THE BLOG
04/12/2013 01:32 pm ET Updated Jun 12, 2013

Smart Subsidy Is Need to Build Tomorrow's Energy Market

It's remarkable how far the energy sector has come over the last five years, from a handful of pioneers innovating around energy products and services designed for the mass markets in the developing world, to where we are today, with dozens of enterprises offering quality solutions. Few people doubt anymore that mass market demand (not just market need) exists for reliable and affordable energy, or that much of this demand will have to be met by small-scale decentralized solutions.

But we still have a long way to go to address the world's 1.6 billion people without access to reliable and affordable energy. Despite much progress made to-date, the market for energy products and services in the developing world is still nascent. Private investors and publically funded development finance institutions have shown enormous interest to support the sector, yet opportunities for these investors to deploy capital at scale are still sporadic at best. There are a number of reasons for this, including a shortage of appropriate skills support and a scarcity of human capital, though two important reasons relate to the role of subsidy -- an issue that remains poorly understood even within the impact investing community. First, there are no dedicated funding institutions established to fulfil the basic working capital requirements of energy enterprises that are already on the path to scale. Second, there is an equal scarcity of capital available to fund early stage innovation in energy technology, both to reduce the cost of existing solutions (such as decentralized power models) and to develop new technologies and business models from scratch (such as new applications at the intersection of energy, water, and agriculture).

Given the risk profile and size of these two market deficiencies, investment capital alone will be insufficient (and in many cases, inappropriate) to address them. It's often forgotten that the microfinance sector (now estimated to be worth over $38 billion) originally required $20 billion of subsidies to help develop and test lending models which ultimately became investable opportunities we're all familiar with years later (even for retail customers today, as demonstrated by ResponsAbility). In a similar way, the energy sector also requires philanthropic capital deployed as smart subsidy to achieve scale and legitimacy.

The idea of smart subsidy was well documented by Monitor's Blueprint to Scale report last year, and refers to philanthropic capital used to build core operational and technical capacity in an organization, rather than traditional, market distorting grants used to subsidise the price of the end product or service. It is core to the approach we take at Shell Foundation.

The Curious Case of the Missing Working Capital

Consider the market for solar lights in Africa. According to Dalberg, that market has grown at 90 percent annually from 2009 to 2012, with 3.9 million lights sold cumulatively. That's a promising trend, but those 3.9 million lights serve only 3 percent of today's market. Five years ago, the main challenge was to actually design lights that were both affordable and sufficiently high quality. Today, over 40 enterprises have products that have passed IFC Lighting Africa quality standards -- an indicator that initial basic design hurdles have been widely overcome. For the enterprises that are already selling thousands of quality lights every month, the single biggest barrier preventing further growth is simply a lack of working capital to manufacture, import, and distribute their lights. These enterprises face a grim set of options to fund their working capital needs, including dipping into limited equity reserves or attempting to raise debt on an exceptional basis from an impact investor or development finance institution, often requiring an elusive loan guarantee as well.

Two years ago we partnered with the OPEC Fund for International Development to set up a revolving working capital pool with d.light to allow their African subsidiary to import products into Africa and extend credit terms to carefully selected distributors. This resulted in the sale of hundreds of thousands of lights (and counting). Developed with smart subsidy, the working capital pool included a substantial training component and has since expanded to include our cookstoves partner Envirofit. While it helped confirm our hypothesis that providing working capital and skills support to a high quality manufacturer will move product at scale, it didn't solve the wider sector bottleneck. By our estimate, the leading manufacturers of solar lights and improved cookstoves could together absorb at least $30-40 million working capital in Africa this year alone, and that requirement will only increase as the market expands. If this demand isn't addressed in a systemic way through the creation of institutions dedicated to supporting energy product manufactures, it will be very difficult for the market to evolve into an established and viable industry.

Shell Foundation is currently in the process of developing a working capital fund that would serve the wider energy product market, and are looking for an aligned fund manager with whom to partner. Given high initial design costs and OpEx requirements, which initially tend to significantly exceed revenues, this kind of fund will require smart subsidy to get off the ground and to help de-risk the fund portfolio through the provision of skills support alongside the working capital.

This working capital barrier is surely not limited to Africa. For example, a similar situation exists for energy SMEs in India as well, prompting us to partner with Intellecap two years ago to co-create IntelleGrow, a dedicated lender to small and growing businesses. IntelleGrow has disbursed over 20 loans to-date (US$100,000 to $400,000) and has raised both equity (from the Michael and Susan Dell Foundation) and local debt to expand operations. We're currently looking for an aligned investor to help drive the next phase of growth over the coming years.

Accelerating Energy Technology Innovation

On the other end of the market, much R&D work still needs to be done to radically improve the economics of existing modern energy solutions as well as develop entirely new product categories that could alter the way energy is delivered to the developing world mass markets. Google calls this "moonshot thinking," which by its nature carries very high risk due to the uncertainty of the outcomes. It is a clear match for smart subsidy.

A few emerging technologies strike us as particularly promising. The idea of "energy product leasing" -- providing consumer finance for energy products and applications that have an energy backbone, is one example. We've been supporting M-Kopa in Kenya since its inception to develop its mobile-enabled technology and accompanying business model, which enables customers to buy a d.light-manufactured solar home system on a pay-as-you-go basis. The core technology is also applicable to many other products with an energy backbone, including applications at the intersection of energy, water, and agriculture, such as solar water pumping. As M-Kopa chairman and co-founder Nick Hughes describes it, "We see a spectrum of power needs to move consumers up the energy ladder, from light to light with TV to energy storage to the applications that run on stored energy." In partnership with DFID, we're also helping M-Kopa to reduce the cost of energy leasing technology -- innovations that will be published for all in the sector to benefit from.

While still slightly more expensive than current alternatives, energy product leasing models that use mobile-enabled technology are materially different to other pay-as-you-go solutions because they generate highly detailed consumer usage data. Crucially, this improves both the ability to select customers as well as the efficiency of the new product development cycle. For the first time, we are able to see how consumers interact with their devices in real time, and be in direct contact with them to better understand their future needs. We expect this to help drive the upcoming "big data" movement of the energy sector.

Decentralized power generation models are also in need of innovation to radically drive down their installation cost requirements. Related enabling technologies also need to be further developed, such as low cost smart meters that might allow mini grid operators to serve larger institutional customers like telecom base stations as well as their surrounding communities. Shell Foundation has been a strategic partner to Husk Power Systems since 2008 and have been deploying smart subsidy in the form of grant coupled with skills support to help address these issues, but far more work needs to be done with them and other mini grid operators.

Addressing these barriers and the corresponding growth that will follow will help legitimise the market in the eyes of commercial investors and governments -- a necessary precondition for the introduction of supportive energy policy and legislation required for long term market growth.

This blog was originally published on the Skoll World Forum site.

This blog is part of our ongoing coverage of the 2013 Skoll World Forum on Social Entrepreneurship. Cisco is the official technology sponsor of the forum.