Renewable risk innovation helps investors see bright side of the asset price bubble
Investors ought to be concerned about the renewable asset price bubble in the same way bond investors are biting their nails about sky high valuations and illiquid markets
Since the global financial crisis, institutional investors, private equity and project finance lenders have sought to earn returns no longer available from low- or negative-yielding investment grade bond markets by using financial engineering to transform low-risk assets into those that generate high returns.
However, early indications suggest that investors ought to be concerned about the renewable asset price bubble, in the same way bond investors are biting their nails about sky high valuations and illiquid markets.
For policymakers, a rise in global interest rates could mean the sun setting on this golden period for the seemingly inexorable decline in renewable energy costs. How risk is allocated in future renewable energy investments will be the biggest determining factor in whether this downward trajectory — and the recent acceleration of the global energy transition — will continue.
At Climate Policy Initiative, the Energy Finance team has been working for several years on alternatives to today’s dominant project financing, utility- and YieldCo-owned models, which would enable (even) lower financing costs in a low interest rate environment (our model shows a cost of energy potentially 17% lower than under existing models) but should also be more sustainable in a world of rising interest rates.
As we’ve discussed before on this blog, during the development of our design of the Clean Energy Investment Trust or CEIT, we aimed the design at an audience whose objectives are well-suited to investing in renewables, but whose participation has hitherto been limited because investment offerings have not been designed in a way that meets their appetite for risk. In particular, we have in mind the teams within pension funds and insurance companies managing asset portfolios specifically designed and ring-fenced for matching predictable long-term liabilities.
We sought to cherry-pick the good parts of existing investments while avoiding the design flaws which have historically been barriers to this investor group. For example:
- Project finance: For the most part, institutional investors do not have the capability or time to conduct due diligence on individual assets and have strict requirements on diversification and liquidity which can prove problematic for project-financed assets. CEITs avoid this problem by outsourcing the due diligence to a specialist asset manager.
- YieldCos: growth rates to satisfy the expectation of their equity investors — and in particular, for regular access to capital markets to fund that growth — introduces a level of market-correlated risk, which is unacceptable for those prioritising long-term cash flow stability over absolute or relative returns.
We would anticipate the CEIT being set up as an equity investment but with debt-like risks and returns. A CEIT would purchase a series of long-term contracted operational assets and make a public offering of that closed asset pool to institutional investors. At the same time as doing this, the CEIT would de-risk the assets, including selling up front the right to receive “residual cashflows” during the contracted life of the pool and the right to receive ownership of the assets after the end of their long-term contracts.
A more granular investigation of the magnitude and profile of the risks currently borne by the residual equity tranche in today’s project financing structures was key to the development of this new financial structure.
We found two principal sources of risk that fall into this category: a) revenue risks during a long-term contract associated with weather, operational performance and curtailment; and b) risks associated with the residual operating life of assets after any initial fixed price contract or feed-in tariff, including in relation to future power prices and market design, as well as the option value associated with repowering assets with more advanced technology.
Identifying these risks, packaging them up into investments and selling them to parties that are better placed to manage them than financial equity investors will help lower the weighted cost of capital for this pool of risks.
Critically, the residual and tail end cashflows are separate products targeted at different investor groups and therefore removes more of the risk from the core product, the CEIT itself, adding a crucial benefit as compared with US YieldCos and UK listed renewable infrastructure funds.
We think these investments could supply a more efficient long-term use of utility, O&M provider and technology provider capital than the equity investments that they undertake today. A successful CEIT would pursue the targeted sharing of risks with co-investors and align that with a series of project-finance style restrictions, including reserves, restrictions on buying and selling assets, and taking on additional debt.
If we can draw more liability-matching investors into the renewables arena, the renewables sector may yet avoid much of the disruption that it could face as interest rates rise.
Matthew Huxham is a consultant at Climate Policy Initiative Energy Finance and worked on the series of reports, Mobilising Institutional Investment in Renewable Energy, and led the analysis for Major barriers and solutions to overcome them. A version of this blog first appeared in Environmental Finance in January 2018.