The next generation

When it comes to most things in life, being retro is timelessly trendy. Except, perhaps, if you are a regulator. For a prime example of how this can be badly received by the crowds, look no further than Spain: when Madrid retroactively cut subsidies for solar photovoltaic farms a few years ago, investors were quick to close their cheque books and leave the country. That left the whole European clean energy industry with a hangover it began to recover from only recently.

Cuts to renewable subsidies, the retroactive kind included, have lately come back to the fore – but this time investors’ reactions seem much more muted. Sure, when the UK recently said it would end the Renewable Obligation (RO) subsidy for onshore wind a year earlier than expected, a few trade bodies responded in colourful fashion.

“The government’s decision to prematurely end financial support for onshore wind sends a chilling signal not just to the renewable energy industry, but to all investors across the UK’s infrastructure sectors,” commented Maria McCaffery, chief executive of RenewableUK, in the wake of the announcement in June.

But established players in the field understood the move, saying that a rationale exists for reducing public support for the most established technologies.

“There’s been some unquestionable successes. Larger onshore wind and solar are probably less and less favoured for subsidies, because they’re very close to being economic without them. And European countries, including the UK, have requirements to rein in their energy support budgets,” observes Gregor Paterson-Jones, a managing director at the UK Green Investment Bank (GIB).

Such regulatory moves therefore convey a new phase in the development of the renewables industry: after years of dedicated support and occasional turmoil, clean energy has become, in an increasing number of situations, a bankable proposition.

“Renewables are now a major part of the European power landscape. Typically over the past five years, well over 50 percent of new power plants installed in Europe are wind or solar. Existing electricity assets and new ones coming online should allow renewables to represent over 20 percent of the region’s power generation capacity within just a few years. They have become a mainstream investment area in Europe,” says Peter Rossbach, a managing director at fund manager Impax Asset Management (Impax).

In a number of markets, Paterson-Jones argues, renewables have even become more attractive than traditional power generation sources when it comes to building new facilities.

“In South Africa, for instance, if your choice is investing in a 3-gigawatt coal plant that will be heavily emitting and take six years to build – with another two to three years of delays – or developing a generation portfolio of IPP renewable assets, you will likely choose the latter. And the eventual price of electricity will be cheaper for the consumer.”

That green investments have become lucrative in their own right is of course good news. But it also means that dedicated investors such as GIB and Impax have to keep to sparser areas of the market to continue making good deals.

Created in 2012, GIB bills itself as the world’s first green bank. Its mandate is to plug a financing gap in the infrastructure investment market to meet the target set by the European Union’s renewables directives, by leading private sector players into less explored areas of the industry.

The need for such an institution was made clear when a study carried out in 2010 by UK consultancy Vivid Economics estimated that as much as £330 billion in investment was needed to hit the EU benchmark, but that projects in the pipeline at the time accounted for less than half of this total.

But the effort had to be carefully balanced: the UK government was under pressure to make sure a green-focused, state-backed institution wouldn’t act in an anti-competitive fashion, which would have had the perverse effect of crowding out private investors from the very market it intended to popularise.

After an extensive review the EU identified three sub-sectors that really needed support to attract private investment on a sufficient scale: offshore wind, waste-to-energy and bioenergy, and energy efficiency. “It was decided that these areas would be the ones that would give the best bang for buck in terms of the ability to leverage private sector finance and where there was deemed to be a financing market failure,” Paterson-Jones explains.

Impax’s mandate is somewhat different in that it mostly targets assets ex-UK, being the manager of euro-denominated vehicles. “We focus on making equity investments in Europe in the renewable energy sector in what we call a buy-build-sell model, which targets capital gains for investors,” Rossbach says.

As such the firm tends to favour countries that offer both fragmented access to the renewable infrastructure market and a “competitive” access to exits. “In each of these markets we need different local knowledge and language skills. Once we have quality deal flow, getting quality execution requires people to go on the ground and follow the construction, and get the projects installed and running with all the last details sorted.”

Cementing strong relationships with developers also makes a big difference. Rossbach explains that Impax has worked with one company on a transaction closed in 2008 in Germany, sealed the first deal of its second fund in 2010 with the same people, and again acquired an asset from them more recently. “There’s a value to repeat business of which we have experience in Germany, France, Finland and Ireland.”

While it is true that renewables have emerged on investors’ radar, competition varies greatly across markets. Rossbach sees Germany as very competitive, for instance, but with about 34 gigawatts of operating wind farms he describes it as a “huge” market. France, Poland, Ireland and Finland are also on Impax’s hit list, he explains. “A number of big markets remain very fragmented. There are dozens of developers in each major country – and they are so locally focused that they often don’t even know each other!”

Where the firm tends not to go is small, yet intensely competitive markets – examples of which, Rossbach says, include Estonia, Croatia and Cyprus. “We have the skills to do a project in a small country and by doing this project you’ll feel proud of what you’ve achieved but this does not guarantee a competitive exit. Indeed, you may have only one buyer there, so actually it does not fit our business model.”

The nature of competition also depends greatly on which sub-sectors you look at, Paterson-Jones argues. The offshore wind market, he explains, is relatively well-known and involves rather hefty projects. “Most developers active in offshore have to make enormous capital commitments to single projects, so they have very deep pockets. As a consequence the market is largely dominated by utilities.”

Gaining access to projects thus requires developing contacts at an early stage. “You have to understand how developers structure projects, what their approach to project risk is, how they procure the engineering, construction and O&M contractual suite. It really is a relationship business.”

The picture is different in the waste-to-energy and bioenergy market, where the technology is much more varied. Having the technical resources in house, Paterson-Jones says, is in this case crucial to ascertain what the risks are for a given project.

“You have to assess the feedstock market in a great level of detail. Even within a single type of waste stream, a certain technology may not work if there is a slight variation in the material you receive. If you get merchant waste on top of local authority waste, for instance, you’ve got to be sure the material doesn’t change over time.”

But the most difficult sector GIB operates in, he says, remains energy efficiency. “It’s not so much a market as it is a concept. It involves a lot of different technologies that you try and fit in an investment remit.” The main players there tend to be services companies, split between independent and utility-owned entities; other energy savings businesses (ESCOs) that only do operation and maintenance; and the host market, also divided between public and private sector.

“Your competition for funding or development in that market varies enormously depending on who’s ultimately taking the savings risk. So when you are out there originating projects, you have to get involved at a much earlier stage in order to have some ability to structure the project. It’s about wearing a lot of shoe leather setting up relationships with each of those parties because a lot of these things aren’t established.”

One of the things GIB did to structure the sector was to try and find markets where there was some ability to aggregate. It identified two of them: outdoor street lighting and healthcare. In the former, the existence of a mature technology, where the amount of drawn energy was already known, allowed the guarantee of a certain – and substantial – amount of savings. There was also a uniform set of hosts: local authorities.

Huge requirements for energy centre upgrades and replacements, meanwhile, made healthcare an attractive market. “There are structures now which are done through common procurement frameworks that allow both the hospital and the ESCO to take different risk in that process,” Paterson-Jones explains.

“It is generally funded through some leasing structure of some sort, either via a receivables model, where revenue streams coming from the hospital are refinanced post-construction, or a more typical asset-financed model, where you finance construction and operation but take security over the asset.”

Operating risks are only one thing both companies focus on, however. As in the infrastructure sector at large, renewables investors put a great deal of effort into anticipating the future evolution of relevant regulations. And despite recent moves to reduce support to mature technologies, Rossbach believes things are moving in the right direction. “Some of the nightmare period that we’ve seen related to the financial crisis has passed.”

He says Impax has a “favourable” view on the Energy Transition law, a new legislation package recently announced in France. “The new law should support the wind industry and help it achieve 1.25GW a year of new installed capacity.” He reckons the situation has lately improved in Germany, Finland and Poland as well.

Positive changes have also occurred in the UK, Paterson-Jones says. “The UK is tackling the classic energy trilemma of security of supply, cost of supply and decarbonisation. Over time, depending on the political and economic cycle, each has taken a slightly more important role. Up until recently decarbonisation was the government’s predominant aim.”

He welcomes the introduction of Contracts for Difference (CfDs), the new incentive system put in place by the UK to incentivise low-carbon generation. “Feed-in tariffs are theoretically subject to regulatory changes during the life of the project. By contrast, CfDs, once signed, are private law contracts. They are subject to the recourse of the court, which should give you more comfort in terms of revenue streams.”

Rossbach compares regulatory reviews as “dams” behind which a lot of projects back up.
Once the dam is released, attractive investment opportunities flow through “in a heavily concentrated vintage fashion”. That’s what happened in Ireland in 2012-2013, he notes. “In Poland the dam only broke four months ago,” he adds, “so there should now be a lot of projects.”

Paterson-Jones agrees, but cautions regulators against underestimating the side effects of tendering many projects at the same time. He cites the example of a recent auction in South Africa, where the narrow window international investors had to source financing for projects once commercial close had been reached ended up putting a lot of strain on hedging markets.

Regulatory changes and stronger competition, symptoms of the industry’s maturation, are inducing both organisations to look at fresh areas to explore.

“We may look for some future investments in places where curtailment could be material and not compensated for, and where we might find a storage solution for this,” Rossbach says. His firm is also considering having a small portion of the revenues it generates from its plants affected by spot market risk in a number of suitable countries, he explains, citing Ireland as an example.

Paterson-Jones believes utility-scale battery storage is not economical yet, but also sees it as a promising investment avenue. “The difficulty with running a utility is that you’re offering a fixed price for something that changes its pricing very short term. Ideally what you would want to do is to spill into the grid from a storage solution at the highest price point of the market.”

GIB can’t invest in technologies below a certain threshold of maturity, he admits. “The edgiest stuff we’ve done is on the biomass gasification side. Although it’s new to the UK, however, the technology’s been commercially developed successfully on other sites around the world.”

But the institution is an undisputed pioneer in another respect: its appetite for backing ventures in emerging markets. Over the last few years, Paterson-Jones explains, the bank went through a process of identifying countries where the bank’s involvement would have the greatest transformational impact as well as be welcomed by a friendly government and enabling environment. Its target list now features South Africa, Guinea, India and East Africa.

A yet more immediate evolution for the organisation is its upcoming privatisation, through a process that got a fair amount of publicity when announced in June. While Paterson-Jones declined to comment on the matter, the government argues that bringing private capital to the holding capital level will give it greater freedom to borrow, removing state aid restrictions and allowing it to grow its capital base.

GIB is meanwhile forging on with efforts to raise a fund, anchored with its own money and focused on offshore wind, from third-party investors. Having reached a close on £463 million in April, the vehicle is now aiming to collect another £500 million.

Fundraising is also on Impax’s agenda: with the previous opus now 80 percent invested, Rossbach says the firm is currently gauging interest for a new vehicle with a strategy similar to its predecessors. Fund II has meanwhile entered the exit process and started distributing dividends.

“A huge amount of money is going into renewable generation as opposed to thermal,” Paterson-Jones concludes. “That is a drastic change. We’ve seen it happen in developed countries and it is now starting to happen in developing economies.”