Published on August 1st, 2018 | by The Beam0
Bridging The Capital Gap To Achieve 100% Renewable Energy Supply
August 1st, 2018 by The Beam
By Matthias Stettler, greenmatch AG
Every year, nearly US$2.5 trillion is invested in energy, shipping, water, and communication infrastructures all over the world. However according to a study by the McKinsey Global Institute titled Bridging global infrastructure gaps, meeting the global growth expectations would take an annual US$3.3 trillion. This leaves a global infrastructure investment gap of roughly US$1 trillion per year! It is the developing and emerging countries which account for some 60% of these investment needs. To get an idea of the dimension of these numbers, only 15 economies of the world have a GDP above US$1 trillion, and only the United States, Japan, China, and Germany are left with a GDP above US$3 trillion per year.
It is a fundamental principle of sustainable economic activity to at least preserve the capital stock, for it to generate sustainably positive earnings. And it makes even more good business sense for national economics, to protect their future generations from being worse off in the times ahead. The lion’s share of these infrastructure investment needs relate to the energy sector. After all, more than US$200 billion are invested in renewable energies every year, with an unabated strong upward trend. The ongoing decline in expenses for investments in renewable energies will continue to further intensify this trend.
And yet it makes you wonder why so little capital is being poured into infrastructure projects and why we have a global investment gap to the tune of nearly US$1 trillion per year. After all, the available supply of capital has never been higher, as suggested by the persistently low interest rates in most important currency areas. But why is it taking so long for this capital oversupply to turn into real assets, and most importantly, what is the best way to accelerate the expansion of renewable energies?
The structuring and financing of renewable energy projects is accompanied by extensive negotiations among many parties
Renewable energy projects — e.g. an average wind farm anywhere in the world with ten turbines and a total investment need of around US$30 million — usually start with a project developer. This local specialized company acts as an initiator by specializing in local and technical environments, by securing land plots, by obtaining approvals, and in most cases also by organizing the civil engineering and construction works. The risk of loss decreases steadily during the course of a project — notably from the time a plant is ready for construction until its commissioning. This is the perfect entry point for investors looking for low risks with a long-term focus like institutional investors, e.g. pension funds, and also — as is usual in renewable energy projects — public utilities and utility companies. Project financing banks are also known to wait for that stage in the process to join a project with debt. It goes without saying that speed is of the essence for the project developer when looking for long-term financing: each project sold will relieve the project developer’s balance sheet and yield a margin, allowing the project developer to embark on new projects.
Consultants acting as economic, technological, or legal key knowledge holders and facilitators between the parties play a further important role in project financing. It is these experts who provide a transfer of knowledge which, alas, often remains limited due to the predominantly personal nature of the relationships.
Investment value chains of renewable energies thrive on the interaction between all players involved. An inevitable issue in project financing is finding a party for transferring the risk to, who will be best capable of shouldering or controlling it. It is just like playing cards among all parties involved during the transaction negotiations. The private equity nature of renewable energies — infrastructure projects are not normally publicly listed — will cause disruptions in this value chain during each transaction. The project developer as seller and the investor as a buyer have to agree upon a price for the shares of a renewable energy project this is why transactions normally go along with complex value calculations and contract negotiations.
Decentralized, small-scale infrastructure projects meet big institutional capital
The market for renewable energies is characterized by decentralized forms of production because the market is dominated by numerous small-scale projects. Large-scale projects are a typical phenomenon in specialized niches such as offshore wind, or in countries where regulation favours economies of scale. Typical investment volumes for renewable energy projects are in the single to double-digit million US dollar range. This is substantially less than typical investments in large-scale projects, involving, for example, conventional energy projects, where the investment per project not infrequently exceeds US$1 billion.
The demand side for renewable energy investments is pretty much as heterogeneous as the supply side. The pioneering phase saw private investors who were slowly replaced by the involvement of citizen participation organizations. As of 2010, the stakeholders investing in renewable energies have increasingly become highly professionalized. In addition to public utilities and utility companies as strategic investors, the market is increasingly dominated by institutional investors. The latter have come to realize that direct and especially indirect investments in fossil resources are fraught with extremely high valuation risks, also known as the carbon bubble. 80% of the known, and hence valuated, fossil resources would have to remain in the ground to keep from heating the earth by more than an additional 2°C. According to the Carbon Tracker Initiative’s estimates, exposed stock exchanges such as London, São Paulo, Moscow, Sydney and Toronto might lose 20 to 30% of their entire market capitalization. The concomitant decarbonization of institutional portfolios has already produced some famous examples such as the Rockefeller Foundation.
When major investors invest in renewable energies, they frequently use their familiar, tried and true approach for classic large project financing. They are in the game for large investment volumes and stable capital yield profiles while angling to keep the risk and transaction costs to a minimum. It therefore comes as no surprise that they normally try to avoid any development and construction risks and are on the lookout for larger-sized plants which have already been in operation for one or two years. This might explain why these investors are not (yet) making a contribution to overcoming the capital gap.
How best to overcome the capital gap
The most widely discussed approaches to overcoming the capital gap concern the political sphere. Reducing the red tape in these cases is of paramount importance. Speed is of the essence to project developers, and centralized and professionalized approval procedures are guaranteed to yield positive effects. Similar effects are achieved by uncomplicated yet market-integrated feed-in tariff regimes for renewable energies. Giving investors a guaranteed production-based remuneration throughout a plant’s lifetime leads to a significant reduction in risk premiums, thanks to planning security. This is particularly important for renewable energies, because power exchanges are oriented to marginal costs, i.e., the rate for every kilowatt hour produced in addition. And since renewable resources such as sun and wind don’t charge for their services, the stock exchange price for electricity produced with high proportions of renewable energies is close to zero. Feed-in tariffs help ensure that the plant’s full cost (notably the initial investment costs) will be factored into the equation.
The demand side lacks enticing investment criteria for the typically very long-term investment horizons and for shouldering the development and construction risks typical of real assets, as outlined above. Financial regulation’s recognition of renewable energies’ characteristics as an asset class in their own right is still inadequate, even if good beginnings are evident, e.g., from the EU’s ELTIF (European Long-Term Investment Fund).
In matters of infrastructure, the government may act in the form of an investor at federal, state and local level, or in the form of a public utility. However, the globally high national deficits hold out little hope for the future, and especially in these cases, there is typically a sore lack of expert knowledge for renewable energies and project financing.
Clean-FinTechs play a role in standardization and know-how transfer
Investments in renewable energies are a private-equity market where prospective investors’ projects are evaluated on a case-by-case basis. Due to time pressure, technical mistakes are a frequent problem during the due diligence process, notably when it comes to financial modelling. This risk is typical of all investments, although it is particularly pronounced for renewable energies, as excessive initial investments will be virtually impossible to correct over a power station’s lifetime. The standardized digitalization of project-specific illiquid infrastructure projects, with a view to achieving transparency and efficiency in valuation and pricing, can therefore be an important contribution to addressing the capital gap. That is why FinTechs can take a bottom-up approach in this segment.
So far, there are only a few FinTechs worldwide addressing renewable energies as an asset class in their own right. Although a few digital marketplaces do exist, they are largely limited to the function and quality of a bulletin board, with simple project descriptions. That is why prospective buyers and investors still have to depend on their personal networks. Other startups are focusing on the software-assisted, optimized operation of the assets. While these approaches are certainly important, they are of little help for overcoming transaction ruptures.
Switzerland has one example of a FinTech specialized in the digital financial structuring of investments in renewable energies: greenmatch is in the business of standardizing profitability calculations — independent of technology, globally, without spreadsheets, and with a certified calculation engine. Their platform allows the direct sharing of projects with stakeholders in a secure environment, or their presentation via the marketplace, along with the relevant financial model. Hence, the platform brings back what market participants have been doing in marketplaces since time immemorial: negotiating contracts and, most importantly, prices — while refraining from discussing calculation methods. This allows for faster project pipeline evaluations by investors and banks alike, based on standardized and hence comparable assumptions. Project developers, in turn, have a much easier time of reaching long-term investors. Increased transaction efficiency and transparency will reduce the risks and transaction costs for all parties involved. This strategy is also bound to go hand-in-hand with a global transfer of know-how. Specialist project financing know-how will cease being clustered around a few select experts — on the contrary: local and specific knowledge will become quickly accessible by involving a global partner network.
These platforms will help turn real assets into exchange-like systems and make them easier to trade, and are therefore an important stepping stone towards overcoming the capital gap for achieving 100% renewable energy supply.