There are performance variables unique to renewable infrastructure. Aaron Konrad looks at the key criteria for analysing funds in the sector
In May, the European Investment Bank announced more than €8bn in funding for 21 green projects throughout Europe, in line with aims to improve energy efficiency and cut emissions as part of EU climate goals to 2020.
It is not just an idealistic push; the private sector is also getting involved. In 2014, the Allianz group made plans to flood the European renewable energy sector with €3bn over the next three years, mainly because of higher expected yields versus other long-term capital investments. The political will, regulatory reform, and search for yields in the current low-interest environment are creating the foundation for further growth in renewables.
A Preqin study points out that, despite the modest slowdown in renewable energy fund issuance in the past year, the medium-term outlook remains positive, with demand for private investment in renewables expected to spur expansion in the sector globally.
Scope Ratings has identified four key criteria to analyse closed-ended funds that invest in renewable energy projects that investors and managers can use to judge the viability and stability of an investable asset.
The timing of the initial investment is crucial for an investor’s expected return. In some tariff schemes, the effective feed-in tariff depends on when the project is commissioned; delays can lead to lower revenue over the project’s lifespan. Investors must consider the impact of possible cash-flow delays, especially when there is no evidence that all permits and investments have been secured, construction is complex, or a new technology is used.
Other factors to consider are the probability and severity of a supplier default, in which case a supplier’s creditworthiness and record with the relevant technology need to be examined, and the potential of incurring additional costs to find a suitable replacement supplier, which may also command higher compensation.
The risk of a contractor defaulting on its obligations is another important consideration. Projects are often based on fully wrapped, fixed-price and turnkey engineering, procurement and construction contracts that allocate all construction-related risks to a contractor, which include cost overruns or delayed completion. The investor must evaluate how a default might affect construction costs and/or the timing of completion, as well as any agreed liquidated damages and performance bonding.
In Europe, generally supportive regulation regimes mean that price risk is often limited for renewable-energy projects. Examples include the quasi-fixed, feed-in tariffs from German renewable energy law (Erneuerbare-Energien-Gesetz, EEG) and the ‘green certificates’ allocated in Italy or Poland.
Increasingly, Germany and other countries are opening up renewable energy to the free market, giving power producers strong financial incentives to sell electricity directly on the spot market, in return for realised wholesale prices and a market premium paid by the grid operators. This market premium is based on a fixed statutory tariff and a market average adjusted for the respective technology. To sell the electricity, the project contracts a direct seller, which introduces default risk. If there is a default, the statutory tariff on which the market premium is based is cut to 80% until a new direct seller is found. Investors must therefore evaluate the impact of a direct seller’s default and the ensuing revenue loss.
When we look at less-supportive jurisdictions, long-term contracts may be used to sell power to an off-taker. While a fully contracted project may not be exposed to price risk directly, its revenue will depend on factors such as the off-taker’s financial standing and its ability to fulfil its contractual obligations as a function of dynamic market conditions. The investor should consider the off-taker’s contractual terms, the off-taker/direct seller’s default risk, and expected market prices.
Price risk is often mitigated by a supportive regulatory framework or long-term contracts. But volume risk is what really drives income. For example, the amount of energy a wind farm creates is determined by the weather conditions at a site. Extreme wind speed, gusts and wake losses can lead to high revenue volatility and lower average energy production. Energy yields might be further limited by technical availability that is lower than expected (this is often guaranteed by turbine suppliers at 95-97%), as well as electrical and grid losses.
When securing land and property for the project, most managers use lease contracts with periodic and fixed rental charges over the project’s life. Investors should evaluate these costs, compare them with similar contracts, and create an estimate for the market rate. This is especially important if there is a negative tail between the lease term and the life of the fund, which may occur if the lease needs to be renegotiated before the fund winds down. The direct seller’s fee is another factor in the investment decision and is a variable cost that is normally linked to the volume of electricity sold. If a direct seller defaults, the seller’s replacement may ask for a higher fee, which will add to the revenue already lost.
In many renewable-energy projects, the supplier of a plant will offer a long-term, fixed-price operation and maintenance (O&M) contract, resulting in high cost visibility. When analysing contract price, it should be benchmarked to an estimate of current market rates, risk of default, and the incentive structure of the O&M provider. This is especially relevant if the O&M contract expires before the project ends. In the example of offshore wind farms, O&M expenses can be much higher because on-site remedial action and regular inspections need dedicated teams and suitable vessels, and may be complicated by extreme weather conditions.
When a project ends, the plant has to be dismantled and the land restored to its original condition. This incurs costs, which can be material and must be taken into account by the investor. The project might still also have value at this stage. This might include additional cash inflows from the plant’s remaining useful life after the guaranteed feed-in period, or the real option to re-power the project. Potential late-stage value typically depends on land lease terms, such as renewal options and whether permits are still valid. However, the long life of a project should provide sufficient reliable evidence to include any estimate of late-stage inflows, which may include purchase commitments or a residual value guarantee by a financial institution.
Aaron Konrad is an analyst at Scope Ratings