The grid power supply in many developing countries is insufficient and irregular resulting in many commercial users relying on inefficient and air pollution intensive off-grid captive diesel generators (DGs) as a backup power supply. This study investigates the fuel consumption and emission level of such DGs and explores the possibility of reducing them through the formation of a microgrid of DGs and solar PV in a commercial area in Kathmandu, Nepal. An optimized microgrid system has been designed using the HOMER framework for both DGs and solar PV based systems. The optimized DG based microgrid results reduction in specific fuel consumption by 19% and cost by 5%. It also mitigates emissions of key air pollutants (PM2.5, PM10, CO, and VOCs) by 21% to 92% as compared to the baseline. If the solar PV based microgrid is used, the emissions can be reduced by 100% but cost increases by 27%. However, the overall economic benefit to the country could be quite significant due to the reduction of external costs of imported fossil fuel and generators, air pollution, adverse health outcomes, investment locking in grey power generation, and energy security issues. The approach used here can be emulated in many other developing countries with similar conditions.