Financial engineering to save the planet


One of the problems with financing green energy is the nature of the asset. Unlike fossil fuel developments, which spread the capital cost of development and production over the life of the asset, most renewable energy projects must be fully capital financed from the outset.

According to Anthony Yuen and Ed Morse of Citi, this means that the cost of financing is the determining factor in making these projects competitive and viable – an increasingly pressing objective in the context of falling fossil fuel prices, which reduce the competitive position of renewable energies in the energy sector. complex.

In a forthcoming report, Financing a Greener Future, experts even argue that this is probably a bigger determinant than changes in global climate change policy. The COP21 meeting in Paris is important, but — says the report — from the bottom up, local and national policies matter more

In fact, what climate change activists in Paris may never have negotiated is the extent to which the abundance and elasticity of fossil fuels has disrupted the economic incentives associated with going green. For renewables, it’s arguably even worse, because the real cost comparison isn’t even oil, it’s even cheaper coal or natural gas.

From Citi:

As gas prices have continued to slide amid staggering productivity gains in hydraulic fracturing, gas’s forays into once-safe coal territory have gone further. Additionally, new environmental regulations, such as the Clean Power Plan which more strictly regulates coal pollution, have increased the liability for the construction of new coal-fired power plants and forced more coal-fired power plants into retirement.

In the rest of the world, however, the story is very different. In nearly every economy except the United States, coal remains a much cheaper source of electricity generation.

Even in Europe, with a carbon load of €9/tonne, burning coal is still much more profitable than burning gas, largely due to the high costs of imported gas (see graph below). In addition to the oversupply, mining costs have been squeezed by 30% over the past three years, even with lower prices, which has cushioned producers. The prospects for significant increases in coal prices that could hamper the competitiveness of renewable energies or gas seem limited and depend essentially on India and China. In the United States, cheap natural gas is expected to tightly limit coal prices, limiting prospects for significant increases.

Even if China decides to reduce its coal consumption, the Citi team expects that the drop in demand – by making coal even cheaper than before – will simply fuel more coal consumption in other countries. other economies like India.

Indeed, with low coal prices undermining the case for renewables, Citi’s Yuen tells FT Alphaville that only lower financing costs can give the sector the boost it needs.

So what kind of financial innovation is needed or even possible in this sector?

Um…mainly, it turns out, the kind involving public balance sheets and government risk reduction. What a surprise.

But first, here’s a breakdown of how different cost factors compare between regions and fuel types:

As the report notes, the relative importance of these costs varies considerably across technologies and regions. For example, in developing regions where financing is expensive, such as Latin America, financing costs for capital-intensive renewable energy projects can be the largest component of overall costs. On the other hand, in developing countries in Asia, with low cost financing and low labor and construction costs, investment costs and financing cost are reduced, making fuel costs the main driver of the overall economy.

In the United States, where natural gas from shale production is abundant, the variable costs of producing gas are almost equivalent to those of coal on a national average basis and sometimes even lower than those of coal in some regions. In other parts of the world that depend on LNG, coal remains the lowest cost alternative on an operational basis. In Asia, it is the technology with the lowest total cost.

For financing to be a differentiator, says Citi, it makes sense that it should be applied to areas where it really makes a difference—that is, areas where cheaper financing can mean the difference between a future in which renewable technologies will eventually compete with coal and gas and one where fossil fuels remain the cheapest alternative throughout our forecast period.

So what are we really talking about?

Citi says there is a wide range of financial instruments and institutions that could make a difference, especially when it comes to recycling capital (banking lingo for not having to wait for the capital costs of the project are repaid before embarking on a new investment). For example, from the private sector:

Sophisticated project finance could help direct investments towards green projects beyond traditional bank loans. The public equity market, through examples such as YieldCos, could provide an effective way for project developers to recycle capital to the right valuation, although the sector has suffered recently due to overvaluation and expansion. excessive for some companies. Instead, private placement with private equity, large institutional investors or strategic players, particularly in times of poor equity market performance, could be another way to recycle capital so that developers of projects sell stakes or withdraw. Strategic players, such as utilities or independent power producers (IPPs), have been traditional buyers or projects. “Strategic” ones often have lower capital costs given the nature of their business, where regulated entities can base their costs on their consumers. Private equity is also active in the space. Many have raised substantial funds to enter the space, with leverage. Some large institutional investors, who used to gain exposure through equities and government debt, are buying at the asset level.

And then there are also green and climate bonds (despite the ongoing confusion over what really qualifies as “green” and the associated system game fears):

Green bonds are somewhat different from other fixed income instruments, as they specify the use of proceeds for green activities. By some measures, $36.6 billion in green bonds were issued in 2014, driven by both new and refinancing activity. However, what defines “green” and the certification process can be quite complicated, making some companies reluctant to pursue. The Green Bond Principles (GBP) are “voluntary process guidelines that recommend transparency and disclosure and promote integrity in the development of the green bond market by clarifying the approach to issuing a green bond.

GBPs are intended for broad market use because: (1) they provide guidance to issuers on the key elements involved in launching a credible green bond; (2) they assist investors by ensuring the availability of information needed to assess the environmental impact of their investments in green bonds; and (3) they help underwriters by moving the market toward standard information, which will make trading easier. Eighty-nine institutions, ranging from investors, issuers and underwriters, joined GBP as members and forty-five organizations have observer status, as of May 2015. “a multi-industry standard certified by a third-party verifier…[and] consists of a certification process, pre-grant requirements, post-grant requirements and a series of sector-specific eligibility and guidance documents.

But if you thought none of this sounded terribly innovative (most of these tools have been around for ages), you’d be right. The chicken and egg problem in green financing persists. The problem is that the market is not mature and the risks remain high because the cheaper the cost of funding, the higher the risk of misallocated funds. Private sector solutions, on the other hand, are only as good as the funding available from risk-hungry investors. The kind of real money investors who can really make a difference, well, they always sit on the sidelines.

So, as usual, all avenues of funding differentiation lead directly back to the public sector. As Citi notes:

For renewable energy and energy efficiency markets, public entities can play an important role by promoting policies and standards, providing indirect or direct financial support, and establishing programs. All of these activities help mobilize private capital for important public purposes.

Besides, it changes.

Related links:
Google is stepping up its purchases of renewable energy — FT
Climate finance is vital to securing the future of LDCs – FT
Why the outrage over Carney’s climate talk? – FT Alphaville
Why climate change is now a real market risk – FT Alphaville


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