The renewable energy sector has been gaining the attention of the investment community in recent years. Following the trend, players both big and small are investing in renewable energy by buying stakes in existing companies or by starting their own businesses in the sector. According to a recent report by Private Equity International (‘The 2016 Investing in Energy Special’), funds are picking renewable energy investments because the sector is less crowded than the commodity market and exhibits less correlation with macro events.
Why Is Investing in Renewable Energy Unattractive?
Renewables are attractive investments for private equity (PE) funds when it comes to emerging markets, who areleading the industry’s trends. Recent economic developments have pushed down the costs in developing economies where, at the same time, demand has skyrocketed. Renewables also provide sustainable and long-term returns.
However, when looking at the worldwide scenario, fewer players than expected are jumping in. So why is there no big rush for it? The answer is a complex combination of the economic system, transition costs and current technologies.
First of all, of course, the economic system still relies on fossil fuels – which, according to recent estimates, supply more than 80% of global energy needs while renewables only account for 2%. Second, the transition costs would be enormous. The International Energy Agency (IEA) projected that an increase of 5% in the renewables supply would cost $7.8trn.
Third, current technologies for storing renewable energy are not as efficient as those used for fossil fuels. Many energy companies are thus reluctant to switch, and many investment funds are not investing in renewable energy because inefficient storage directly shrinks profit margins and increases expenses, making them unwilling to do so.
It is interesting to understand the financing needs and strategies in the sector. Renewable energy companies can combine different sources of debt, which usually makes up most of the total investment. Usually, two targets for debt funding are distinguished: the project and the company.
In a 2016 report by FS-UNEP Collaborating Centre for Climate & Sustainable Energy Finance, it is claimed that projects are often financed with bonds, leasing, or in the form of non-recourse loans. Non-recourse debt provides a collateral – usually a property or a tangible asset – that can be claimed by the lender in case of the borrower defaulting.
In this way, the borrower is not personally liable for the loan. Hence, given the limited liability component and the fact that the collateral value drops in the default scenario, it is common for the lender to charge a premium or to ask for greater involvement in the project’s decision-making. Major providers of project-level debt are commercial banks that have recently focused on wind farms and solar parks.
Energy companies are can also issue corporate bonds. The variability in the bond rating is high and depends on many factors. If the business is at a mature stage and its stream of cash flows is positive and relatively stable, then the company will pay lower interests on debt. The location of the power plants can also change the required return by lenders, depending if they are in emerging markets or developed economies.
The stability of the regulatory environment and the level of public incentives can also play a crucial role. In general, national and multilateral development banks are the major players in the debt market for renewable energy companies.
The abovementioned report also outlines the role of external capital providers. Private equity and infrastructure funds provide equity in the sector. Usually, these players avoid development and construction risk. They enter the business right after the early stage: when the company has set up the business, found the best geographical locations for the power plants, complied with relevant regulations and obtained the operating license.
Building Value in the Sector
Private Equity International interviewed in 2016 Mikael Karlsson, Actis partner and co-head of energy, about the steps to a successful private equity strategy in the sector. He claimed that, once a private equity fund acquires equity stakes in an energy company, it plays a key role in its future objectives, management and operational decisions.
Funds want to build scale to make the assets attractive for acquirers during the exit strategies. Also, a solid management team with high expertise in the segment is crucial. In emerging markets, for example, the company can’t outsource to experts to the same extent as in developed economies, so everything has to be done more or less in-house. The best alternative applied is usually hiring locally whenever possible, in order to bring on board additional experience of the local market.
Without a doubt, renewable energy has built up a great momentum in recent years, with private equity and technology leading the development of the market. However, they appear to be accessible only to very experienced investors. As awareness rises, new investment vehicles ought to emerge in order to allow capital inflows from smaller and less sophisticated investors.
Finally, with the USA and Canada strongly incentivising investments in the oil and gas sector, Europe can seize a strong competitive position in the market for renewables. This can only happen with incentives at the EU level for investing in renewable energy, together with a comprehensive economic policy, effective and stable regulations.