Emerging risks due to Covid-19 to restrict the project finance market for renewable energy development

GlobalData Energy 20 May 2020 (Last Updated May 19th, 2020 16:53)

Emerging risks due to Covid-19 to restrict the project finance market for renewable energy development

The ongoing Covid-19 crisis is disrupting everyday life and causing major economic uncertainty. Globally, countries are implementing measures to restrict the transmission of Covid-19. The effect of such measures is having significant implications of various sectors, including renewables. Until the outbreak, the renewables sector enjoyed rapid growth supported by technology advancements, market competition between developers and suppliers, robust supply chain, growing investor interests, and innovative business models, along with the global agenda to embrace low carbon power generation. At present, the sector is likely to face a lean period with stakeholders along the value chain, facing disruptions that threaten the sector’s growth trajectory. Renewable projects at various stages of development are exposed to the risks originating from the crisis induced by Covid-19. Projects are exposed to legal issues, logistics risks, personnel shortages, project development hurdles, and most importantly shortfalls in financing.

There are three types of finance instruments used by developers to fund renewable energy projects: debt, equity, as well as grants and subsidies. Debt is raised in the form of loans from banks, or by issuing bonds market. Equity is raised from shareholders in different domains, including venture capital, private equity funds, and public share capital markets. Grants and subsidies are typically provided by governments and public agencies to projects, in an effort to reduce the financial cost of renewable energy technology projects and enhance their competitiveness. Although there is strong government support for deploying renewables, private sector plays a crucial role in financing technology development across the value chain. According to a study conducted by UNEP, asset finance accounted for nearly 75% of the investment flow into renewables. Asset finance refers to using an owner’s balance sheet to procure loans or borrow money for project development. Within asset finance, there are different types of investors who provide capital based on their expected returns. Some of the prominent kinds are:

  • Debt investors are often the least exposed in terms of risk and therefore earn the lowest returns. These investors are wary of default risks on their investments and would require contractual arrangements, to protect them from delays or underperformance.
  • Balance sheet equity investors finance new projects from their own capital and take on most or all of the project risks. Balance sheet investors generally look at the internal rate of return (IRR) or the return on equity (ROE) of a project as a metric of profitability.
  • Project finance equity investors take an ownership stake in their projects, often along with other partners. In a project finance arrangement, equity investors take on the majority of project risks and are compensated with higher potential returns. They seek to maximise the risk-adjusted rate of return on their investment, which implies reducing the amount of risk involved in generating the expected returns.

Renewables have high upfront costs but over the project’s lifetime have comparatively low operations and maintenance costs. Associated risks and returns vary based over the development cycle of the project. Projects beginning construction carry the highest risks and once the project is commissioned, associated risks decline but do not diminish entirely. The money to cover upfront capital expenditure can be raised from the developer’s own balance sheet or from outside equity investors and banks but will depend on the investor’s confidence that the project will make adequate returns, which is known as bankability. To enhance a project’s bankability, developers seek to win contracts in futures auctions or sign power purchase agreements (PPAs) with commercial entities and utilities, with high creditworthiness, that assure lenders of a guaranteed cashflow once the project is commissioned. Apart from securing revenues, engineering, procurement, and construction (EPC) agreements also play a significant role in structuring a financial package for a given project. Under an EPC agreement, the contractor must deliver the project at guaranteed price by a guaranteed date and it must perform to the guaranteed level. EPC agreements should be comprehensively designed to effectively mitigate construction, price, and performance risks, all of which can have a detrimental impact on attracting investors.

In the current market environment, there is growing concern over Covid-19 and in the context of project financing, delays of construction or operations are emerging to have significant implications. Projects in the development or pre-construction phase that are seeking financing may face delays in closing deals. Lenders are wary of the current market volatility and could refrain from investing in the short term. Moreover, difficulty in assessing emerging risks would likely increase debt pricing in the short term to compensate for the additional uncertainties for a given project. The increase in debt pricing would not be an attractive proposition for developers seeking to commit to a long-term contract, as markets are expected to stabilise and consequently financing rates would drop. Projects under construction face market disruptions that have a direct impact on the development timelines of projects. Financing is made in tranches, which are executed once the project achieve certain development milestones. Therefore, developers are either liable for not adhering to development timelines or are forced to source equipments from other markets at higher prices and remain committed to development schedules. It is also likely existing deals will need to be refinanced at a cost for all the stakeholders involved to provide flexibility for developers to execute projects, while mitigating Covid-19 impact. Operational projects face a reduction in cashflows, which can consequently repayment dues. Financiers will need to assess the current market volatility to make projections that will further need to be agreed by all involved parties and could see loan tenures extend beyond the initial time period.

Moving forwards, other challenges are likely to emerge. Creditworthiness of several institutions are taking a hit, which has a direct impact on sourcing potential financing options. Investors or lenders seek security by dealing with creditworthy partners, in a market of high uncertainty or volatility. In the renewable energy space, this is expected to impact both on the seller side, with a preference to finance projects brought by developers with demonstrated track record and on the buyer side with preference for PPAs signed with credit worth off-takers. In addition, investors may seek additional risk-mitigating contract terms to protect their interests.

The emerging uncertainties in the market are expected to have significant impacts on project finance transactions for renewable energy development in the short term. Perception of high risks and volatility in the market are defining the mitigation measures being undertaken by stakeholders and this would serve as a template for structuring future financing deals. EPC agreements are witnessing the biggest impact, due to supply chain disruptions and restrictions imposed by governments. The current market poses a significant risk to projects in terms of time and cost overruns, project delivery, and profitability, which could escalate to project closures and affect investors of all classes. The long-term outlook remains positive, as institutions across the world are committed to renewable energy and the ongoing crisis could guide investors to manage their capital more effectively and remain resilient in unprecedented situations.