Financing Mechanisms for Cookstove Dissemination

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Introduction

In the world of business, ‘financing’ is a necessary link between products and services, as both the supply side and demand side need to the required capital to either invest in business infrastructure or buy goods. Financing is needed for monetary cash flows, support activities that enhance the quality and reduce the cost of products and services, increasing customer awareness, and building market share.
For the product supply, availability and the cost of financing determines whether it is feasible to start up a business, and the price demanded for the offered products and services. Strategies to address supply side financing include direct subsidies as start up grants, soft loans, and measures to reduce production costs. Production costs include material costs, and the design and efficient production process and technology.

On the demand side, the willingness and capacity to pay will strongly influence the effective demand for the product. Strategies to address demand side financing include direct subsidies as buy down grants, awareness-raising and product promotion campaigns, and micro-credits schemes.

 

‘I like your stove – but I cannot afford to buy it. It is too expensive for me!’

 

Access to financing is a key factor in enabling target groups to purchase modern cooking energy in development countries.
Many have come across this statement in the process of developing a programme for the promotion of improved cookstoves. Often there is a perfect stove that fits the needs of the target group perfectly, and yet they say they cannot afford it.

If you meet this statement, you have several options:

• a) Analyse the statement: Perhaps ‘I cannot afford to buy your stove’ is just the socially accepted way of saying ‘I do not like your stove’ (maybe because it is not perceived as a good stove or maybe the access to firewood is not a ‘burning issue’ to the person in the household who is controlling the cash).
• b) If the statement is really true, you might consider simplifying your stove design to compromise between performance and cost. Even the best stove – if used by only a few households – will not contribute to development as much as a stove with medium efficiency used by many thousands of households.
• c) Often this is the point at which the issue of financing comes on the agenda. Providing financial assistance to the producers or the users of the stoves may assist in removing barriers for access of the target groups to improved cook stoves.

There is a comprehensive debate on subsidies for stove producers, as well as stove users, usually focussing on aspects such as their impact on sustainability, or the feasibility of direct targeting.

Any development programme is designed to spend money for the promotion of a change process. By definition, this money is a subsidy to the development initiative, as the beneficiaries do not pay for the services rendered to them by the programme. The subject of lively debate is therefore not the subsidy of development processes as such, but the ‘IF’ and the ‘HOW’ of direct or indirect subsidies to the producers or users of Improved Cook Stoves.

Firstly, the topic of subsidies is outlined in a systematic manner, with a listing of commonly perceived opportunities and challenges in the use of direct subsidies for consumer goods and other end products.

If , as outlined above, a development programme is a sort of indirect subsidy to a specific change process, it is following not following the same rationale as a commercial banking decision. A loan from a development agency is commonly perceived as a grant rather than something to be repaid. The financing of a cookstove programme will benefit from collaboration with a micro-finance institution, because this will visibly and organisationally distinguish between aid and business.

Financial assistance for stove producers and commercial stove users (such as restaurants) adopts a similar manner to that used by micro-finance institutions. The beneficiary of the loan is earning money with stoves (production or use) and can use the profits to repay the loan.

Much more controversial is the use of loans for households, so that they can buy improved cookstoves. It is only in a fully commercialised fuel market that the fuel savings can be used to repay the loan. It is difficult to prove that ‘time saved’ through reduced wood collection, less washing and cleaning, and faster cooking, translates directly into more cash income. This makes it more difficult to prove the case with micro-finance institutions for supplying finance for improved cookstoves for household use.

Secondly, many aspects of using micro- finance especially micro-credit for improved cookstove promotion (in collaboration with micro-finance institutions) are discussed in more detail.

Subsidies

As with many other products, the array of subsidies for stove dissemination is extensive, and their use is hotly debated among those working on cooking energy. A good example of this is the recent debate reported on the HEDON Household Energy Network.

http://www.hedon.info/goto.php/CleanAirSIG:Subsidies 

There is general agreement that a purely market-driven approach to dissemination of improved stoves in rural areas without established markets would be a challenge. The high risk, and consequently high financing costs, of introducing products into remote markets would lead to prohibitive stove prices. Since existing fuel markets in these locations consist mainly of woodfuel (collected at no monetary cost), and kerosene or LPG (which typically is subsidised already), there is little economic motivation for households to buy an improved stove. So the debate is not about whether to use, or not use, them at all, but rather how they should be used.  

 

There are two approaches to subsidies for stove dissemination:

• The use of direct subsidies to bring down the selling price of stoves (partially or totally)
• The use of indirect subsidies to help establish a market through activities such as  subsidised training, product promotion, awareness creation

The essential question for both these approaches is how to make subsidies that are both fiscally sustainable, and that lead to a rapid increase in market uptake (with subsequent improvements in costs, performance, and supply chain reliability).

What distinguishes direct from indirect subsidies?

Direct subsidies typically involve a direct cash transfer to the stove producer or consumer. Various types of direct subsidies are described as follows:

l        Buy down grant to reduce the product price directly. There are different approaches to channel a buy down grant, such as paying the producer for every system sold or installed, or providing the money (or an equivalent voucher) directly to the customer. The extreme form of a buy down grant would be a 100% subsidy of the consumer price (an approach of used by the health sector).

l        Start up grant and/or soft loan to support the setting up of production and marketing infrastructure for a stove producer. To start up new (or to extend existing) businesses to rural areas often includes a high primary investment in infrastructure, staff and marketing, with high risks and transaction costs. Start up grants or long-term loans with low interest rates spread out the initial financial burden for stove producers.

l        Custom reduction for imported stoves (and components), and tax reductions for stove producers or fuels. A few improved stoves require imported high technology components, though this is less common than for other renewable energy technologies (e.g. solar home systems). Their added value will mostly take place in their country of origin, so there is little scope for custom exemption. During the start up period, there is a case for a reduction in income tax and value-added tax for stove producers. Tax reductions on many fossil fuels, such as LPG or kerosene, have a much greater influence. 

Indirect subsidies refer to subsidies that reduce the price to the consumer, but not through a direct cash transfer. The most frequent types of indirect subsidies for improved stoves are:

l        Public awareness and product promotion campaigns increase public understanding, and thus increase the demand for improved stoves. (cf. preceding subchapters of section 4 and section 5). This awareness could be about indoor air pollution alleviation and the subsequent reduction in respiratory diseases, or the cost reduction potential of efficient cooking technologies. If the cost of such promotions is not borne by the stove promoter, this is an indirect subsidy.

l        Introduction of standards and certification systems that increase the product image and give the customer a certain guarantee about quality. During set-up and introduction of such a system, external support is important. In the longer term, an established market can finance certification and quality systems without external support.

l        Support from microfinance institutions (MFI) can bridge the gap between the stove price and what people can afford by providing micro-credit to stove customers. In some cases, MFIs might not cover the total target area, or might not have sufficient resources for large numbers of new customers, they could be supported with start up grants to extend their infrastructure, or by refinancing with soft loans, to extend their portfolio. A more detailed discussion of the use of micro credits can be found below.

l        Training and capacity building is one of the most frequently used types of indirect subsidy. It can include business, technical and administrative training – in most cases given free of charge, and providing support to stove producers, financing institutions, NGOs, local government and certifiers. 

l        When support to research and  development for improved stove technologies uses public finance, this indirect subsidy is not recouped in  the final product price.

What type of subsidy should I use?

While there exists a certain agreement on the positive effects of indirect subsidies for establishing a market, the use of direct subsidies is more controversial. These key questions need to be addressed by those wanting to use subsidies: ‘Should I avoid direct subsidies or use them to reduce the consumer price of fuels or technologies?; ‘Should they be: partial or full subsidies? And should they be temporary or permanent subsidies? 

 

Direct subsidies are promoted for the following reasons:  

Market failure: 

Economic theory demonstrates that several requirements have to be fulfilled for markets to function effectively (Perman 2003:124)1 . In practice, these conditions may not exist where stoves are being disseminated. Using this argument, subsidies are justified where there is:

• Asymmetric information: 

Lack of demand, as indoor air pollution and its consequences are endemic and thus people are not aware of risks

• Insufficient market power:

Market failure both on demand and supply side, as the existing effective demand might be insufficient to overcome the opportunity costs for a market driven supply chain.

• External effect on the public good: 

Indoor air pollution makes respiratory diseases more likely and advancing deforestation and desertification reduce the available firewood resources. Because these external effects increase health and environmental expenditures, the state takes responsibility and interest to protect the public goods of health and environment.

Poverty targeting:

Direct subsidies can significantly increase the use of a cooking technology or fuel, particularly by the poorest strata of the rural population. For example, in Brazil, subsidised LPG reaches 98% of households, including 93% of rural households, at a cost of slightly less than US$60 per year per low-income household. It has been stated that there is a benefit to many of those living in poverty, even if direct subsidies are abused, and that these benefits at least match the costs lost by abuse. 

Transparency: 

Direct subsidies are more transparent that indirect subsidies. 

 

Direct subsidies are criticized for the following reasons: 

Inhibiting market development:

When direct direct subsidies (particularly 100% subsidies) are applied, beneficiaries expect that the product will continue to be given away in future. This undermines a sense of ownership by the customer, and devalues the economic value of the item on both supply and demand sides. This undermines commercial activities and inhibits a  sustainable market. 

·         Cooking technologies and fuels are not basic health-related goods in the same way as drugs or mosquito nets. The adoption of an improved stove depends on its quality, and on its image as a modern, useful and efficient improvement, rather than the user’s capacity to pay for it. A free widely-distributed product could well be perceived as inappropriate and be sold on for profit, or not used at all.

·         The cost of a permanent subsidy for an expanding market creates a growing burden on the public purse. The viability of the approach will completely depend on the availability of public revenues, and is often applied without a well-planned exit strategy.

Targeting and abuse of subsidies: 

In some cases, direct subsidies are abused, for example, when stoves are bought for a subsidised price, but instead of using them, they are sold in other regions for a higher price. 

Non-transparent costs:

The additional transaction costs of direct subsidies are substantial and often underestimated. The costs are difficult to foresee and to assess, e.g. for: development of policy and target of the subsidy, voucher systems development, identifying beneficiaries and deciding if they qualify for subsidy (when their status may be changing by the day), and monitoring the effects of subsidy. The costs may not justify the expected benefit.

Political abuse: 

The distribution of partially or fully subsidised items to low income households is often used by political parties to rally for the election of their party. Targeting sometimes becomes distorted by political influences, as observed in Malawi with food aid, and boreholes.

There is no clear answer as to whether subsidies, and in particular direct subsidies, should be used or avoided. The question must be answered individually for every case, assessing the specific circumstances and framework conditions.

 

Smart subsidies

The term smart subsidy was introduced to describe an appropriate subsidy, which dealt with the problems that have been described. Currently (2008), the term is not precisely defined.

How to design smart subsidies

The central questions when designing a smart subsidy deal with the ‘how’, ‘how much’, ‘to whom’, ‘under what rules’, ‘at what cost’, and ‘what is the exit strategy’? Answering these questions leads to different strategies for particular circumstances. However, some important recommendations have been highlighted for smart subsidies:

·         Support only those rural energy products and services that would not be viable without the subsidy, but for which there is verified sufficient demand

·         Follow rules that are clear, transparent and predictable to all parties and do not create or reinforce a monopoly or other market distortion

·         Focus on a clearly defined target group

·         Link subsidies to optimal results. Support least-cost options that are neutral in terms of technology choice, but which are high quality and energy efficient, and encourage commercial participation

·         Focus on increasing access by subsiding the initial purchase price rather than the operating costs or fuel consumption

·         Rely on existing and sustainable financial resources  (budget, cross subsidies, foreign help, carbon finance) and have a clear exit strategy

·         Cover all aspects of the project including end-use investments, to encourage pro-poor income-generating end uses

 

Further resources for smart subsidies:

'l        'Barnet, A. Voluntary Codes of ‘Best Practice’ for Donors and NGOs for Renewable Energy & Developing Countries        http://www.hedon.info/goto.php/CodeOfBestPracticeForRenewables

'l        'ESMAP: Best Practice Manual: Promoting Decentralized Electrification Investment, October 2001

'l        'Lindlein P., Mostert W.: Financing Instruments for Renewable Energy, Part of World Bank’s ‘Road Map for Scaling up Access to Modern Energy Services and Clean Energy’, World Bank, Washington DC, 2005, Chapter 4.4.5 on smart subsidies’ (page 75)

l        Smart subsidies: Getting the conditions right - The experience of expanding rural telecoms in Nepal    
http://www.lirneasia.net/wp-content/uploads/2006/02/de%20Silva%20Tuladhar%202006%20Nepal%20final.pdf

l       Smart Subsidy for sustainable microfinance http://www.ruralfinance.org/servlet/BinaryDownloaderServlet/29361_Document.pdf?filename=1133368408225_Smart_subsidy_for_sustainable_microfinance.pdf&refID=29361

l        ICT Regulation Toolkit, section 7: http://www.ictregulationtoolkit.org/en/Section.3296.html

 

Other resources for general subsidy issues:

l        Perman, R., & Perman, R. (2003). Natural resource and environmental economics. Harlow England: Pearson Addison Wesley.

l        UNEP (2008). Reforming Energy Subsidies - Opportunities to Contribute to the Climate Change Agenda, United Nations Environment Programme, Division of Technology, Industry and Economics. www.unep.org/pdf/PressReleases/Reforming_Energy_Subsidies.pdf

Purchasing improved stoves through microfinance

Introduction to microfinance

This section defines the key expressions used in microfinance, and the main concepts needed to understand how it works. Later, it describes the principal mechanisms for accessing micro-credit for improved energy access, and how to develop a project with a microfinance institution. The article ends by discussing the potential of microfinancing, and the limits to its use in disseminating improved cooking technologies.

Microfinance definitions Microfinance This term describes the provision of sustainable high quality financial services to poor or low-income clients for productive purposes or for buying goods or services. It includes micro-credid, savings, insurance and fund transfers Microfinance Institution (MFI) This can be an NGO or a regulated bank that offers microfinance services like micro-credit, insurance or savings. The main roles of the MFI are to:  assess whether the clients are credit worthy, disburse the loans, collect the installments, and follow up those who default on their repayments. A number of methodologies have been developed in the microfinance industry to support the MFIs so that they become economical sustainable entities. Micro-credit This is a microfinance instrument that facilitates very small loans to poor or low-income clients whom the banks do not consider viable as customers. In general these individuals lack collateral and therefore cannot meet even the most minimal qualifications to gain access to traditional credit. For this reason, micro-credit is often disbursed via a group guarantee, as a group loan, where group members guarantee for each other. More wealthy clients that can offer a small collateral can also qualify for an individual loan. The majority of MFI clients are women. In most cultural contexts, men do not accept the group lending principle, so they have to qualify for an individual loan. Experience has shown that they are less reliable in repaying the debt.

The year 2005 was declared the United Nations Year of Microfinance. In 2006, Muhammed Yunus and the Grameen Bank got the Nobel Price of Peace in 2006. Since that time, microfinance has become a well known, successful tool to reach those living in poverty in regions with weak infrastructure and low incomes. 

Can microfinance play a role in expanding access to improved cooking stoves (ICS)?

Microfinance splits high investment costs into affordable monthly rates, offered through Microfinance Institutions (MFI). MFIs develop a whole network of close relationships with their customers.

• Credits have to be disbursed
• Installments have to be collected
• Failures have to be followed up and, in this case, guarantees have to be recovered

Note: ‘Microcredit’ needs an institution in the background. It is not a tool by itself.

Currently (2008), only a very few projects that combine energy and microcredit have been implemented successfully. The main reason is the lack of communication between the different stakeholders in the finance and energy sectors. The following sections seek to create a mutual understanding betwee both these sectors. They are specifically targeted at practitioners who are implementing ICS programs. These sections will support them to understand more clearly the perspective of those working in microfinance.

There are two ways in which MFIs can respond to energy projects. In most cases, energy projects need a finance mechanism for local suppliers and/or end users to raise capital. However, in some cases, MFIs may have identified energy as an important need for their customers, or they may have recognized energy as an attractive new venture.

 

Figure 1: Grameen Bank Meeting in Bangladesh

 

Financing local suppliers and customers

One mechanism is that the energy project may hire a microfinance specialist, and together they will develop an adapted mechanism specifically for the project. In this case it is important to integrate the microfinance specialist into the preliminary market research, because the criteria to identify potential clients or ICS producers will not only include ability and willingness to pay, but also their eligibility for credit (measured by their known levels of repayment or default). Failure to integrate the specialist at an early enough stage is a common problem, as the project manager may search for a financial mechanism, only to discover too late (when the client assessment is undertaken), that only a few of those identified as end users in the market survey are creditworthy for an energy loan. Exactly the same can happen with a potential ICS producer. They may fulfil important criteria in terms of skills and technical know-how, but not the requirements of an MFI to get a loan.

A microfinance system for improved household energy access requires a solid infrastructure in the background, as offered by MFIs. In small, time-constrained energy projects, it is often difficult to organize such a system and to reach long-term sustainability. The following section discusses the use of microfinance as an end user financing tool.

'High value turnover versus business costsfor profitable micro-finance systems' The main barrier in financing the customer for energy products is the price and financial requirements of an energy-financing mechanism. The development of a sustainable microfinance infrastructure is costly and time-consuming because of the following:

• Cost of field and market research, business planning, monitoring and evaluation
• Staff salaries; staff must be hired and trained
• ICS stock has to be bought and managed
• Transport has to be organized
• Logistics, maintenance and overhead costs
• Access to cash flow as technology needs to be paid up-front
• Interest payments from capital borrowed for up-front costs

All these issues represent business costs, and are part of the service charge that the customer has to pay in addition to the price of the energy system itself. It needs a large number of clients to keep the running costs down and to reach break even, so most microfinance energy projects start with a high value technology to ensure that the turnover has a high value, and business costs do not exceed 30% of the total price charged for the item. The problem of financing a lower price technology in the initial phase, such as an affordable improved stove, is that the business costs do not depend on the system cost. The implementation of financing a ten Euro10 stove is not much cheaper than a 500 Euro solar system, since the dissemination infrastructure and networks that need to be developed, are the same.

Recommendation It is recommended that low-cost energy technologies, such as improved cookstoves, work through microfinance institutions that are already in existence. In this case, additional costs are only generated for organizing the supply and, in part, for any technical services that may be required (if they are part of the business plan).<o:p></o:p>

Developing an ICS Project with an MFI

This section provides an overview of project development requirements, and steps that need to be taken when developing a partnership with a micro-financing institution.

Requirementsfor cooperation

MFIs need a high level of technological standardization to be effective and economically sustainable. This is the reason why a few successful microfinance ICS programs are disseminating LPG. The technology they are using comprises standardized bottles and a high quality management system.MFIs have a long credit relationship with their customers, focusing on their businesses (and not their households). The mutual trust, which is an important part of the relationship, makes MFIs a powerful partner for awareness creation and marketing. On the other hand, the MFIs demand reliable products and producers. Where this relationship breaks down, it will adversely affect the stove image and its dissemination. Since the client networks of MFIs are highly organized, this kind of bad news could spread rapidly. It is thus recommended that improved stoves are not disseminated through MFIs until the stove is well tested and quality control instruments are implemented. The stoves should first prove to be reliable as follows:

• Quality standards, within a measurable range, must be met by producers. Any rumor that a product is likely to fail, or not save as much as promised, will be disseminated rapidly within an MFI network, and could lead to the failure of the whole project.
• Serious reductions in the performance of the stoves during the period of repayment will be seriously damaging. Stove efficiency will almost inevitably decrease while in use. Loans should be adopted based on a realistic fuel saving scenario. The more often that good news is disseminated within the MFI network that ‘the product almost pays itself’, the greater the number of consumers.

Finding the right MFI partner'''

Depending on the type of stove that is to be disseminated, the appropriate MFI should be approached as described:

• MFIs that target the poorest – mainly people earning less than a dollar per day
• MFIs that target the active poor – generally people who have already a small business and need capital to grow
• MFIs that focus on urban and peri-urban areas
• MFIs that focus on rural areas
• MFIs with NGO status
• MFIs with banking status

These categories are not exclusive. For an energy project, it is important to identify the focus of each MFI, identify the right one, and decide how it can be approached for a given product. More details regarding the categories can be found in the background document.

Figure 2 MFI Client in Ghana, cooking in her restaurant

Almost all MFIs have available data regarding the categories of businesses they finance. A first evaluation of those categories will give an insight into the relevance of cooking-fuel dependent businesses (for example: Restaurants, canteens, food processing and bakeries).

Some MFIs such as FINCA already monitor the cooking fuel expenses of their clients. Depending on the project relevance and assessment, MFIs will decide whether or not to go for an ICS project.

FINCA (www.villagebanking.org)

The assessment should include an investigation of which MFI clients might become part of the ICS supply chain through production and retailing services and the like. If the MFI data is not precise enough, these aspects should be included in the market assessment.

How do you assess an MFI

The goal of this type of institutional assessment is to identify the capacity of the MFI to develop, implement and evaluate an ICS project, and to determine the required institutional support required in terms of capital, facilities and training. The following aspects should be taken into consideration:

• Organizational aspects:

- How is the decision-making process organized? - What is the hierarchical structure? - Will the board only approve a new project after market assessment and business planning has been completed?

• Available funding and capacity to access capital:

- Can the funding and accessible capital be used? - Is it flexible enough for the ICS project – especially if the MFIs have a banking status?

• Human resources capacities

- Is there enough staff for the implementation of a new project? - What are the professional capacities of the staff? Can their skills meet the requirements of an ICS project? - Does the MFI have training capacity? - What is the capacity of the MFI regarding the integration of staff with new professional backgrounds?