implementing the energy [r]evolution
3.1 renewable energy project planning basics
The renewable energy market works significantly different than the coal, gas or nuclear power market. The table below provides an overview of the ten steps from “field to an operating power plant” for renewable energy projects in the current market situation. Those steps are similar for each renewable energy technology, however step 3 and 4 are especially important for wind and solar projects. In developing countries the government and the mostly state-owned utilities might directly or indirectly take responsibilities of the project developers. The project developer might also work as a subdivision of a state-owned utility.
3.2 renewable energy financing basics
The Swiss RE Private Equity Partners have provided an introduction to renewable energy infrastructure investing (September 2011) which describes what makes renewable energy projects different from fossil-fuel based energy assets from a finance perspective:
- Renewable energy projects have short construction periods compared to conventional energy generation and other infrastructure assets. Renewable projects have limited ramp-up periods, and construction periods of one to three years, compared to ten years to build large conventional power plants.
- The Renewable Energy Directive granted priority of dispatch to renewable energy producers. Under this principle, grid operators are usually obliged to connect renewable power plants to their grid and for retailers or other authorised entities to purchase all renewable electricity produced.
- Renewable projects present relatively low operational complexity compared to other energy generation assets or other infrastructure asset classes. Onshore wind and solar PV projects in particular have well established operational track records. This is obviously less the case for biomass or offshore wind plants.
- Renewable projects typically have non-recourse financining, through a mix of debt and equity. In contrast to traditional corporate lending, project finance relies on future cash flows for interest and debt repayment, rather than the asset value or the historical financial performance of a company. Project finance debt typically covers 70–90% of the cost of a project, is non-recourse to the investors, and ideally matches the duration of the underlying contractual agreements.
- Renewable power typically has predictable cash flows and it is not subject to fuel price volatility because the primary energy resource is generally freely available. Contractually guaranteed tariffs, as well as moderate costs of erecting, operating and maintaining renewable generation facilities, allow for high profit margins and predictable cash flows.
- Renewable electricity remuneration mechanisms often include some kind of inflation indexation, although incentive schemes may vary on a case-by-case basis. For example, several tariffs in the EU are indexed to consumer price indices and adjusted on an annual basis (e.g. Italy). In projects where specific inflation protection is not provided (e.g. Germany), the regulatory framework allows selling power on the spot market, should the power price be higher than the guaranteed tariff.
- Renewable power plants have expected long useful lives (over 20 years). Transmission lines usually have economic lives of over 40 years. Renewable assets are typically underpinned by long-term contracts with utilities and benefit from governmental support and manufacturer warranties.
- Renewable energy projects deliver attractive and stable sources of income, only loosely linked to the economic cycle. Project owners do not have to manage fuel cost volatility and projects generate high operating margins with relatively secure revenues and generally limited market risk.
- The widespread development of renewable power generation will require significant investments in the electricity network. As discussed in Chapter 2 future networks (smart grids) will have to integrate an ever-increasing, decentralised, fluctuating supply of renewable energy. Furthermore, suppliers and/or distribution companies will be expected to deliver a sophisticated range of services by embedding digital grid devices into power networks.
Risk assessment and allocation is at the centre of project finance. Accordingly, project structuring and expected return are directly related to the risk profile of the project. The four main risk factors to consider when investing in renewable energy assets are:
- Regulatory risks refer to adverse changes in laws and regulations, unfavourable tariff setting and change or breach of contracts. As long as renewable energy relies on government policy dependent tariff schemes, it will remain vulnerable to changes in regulation. However a diversified investment across regulatory jurisdictions, geographies, and technologies can help mitigate those risks.
- Construction risks relate to the delayed or costly delivery of an asset, the default of a contracting party, or an engineering/design failure. Construction risks are less prevalent for renewable energy projects because they have relatively simple design. However, construction risks can be mitigated by selecting high-quality and experienced turnkey partners, using proven technologies and established equipment suppliers as well as agreeing on retentions and construction guarantees.
- Financing risks refer to the inadequate use of debt in the financial structure of an asset. This comprises the abusive use of leverage, the exposure to interest rate volatility as well as the need to refinance at less favourable terms.
- Operational risks include equipment failure, counterparty default and reduced availability of the primary energy source (e.g. wind, heat, radiation). For renewable assets a lower than forecasted resource availability will result in lower revenues and profitability so this risk can damage the business case. For instance, abnormal wind regimes in Northern Europe over the last few years have resulted in some cases in breach of coverage ratios and in the inability of some projects to pay dividends to shareholders.