Will renewable energy assets remain attractive to investors as subsidies fade out?

April 2021  | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2021 Issue

Renewable energy generation assets have become a primary asset class for institutional investors. With the rise of climate change up the political agenda, lots of low-cost capital has lined-up for these assets.

However, for many years, investors have invested in these assets with the expectation that they would get a relatively attractive risk-weighted return on their capital, and that the liquidity profile would resemble a steady bond profile.

Can investors still expect to receive a relatively attractive risk-weighted return? Can they still expect to get a steady bond-like return on their investments, and will investors still be willing to invest in renewable energy generation assets, if these trades of the investments can no longer be expected?

During the 2000s, most western markets offered certainty by way of a long-term feed-in-tariff regime or a certificate regime to attract investors to invest in renewable energy generation assets.

Many argued that it was too costly to keep subsidising these assets. The renewable energy world argued that the primary subsidy was in fact given to the ‘black’ thermal generation capacity, as they were not paying for their CO2 emissions and few really believed that we would ever see subsidy-free renewable energy generation projects.

However, the cost of capacity for both wind and solar assets has continued to fall, the number of government-supported subsidy schemes has gradually been reduced and, in several countries, de facto has been terminated. More governments began to offer concessions on competitive terms through public tenders, which forced the market to find further cost reductions, and today we see more subsidy-free projects being realised than ever before, such as the Hollandse Kust offshore wind project in the Netherlands, which is soon to start construction, and the 415MWp Danish solar transaction between BeGreen A/S and Luxcara.

While it is encouraging that renewable generation capacity has proven itself and that we can look forward to an increasing share of green electricity, a number of issues remain.

Low interest environment. There is no doubt that as investors have become more comfortable with the asset class, the risk perceptions related to this asset class have generally dropped – and the required equity yield of the investors likewise. Further, investors have had to cope with a low interest regime for more than 10 years and are thus struggling to find an attractive stable yield. The yield requirement has thus generally contracted, and investment directors have undoubtedly faced increasing pressure from their investment committees, boards and customers to support the fight against climate change. There have thus been several supporting factors favouring the development.

The political winds will undoubtedly also favour green investments in the years to come, but that appetite is likely to be affected if the risk-weighted yield drops below other recognised asset classes. This gap could be further widened by the fact that many investors are currently seeking to deal with low unlevered returns through leveraging with cheap long-term senior debt.

System risks and balancing. As more peak capacity from renewable energy generation assets flow into the electricity distribution systems, it will become harder for transmission system operators (TSOs) and distribution system operators (DSOs) to balance their systems. The imbalances already create temporary forced shutdowns in some systems – shutdowns that are likely to increase with the continued growth in the peak load if the systems are not reinforced and not all legal frameworks offer compensation for the losses related to such forced shutdowns.

Further, as the costs of reinforcing systems are very high and regulators have an interest in ensuring better distribution of peak capacity to better balance the system, more regulators leave the risk of shutdowns or the costs of reinforcement with the generators. The system balancing related risks has thus become an increasingly important risk to analyse and potential loss to factor into the financial model.

Merchant risk. With the feed-in-tariff and certificate regimes fading out, investors are typically left with the choice between a merchant risk and the possibility of entering a corporate power purchase agreement (PPA).

A PPA may be the better option, but there may be regulatory hurdles and, when negotiating a corporate PPA, it is basically, as with any commodity trade, a bet on the forward price curve. A premium is thus payable to de-risk the merchant risk. This premium may very well be too high for a project with an already contracted yield offering. It is, however, recognised that the off-taker may find indirect political value in the supply of green power and the generator may have an upside from more attractive finance terms by de-risking future cash flows. It is thus often easier to find a commercial agreement than the bare financial numbers would suggest.

Banks typically not only debt size on the basis of contracted versus non-contracted cash flows, but they also apply different margins, financial covenants and cash sweeps in order to cater for the risks related to market exposure. Whereas banks in their debt sizing often require a conservatively modelled debt service coverage ratio (DSCR) of 1.20-1.25 on the contracted cash flows, they often require a DSCR of 1.50-1.55 on the non-contracted cash flows in combination with a cash sweep mechanism based on the development in an independent, forward-looking electricity price curve.

Storage and spot prices. As spot prices reflect supply and demand at a given time, the increasing peak power will not only potentially cause imbalances in the system, but also affect the spot price. In several markets we already see periodic negative prices. These periods are likely to increase if we do not secure a better distribution of the loads or the possibility of delaying  dispatch.

The focus on storage, both centralised and de-centralised, is thus very relevant. Delaying dispatch by a few hours may, in many cases, have a positive effect on the average spot price obtained, and the generator is likely to also see a significant saving on the balancing cost payable, or upside from being able to provide base load to the market or a better match to the agreed dispatch profile.

However, as more generators or system operators invest in storage solutions, the upside will diminish. The generator should thus carefully consider for how long an upside can reasonably be expected and thus whether the additional investment is likely to offer an attractive return.

To summarise, we celebrate the evolution of renewable energy generation assets from a subsidised high-yield asset to a price-competitive primary investment asset class and we support the continued development.

We thus also urge regulators in various markets to be careful not to stress the case too much, too fast, as the continued green transition is dependent on the ability to continuously attract low-cost capital from various investors.

 

Jens Blomgren-Hansen is a partner at Kromann Reumert. He can be contacted on +45 38 77 43 09 or by email: jbh@kromannreumert.com.

© Financier Worldwide

BY

Jens Blomgren-Hansen

Kromann Reumert

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