Inflation has been the biggest talking point for the world economy this year. Pent-up consumer demand and the need for countries to curb borrowing incurred in the pandemic; increased competition for raw materials as economies have opened again; and the impacts of the war in Ukraine. All have had significant effects on the supply chain, and inflationary pressures.
Inflation impacts renewables in numerous, highly complex ways, which prompted us at RealPort to explore how inflation affects renewables investors, while also identifying who is likely to win and lose in this new market paradigm. We released our findings in a report we published in September and which we present here.
To understand how we got here, we must take a brief look back at the 2008 financial crash. In response to that crash, central banks introduced historic low interest rates – and largely maintained them at very low levels until early 2022. This supported huge growth in renewables, especially in the wind and solar industries. Investors flooded in, attracted by the stable returns offered by income-generating renewables assets.
Throughout the 2010s, developers and operators became more efficient about how they developed and delivered projects; and technology gained economies of scale. Even so, the pool of assets has not been large enough for the so-called ‘wall of money’ entering the sector. This raised valuations and squeezed returns – but has not been a big challenge as capital was cheap and other costs kept falling.
However, the pandemic has changed the game. Investor appetite for renewables kept growing in 2020 and 2021, because the sector was seen as safe and ‘future-proofed’. This pushed up valuations further, meaning some of the prices paid in the last two years have been too high, and this may become problematic, as other costs are also rising.
The result is that the coming years will be very different to the decade just gone, and those who leveraged aggressively since the start of 2020 are likely to struggle.
The new era of inflation is increasing costs throughout the project life cycle and will affect investors’ business cases. Construction is becoming more expensive because of rising raw materials and transport costs; and firms reliant on debt will see their borrowing costs become more expensive too. Inflation will affect everyone, but those who rely on debt to fund project acquisitions or construction will be hit the hardest.
As far as investment is concerned, we expect companies that aggressively leveraged their projects after covid hit in early 2020 to face more challenges than those who did beforehand.
As demand for renewables continued throughout 2020 and 2021, we saw asset prices continue to rise and this has led to unsustainable yield compression. Most investors are reluctant to reveal their figures, but we understand there is a significant number of projects funded at high prices during this period that are over-leveraged and set to face problems when it becomes time to refinance. Our view is that the companies that leveraged aggressively will need to replace debt with equity in the coming years.
We also anticipate challenges for firms that need to raise follow-on financing in a period when asset prices are falling from pandemic-era highs; and those that secured their funding with floating/variable interest rates, which are set to see repayment costs rise steeply over the next 12-18 months as interest rates rise further. The high prices paid for assets since 2020 will lure many to refinance at higher, potentially unhealthy rates, and this may become unsustainable when energy wholesale market prices recede to healthier levels.
This age of inflation also includes some significant unknowns.
First, we do not know how long power prices will remain high and what will happen to energy providers when they fall; and second, we do not know how far governments will accelerate the growth of wind, solar and other renewables as they seek energy independence. This could further exacerbate current demand for materials and skilled labour.
There are no simple solutions and investors need to weigh up their decisions carefully. But it is clear the game has changed, and businesses need to evolve too. Who will be the winners and losers in this new environment?
Winners and losers
The winners will be those whose projects benefit from returns linked to inflation, or, even better, beat inflation. This includes projects with some type of power purchase agreements; or those with contracts for difference with revenues linked to inflation. Projects in the UK, as well as in France, Poland and Hungary are well placed in this respect.
Other beneficiaries of the current market will be those with a meaningful percentage of merchant risk that can take advantage of the very high power prices in Europe.
For example, onshore wind farms in Germany built with LCOEs of €45-€65/MWh will be able to make huge margins in a system where open market power prices exceeded €250/MWh at the end of June 2022 (though these prices have now fallen). The benefit will be biggest for projects that are already operational, as they were built before inflation started to bite but now benefit from inflated wholesale power prices. However, the economics help new-build developments too.
Finally, the winners will include those with projects that have been financed at the very competitive terms that have prevailed in the past few years and which are now enjoying inflation-beating revenue while paying negative or low interest on cash.
And the losers? Clearly, we expect to see problems for those whose returns feature fixed feed-in tariffs or PPAs that are not linked to inflation, and which are set to see operational costs rise due to the inflationary pressures discussed earlier. This can only eat into their profit margins and reduce their ability to reinvest in new projects – but this may open opportunities for investors to buy assets from distressed sellers.
This group includes investors that own renewable assets with fixed nominal revenue, such as under Germany’s Erneuerbare-Energien-Gesetz regime. They will not see their revenues rise in line with any squeeze they feel on their operational costs.
Another group that is set to struggle are investors who paid ‘top dollar’ for assets in recent years on the assumption that operations and maintenance costs would come down, inflation would stay muted and refinancing would lower overall debt service.
This will force investors to think carefully about the extent and terms of debt financing and off-take structures they put in place. If these deals take into account the rises in interest rates and energy prices, then investors may have the chance to invest in inflation-beating assets, but they will need to be sensible about valuations to achieve the real value.
Over the longer term, rising interest rates may eventually put downward pressure on valuations, as projects need to compete with rising bond rates by offering higher returns. This may leave assets with a high leverage ratio exposed when rates move higher.
Overall, though, we see good news for renewables. The sector continues to be an attractive investment class and has become the most economical way of delivering power for a greener future. There may be some losers, but we are confident that the sector as a whole can continue to adapt.
This change can herald a positive evolution for the sector.
Ekow Yankah is founder and chief executive of RealPort, a digital brokerage platform dedicated to renewables and based in Berlin