TABLE of CONTENTS of the PROJECT APPRAISAL DOCUMENT (PAD) Cover Sheet

Document of

The World Bank

Report No.:

PROJECT DOCUMENT

ON A

PROPOSED loan

IN THE AMOUNT OF US$200 MILLION

AND A

PROPOSED GRANT FROM THE

GLOBAL ENVIRONMENT FACILITY TRUST FUND

IN THE AMOUNT OF us$13.5 MILLION

TO THE

PEOPLE’S REPUBLIC OF CHINA

FOR AN

ENERGY EFFICIENCY FINANCING PROJECT

March 5, 2008

CURRENCY EQUIVALENTS

(Exchange rate effective February 26, 2008)

FISCAL YEAR

ACRONYMS AND ABBREVIATIONS

CHINA

ENERGY EFFICIENCY FINANCING PROJECT

Contents

Page

A.STRATEGIC CONTEXT AND RATIONALE

1.Country and Sector Issues

2.Rationale for Bank Involvement

3.Higher-Level Objectives to Which the Project Contributes

B.PROJECT DESCRIPTION

1.Lending Instrument

2.Project Development Objective and Key Indicators

3.Project Components

4.Lessons Learned and Reflected in the Project Design

5.Alternatives Considered and Reasons for Rejection

C.IMPLEMENTATION

1.Partnership Arrangements

2.Institutional and Implementation Arrangements

3.Monitoring and Evaluation of Outcomes and Results

4.Sustainability and Replicability

5.Critical Risks and Possible Controversial Aspects

6.Loan/Credit Conditions and Covenants

D.APPRAISAL SUMMARY

1.Economic and Financial Analyses

2.Technical

3.Fiduciary

4.Social

5.Environment

6.Safeguard Policies

7.Policy Exceptions and Readiness

Annexes:

Annex 1: Country and Sector or Program Background

Annex 2: Major Related Projects Financed by the Bank and/or 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

Annex 17: IBRD Map No. 33387

CHINA

ENERGY EFFICIENCY FINANCING PROJECT

PROJECT DOCUMENT

EAST ASIA AND PACIFIC

EASTE

1. STRATEGIC CONTEXT AND RATIONALE

1. 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 5.8 percent annually between 1990 and 2006--more than three times faster than the world’s average annual growth, rising from 990 million tons of coal equivalent (Mtce) in 1990 to 2,442 Mtce in 2006. Despite the high growth, China’s per capita energy consumption is still less than one fifth of the Organization for Economic Cooperation and Development (OECD) average. If left unchecked, China’s energy consumption, primarily met by coal, will accelerate its 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 are 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 energy-consuming sectors. In the nation’s Eleventh Five-Year Plan (2006-2010) 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 2010. The NDRC launched the “1000 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.[1] 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 11th Five-Year Plan, 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.

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 IBRD and the Global Environment Facility (GEF), have been credited for the development of China’s energy services industry. The energy management companies (EMCs)[2] 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 IFC/GEF China Utility-Based Energy Efficiency Finance Program, 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 and financial 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 lost production and revenues which increase overall project cost. These characteristics lead to the perception that energy conservation projects are technically risky and yield lower 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.

(b) Perceived high financial risks of industrial energy conservation lending among Chinese banks. Interests in developing and implementing industrial energy conservation projects have 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 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 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 to encourage industrial enterprise to undertake energy efficiency investments.

1. 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-funded First and Second China Energy Conservation Projects which successfully introduced an energy performance contracting mechanism through EMCs to support small commercially viable energy conservation projects. The IFC/GEF China Utility-Based Energy Efficiency (CHUEE) Project, currently under implementation, is also focused on promoting small-sized 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 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.

8. The sharp increase in coal consumption since 2001, driven by a demand surge in power generation and energy-intensive commodities, such as steel and cement, has increased the energy intensity of the economy, reversing the decreasing trend of the 1980-2000 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 Five-Year Plan (2006-2010). Achievement of the ambitious energy conservation target for 11th Five-Year Plan 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 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 in recent years.

1. Higher-Level Objectives to Which the Project Contributes

9. The objectives of the proposed project are fully consistent with the Country Partnership Strategy for 2006–10 (Report No. 35435-CN), approved by the Board on May 23, 2006. It directly supports a major pillar of the Country Partnership Strategy for China: managing resource scarcity and environmental challenges. It will also contribute to 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 2005–10.

10. 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.

1. PROJECT DESCRIPTION

1. Lending Instrument

11. The project consists of 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 fixed-spread loan (FSL) at US$ 100 million. MOF has selected a 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.