Financing options for renewable energy

Virginia Sonntag-O’Brien and Eric Usher review the obstacles to mobilising finance for renewable energy projects and recommend some ways in which they can be overcome

Renewable energy (RE) has a significant potential to mitigate global climate change, address regional and local environmental concerns, reduce poverty and increase energy security. The challenge is to provide the right policy frameworks and financial tools that will enable RE to achieve its market potential and move from the margins of energy supply into the mainstream.

Policy-makers thus have a mandate to take action and, since most of the capital for this greening will not come from public treasuries, most of this action will need to focus on creating enabling frameworks and finance mechanisms for technology R&D, commercialisation and investment.

Renewable energies, although subject to the same market forces as conventional energy sources, involve markedly different technologies and thus their financing requires new thinking, new risk management approaches and new forms of capital. Half the battle for renewables is to instill confidence within the investment community, which will happen only after financiers have travelled up the learning curve that gives them exposure and understanding of the real risks and opportunities associated with financing RE. Accurate and standardised information, for example, on failure rates and operating costs, can help reduce the tendency to overrate project risk and can bring down transaction costs.

Financial structure and scale pose a further challenge to investment in RE. Renewable energy projects usually carry higher up-front capital costs and lower operational costs than their conventional counterparts. The external financing requirement is therefore high and must be amortised over the entire project lifecycle. Moreover, most RE projects are small, which means that transaction costs (eg, feasibility analysis, due diligence, legal and engineering fees, consultants, etc) are disproportionately high, as these do not vary significantly with project size. Finally, RE project developers are often under-financed with relatively limited track records, which causes financiers to perceive them as high risk and to refuse non-recourse project finance.

Eventually, market forces will best determine how and where RE is used. This ideal solution, however, assumes mature technologies, efficient markets and full internalisation of environmental and social costs – conditions that currently do not exist in any country. Public interventions are therefore needed to help accelerate investment in the RE sector.

A key tool for catalysing investment in renewables in many countries is creating price support mechanisms that provide stability and predictability over the medium and long term. Such mechanisms reduce the risk premium in the cost of capital, which will increase the amount of investment in RE and lower the price that consumers have to pay. Policy interventions are taking a range of forms including market-based quota mechanisms such as carbon emissions trading and renewable obligation arrangements, and fixed-price schemes such as the feed-in laws in Germany and Spain.

No one approach will be equally appropriate in all markets and regulatory environments. However, they all must create financial incentives for investors to change the pattern of investment away from carbon-emitting conventional technologies in favour of large-scale investment in renewable/non-carbon emitting technologies.

Bridging gaps in the finance continuum
Besides pro-renewable policies such as quotas and feed-in tariffs, public interventions and commercial innovation are also needed in the finance sector. For RE, the variety of forms of capital – the finance continuum – needed to realise a project is generally incomplete and the gaps can often only be filled with niche financial products, some of which exist and some of which need to be created. Figure 1 ¹ shows which types of finance are often secured today by mid- to large-scale on-grid RE projects, which types are occasionally secured, and the current gaps and barriers in the continuum. It also proposes some interventions that might be supported by public sources to close the gaps.² The following discussion takes the reader through this chart, moving from left to right.

Project preparation for on-grid RE projects is generally carried out either by large energy companies or specialised project development companies, as is usually the case in Germany. Energy companies finance project preparation from operational budgets. Specialised companies finance project development work through private finance, capital markets, or with risk capital from venture capitalists, private equity funds, or strategic investors.

Facilities that can share some of the costs of development on a grant, or contingent grant, basis can effectively help move RE projects forward. These facilities need to be carefully structured to target the right projects and align interests on project development.

If the concept successfully passes through the development stages, the project developer is in a strong position to attract external financing, both from equity sponsors and eventually from the banks. To secure loans, developers and their sponsors will generally need to provide between 25% and 50% of the capital required for a project in the form of shareholder equity. As the risk (real or perceived) associated with a project increases,³ lenders will require that equity play a larger role in the financing structure. This not only strains a developer’s capital resources, it raises the cost of the entire project, since equity capital always costs more than debt capital. Therefore, innovative structures are needed that can fill the widening gap between the equity and debt available to a project.

Further along in the finance continuum, another option to fill the equity/debt gap is quasi-equity or mezzanine finance, which constitutes a variety of structures positioned in the financing package somewhere between the high risk/high upside equity position and the lower risk/fixed returns debt position. Public participation in mezzanine funds, if structured appropriately, can help mitigate the risks for commercial investors. A number of RE mezzanine funds are now being developed that target specific emerging markets. ⁴

The bulk of the financing provided to a project is usually in the form of senior debt, which can be structured as on-balance sheet corporate finance or off-balance sheet project finance. Corporate financing requires a decision by the corporate sponsor to accept the risk and potential reward of a project in its entirety and can only be used by sponsors with a significant base of assets, debt capacity and internal cash flow. Tax incentives, such as accelerated depreciation, and leasing structures can help improve the financials of RE projects for corporate sponsors.

Off-balance sheet project financing involves the use of a special-purpose financial vehicle to fund a specific power-generation project with only limited recourse to the assets of external investors if the project under-performs or fails.

In terms of transaction costs, particularly for project finance, but also more generally for any debt financing, the extra costs associated with satisfying the higher ‘burden of proof’ that a bank’s loan committee would normally apply to the first few RE investments normally fall on the project developer. Public facilities that share the costs of the investment decision-making and the transaction process can help bring bankable projects through to financial closure. At the same time, building RE awareness and capacity within financial institutions is also important.

An integral element of deal structuring, particularly for off-balance sheet projects, is risk management. This process entails assessing the risks, mitigating them where possible and, where not, shifting them to insurers and other parties better able to underwrite or manage the risk exposure. Applied correctly, certain risk management instruments can help mitigate the perceived risks associated with RE and affect the degree and terms of investment into such projects. There are currently constraints on the availability of such risk management instruments, however, which relate to factors such as the willingness and capacity of insurance and capital markets to respond.

A fully financed wind project today will usually find insurance cover. Though cover for biomass is available for larger projects, a product is still needed that covers the security of fuel supply. Large-scale hydro is well understood and can be insured. Run-of-river hydro facilities are also catered for, although small-scale and micro-hydro developers sometimes have difficulty finding sufficient cover, particularly for Contractors All Risks (risk of nondelivery of contracts).

There are still many insurance gaps in the finance continuum and various barriers hinder the development of new instruments. Many risks associated with RE projects are non-traditional and hence uninsurable. It can be difficult to diversify risks and actuarial data may not be available to properly assess the risks (eg, offshore wind construction risk). Underwriters have limited understanding of RE projects and associated risks and have difficulty aligning strategies for dealing with them. Underwriting mentalities are generally rigid and inflexible.

Public–private partnerships can help move new risk management instruments forward. Efforts in the risk management area should aim to help extend existing energy insurance product lines, change underwriter risk perceptions and rating methodologies, bundle heterogeneous risks, and aggregate projects to create portfolios of scale and risk diversification.

Developing and improving risk management instruments in developing countries to support RE infrastructure and institutional capacity would also help immeasurably. Export credit agencies (ECAs) can provide cover for some commercial and political risks in developing countries, although to date they have had little experience with RE support. With clear direction from their governments and shareholders, ECAs could develop new products and approaches to address the specific requirements of RE projects.⁵ Some of these could be developed directly by the individual ECAs, others would require the respective ECA guardian authorities to collectively change relevant international agreements, including the OECD arrangement on export credit finance. ⁶

Moving off-grid…
The finance continuum analysis can also be applied to off-grid RE small and medium-size enterprises (SMEs) such as solar home system, biogas digestor, or wind water pumping businesses. At present, there are also many gaps in this continuum, both financial and non-financial, as is shown in figure 2.⁷ Ultimately, these gaps make it difficult to launch a new off-grid RE business or even to expand an existing proven business.

An early gap in the off-grid continuum is the lack of early stage capital and donor support needed to help RE innovators develop their business models, raise market awareness, and take the risks associated with new product/service offerings. Suggested solutions in this area of the continuum are business development grants and risk-capital instruments – approaches that align interests around creating new enterprise models, thereby preventing the usual moral-hazard problems associated with grant-making activities.

A fairly new form of early-stage financing mechanism for SMEs is seed capital, which is applied as a small initial investment to help an entrepreneur plan and launch a specific business.The willingness to take more risk than conventional sources, combined with the provision of enterprise development services, constitute the main concessional aspects of the seed-financing approach.

As a new company scales up its operations, it will usually need additional injections of capital to manage its growth. These ‘second stage’ growth capital requirements include both short-term needs (eg, working capital) and long-term needs (investing in service infrastructure), both of which should normally be financed with loans from local commercial banks.

For SMEs in the RE sector, however, this is rarely possible. Very few commercial lenders today are financing off-grid renewable energy SMEs in developing countries. If they do, they usually provide funds in the form of private or corporate finance. Access to these loans depends less on the business model than on the size of the owner’s asset base and the owner’s willingness to provide these assets as security.

Public and donor funding mechanisms and capacity development are needed to help engage commercial lenders and investors in financing the operating capital needs of off-grid RE companies. Typically, these support mechanisms have taken three forms: lines of credit, credit enhancements for loan provision and SME growth capital funds. Public support for these various mechanisms must be redoubled, building on the approaches that have worked to date.

Lines of credit are a common approach for development finance institutions to support the creation of credit windows in national or local banks for specific areas of lending, including RE enterprises. Credit enhancements are a variety of subsidies aimed at softening loan financing, either for the lender or the borrower. The concessionality comes in the form of partial risk or credit guarantees, or interest-rate reductions. Guarantees are most effective at addressing elevated banker perceptions of risk; once a bank has gained experience managing a portfolio of RE loans, it is in a better position to evaluate true project risks. Interest rate subsidies lower the cost of financing for the borrower and can be an effective means of helping banks build their loan portfolios in specific RE sectors.

In contrast to seed capital funds, which are generally purely donor financed, growth capital funds can be financed with a mix of donor and commercial capital. This blending is used to either buy down the risks or buy up the returns for commercial investors. Experience with these funds has been mixed, as some have not managed to meet their investors’ expectations and consequently have been dissolved.

Finally, there are a number of models that have been attempted for financing RE transactions with the end user, including the supplier credit model, the consumer credit (or micro-credit) model, the fee-for-service model and the leasing model. Of all of these, the consumer credit model has been the most successful means of facilitating individual household purchases of renewable energy systems, with the largest portfolios being achieved in Sri Lanka, Bangladesh and India.

Conclusion
A free market does not function according to rules of social responsibility and therefore needs to work within certain boundaries that serve social and environmental, as well as economic goals. Policy-makers have a social responsibility to set those boundaries. Legislators and regulators have it in their control to shift the future energy portfolio if they choose to decrease demand by improving energy efficiency and to push energy generation towards renewable energy.

Financiers have a social responsibility to develop and deliver market solutions to the challenges of building a sustainable energy future. That energy future must take the form of a free energy market with less carbon, less fuel and fuel-price risk, and more and better access for the poor. EF

Virginia Sonntag-O’Brien is managing director of BASE (Basel Agency for Sustainable Energy) and Eric Usher is responsible for sustainable energy finance activities at UNEP’s Paris-based Division of Technology, Industry and Economics. E-mail: virginia.sonntagob@energybase.org or eric.usher@unep.fr

1 Financial continuum analysis based on work of Phil Larocco (E+Co)
2 The reader should note that for the sake of brevity, this paper does not cover all RE technologies and financing models in detail. More information is contained in the Thematic Background Paper on Financing Renewable Energy, which was prepared for the International Conference for Renewable Energies. The paper can be downloaded as a conference document from www.renewables2004.de
3 Two trends today that are increasing RE commercial project risks are the shift from long-term power purchase agreements to spot markets, and increased power off-take (or counterparty) risk due to overall energy market deregulation
4 The Central American Clean Energy Fund (E+Co) and the Central European Renewable Energy Fund (EIP)
5 Further information on this topic will be available in the forthcoming UNEP paper Making it Happen: Renewable Energy Finance and the Role of Export Credit Agencies
6 Specific sector understandings have been created under the arrangements for aircraft and the nuclear power sector
7 Although this analysis applies mostly to developing country enterprises, generic elements of the financing needs/responses are the same for developed country SMEs