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Renewables need some benign financial engineering

Solar power farm renewable energy from Adobe 23Jun20 575x375
By Jon Hay
23 Jun 2020

Clean, green energy exists; it is more or less unlimited and it is increasingly cheap to harvest through solar and wind farms. Why are we not converting to renewables wholesale — especially in poor countries, which tend to have abundant sunshine? A significant part of this market failure is financial, and capital markets must solve it.

The first task in fighting climate change is getting the world wired up to clean renewable energy, which means wind and solar.

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

Mainstream projects in wealthy countries — solar and wind farms that can secure long term offtake contracts with creditworthy utilities, governments or industrial companies — have a plethora of funders to choose from.

This wall of money is only likely to increase, as banks and investment firms try to bulk up the green financing they are doing — partly to offset the very large amounts they are still ploughing into new oil and gas production. Stakeholders are starting to ask to see the figures on both.

The real scale of investment required is multiples of what is happening now, but that’s alright — western society has the resources.

The glaring funding gap is between developed and emerging markets. Building infrastructure in developing countries is always challenging. Only the countries themselves — with suitable international help — can formulate the right policies and actions to make this easier.

But companies are willing to engage with the risks and try and negotiate solutions. To some extent, in markets that are reasonably stable and have decent infrastructure, the equity capital for renewables investment is available.

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

Where the wild risks are

Counterintuitively, the hard part can sometimes be the debt. Here, the job of finding a solution lies in the in-tray of the international capital markets.

Renewable power is a great kind of infrastructure to finance. Demand for electricity is only likely to grow in emerging economies. Once installed, the equipment produces energy without exposure to commodity price risk. There is an obvious revenue model — selling power — unlike assets such as roads, bridges or hospitals.

Revenue volatility can be derisked to the extent that customers can be found to contract to buy the power for long periods into the future. This transfers price and volume risk to the customer, rather than abolishing it, but at least the buyer obtains certainty of supply, and renewables are often now the cheapest form of new power available.

Plus, funders get to boast about it and use the assets to back green bonds. What’s not to like?

The big wrecking ball is currency risk. For all their noble aspirations to finance the low carbon transition, the brimming pots of money in western capital markets are not overly keen on taking exposure to the Pakistani rupee, Ghanaian cedi or Ethiopian birr.

Each EM currency embodies the whole set of risks inherent in that economy — and they tend to be far more fragile than developed ones. It doesn’t matter how well designed a renewables project is, or how loyal its customers — several times over the asset’s 20 or 30 year life, that economy is going to go through downturns, and when it does, the currency will plunge.

That is even more certain, considering that EMs are at the mercy of not just their own economic fortunes, but those of the West. Whenever there is a loud pop in the dollar or US interest rates, EM investors scatter like pigeons.

If you have any doubt, look at how Brazil’s stock market has rebounded 53% since mid-March and Argentina’s 86%. One country is gripped by a horrendous pandemic, the other is defaulting on government debt. Their markets are obeying the US.

Dollars not the answer

This poses a problem for financiers. In the past, banks often structured infrastructure projects to have dollar cashflows. But that is manifestly not what emerging countries need. To be hit with energy bills going up, just at the same time as they face an economic crisis, is the worst kind of pro-cyclical trap.

Far better is to sell the power in local currency. That means cashflow to service debt is also in local currency — creating risk for hard currency-based lenders.

Local currency debt would be ideal, but many EMs do not have the large banking systems or capital markets required. 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) do their bit, but they cannot finance everything.

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

Risk takers wanted

This is a problem crying out for a financial solution. FX markets in out-of-the-way currencies are shallow and illiquid, but they do exist. There are investors out there willing to take exposure to EM and frontier market currencies. What they may not want is that exposure mixed with project risk, or in the form of long term, amortising cashflows. But it ought to be possible to pick these strands apart and give them to the most suitable holders.

There may also be some scope for laying off local currency exposure to domestic players that stand to lose if the currency rises, such as exporters. The agricultural sector, with low margins and exposure to volatile international prices in hard currency, might be one that could benefit from a steady supply of local currency to pay wages with.

Theoretically, two other forces could be brought to bear on the problem: diversification and maturity transformation.

If a variety of EM currency risks from around the world can be pooled, the volatility any one lender is exposed to on a particular loan could be to some extent reduced.

And over time, EM currencies that suffer knocks should recover. If elasticity can be built into the system, it may be able to smooth out year to year volatility.

Reality’s battering ram makes short work of that ivory tower. Diversification might help with short term blips, but the big picture is pretty well all EM currencies have been on a sustained downward trend since 2011 — some of them for longer. Patient capital might be able to tolerate that, but it will have to be very patient.

Thinking caps on

It is possible to imagine the rough silhouette of a 'blended capital' solution. Risk capital could be sourced from developed world donors, whether government or philanthropic, as well as multilateral development banks. Expertise could come from the MDBs, versed in EM financial markets, and from private sector derivatives and risk management whizzkids. Together, they could create a climate finance FX facility to suck out, and where possible hedge, currency risk from those lending to renewables and climate change adaptation projects in developing countries.

A simpler solution, at least in middle income countries, might be a lower tech one, which would also probably have wider side benefits.

Avoid FX risk altogether by keeping the financing domestic: apply support to the local banking sector, including through equity investments.

This is what MDBs such as the International Finance Corporation and European Bank for Reconstruction and Development have been doing for years — including in specific programmes to support green loans.

But there is clearly scope to expand this, with targeted guarantees, to make it easier for banks to make longer term loans and take what might be outsized exposure to the energy sector. There is lots of motivated capital in the developed world that would buy into this cause.

It might seem an arcane problem, or even an insoluble one. But if human beings, wanting energy, can drill through thousands of metres of rock on the seabed to find oil and gas, they can surely work out a way to pipe some of the billions of dollars wasting away at negative interest rates in western capital markets to build no-brainer green infrastructure in developing countries that might save us all from being frazzled or flooded in a couple of decades’ time.

Financial engineers — over to you.

By Jon Hay
23 Jun 2020