted a multi-disciplinary team to prepare such a study, taking into account Brazil’s business and financial context as well as international experience with facilities created for this purpose.
The report also addressed why a guarantee facility was desirable specifically for EE given the fact that more general guarantee facilities already exist. Indeed, given the minimal use in general of these existing facilities why should any new one be contemplated and how would it be different?
The report concluded that a specialized facility for EE projects was justified, at least as a transition mechanism (Lima et alii, 2005). During this transition period experience would be accumulated (a “track record” would be created), and the practices of the different agents – ESCOs, consumers and financial institutions – would evolve. The report proposed some guidelines for the facility and highlighted key differences from the existing guarantee facilities in Brazil, such as:
· Execution of the guarantee would be immediate and would not require the bank to initiate formal bankruptcy procedures against the client.
· An entity with a separate legal status would be created outside the bank originating the credit (in practice BNDES) to manage the Guarantee Facility.
· This entity would perform all the due diligence and have direct relations with the borrowers as well as the banks.
· The coverage of the loan principle would be complete, not partial.
A summary of the hypothetical Guarantee Facility (GF) and the associated operations is shown in Figure 2. The GF manager would use technical evaluations of proposed projects by accepted certifiers.
Figure 2: Schematic of a Guarantee Facility and Associated Actions
The report also made quantitative simulations of the cost and viability of the proposed guarantee facility. The parameters used were quite conservative, especially regarding the baseline default rate. This was to ensure the robustness of the facility’s guarantees, essential to maintain credibility with the lending banks. Consequently, the baseline commission fee was quite high (0.26% of the principal per month of a 3 year contract), adding significantly to the cost of financing.
The size of the initial capital reserve was assumed to be only R$6.5 million (roughly US$3.4 million today). From this small base, it was estimated that projects worth R$780 million (US$410 million) could be guaranteed over a 7 year period in the baseline scenario (the facility was assumed to have a lifetime of 10 years). Deeper analysis of the market volume for EE projects would be needed to define the size of the initial capital, but it is clear that a relatively small allocation of capital could in principle have a large effect.