What does the retreat of subsidies mean for renewable energy projects?
Justin Fitzhugh, partner at Augusta & Co, explores what the rollback of subsidies means for investors in wind, including the limits of relying on PPAs. Justin was one of the guest speakers at Financing Wind Europe 2018 - click here to find out about upcoming conferences.
The retreat of subsidies is the most significant trend in today’s renewable energy market, and it's coming in many forms.
Sometimes, as in the UK, subsidies have simply been removed. In other countries, such as Norway and Sweden – and arguably Finland and Spain – the subsidy is of little or uncertain value.
Even in the markets where some form of tariff persists, auctions are restricting eligibility, prices are being driven down, and the security of the structure is being eroded as intermittent generators are being exposed to true balancing costs and capture pricing.
In our view, these changes are bumps to be expected on the road to a mature, cost-competitive industry. How close we are to that destination should be cause for celebration. Those who have argued against renewable energy on the grounds of cost have been proved dramatically wrong.
However, the move away from subsidies is posing some fundamental questions for developers, lenders and investors that the industry will need to answer if it is to continue to flourish. In this context it’s useful to sketch the outlines of a world where subsidies don’t exist to see what the answers might be.
The cost of wind turbines: benefits and limits of PPAs
Some of these outlines are quite clear. There will be more long-term power purchase agreements (PPAs), corporate or otherwise. Augusta has helped projects totalling over 1GW to secure such contracts, with parties including Google, Facebook, Alcoa and Norsk Hydro. However, we think that such PPAs – the closest substitutes for feed-in-tariffs – will not be available in sufficient volumes to enable the scale of development required by European Union targets.
This gap will lead to a more diverse and creative industry, with more varied approaches to managing risk and more participants helping to manage those risks.
We expect corporates, utilities and market makers playing a bigger role. In addition to that, we expect more activity from investment banks providing derivatives to protect against merchant price, credit and wind risk, from insurers providing credit and other specialist insurance and other new entrants better placed to take risks than the projects or developers themselves.
On the capital side, there will be less debt and more equity. With more merchant risk, lender views of cash flows per unit of capital expenditure will be lower than with a fixed tariff protecting the debt. This will also mean that lender views diverge further from investor views of the same cash flows. Leverage levels will fall.
Investing in wind energy: negotiating the post-subsidy world
For equity investors, the world will get more complex. Lower leverage will lower the sensitivity of equity returns to movements in merchant prices, but there will typically be higher exposure to those movements from a less contracted offtake structure.
Investors in the subsidised world had these trade-offs too but, because all projects in the same market had the same offtake structure, these sometimes got hidden behind a simple view of returns.
It was possible to talk about an IRR (internal rate of return) for German wind or French solar – or even UK ROC (Renewables Obligation Certificate) wind – without stating the underlying assumptions that leverage was maximised, the operating life was 25 years and, largely, that any merchant exposure followed the consultant central case view of forward power prices.
In an ex-subsidy world, this will no longer be possible. Even now there are projects in the same European market being built with full merchant power price risk, and others being built under 29-year PPAs. Equity risks will not be the same in both projects. But then leverage, the PPA structure and volume, the quality of the off-taker, the structure of the O&M contract and other factors will all impact the appropriate return.
Benchmarking across projects will become more difficult because project structures will be more varied and the market will be less commoditised. Smart investors will find their niches where they can take views on, or develop structures that help them to manage, certain risks better than others. Those who can only invest in projects with a 15-year PPA with an investment grade off-taker will find themselves in a very competitive corner of the market.
Finally, for developers in need of funding for their projects, an ex-subsidy world will require new skills and new ways of thinking.
Off-take sourcing will be critical, but they will also need to understand individual investor and lender approaches better to ensure that they deliver attractive projects to the market. Investor partnerships will become more common, but some investors may prefer to leave the contracting phase of development to investors who have those skills in-house.
Want to hear more from Justin? He'll be speaking at our Financing Wind Europe conference on 1st November. Find out more by clicking below.