Propelling the energy transition: clean energy finance

April 2022 | EXPERT BRIEFING | SECTOR ANALYSIS

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The global push to tackle climate change has kickstarted the ‘energy transition’, and this has led to exponential growth in the share of power coming from clean energy. In recent months, there has been significant press and policy direction in relation to clean energy and decarbonisation. This article discusses recent trends relating to clean energy and decarbonisation and some of finance structures deployed in those contexts.

What do we mean by clean energy?

Clean energy can be defined as energy that is produced in a manner that does not pollute the atmosphere. In the context of power, it means power that is generated with limited or no negative environmental impact.

Globally, there has been a huge push toward clean energy, and it was at its peak in 2021 in the run up to the COP26 Conference. The energy transition has seen year-on-year growth in the use of renewable power generation – 2020 saw the highest increase since 1999, with capacity increasing by 45 percent to 280GW of renewable electricity.

The push toward clean energy is being backed further by policy support and a booming corporate power purchase agreement market in Europe, especially as solar photovoltaics (PV) costs continue to decrease (data from IRENA shows that solar PV costs fell by 82 percent between 2009 and 2019). The rate of year-on-year grown in renewable electricity production capacity has accelerated in 2022.

Current trends in clean energy

Significant trends are emerging in clean energy, driven by the energy transition. There is a lot of activity at both the government and private sector level to help reach government targets of achieving net-zero. Government climate policies and green new deals are a big driver behind the energy transition. At COP26 in Glasgow, some key outcomes were: (i) agreeing to provide finance for de-carbonisation; (ii) establishing an International Sustainability Standards board to develop baseline for disclosure standards on environmental and social matters; (iii) increasing the pace of implementing the Paris Agreement; and (iv) phasing down the use of coal and phasing out inefficient fossil fuel subsidies.

The North Sea Transition deal, between the UK government and the offshore oil and gas industry, was also important. The deal aims to decarbonise the North Sea region with new, cleaner energies.

Likewise, the EU Climate Benchmark and Paris Aligned Benchmark both seek to provide for a harmonised and reliable tool to pursue low-carbon investment strategies by establishing new financial benchmarks.

Finally, the Korean New Deal, which was announced in July 2020, introduced a carbon tax, and looks to expand solar and wind capacity by 42.7GW by 2025.

In addition to governmental activity, private sector policies and decarbonisation targets are proving key in the energy transition. For example, as investors and financiers begin to back out of certain oil & gas investments, a number of oil & gas companies have reshaped their business. For example, Orsted has divested its hydrocarbon positions to instead become the largest developer of offshore wind. There has also more generally been an increasing rate of disposals of hydrocarbon assets by large oil & gas companies, with US$28.1bn in assets being sold since 2018 by six oil & gas majors. The public commitments of large oil & gas companies to reduce carbon emissions has also led to these companies looking to sustainability bonds for financing. In July 2021, ENEL issued a US$4bn sustainability bond, which is the largest sustainability-linked transaction ever priced.

Other trends in clean energy include the attraction of new project participants and investors for projects, such as private equity funds.

Current trends in clean energy finance

An important trend is the significant liquidity available to support financings of clean energy projects. One example of this is the record year-on-year global green and sustainable bond issuances, with a 49 percent growth rate from 2016 through to 2021. There has also been increasing venture capital and private equity investment, which rose by 22 percent in 2020 to US$3bn.

There is currently a strong appetite for green projects and the scale of financing for such projects is also increasing. The trend is mostly for project debt to be used to finance these projects, sometimes with the support of export credit agencies. The debt structure of clean energy transactions is increasingly seeing mezzanine debt and second lien debt featuring alongside senior debt in several transactions, given the heightened technology risks associated with some clean energy projects.

The enthusiasm for clean energy finance and related projects comes as the renewable energy price gap is closing. However, the interest-rate corrections expected in 2022 and 2023 to rein-in inflation will have an impact on financing costs. This raises the question of how competitive clean energy projects will be against conventional projects.

There has also been an increase in the buying and trading of carbon credits. Carbon credits are financial instruments that are generated by projects that reduce or avert greenhouse-gas emissions, such as solar and wind power projects. The project’s owners sell the credits to companies producing pollution, which can then claim that their emissions have been offset by this investment.

Clean energy finance structures

The main finance structures for clean energy projects are project, export and corporate finance. Grants and concessional finance are also becoming more common and have increased by 30 percent year-on-year since 2013, according to IRENA.

Project and export finance is the main financier, representing around 32 percent of total investments. In 2020, the public sector provided US$31bn in project and export finance. A significant proportion of this is going toward solar PV and onshore wind projects. In the period 2019-20, 91 percent of project debt in renewables went toward solar and wind projects.

Corporate finance is seeing an upward trend, particularly in renewables other than solar PV and wind projects. Although corporate finance is typically directed toward a narrower group of technologies than project finance debt, we expect to see more corporate financings, particularly with newer and riskier technology, where project financing may prove to be more challenging.

Grants and concessional finance is where the financing depends on concessions or grants in order to be bankable. In 2020, US$36bn was provided internationally in grants and concessional finance. This type of financing is often directed at less mature renewable technologies and jurisdictions. For example, hydropower is a key beneficiary of grant finance, principally into developing countries.

Clean energy finance structures developed for green projects

In addition to finance structures, there are some structures that have been developed specifically for green projects which are becoming more prevalent. These include green loans, green bonds and sustainability bonds.

Green loans are funds that are made available exclusively to finance or refinance new or existing eligible green projects. Green loans are required to comply with the Loan Market Authority Green Loan Principles, which have four core components: (i) use of proceeds requirement; (ii) a process for project evaluation and selection; (iii) management of proceeds; and (iv) reporting. The principles aim to create a framework of market standards, as well as preserving the integrity of the market. When using green loans in financing projects, a key point to consider is whether a failure to apply the proceeds of a green loan toward the project will trigger an event of default under the loan documentation.

The proceeds of green bonds are exclusively applied to finance or refinance new or existing eligible green projects. Green bonds are increasing in popularity, evidenced by green bond issuance at the end of 2021 standing at more than US$620bn.

For sustainability bonds, the proceeds can be applied to a combination of renewables-based or green and social projects. There has been a sharp increase in the use of sustainability bonds, and bonds with a social dimension saw the steepest increase in the first half of 2021, reaching 20 percent year-on-year growth. This was driven, in part, by a heightened market focus on coronavirus response efforts.

Environmental, social and governance (ESG) standards

Clean energy is not just about financing renewable energy, but also about compliance with ESG standards. In loan documentation, the key standards for ESG are the IFC Performance Standards and the World Bank Guidelines. The IFC Performance Standards are an international benchmark for identifying and managing environmental and social risk, and the World Bank Guidelines go on to provide more technical guidelines with general and industry specific examples of good industry practice to meet the IFC Performance Standards. The IFC Performance Standards encompass eight topics, including environmental and social management systems, labour conditions, pollution prevention and abatement, biodiversity and indigenous people.

Conclusion

As the global discussion surrounding the climate crisis intensifies, trends in clean energy and clean energy finance will continue to develop and remain at the forefront of investors’ minds when considering and choosing financing structures.

John Dewar is a partner and Munib Hussain is a special counsel at Milbank LLP. Mr Dewar can be contacted on +44 (0) 207 615 3004 or via email: jdewar@milbank.com. Mr Hussain can be contacted on +44 (0) 207 615 3013 or via email: mhussain@milbank.com. The authors would like to thank Isabella Nappert-Rosales for her assistance with this article.

John Dewar and Munib Hussain

Milbank LLP