Renewables need benign financial engineering

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The first task in the fight against climate change is to connect the world to clean renewable energies, i.e. wind and solar.

The industry has been isolated from the effects of Covid-19, but is not immune. As elsewhere, the pandemic has widened the gap between rich and poor.

Traditional projects in wealthy countries – solar and wind farms that can secure long-term operating contracts with creditworthy utilities, governments or industrial companies – have a plethora of backers to choose from.

This wall of money will only grow, as banks and investment firms try to increase the green financing they offer, in part to offset the very large sums they continue to invest in new oil and gas production. Stakeholders are starting to ask to see the numbers on both.

The actual scale of investment required is a multiple of what is happening now, but that’s okay – Western society has the resources.

The glaring funding gap is between developed and emerging markets. Building infrastructure in developing countries is always a challenge. Only countries themselves – with appropriate international assistance – can formulate the right policies and actions to facilitate this.

But companies are willing to take the risk and try to negotiate solutions. To some extent, in reasonably stable markets with decent infrastructure, equity capital for renewable energy investments is available.

Voltalia, the French renewable energy developer, for example, is present in Colombia, Kenya, Ivory Coast and Myanmar, among other emerging markets.

Unexpectedly, the hardest part can sometimes be debt. Here, the task of finding a solution lies in the inlet tray of the international capital markets.

Renewable energy is an excellent type of infrastructure to finance. Electricity demand is only expected to grow in emerging economies. Once installed, the equipment produces energy without being exposed to commodity price risk. There is an obvious revenue model – selling power – unlike assets such as roads, bridges or hospitals.

Revenue volatility can be mitigated to the extent that customers are seen to contractually commit to purchase electricity for long periods in the future. This transfers price and volume risk to the customer, rather than abolishing it, but at least the buyer gets certainty of supply, and renewables are often now the cheapest form of new energy available.

Moreover, backers can brag about it and use the assets to support green bonds. What’s not to like?

The big wrecking ball is currency risk. For all their lofty aspirations to finance the low-carbon transition, the overflowing funds in Western capital markets are not too keen on exposure to the Pakistani rupee, Ghanaian cedi or Ethiopian birr.

Every currency in emerging markets embodies all of the risks inherent in this economy – and they tend to be much more fragile than developed currencies. No matter how well a renewable energy project is designed or how loyal its customers are – many times over the 20 or 30 year life of the asset this economy is going to experience downturns, and when that is case, the currency will plunge.

This is even more certain, considering that emerging markets are at the mercy not only of their own economic fortunes, but also of those of the West. Whenever the dollar or US interest rates explode, emerging market investors scatter like pigeons.

If you’re in any doubt, watch how the Brazilian stock market has rebounded 53% since mid-March and Argentina’s 86%. One country is in the grip of a terrible pandemic, the other is defaulting on its public debt. Their markets obey the United States.

This poses a problem for financiers. In the past, banks often structured infrastructure projects to have cash flow in dollars. But this is clearly not what emerging countries need. Being hit by rising energy bills, at the same time as they face an economic crisis, is the worst of the procyclical pitfalls.

It is best to sell electricity in local currency. This means that the cash flows needed to service the debt are also in local currency, which creates risk for hard currency lenders.

Local currency debt would be ideal, but many emerging markets lack the large banking systems or capital markets needed. Some debt may be available, but it is often short-term – not optimal for a project with a 20-year payback period, where all parties are more comfortable without refinancing risk.

Multilateral Development Banks (MDBs) are doing their part, but they cannot finance everything.

The need is for private capital willing to make long-term loans in local currency.

This is a problem that calls for a financial solution. Foreign exchange markets in out-of-the-money currencies are shallow and illiquid, but they do exist. There are investors willing to gain exposure to emerging and frontier market currencies. What they may not want is this blended exposure to project risk, or in the form of long-term amortizing cash flows. But it should be possible to separate these strands and give them to the most appropriate holders.

It may also be possible to remove local currency exposure to domestic players who stand to lose if the currency rises, such as exporters. The agricultural sector, with low margins and exposed to volatile international prices in hard currencies, could be one that could benefit from a steady supply of local currency to pay wages.

Theoretically, two other forces could act on the problem: diversification and maturity transformation.

If a variety of currency risks from emerging markets around the world could be aggregated, the volatility a lender is exposed to on a particular loan could be reduced to some degree.

And over time, EM currencies that take a beating are expected to recover. If elasticity can be built into the system, it may be able to smooth volatility from year to year.

Reality’s ram makes short work of this ivory tower. Diversification could help weather short-term issues, but overall all emerging market currencies have been on a steady downward trend since 2011, some longer. Patient capital may be able to tolerate this, but it will have to be very patient.

It is possible to imagine the approximate silhouette of a “mixed capital” solution. Venture capital could come from donors in the developed world, whether governmental or philanthropic, as well as from multilateral development banks. Expertise could come from multilateral development banks, well-versed in emerging financial markets, and from private sector derivatives and risk management whiz-kids. Together, they could create a climate finance facility to absorb and, if possible, hedge the currency risk of those lending to renewable energy and climate change adaptation projects in developing countries.

A simpler solution, at least in middle-income countries, might be a less technological one, which would also likely have broader side benefits.

Avoid currency risk altogether by retaining domestic funding: support the local banking sector, including through equity investments.

This is what MDBs such as the International Finance Corporation and the European Bank for Reconstruction and Development have been doing for years, notably through specific programs to support green loans.

But there is clearly room to expand this, with targeted guarantees, to make it easier for banks to lend at longer terms and take on what could be outsized exposure to the energy sector. There is a lot of motivated capital in the developed world that would buy into this cause.

This may seem like an obscure, even unsolvable problem. But if human beings, hungry for energy, can drill through thousands of feet of rock on the seabed to find oil and gas, surely they can find a way to funnel some of the billions of wasted dollars to negative interest rates in Western capital markets. to build simple green infrastructure in developing countries that could save us all from being exhausted or flooded in a few decades.

Financial engineers – over to you.

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