A breath of fresh air for utility investments in renewable energy
In energy markets, as in politics, recent years have shown that there are few certainties. Renewable energy technologies have bucked the trend. In the last 18 months, barely a month has seemed to go by without a new record-setting auction result, from “subsidy-free” offshore wind in Germany to this week’s renewable energy tender in Saudi Arabia which saw Masdar and EDF win a solar PV contract priced at less than 2 cents per kilowatt hour.
There have been many factors driving prices down: from offshore wind turbines doubling in size to efficiencies in high volume manufacturing for PV panels; innovative O&M contracting and data analytical strategies as well as an extraordinary amount of financial investor money chasing a limited number of quality projects. For EMEA utilities, who in many cases were late to the renewables party, the crunch in available financial returns has meant pickings have grown increasingly slim from a sector which was supposed to prevent or at least stave off the “death spiral” that analysts have been commenting on for years.
Faced with an existential crisis, utilities have taken a range of strategies from the incremental to the drastic. Most have tried out a variety of “capital recycling” — selling an asset (or a share in an asset) to an investor with a lower cost of capital as it enters a lower risk phase — while others have chosen radical corporate restructuring (eg, EON, innogy). Many will have been debating these issues at European Utility Week over the past few days where we presented some of our work.
The most common approach has been to borrow strategies and structures from other sectors: for solar PV and onshore wind, the develop and flip model common in the real estate sector and offshore wind has seen increasingly complex unincorporated joint ventures as historically common in the oil and gas sector. At the same time, asset managers as the most competitive buyers of assets, supporting utility capital recycling aspirations and drawing on the experience of listed Public Private Partnership infrastructure funds in the UK and Master Limited Partnerships in the US.
Most financing strategies for renewable energy then, just like many policy responses to the changing energy market, have been the equivalent of trying to fit a square peg in a round hole. At Climate Policy Initiative, the Energy Finance team have been working for a number of years on a financing structure and carried out detailed analysis of the risks faced by renewable energy assets and the causes of institutional inertia in the asset management industry. This model sees a continued role for today’s energy market actors but with risks and rewards distributed differently.
In our model, the cashflows from operational wind and solar farms fall into three groups offering different packages of risk and reward and targeted at different investor groups:
- The Clean Energy Investment Trust or “CEIT” is an “unlevered” equity vehicle de-risked so that cashflows exhibit similar volatility to an investment grade bond. This investment would be targeted at institutions with predictable long-term liabilities for inclusion in their matching portfolios. The approach for de-risking the CEIT is likely to include classic project financing techniques for contracting out and reserving against specific risks and new approaches, such as creating opportunities to invest in specific risks.
2. One of these new investments is the “surplus” product. “Surplus” investors would invest alongside CEIT investors during an asset’s fixed price contract period, receiving a return only when asset performance (whether due to weather, availability or technology) exceeded CEIT base case expectations. Utilities and other project developers might be interested in these investments in order to retain a small stake. Equipment manufacturers may seek to take price and performance risk in return for access to detailed data on performance.
3. The other key investment is the “tail” or “post-contract” product. Investors in this product would pay up-front to gain access to asset cashflows after a fixed price period has ended. This could mean no cash returns for almost 20 years but a steadily appreciating asset (which could be of interest to financial investors with a long investment horizon) and early access to potentially very valuable repowering rights, which would be of interest for equipment manufacturers, utilities and developers.
Our modelling, which has focused on the US and the most stable European markets, suggests that this model with risks allocated between CEIT, surplus and tail investors would mean a lower weighted average cost of capital, a levelized cost of energy 17% lower under existing models and financing costs which are relatively resilient to interest rate rises. For Climate Policy Initiative, a mission-driven organisation focused on reducing the cost of mitigating climate change, we see this model having a clear positive impact.
What then of today’s (or yesterday’s) energy market giants, the utilities? Our research shows that as institutional owners increasingly dominate infrastructure- or debt-like businesses, utilities can still find higher returns from less capital-intensive strategies in power generation as well as in the integration of distributed generation, demand response and behind the meter resources. A focus on managing development and construction (including the repowering rights associated with the “tail” investment); O&M and energy price risks (through the “surplus” investment) can lead to increased profitability that does not rely on investments in ever riskier markets, technologies and capital structures.
Matthew Huxham is a consultant at CPI Energy Finance.