Financial Instruments & Support for Renewable Energy

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Overview

Finance is essential for renewable energy technology (RET) projects in two ways:

1. Without funds projects would not materialize, and
2. With inadequate financing structure and conditions the disadvantage in competitiveness of RET would even increase, as the costs of electric power utilizing renewable energy technologies are highly sensitive to financing terms.

Financial Instruments

There are various types of financing instruments that exist to support the scaling up of renewable energy technologies (RETs). The choice and availability of instruments largely depends on if the project is being undertaken in a developed or developing country, and also on the stage of development of the technologies or projects in question. These can be broadly grouped into those that can be used in addressing financing barriers; those used to address the risks of RET investments; and those that address both simultaneously.

These financial instruments can be distinguished by the level of risk assumed by the the entity funding the instrument concerned, and also by the level of leverage involved. The figure below illustrates this. The financial instruments in the figure are organised on the horizontal axis by their primary focus: whether to address underdeveloped financial markets, the risks and costs of RETs or both. The vertical axis organises the instruments by the level of risk and leverage associated with their use.

Source: The World Bank, 2013. Financing Renewable Energy - Options for Developing Financing Instruments Using Public Funds. [Online] Available at: https://www.climateinvestmentfunds.org/cif/sites/climateinvestmentfunds.org/files/SREP_financing_instruments_sk_clean2_FINAL_FOR_PRINTING.pdf

Most renewable energy (RE) financing instruments fall under three main categories:

1. Energy Market Instruments (Feed-in Tariffs, Premium, Renewable obligations, Tenders, Fiscal incentives);
2. Equity Finance Mechanisms (Venture Capital, Equity, R&D Grants, Capital/Project Grants, Contingent Grants);
3. Debt Finance Mechanisms (Mezzanine Debt, Senior Debt, Guarantees).

On-Grid Renewable Energy Finance

On-grid renewables projects face the key issue of how to create a price support mechanism that provides stability and predictability over the medium and long term. This can reduce the risk premium in the cost of capital, which in turn can increase the amount of investment in renewables and lower the price that consumers have to pay for RE. For on-grid projects the finance sequence is incomplete, and these gaps can often onl be filled with niche financial products. Some of theses products already exist, while some need to be created. The figure below shows which types of finance are often secured by on-grid projects, which types are occassionaly secured, and the current gaps and barriers in the finance sequence .

Various forms of capital are involved in the financial sequence/'continuum' of grid-connected RETs as shown in the figure below. The conventional power sector financial sequence includes these sources of capital:

• Equity Finacnce
• Corporate or Project Finance
• Guarantees
• Insurance
• Key parties to the transaction, such as fuel suppliers or power purchasers who have entered into long-term contracts with the project.

Source: Sonntag-O’Brien, V., Basel Agency for Sustainable Energy, Usher, E. & UN Environment Programme, 2004. Mobilising Finance for Renewable Energies - Thematic Background Paper, International Conference for Renewable Energies. Bonn, Renewables 2004.

Equity Finance

Renewable energy equity investments taking an ownership stake in a project, or company, involve investments by a range of financial investors including Private Equity Funds, Infrastructure Funds and Pension Funds, into companies or directly into projects or portfolios of assets.
Depending on the type of business, the stage of development of the technology, and degree of risk associated, different types of equity investors will engage e.g. Venture Capital will be focused on ‘early stage’ or ‘growth stage’ (depending on how far from the laboratory and commercial roll out) technology companies; ‘Private Equity’ Firms, which focus on later stage and more mature technology or projects, and generally expect to ‘exit’ their investment and make their returns in a 3 to 5 year timeframe; Infrastructure Funds, traditionally interested in lower risk infrastructure such as roads, rail, grid, waste facilities etc, which have a longer term investment horizon and so expect lower returns over this period; Institutional Investors such as Pension Funds have an even longer time horizon and larger amounts of money to invest, with lower risk appetite.
Funds use Internal Rate of Return (IRR, or ‘rate of return’) of each potential project as a key tool in reaching investment decisions. It is used to measure and compare the profitability of investments. Funds will generally have an expectation of what IRR they need to achieve, known as a hurdle rate. The IRR can be said to be the earnings from an investment, in the form of an annual rate of interest.

Features of Funds Providing Equity
Venture Capital Funds	Private Equity Funds	Infrastructure Funds	Pension Funds
Money raised from a wide range of sources with high risk appetite to include insurance companies, pension funds, mutual funds, high net worth individuals • Target new technology, new markets • Interested in early-stage companies • High risk of failure in every venture • Investment horizon around 4-7 years • Return requirement, many multiples of original investment (50 – 500% IRR)	Money raised from a wide range of sources with medium risk appetite to include institutional investors and high net worth individuals •Target opportunities with possibility for enhanced returns (or‘upside’) • Interested in companies and projects with more mature technology, including those preparing to raise capital on public stock exchanges (‘pre IPO’), demonstrator companies, or under-performing public companies. • Shorter investment horizon, 3-5 years • Higher return requirement, 25% IRR	Funds drawn from a range of institutional investors and pension funds • Target ‘infrastructure’ i.e. an essential asset, long duration, steady low risk cash flow • Interested in roads, railways, power generating facilities • Medium term investment 7-10 years • Low risk and return, 15 % IRR	Typical investments include: - Public equity (via stock markets) - Corporate and government bonds - Real estate - Inflation-linked assets (such as commodities, inflation linked bonds, infrastructure and energy, forest land) - Private equity - Cash and cash equivalents • Investing directly they seek ‘cash yielding’ investments, i.e. those that generate a stream of cash year on year, as opposed to an investment in which all cash is realised at the end of the investment period through an ‘exit’ (by either sale or IPO). These investments are required to support their long term liabilities; For these investments they display a low risk appetite, reflected in expectations of stable returns at around the 15% level; • In RE they make very low risk investments e.g. a portfolio of operational onshore wind assets; • As they have very large funds to invest, they do not commonly get involved in individual projects.They may allocate monies to specialised Private Equity or Venture Capital funds (including infrastructure or renewable energy funds) that manage the investments and provide the pension funds with a return; • A handful of specialised RE bonds have been issued which have been of interest to pension funds. Risks are described in the project bond issue documents. Project risks will be extensively mitigated (such as reserve facilities, for example for maintenance problems, distribution restrictions, cash sweeps) in order for the project to attract “an investment grade rating”3 making it attractive to investors (a higher rating suggests less risk that the project will default on its bond obligations leaving bond investors at risk of not being repaid).
Source: Adapted from

Off-Grid Renewable Energy Finance

Source: Sonntag-O’Brien, V., Basel Agency for Sustainable Energy, Usher, E. & UN Environment Programme, 2004. Mobilising Finance for Renewable Energies - Thematic Background Paper, International Conference for Renewable Energies. Bonn, Renewables 2004.

Further Information

• Funds Revolving Funds