How To Structure The Investment Process

Published Date: 02 Nov 2017

Appropriate structuring is a critical part of the investment process. Clean energy has many advantages over other sources of energy, but have potential traps associated with them. Studies have shown a vast majority of larger renewable energy projects in the US continue to stall despite having a renewable portfolio standard (Sovacool & Cooper, 2006). The authors argue that the key constraints are a lack of political, financial, and social commitment.

A thorough evaluation of an investment opportunity needs to be undertaken. Ubaja (1996) conducted a study that investigated the role of project finance in renewable energy projects. This article looked at structuring the investment process towards financing this project for renewable energy, to ensure its success. According to Ubaja, investors and sponsors need to be able to predict and understand the potential risks, seek ways to mitigate them, and communicate this effectively.

The paper mentioned the high level of perceived risks involved, and how these can be reduced in the long term. This, he explains can be done with proper risk mitigation techniques, which may result in the success of more renewable energy power projects. The article outlines details of the various financing options available in overcoming these obstacles, and bringing these types of projects into reality. It demonstrated how capital can be obtained for project financing through a combination of debt and equity investment, debt being available through bank loans, institutional debt or through public markets. The paper mentioned the possibility of procuring equity from internal or external sources in public and private markets, and sponsorship through developers, contractors, equipment suppliers, operators, off-takers and fuel suppliers, who are active equity investors.

The factors limiting project finance of renewable energy power projects (REPP’s) were examined. The author indicated that resource and technology risks were high and that financial institutions lacked the experience in evaluating risks related to REPP’s. The author also noted that with the rapid change in technology and the shortage of REPP technology engineers, they would have lacked the technical expertise in this area to assess and monitor REPP’s. Other factors mentioned were:

REPP’s were smaller than traditional power plants and lenders were not really enthusiastic about small transactions;

REPP’s are for the most part capital intensive and would require a lot more upfront investment than competing traditional power plants with lower capital costs, thus their power prices are often more expensive.

Less cash flow is generated from renewable energy sources (RES) in comparison to fossil fuel fired plants, as they can only operate when their resources are available. This therefore results in a smaller margin for project financing and consequently puts pressure on costs related to maintenance and overheads.

The author also pointed out that government policies, which are often unpredictable, greatly affect the economies of REPP’s.

The paper gave focus to the importance of equity, seeing it as the main protection against risks. Lenders will therefore favor equity contributions in the initial part of the project. Lenders see equity investment as a form of commitment by the developers and sponsors. The author also found that security was another significant consideration for the lender, so they would implement safeguards such as a fixed charge over the projects site; a floating charge over the assets of the projects company; requiring that all cash flow be paid into a project account where they would have control, and contingency funds in place for unforeseen problems. The experience and credit worthiness of all participants would also be considered by the lender. There financial strengths would be assessed and the ability of these parties to carry out their contractual obligations with the project company would be determined.

The article highlighted a number of risks that should be considered. The risk areas include the project itself, technology, construction, fuel/resource, the market, regulatory risks, mitigation and pass through. Project risks affect the amount, timing and availability of funds for the project finance. For technology lenders want to ensure that it is tested and proven, and that it will not be obsolete anytime soon. In relation to the construction risks the paper looked at the probability of cost overruns and delays in completion; most importantly the risk that the project is never completed, and the revenue is never generated to repay the loan. The intermittent nature of RES was looked at as a main reason for its risk. Market risks involved the fact that sufficient revenue may not be earned by the project company to service its debt. Policy stability would be essential when looking at regulatory risks.

In concluding the author suggests that in financing REPP’s the transaction costs associated with it can be reduced by bundling together smaller projects that are similar and meet particular financial criteria, therefore reducing financial costs.

The authors of this article states that despite a renewable portfolio standard a vast majority of larger renewable energy projects in the US continue to stall for lack of political, financial, and social commitment.

What are the strengths and weaknesses of a project in regard to renewable energy projects?

The factors affecting the uptake of clean energy have been studied by Demirbras in Global Renewable Energy Resources (Demirbras, 2006). The key advantage of renewable energy is the reduction of harmful environmental impacts. The MENA countries have the potential to use energy sources with zero, or almost zero emissions of both air pollutants and greenhouse gases, this reduces the environmental impact. In addition, deating and cooling costs can be reduced by as much as 70% (Demirbras, 2006) author emphasized that renewable energies have been the primary energy source in the history of the human race. The share of the renewable energy sources is expected to increase very significantly as people become more environmentally aware. Currently, renewable energies contribute only about 2 percent of the world primary energy use.

Geothermal energy together with wind and biomass are commercially competitive and are making relatively fast progress (Demirbras, 2006). US environmental protection agency (EPA) states the geothermal systems are "the most energy efficient, environmentally clean and cost effective space conditioning systems available (EPA, 1999)"

Important and detailed information were provided on the various RES in Demirbras’ paper. Demirbras reviewed biomass, wind, hydro-power, solar and geothermal energy. In the paper it stated that geothermal is used for urban heating, power generation, hydrothermal and hot dry rock. In 2000, geothermal resources were present in 80 countries and there are quantified records of geothermal utilization in 58 countries. It is clean, cheap and renewable; direct applications of geothermal energy is wide and includes end uses such as space heating and cooling, domestic hot water supply, carbon dioxide and dry ice production process, heat pumps, industrial processes, fish farming greenhouse heating, swimming and therapeutic baths, and electricity generation. It was noted that straight forward engineering and existing technology are mostly used.

A study by Bharat Book Bureau (2011), explored the strengths and weaknesses of renewable energy projects. The authors indicated that the growth of solar power technologies is restricted because the solar PV panel is comparatively expensive. That conclusion is supported by evidence presented in Ubajaka’s study (2006), which also notes that solar can only be supplied when nature permits.

The Bharat Book Bureau study also concludes that the growth of solar power technologies is restricted because the solar PV panel is comparatively expensive; the cost of electricity generation through solar panels increases as large arrays of solar panels are needed to provide a sufficient level of electricity; the number of insulation areas are limited as only approximately 53% of the Earth’s surface is ideal for solar power. Additionally, the operating life of CSP technologies is short compared to solar PV and this is expected to be the key factor inhibiting its growth. In their review, Heiman & Solomon (2004) concluded that renewable energy generation including solar and geothermal must overcome obstacles such as price distortions, discriminatory transmission system access, lack of storage capacity, and the end of linked utility rate hikes guaranteed to take care of the added expense of renewable generation, under the restructuring of the electric utility market.

A number of studies have identified other significant drawbacks [1] . For example, geothermal projects are capital intensive, and they also require deep wells to tap steam and hot water to power turbines. The process can become even more difficult when stumbling blocks like government red tape are added. The Philippines, which is currently the second-largest geothermal energy producer behind the United States, is home to many active volcanoes that cause high acidity and therefore corrode pipes. This problem has become the country’s biggest obstacle in developing reserves. The investment required is large and in addition to that it takes nearly 8 years for a geothermal plant to be fully operational. Furthermore there are plant and drilling costs as well as additional expenses such as building access roads in treacherous terrain.

Future Demand

At present, the current markets for renewable energy technologies range from "specialized niche markets, where the technologies are already cost-effective, to centralized energy production" [2] MENA Geothermal states there are a number of factors that are driving the demand for renewable energy. The most common ones are the rapidly increasing energy demands and decreasing worldwide energy supply. According to Fulton (0there are emerging markets Australia, The Middle East and South East Asia.)

Renewable energy is therefore essential to the success of sustainable urban development. In Global Renewable Energy Resources, Demirbras (2006) expressed the view that energy sources will play an important role in the world’s future. The writer broke down the energy sources into three categories, namely fossil fuels, renewable sources and nuclear sources. He noted that renewables are the primary, domestic and clean or inexhaustible energy sources and they supply 14% of the world’s energy sources. He stated that RES that use domestic resources have the potential to use energy sources with zero, or almost zero emissions of both air pollutants and greenhouse gases, this reduces the environmental impact. This is in comparison to fossil fuel energy that they would replace. RES should never run out as it occurs naturally. In the document it was pointed out that renewable energy sources is expected to increase very significantly to between 30 to 80% in 2100.

In this paper the writer explained that while there is a limited number of RES, there are a large number of technologies allowing the exploitation of these resources, most of which are still at the Research and Development stage or have not yet reached commercial maturity.

The direct use of geothermal energy through its technology, reliability, economics, and environmental acceptability has been demonstrated throughout the world. Geothermal steam is used to produce electricity in 21 countries spread over all continents. Also mentioned is that low temperature geothermal energy is exploited in many countries to generate heat, and with estimated capacity of about 10,000 MW thermal. World’s top country using geothermal energy are China, Japan, USA, Iceland, Turkey, New Zealand, Georgia, Russia, France, Sweden, Hungary, Mexico, Italy, Romania, and Switzerland, from a high of 2282 MW to a low of 547 MW power installation, and production from a high of 10531 GWh/a to a low of 663 GWh/a respective for these countries.

For solar power the energy comes from processes called solar heating (SH), solar home heating (SHH), solar dryer (SD), solar cooker (SC), solar water heating (SWH), solar voltaic (SPV: converting sunlight directly into electricity), and solar thermal electric power (STEP: the concentration of the sun’s power to heat water and produce steam, which is used to produce electricity), as defined in the paper. It is described as the most direct renewable energy source.

It further stated that solar dryers are used for drying fruits and spices. Box type, cabinet type and tunnel type are the three most popular types of solar dryers. Box type uses direct heat for dehydration, while air heated by the collector, and dehydrates the food in the cabinet type dryers. The tunnel type dryers yield a high level of dried products, but they are very bulky and costly compared to the box type dryers.

The writer also stated that photovoltaic systems, except SHH systems are used for communication, water pumping for drinking, electricity generation and irrigation. PV markets have seen rapid growth and costs have fallen dramatically, similarly wind power markets. The total installed capacities of such systems are

Approximately 1000Kw. Together with grid-connected wind energy, solar PV installed capacities are growing at a rate of 30 percent per year.

Studies have shown that renewables are typically more expensive than traditional generation [3] . Investors may be able to invest this amount on the condition that there are sufficient orders and extensive guarantees of performance are in place (Ubajaka, 2006).

There is a difference of opinion as to what the best strategy to promote solar is and geothermal energy. Sovacool & Cooper (2006) quoted Kerry W. Bowers as stating during a Senate meeting in 2005 that: "a renewable portfolio standard (RPS) would require us to use more costly renewable resources, increasing costs to our customers.’ The article also quotes Claudia J. Banner, the Senior Engineer Renewable Energy Planning at American Electric Power as stating that: ‘‘utilities are usually not receptive to mandated‘‘. She cited an increase in generation costs that could get passed back to the consumer, resulting in larger utility bills.

What are the forces that determine the renewable energy for emerging markets?

Sovacool & Cooper (2006) indicate the government of the US Mandates that suppliers’ provide a certain percentage of their electricity from renewable resources by a particular date. While no federal legislation requires the deployment of renewable energy, 22 states have passed their own RPS, launching an estimated $475 million in energy projects. The most aggressive are California, which requires that 33 percent of its electricity come from renewable energy sources by 2020; New York, which mandates 25 percent by 2013; and Nevada, which seeks 20 percent by 2015

In the paper, Geothermal Energy Emerging in Australia, the author indicates that new projects are fundamental and in order to reach the target of 20 percent of the total energy supply from renewable energy sources by 2020, geothermal energy is of importance. Currently, only 8.2 percent of the energy in Australia is harnessed through renewable energy.

How can renewable energy projects position itself in such a difficult market?

Solar International Management, Inc.

In order for projects to properly position it policies need to be put in place to address the financial attractiveness of such projects [4] . In order to make standard loans lenders seek to be repaid from three sources: (1) the borrows willingness and ability to pay as reflected in the borrowers cash flow and character; (2) the collateral value of the solar system; and (3) guarantees from third parties.

The writer further states that this mentality of the lender can be used to form a useful structure for planning and evaluating policies aimed at improving the ability and willingness of the borrower to repay which would involve reducing the cost of the R&D component of solar systems. In improving the collateral value of solar systems, the system needs to be physically recoverable and there must be a secondary market for used equipment. Possible policy options to create collateral value include: component and system standards, warranties, insurance, creation of a secondary market for used equipment, and other mechanisms that can be used to enhance the collateral. Third party guarantees is a source of repayment in case the borrower defaults and the collateral is not worth the value of the loan amount remaining. Policies that serve to enhance the "guarantee" mechanism for solar energy include the extension of existing loan guarantee programs to now encompass solar energy explicitly.

The writer also indicates that in order to improve the profitability of solar energy loans incentives need to be created for the lenders as a form of encouragement to grant loans for solar energy purposes. The real basis for doing so is because the lenders bear the most of the risks associated with solar energy systems. Policies include loan guarantees, interest rate subsidies, secondary markets for solar loans, and other programs which focus mainly on reducing risks.

Are there any market niches such as solar power and geothermal energy?

The current markets for renewable energy technologies range from "specialized niche markets, where the technologies are already cost-effective, to centralized energy production" [5] 

Solar Power Niches

The writer states that several niches exist in the Green Technology Industry. Creating a niche in an industry segment does not necessarily involve as large capital investment and only careful consideration is required. Furthermore, the Consumer Power Technology business may include five separate niches. They may include a Consumer Solar Power Company that provides installation services to the customer; a Solar Collector Manufacturing Company which manufacturers the solar optical energy lights tubes; a Photo-Electrical Converter Manufacturing Company "which adopts off-the-shelf photovoltaic cells in configuring compact application-specific design;" a Light-Tubes Manufacturing Company which manufacture Light-Tubes for the movement of light from the collector to the point where it is to be used.; the Electric Supplies Manufacturing Company which designs the power supplies system that processes the direct current from the Pho-Electrical Converter in alternating current that is suitable for the home.

According to the writer the entity driving the process here as well as assuming the task of creating a niche is the Consumer Solar Power Company. The consumer would first deal with the Consumer Solar Power Company as it is the company that assumes the task of developing the power technology and the market. This company for the most part is undertaking the task of forming a prospective vendor team. The writer also states that in consistency with the general guidelines for positioning in any particular niche of the green business, the company carrying out the particular venture should preferably already be in the consumer market and therefore will more likely have an established customer base for market development through leveraging. The task of niching as suggested by the writer is to ‘Stick to Niche’. However, the writer points out that even then a comprehensive analysis of the venture should be undertaken.

Identify the feasibility of an investment strategy in both regions.

According to the author geothermal projects are feasible in places like the Philippines and Indonesia (which is located South East Asia) as they foresee a "looming energy crisis facing their power hungry developing economies [6] . The author indicates that both countries lie in the largest reservoir of geothermal power: an area that is rich in volcanoes and which is called the Pacific Ring of Fire.

A large solar power project is currently taking place in Abu Dhabi. This area is suitable for solar power because the Middle East consists of mainly desert and so there is enough room to place the equipments necessary for solar power without harming plants. The government of Abu Dhabi is currently working with several major companies in Europe to set up solar panels in approximately 62,000 homes in the country.

What is the most suitable investment strategy for such projects?

It is suggested that a mixture of debt and equity could be used [7] . Additionally, sponsorship through developers, contractors, equipment suppliers, operators, off-takers and fuel suppliers who are active equity investors was another possibility. Further, the writer suggests a bundling together of smaller projects.

It is also states that venture capital can be used as a form of finance [8] . Venture capital is normally high risk and high return. Venture capitalists normally look for returns in excess of 25% and they accept that a certain number of projects will fail. They normally have a long term focus. The writer further stated that venture capitalists normally take an active role by participating in the management of the business. They aim to help with the business strategy.

RE Financing: Risks and Barriers

From the perspective of an investor "risk" can be defined as the potential for unexpected events to occur or for unexpected events not to occur, either of which can affect project returns and / or fluctuations in revenue. Where returns or profitability of an investment are lowered, investors require a risk premium, or compensation for undertaking the risk of the realized revenue becoming smaller than expected.

Other factors which are not unexpected but can negatively impact on project returns in this context are known as barriers.

The objective of analyzing risks and barriers is to define major risks or barriers associated with projects involving various RETs. Because risks are widespread and the assessment of risks is normally project specific, taking a general risk approach can only be an indication of which main risks and barriers have to be assessed for the RETs being specifically considered.

Thus, each investment in a particular RET project demands necessarily a risk assessment and this includes the concrete facts and data of the project, e.g. legal, administrative, political, economic and technical preconditions. Above all the influence of the location is central to any risk assessment as several RETs are directly connected with natural resources such as wind, solar radiation or geothermal energy where resource availability can be more or less dependable.

As part of our analysis we have identified a few of the critical project issues and undertaken more detailed analysis. This analysis includes project risks, political/institutional risk, and business risk.

Project Risks

Project risks can be described as likely future occurrences that will adversely affect the project's objectives or goals. They are adverse factors that have the potential to influence process or operation, technology (failures, defects, etc), schedule of a project, and costs (investment, maintenance, operating, etc).

Conventional fossil fuel energy projects generally employ mature technologies that have been proven through years of successful commercial application. Conversely, RET projects often employ recent technologies that risk-averse insurers and financiers penalize with prohibitive premiums and terms.

Resource Risks, Technology Risks and Operational Risks

Resource Risks

All RETs use, directly or indirectly, natural resources that have very different characteristics. Depending on their origin there can be considerable fluctuations in supply, cost of supply, properties, etc. On one hand resources such as sun or wind can be influenced strongly by climatic conditions, on the other hand the properties of, for example, deep geothermal water can only be evaluated during the first pump trials after the first drilling, which requires a considerable investment.

Technology Risks

Technical risks comprise all technology risks of the implemented RET, in particular the main components, maintenance and repair, failure of power generation components or other technology components. As RETs are generally young technologies questions concerning the reliability of the technology over the long term (e.g. geothermal power plants with operation time of more than 50 years) and the availability of spare parts are also crucial.

Operational Risks

The operational risks describe risks or barriers that can have an effect on the complete plant operation, e.g. security of operation, availability, expenditures for maintenance and repair, availability, etc. Operational risks are those risks which occur post installation, testing and commissioning and include breakeven analysis or the development of costs over the long term.

Geothermal

The three main risks for a geothermal project are:

Problems with pumps. As they can be considered the main component (if there is no power generating installation planned), the efficient functioning of the pumps is fundamental for a successful project.

Lack of long-term (>20 years) experience of the technology for (low enthalpy) power generation using Kalina or ORC process.

Uncertainty about the quantity and temperature of geothermal resource is not known 100% before finishing the first drilling. Risk C can be minimized, but not eliminated, if sufficient time is spent with specialists during the pre-planning of the project. The quality of the expertise is of critical importance and experienced partners have to be involved to evaluate the adequacy of the project location.

Large Scale Photovoltaic

Photovoltaic installations are special within the group of RETs. The main application of PV-installations is "island" or stand-alone systems. Larger installations can reach 150 kWp, but typical installations are between 1-5 kWp. As meteorological data is usually analysed before the location is chosen and an investment is realized, there is remote resource risk. Default risk accepted, the technical and operational risks are limited for the operating company (or owner), as the panel manufacturer typically provides a guarantee of up to 25 years. Other technical parts (like a.c. converters) are not critical and can be substituted easily. The oldest panels (more than 20 years) do show a decline in efficiency, but results of the Technical University of Berlin demonstrate that the decline of efficiency of modern modules is acceptable.

Solar Thermal (Concentrating Solar Power Technologies)

The risks connected with CSP technology are relatively low. The pilot project "SEGS" by KJC in California, which began in 1984, demonstrates the potential and reliability of CSP systems over the long term. For stable climatic regions (regarding resource risk) the implementation of CSP systems is only concerned with the question of economic efficiency and therefore depends on the economic circumstances of the country, where an installation is planned. The technological risks are low, as the electricity generating components are standard and therefore can be substituted without difficulty. The availability reaches the factors of conventional power generation (98%) and therefore the operational risks can be disregarded.

Lead Time Risks

An investment project can be divided into several phases: 1. the planning phase, 2. the construction and commissioning phase, 3. the production phase, and 4. the decommissioning phase. Revenue is generated only in the production phase. The first two phases don’t generate revenue; on the contrary they bring about many costs and uncertainties. These costs and uncertainties have to be taken into account in the evaluation of the investment by the investor. More or less time can pass between the investor’s first moves about a project and the start of the production phase. The investors have many different steps to undertake between the moment they become interested in a site and the moment their production unit is finally generating and bringing in the first flow of money. In order to evaluate their investment correctly, they need to be able to estimate the time and costs the first two phases take. This can be done quite easily regarding the construction and commissioning phase. The time required for construction depends on factors that do not vary a lot: the availability of material, and of technical staff. There is little uncertainty. On the contrary, evaluating the costs and length of the planning phase is much more difficult.

An aspect that is often overlooked, but was brought into focus with the Brent Spar incident is decommissioning. For most RE this should not be a major problem, but their remote locations and the possibility of contaminated substance leakage need to be factored in to the equation.

Political / Institutional Risks

Regulatory Risks

One of the greatest concerns and certainly a major barrier to investment in RET arises from regulatory risk of government policy changes in the energy sector. This relates particularly to RET markets supported by specific government policies aimed at encouraging the deployment of renewable energy.

The fundamental concern relates to the fact that any investment made under a policy regime is exposed to the numerous reviews and potential changes which may take place between the time the investment is made and the time at which invested capital is fully repaid from project cash flows. The regulatory uncertainty makes financing difficult and in some cases impossible.

Whilst 10 years of regulatory certainty is probably sufficient for RETs such as onshore wind, for RETs that are more marginal in economic terms and have longer planning and financing horizons, such as offshore wind, there is a need for 15 years or more of price certainty for financing purposes.

Political Risks

Financial institutions engaged in cross-border lending are often hindered in pursuing similar transactions by limit restrictions to country exposure mandated by regulatory agencies or internal bank guidelines. In addition, international events affecting the repayment of underlying loans can occur without warning, leading to potential losses in the portfolio and negatively impacting the profitability of a lender’s portfolio of assets.

While most host governments seek to attract foreign capital and promote foreign investments in their countries, the world of politics is a constantly changing environment. We have yet to hear any analyst accurately predict government policy in non-OECD countries over the medium to long-term, which makes the underlying financing of most overseas projects and transactions exposed to unforeseeable political risks.

Business Risks

Counterparty Credit Risks

Even when a project is large enough and theoretically profitable enough to attract the interest of banks and insurers, the actual or perceived credit risk posed by the project’s host country or developer can often kill a deal. Furthermore, due to the fact that suppliers and consumer groups are also often "small", this can increase the perceived credit risk, and also deprives the financier of ECA support. As a result, credit enhancement is widely believed to be one of the most effective uses of public funds made available to support private financing of clean and renewable energy infrastructure projects.

Scale and Returns

Generally speaking, compared with conventional fossil fuel power generation plants, RET projects are of significantly smaller scale in terms of physical size as well as financial returns. RET projects are usually unattractive prospects for commercial lenders and insurers because the administrative costs associated with risk assessments, loan processing and insurance for such projects are high and the returns are low.

Attracting the financial interest of international lenders and insurers generally requires a minimum project size of €10 million, particularly when the project location is a developing country. Time and again, the small scale of a potential project has prevented an otherwise viable deal from attracting sufficient private financial interest to become a reality and this is particularly the case when shareholder-driven financial institutions are involved. The tight commercial lending and insurance markets of the last few years have exacerbated the situation. Even in the EU, viable but small-scale biomass (mature technology) projects with power off-take agreements and solid fuel supply contracts in place struggle to attract the attention of insurers and financiers. Theoretically, it is possible to "bundle" small projects together to create a package that is large enough to achieve critical mass. In practice, however, there is little evidence of this happening.

High Relative Transaction Costs

The aim of this section on transaction costs is to give an overview of potential cost drivers and to create awareness of their importance. Investors may want to use the given framework to structure several sources of transaction costs and include them in their economic analysis of an investment project.

In general, transaction costs are the costs that arise from initiating and completing transactions, such as finding partners, negotiating, consulting with lawyers and other experts, monitoring agreements, etc., or opportunity costs, like lost time and resources. The most obvious impact of transaction costs is that they raise the costs for the participants of the transaction, i.e. the investors, and thereby lower the expected profits or even discourage some transactions from occurring.

In addition to their relative small size, RET projects suffer high relative transaction costs because they often involve newer technologies and less experienced sponsors. As a result, these projects are more time-intensive and difficult to execute than conventional energy projects.

Another key barrier is the time-profile of risk, which is quite different to conventional fossil fuel. The costs are 90% up-front, since the energy source is generally free, but there is a strong element of pre-installation expense and then the power plant is the main item. Therefore revenues materialize much later than in a fossil fuel powered plant. This is unsettling for many financiers.

Risks Associated With Medium Scale RE Projects

Medium scale RE projects can be grid connected, isolated mini-grid projects for rural electrification, or captive projects for industry. When comparing medium and large scale projects, the characteristics/nature of risks associated with regulatory, market and legal aspects are significantly different. However, with respect to risks that can be mitigated through FRM instruments (see next chapter), such as completion risk, performance risk, financial risk, political risk and Force Majeure risk, it is observed that the risks and associated mitigation approaches are similar to those under large scale projects. The difference is only with respect to the magnitude of the respective risks.

These projects are typically funded through the corporate finance route, where a significant portion of the project risk is assumed by the project sponsor, thereby making the credit worthiness of the project sponsor critical. Given a strong project sponsor, financing can be executed quickly with lower associated transaction costs. However, where such projects are for rural electrification, financing becomes a challenge primarily because the project sponsors are small and unknown, have a limited track record, or suffer from weak financial positions.

Risk Associated With Small Scale RE Projects

Small scale standalone systems often find application in rural and semi-urban areas, where people have limited or no access to energy. The risks associated with such projects are significantly different from large and medium scale projects. Project developers here are equipment dealers or system integrators. The major barriers they face are in terms of raising start-up capital, raising working capital loans, and limited end consumer financing for their products.

Development Risk (Credit Risk) – Small scale project developers are relatively unknown and have limited track records as a result of which financial institutions are reluctant to lend either towards capital investment or towards meeting working capital requirements. Even when they lend, they impose higher interest rates and significant collateral requirements. As discussed under medium scale projects, guarantee funds can play a role in making economically viable projects bankable. The need for start-up capital can also be met through sources that provide grants or patient capital.

Market Risk – RE entrepreneurs and innovators require substantially large investments upfront to generate awareness of their products and to establish elaborate and effective servicing networks (that are a key requirement for their business). Most project developers require significant time and effort to generate awareness and associated benefits for their products. Moreover, they have to use their own resources for such activities with limited support from intermediaries and government organizations. Another challenge is that there is no "first mover" advantage for these entrepreneurs. Late entrants can ride on the efforts of the first movers and still grab a fair share of the market. There is also a challenge associated with affordability of these systems by the end users. Developers have to tie up with consumer finance or micro-finance institutions to develop innovative financing solutions to address this issue.

Regulatory Risk – There is a lack of clear direction and policies for investment in this segment. Further, the markets are mainly driven by subsidies which may not be sustainable in the long run. Some project developers have adopted successful nonsubsidized driven business models, but they face a continuous threat from developers operating on a subsidy-driven model.

Performance Risk – Systems supplied by small scale developers may not meet the required quality standards. Also, small scale developers may not provide adequate maintenance as a result of which these systems do not perform as required. There is also a risk associated with theft or damage to equipment during natural disasters. Micro-insurance has a role to play here, especially in cases where such systems are linked to income generation. Developers have also realized that poorly performing systems lead to credit default i.e. the end customer stops meeting his loan repayment obligations, if the system is no longer working. Thus, project developers that work closely with micro-finance institutions are bound to provide good quality systems and establish a strong network for maintaining the systems.

Credit Risk – Standard approaches to consumer financing cannot be applied in rural areas since most households have seasonal or variable incomes. Further, due to the size of the transaction being very small, high transaction costs result. While traditional financial institutions have a limited role to play here, entrepreneurs have tied up with micro-finance institutions, rural co-operative banks and self-help groups to develop innovative financing solutions. The results in these cases have been very encouraging, with the defaults rate being low in many countries.

Risks Associated With Developing Countries

A particular concern with regard to RE projects in developing countries is the ability of local society to absorb the relatively high level of technology inherent in RE. For examples the advances in Western wind power mean that monopoly are too large for the local infrastructure to manage and thus western-scale wind power cannot be easily deployed in many developing countries. This means that a considerable amount of "capacity-building" is needed in terms of education and training, to build acceptance, and then to ensure that the inevitable downtime etc is coped with. This type of barrier is not generally recognized by ECA’s.

RET projects are often intended for implementation in developing economies where there are a range of governance issues that deter foreign direct investment (FDI) and limit the availability of many currently available commercial risk management products. While low-cost, low-wage countries such as India and China are growth markets for FDI and associated risk mitigation products; there is little commercial incentive to develop such markets in other developing countries.

When asked what could help mobilize debt finance for clean infrastructure projects in emerging markets generally, most private lenders focus on credit issues. Several suggest that wider application of credit enhancement for local debt issues would be quite useful. However, some local financial institutions such as pension funds and life insurance companies can provide substantial local currency funding for asset-backed (infrastructure) debt investments insured through a multilateral / bilateral agency credit enhancement. In all cases, it is in the interest of both the project sponsor and provider of FDI to secure the interest of a local financial institution because the presence of such an investor can help to mitigate non-commercial risk. One new credit enhancement facility that has attracted interest from the World Bank is the Guarantee Facility for Sub-Saharan Africa or GaurantCo. This facility is intended for larger infrastructure projects but, if successful, could be adapted for smaller project finance deals as well.

In developing countries, the distinction between "non-commercial" and "commercial" risk is often blurred. This is a critical issue. If financial systems are weak (generally considered non-commercial risk) then they can certainly affect commercial risk. Payments that are not cleared or get lost in antiquated internal systems can affect a project’s cash flow badly enough to disrupt its operation. When the governments are the off-take buyers or regulators (e.g. utilities), their commercial behaviour (as distinct from their behaviour as political entities) can result in situations that make it difficult to distinguish whether a non-commercial or a commercial risk has materialized. This is problematic for both investors and insurers and is an area where public assistance and new thinking are needed if more/better FDI is to be attracted into "clean infrastructure" in developing countries.

The costs of managing everyday commercial risks in developing countries for foreign private sector investors are higher than in their own markets. This is due to the inadequacies of administrative systems, market supporting institutions, human and social capital constraints and lack of infrastructure. Foreign firms in developing countries might be expected to cover risks (and sub-risks) classified as financial and operational. But these ‘commercial’ risks cannot be expected to extend to the business environment itself. Except for certain risks such as renewable energy policy, regulatory and environmental, these risks do not arise in other locations. This point is important because of the distinction that private insurance companies and multilateral/bilateral insurers make between commercial and noncommercial risks when providing cover. A project sponsor who buys comprehensive non-commercial risk insurance (NCRI) is by no means comprehensively insured for any number of quasi-commercial reversals of fortune and business interruption caused by poor communications or hidden agendas in a developing country.

The Role of Financial Risk Management Instruments

The following section details the various Financial Risk Management Instruments that are available for addressing some of the risks identified above. The focus is only on Financial Risk Management instruments and any risks that cannot be addressed by them have not been elaborated upon in this section.

Financiers make lending and investment decisions based on their estimation of both the risks and returns of a project. In considering a project, a financier will usually prepare a risk/return profile, as is shown below. The analysis involves assessing each individual risk and the means to mitigate its potential impact on the project.

Assessing the returns involves verifying the cost and revenue projections and then comparing the financials of the project with the cost of financing to be used.

A lender will specifically focus on the ability of the borrower (or, in the case of project finance, the project) to make loan repayments. An equity investor, who shares in the upside of the project, will base his decision on an estimation of the risk-adjusted return of the project, which graphically (see smaller figure) means deciding whether the project falls above or below the investors risk/return yield curve. For on-grid RE the returns are usually easy to assess; it is the risks that can be difficult to assess or manage. When it comes to off-grid business models, a financier has difficulty understanding both the risks and the returns.

The Need for Risk Management Instruments

Continued support for RET projects and their future success is dependent upon the involvement of the financing community. As investors and lenders are averse to risks that can give rise to unexpected reductions in a firm’s or project’s cash flows, value, or earnings, the application of appropriate risk management instruments is essential.

Furthermore when considering the generally poor reputation renewable have with the financing community and the fact that they are often viewed as higher risk investments, this results in stiffer requirements (seen in the terms, conditions, structure and documentation required for such transactions) for investors and developers alike. Briefly, the risk management process can be described as the process by which an enterprise tries to ensure that the risks to which it is exposed are those risks to which the enterprise wants/needs to be and thinks it is exposed.

Notwithstanding the range of risks RET projects face, there are in reality only four possible responses that the parties involved in a RET project may adopt to deal with these risks. Risks may be:

Avoided

Mitigated

Retained or

Transferred

Within the risk management continuum the first two responses (avoidance and mitigation) may be categorised as risk control and the latter two (retention and transfer) as risk financing.

A company’s or project’s retention decision is the part of the risk management process that determines what risks (and how much) the enterprise should bear as a part of its normal business and what risks the enterprise should transfer to one or more market participants.

In general terms, the normal approach to risk management is to control all those risks that management feels it can control within the physical resources of the enterprise and finance the remainder.

Effectively, risk financing funds those losses that remain after the application of risk control techniques, including both those risks accepted as not being able to be controlled and those where controls proved inadequate to contain the risk.

There may be various risk management instruments that are available to support

RET projects.

POTENTIAL RISK MANAGEMENT INSTRUMENTS FOR RE PROJECTS IN DEVELOPING COUNTRIES

Approach to Identifying Potential FRM Instruments

A demand- supply approach was adopted to identify potential FRM instruments for RE projects in developing countries. In Stage I where the risks associated with RE projects were outlined, the probability of occurrence as well as the extent of impact was also documented based on experts’ opinion. Considering these factors together, it is possible to specify a priority of demand for FRM instruments for RE projects. It is to be noted that the rating below has been generalized based on the information gathered in the availability survey. Though the economies are in different stages

of development, an average has been taken to arrive at the high (H), medium (M) and low (L) ratings given below.

On the supply side, the typical parameters taken into account when evaluating the readiness of a market for introduction of a financial instrument are:

Financial Market Parameters

Depth of the market

Liquidity in the market

Stability of financial markets

Market efficiency

Capital movement across markets

Transparency

Investment grade debt rating

Institutional capacity

Insurance Market Parameters

Regulatory considerations

Institutional capacity

Economic Parameters

Free movement of financial assets

Convertibility

Legal Framework

Contract enforcement

Regulatory Framework

Extent of privatization

Transparent rules and policies

Ease of entry to foreign players

Table 1 indicates how developing countries measure against these parameters. On the basis of data collected through the availability surveys, the information is presented on a regional basis but it applies to developing countries in general. This was compared against the conditions required for introduction of instruments/class of instruments to arrive at the markets’ ability to make available certain FRM instruments or class of instruments.

Table 1: Evaluation of Key Market Characteristics in Developing Countries

Market Characteristic

Status in Developing Countries (H/M/L)

Asia

Africa

Latin

America

Aggregate

Financial Market Parameters

Dept of Market

M

L-M

M

M

Liquidity in the Market

M

L-M

H

M-H

Stability of Financial Market

M

L-M

M

L-M

Market Efficiency

L-M

L-M

M

L-M

Capital Movement Across Market

M

M

M

M

Transparency

M

M

M-H

L-M

Investment Grade Debt Rating

L-M

L-M

M

L

Institution Capacity

M

M

M

M

Insurance Market Parameters

Regulatory Considerations

L

M

M

L-M

Institutional Capacity

L-M

M

M-H

M

Economic Parameters

Free Movement of Financial Assets

M

L

L

L-M

Convertibility

L-M

L-M

M

L-M

Legal Framework

Contract Enforceability

L-M

M

L-M

L-M

Regulatory Framework

Extent of Privatization

M

L-M

M

L-M

Transparent Rules and Policies

L-M

L-M

L-M

L-M

Ease of Entry for Foreign Players

L-M

L-M

M

L-M

*H: High, M: Medium, L: Low

The demand for FRM instruments was matched with the ability of the market to support such instruments to identify a set of instruments with the highest potential for introduction in developing countries.

6.1 Priority of Demand for FRM Instruments

6.2 Large Scale RE Projects

Table 2 provides, in decreasing order of priority, the demand for FRM instruments in large scale RE projects. This analysis indicates that the maximum impact in terms of increasing investments in large scale RE projects can be achieved by introducing standard insurance covers for the construction and operations phase, using derivative products to address the credit risk, and extending MFI guarantee products to address the political risk.

Table 2: Demand for FRM Instruments in Large Scale RE Projects

Risk

Probability of Occurrence (H/M/L)

Level of Impact (H/M/L)

FRM Instruments

Political

M-H

H

Political Risk Insurance, Partial Risk Guarantee

Construction

M-H

H

Insurance – Construction All Risks, Erection All Risk, Delay in start-up

Credit

M-H

H

Multilateral Financial Institution Guarantees, Credit Derivatives

Force Majeure

L

H

Standard Insurance Covers, Catastrophe bonds

Performance

M-H

H

Surety Bonds

Fuel Supply

M

M-H

Weather Derivatives

Counterparty

M-H

M

Surety Bonds

Financial

M-H

M

Standard Derivative Products

6.3 Geothermal Projects

In the case of geothermal projects, the added risks faced are on account of resource development, which includes exploratory and drilling risks. Aside from pure public sector assistance, to date, the products used to address these risks are: contingent grants, partial risk guarantees and discovery risk insurance.

6.4 Carbon Financed Projects

In the case of carbon financed projects, there have been attempts to develop insurance products such as carbon delivery guarantee and permit delivery guarantee in order to mitigate the risk associated with non-delivery of carbon credits. However, given the early stage of product development, the level of impact is yet to be determined.

6.5 Small Scale RE Projects

Table 3 outlines the demand for FRM instruments in small scale RE projects. In the case of risks associated with project developers who require assistance in the project developmental stage, there is a need to bring in various instruments such as guarantee funds, partial credit guarantees and patient capital. In the case of risks associated with end-users, there is a demand for micro insurance, especially in cases where these systems are linked to productive use. Credit risk does not appear to be a major problem in some developing markets, but availability of financing is still

difficult and can be enabled through guarantees provided to local financial institutions in establishing credit lines.

Table 3: Demand for FRM Instruments in Small Scale RE Projects

Risk

Probability of Occurrence (H/M/L)

Level of Impact (H/M/L)

FRM Instruments

Project Developers

Development/

Credit

M-H

H

Guarantee Funds, Partial Credit Guarantee.

End-users

Physical risk including theft

M-H

H

Micro-insurance

Credit

L-M

M

Guarantees

6.5.1 Ability of the Market to Provide FRM Instruments

6.5.2 Large Scale RE Projects

Table 4 provides details of the market status that is required for introducing various FRM

instruments for large scale RE projects. Market based instruments such as standard insurance covers are already available in developing countries for other types of projects, and extending this to RE projects is technically not likely to be very difficult. Instruments from multi-lateral agencies, such as political risk insurance, and MFI guarantees are also available in developing countries for other types of projects and can be extended to RE projects. In the case of instruments such as credit derivatives, contingent capital, weather derivatives and catastrophe bonds, many markets in developing countries generally lack the capacity to absorb such complex products.

There are exceptions, such as South Africa and Chile, where the markets are well-developed, and products such as credit derivatives are already available, as indicated in the availability survey.

Table 4: Market Characteristics Required for Introduction of FRM Instruments for Large Scale RE Projects

FRM Instrument

Status of Market (H/M/L)

Market support introduction of Instrument (Y/N)

Financial

Insurance

Economic

Legal

Regulatory

Insurance – Standard Covers

M

H

H

M

M

Y

Political Risk Insurance

M

M

-

M

-

Y

MFI Guarantees

M

-

M

M

M

Y

The table below is a general overview of risks relevant to RE projects and the instruments that mitigate these risks.

Among those instruments, the survey indicated that secure contracts, equipment warranties, insurance products and various national government guarantees are the most utilized risk management instruments to facilitate the construction and operation of renewable energy projects in the focus countries. Naturally, the underlying business case for generating renewable energy (tariff structures, privatization) will determine RE investments in the first case. For example, South Africa has one of the lowest power tariffs in the world and the state utility Eskom dominates over 90% of the market.

Risk Allocation and Due Diligence

The financial community understands and perspective is driven by the answer to one central question: will the investors and lenders earn the return or receive the interest payments that they expect?

Senior and subordinated lenders, equity investors and investment bankers look at renewable energy projects in distinct ways.

Investment bankers expect to earn a fee, lenders to receive long-term and fixed payments and equity investors to earn a shorter-term payback and return. Each of the players in these deals must do its own due diligence -- or examination of the project before committing money to the project.

This may include a review and scrutiny of:

The business plan (including fatal flaw analysis)

Financial models showing how the project will incur expenses and generate revenue over its life including;

- Historical

- Assessment of sales projections, market/ off takers, input costs, competitors, substitutes

- Projected cash flows, margins, IRR, NPV for Project (and Sponsor)

- Sensitivity to changes in key assumptions

Fuel source and security of supply – e.g. wind resource assessments

Permits and environmental approval – required for project to begin construction and operation

Technology involved – reliability and operating history

Power Purchase Agreements

- Price per kilowatt hour of electricity/tenor of agreement

- Experience and reliability / creditworthiness of all parties involved

Schedule of project milestones for completion of various tasks

Security payments that the contract requires

Insurance provisions for any losses than can impact on revenue generation

Regulatory environment – possibility of changes to policy environment which can affect the economics of the project

Project sponsor financial interest in project

Other risk elements that can impact on the project’s ability to service its debt

This process of risk allocation and due diligence is important and expensive, requiring the financial community to have an excellent understanding of the technologies and markets with which it is dealing. Ultimately the investors and lenders attempt to strike a deal that allocates risks to the party best able to handle them, that provides ways to measure the project’s performance and that gives some monetary safeguards to protect investors and lenders.

The probability and severity of risks for infrastructure projects is assessed on a project-by-project basis. Perspectives will differ depending on who assesses the risk involved. Some risks can never be properly assessed or quantified. Once assessed, a risk never actually disappears – it is simply transferred (allocated) to somebody else’s balance sheet. Project sponsors and creditors usually focus on business and non-commercial risks.

Fund investors, creditors, guarantors and governments are often more concerned about operational and financial risks being taken by the project sponsor relative to its financial and management capability and operational track record. Sponsors and governments may be concerned about the financial risk aversion of creditors and their on-going commitment should the project run into difficulties during construction.

For the same project, the risk borne by each of the parties is different, especially in project finance. The first step to mitigating project risks in developing countries is to identify which party involved in a project is ‘best placed’ to take on a particular type of risk. Risks may also be allocated to parties whose actions influence the probability of a particular risk materialising. What represents unacceptable risk to one investor (say, the future value of carbon credits) may not be seen as a significant risk by another.

Project sponsors are normally expected to take on all the commercial risks. For large infrastructure projects in developing countries, governments (often backed by bilateral / multilateral agencies) need to partially or fully assume the risks that result from their own actions (or lack thereof) including policy, regulatory and country risks.

Risks concerning events that neither governments nor project sponsors can control need to be covered by insurance or other contracts/solutions from private sources depending on the insurance premium demanded relative to the risk. Where such insurance is unavailable or premiums are too expensive, then public assistance is required to mitigate risk. Along with subsidized insurance cover and credit enhancement vehicles, public funds can be usefully employed to securitize revenue streams using contingent capital. When a structure for risk sharing can be identified and agreed upon, each of the key risks involved can be allocated and priced under contractually binding arrangements.

Risks with Strongest Impact on Successful Development of the Project

As shown above the role of the financial risk management and the importance of identifying the risks in order to ascertain the impact they have on a project’s cash flow as renewable energy project financing can be an expensive undertaking. Moreover, debt for renewable energy projects is typically nonrecourse to the equity sponsors of the project, thus making it commensurately more risky and expensive.

Risk allocation is also essential for another reason, this process, in fact, is a vital prerequisite to the success of the initiative.

Marketing Strategy in MENA

This section has three main objectives. It begins by identifying potential customers to sell renewable energy to. The second objective is to review the marketing strategies. The final objective is to determine the role marketing can play on demand.

Customers

The customers of renewable energy can be divided into two main categories. These are: retail (business-to-consumer) and wholesale customers (business-to-business). According to research evidence, retail customers will purc