By Angus McCrone
Chief Editor
BloombergNEF
A cold wind pinching the cheeks, a spit of rain in the air, clouds swirling over undulating ground and, overhead, a threshing sound as the 56-meter blades of a wind turbine hurtle round at hectic speed. You could be in Scotland. Or Sweden. Or Ontario.
Well, except for a couple of details: the safety talk you hear before donning your helmet and going on site mentions brown and yellow scorpions, Egyptian cobras and camel spiders; and dotted among the stony hillsides around the wind farm are flocks of sheep and goats, each tended by a Bedouin woman swathed from head to toe in colorful robes (including face covering).
The 86-megawatt Al Rajef wind project, completed last October in the hills of south Jordan at a cost of $185 million, and the 24-megawatt, $67 million Ma’an solar park on a dusty plain 15 miles away, are examples of a roll-out that is gathering pace in developing countries as renewables seize the cost advantage over fossil fuels.
There are set to be many, many equivalents of Al Rajef and Ma’an built. BloombergNEF’s annual New Energy Outlook, to be published next month, is likely to show more than $2 trillion being invested in wind and solar in developing countries outside China between now and 2050. That would help meet rising electricity demand, at the lowest cost available, and ensure that the bulk of new generating capacity is sustainable, not fossil-fired.
But there is an issue here. These trillions of dollars will have to be provided by somebody and, realistically, only a slice of that sum can come from domestic sources in the countries concerned, and only another slice from those ‘usual suspects’ of international project finance – the development banks. Advanced-economy commercial banks are nibbling at a further slice, supplying debt to their project developer clients who are active in overseas markets. But another, large slice – at least until those economies mature further – may have to come in the form of equity from institutional investors from developed countries in Europe, North America and Asia-Pacific.
On paper, it makes sense for them to provide it. Institutional investors such as pension funds, insurance companies and wealth managers are hungry for the predictable yields that come from infrastructure investments such as renewable energy assets. In Europe, for instance, institutions have been breaking records year-in-year-out for the amount they are committing to green generation projects.
Last year, on a relatively narrow measure tallied by BNEF, they committed $10.4 billion in Europe, mostly via four mechanisms – direct purchasing of equity in projects, subscription to project bond issues, investment via quoted specialist project funds and investment via private specialist funds. That total was up more than 10-fold over a decade earlier.
However, so far, most institutions are not making the jump to where the biggest action will be in green power in the years ahead: in developing economies.
The opportunity
The Al Rajef and Ma’an projects were financed in the tried and trusted way for renewables in emerging markets: the majority in debt from development lenders the European Bank for Reconstruction and Development, Proparco of France, DEG of Germany and Overseas Private Investment Corporation of the U.S., and the minority in equity from developer Alcazar Energy.
Daniel Calderon, chief executive of Alcazar, said he sees a vital role for institutional investors in solving what is still a capital shortage for renewables in emerging economies. In so doing, they will bring down the cost of capital for projects – and therefore the cost of electricity for the countries that host projects.
“When the company began, we saw an arbitrage,” Calderon said. “In OECD countries, the internal rate of return on renewable energy projects was about 400-600 basis points above the local risk-free rate. Here in Jordan, however, it was about double that amount above the local risk-free rate. When companies like ours are able to unlock institutional investor capital and get it flowing here, you should see that spread go down to the normal levels for this asset class.”
In Jordan, the cost of capital for wind and solar has already come down substantially thanks to the fact that early projects like Al Rajef and Ma’an have generally gone to plan. This, and falling equipment costs, have contributed to a more-than-halving over five years in the tariffs payable on new electricity generation in the country.
From more or less a standing start in 2013, after an interruption to gas supplies from Egypt had plunged Jordan into an energy and economic crisis, the Hashemite kingdom has invested $2.9 billion in solar and $1.3 billion in wind. In 2018, Jordan ranked third (behind Chile and India) out of more than 100 developing countries analyzed in BNEF’s Climatescope study, in terms of suitability for clean energy investment.
The predicament Jordan found itself in early in this decade, and the rationale for its leap into renewables, was eloquently laid out by Imad Najib Fakhoury, the country’s then planning minister, in an interview with BNEF in 2015 (client links: web | terminal). He described it as “a question of survival”.
Other developing countries have also been identifying wind and solar as a ticket to economic opportunity – ever since the levelized costs of generation from these green sources fell close to, or below, those of the cheapest fossil fuel alternatives.
In 2018, the top 20 countries worldwide investing in renewables excluding large hydro featured not just China (first at $91.2 billion) and India (fourth at $15.4 billion) but also Vietnam (12th at $4.1 billion), South Africa (13th at $3.9 billion), Mexico (14th at $3.7 billion), Morocco (17th at $2.9 billion) and Ukraine (19th at $2.1 billion).
The attractions are the following. One: affordable electricity. Two: speed, since wind farms and solar parks can be constructed in a matter of months, not years as for coal, gas or nuclear. Three: energy security since neither solar nor wind depend on importing fuel at uncertain price from other countries that may or may not be reliable. Four: balance of trade benefits, as that import dependency is reduced. Five: jobs and investment. On the last point, the Al Rajef wind farm took 550,000 man-hours to build (equivalent to roughly 305 man-years of employment), and Alcazar is committed to spend $15 million on community projects in Jordan and Egypt over the next 25 years.
For institutional investors, the attraction of renewables in emerging markets is the same as that of those in Europe or North America: namely steady cash flows that are higher per dollar invested than from most other infrastructure assets, and far more than available on government or high-quality corporate bonds. The U.S. 10-year Treasury, for instance, is currently yielding less than 3.2%. To borrow a slang phrase from Broadway in the 1960s, what’s not to like?
State of play
Clearly, something is not to like – because developed-economy institutional investor involvement in wind and solar projects in developing nations has been very modest to date.
Instead, the status quo has largely been domestic or international project developers providing equity, and development banks or – in countries like South Africa or India, local lenders – providing debt. By the way, I am excluding both China and the rich Gulf states from this discussion, because they have access to their own, ample pools of capital.
Part of the problem comes down to sentiment. Are people safe to work in the countries concerned? Actually, they may now be much safer than they would have been years earlier when the location was last in the global news. And there are scare stories, myth or not, like the one about the wind turbines lying by the side of the road in Africa because someone did not get paid.
Let’s go back to the four main ways institutional investor money has been reaching projects in Europe. The first, direct investment by advanced-economy institutions in projects – as Allianz, several of the Danish pension funds and many others have done in Europe – was zero, or close to zero, in developing economies in 2018.
Project bonds have also been a big feature in Europe, none bigger than the $2.1 billion issue last year to fund Global Infrastructure Partners’ purchase of 50% of the Hornsea 1 offshore wind project. But they have been few and far between in developing-country renewables. Almost the only examples to date have been bonds issued to help finance a few wind farms in Uruguay and Brazil, and one bigger wind portfolio in Mexico.
European quoted renewable energy project funds and their North American cousins, the ‘yieldcos’, have raised $18.5 billion from public market investors in the last six years, but this type of entity has been largely absent from emerging markets so far. A rare exception was TerraForm Global, a U.S.-based yieldco that owned projects in Brazil, India and China and was taken over by Brookfield Renewable Partners last year after a bumpy three-year life on public markets.
That leaves the fourth category, private equity and infrastructure funds. Copenhagen Infrastructure Partners, for instance, has raised a total of 6.8 billion euros from institutions for its first four funds, investing mainly in European renewables. In emerging markets, a few managers have succeeded in raising significant sums for funds that will back wind and solar as part of a wider remit. For instance, Actis secured $2.75 billion in 2017 for its fourth energy fund, which will invest in green power but also gas-fired generation and electricity distribution.
Some institutional investors have recently begun to voice strong interest in getting into developing-economy renewables. Bruce Hogg, head of power and renewables at Canadian pension fund CPPIB, told the BNEF Summit in New York in March that his group is looking for higher-risk opportunities “and that means earlier stages, more commodity [risk], more complex situations and, increasingly, emerging markets.”
The problems
There is an array of risks that face investors. They are set out in a note by my colleague Victoria Cuming, How to Mitigate Renewables Risks in Emerging Markets (client links: web | terminal). Not all risks are peculiar to developing economies, although things like land tenure uncertainty and the danger of curtailment may be greater there than in, say, Europe or the U.S. The biggest three hazards, however, are foreign exchange risk, counter-party risk and political risk.
Taking the first of these, foreign exchange risk is the danger that, having invested dollars, euros or yen in a 15-, 20- or 25-year renewable energy project, the investor finds that the hard-currency value of the cash flows gets eroded because the local currency depreciates. On the face of it, Egypt would appear to be a good example of this problem, since the local pound was devalued dramatically in late 2016 and is now worth only half what it was in dollar terms.
However, how the tariff is payable may address this issue. Calderon, whose company Alcazar Energy is one of the main developers of solar at the giant Benban site 650 kilometers south of Cairo, said: “90% of our dividends from electricity tariffs are dollarized, in that they are either paid in dollars, or they are paid in local currency but the amount of that currency paid reflects a fixed dollar amount. And we don’t need 100% cover because we need to cover local expenses in local currency.”
Having the tariff denominated in dollars, or else payable in local currency but on a sliding scale depending on the dollar exchange rate, does not necessarily solve every issue. The central bank might, in extremis, not make the dollars available, or the offtaker (usually the national utility) might not pay up. The latter is counter-party risk.
Lucy Heintz, partner for energy at Actis, said: “The risk we focus on most is the offtaker credit risk in the countries concerned. You need to have the right mitigation in place, for instance written into the contract that there will be termination payments in the event of buyer default. And the PPA [power purchase agreement] would need to be insured via MIGA [Multilateral Investment Guarantee Agency] or OPIC.”
Political risk can be closely connected to counter-party risk, in that the government may pull the strings at the offtaker (as evidenced in South Africa last year, when the change of president led to a belated unlocking of renewable energy PPAs by the utility, Eskom). However, it encompasses several other dangers: for instance, that the regime may force changes to the agreed tariff, or introduce a tax that hits investor returns; or that the country descends into disorder that puts the site and its staff in peril.
Insurance for political risk is available from both the private sector, and public sector entities such as the World Bank’s MIGA. However, it comes at a price. Tom Murley, director of Two Lights Energy and a veteran project financier, said: “Political risk insurance from MIGA may be available but it is expensive – the equivalent of about 1.5 points off the percentage equity return.” Others say that MIGA support is not always popular with host governments, since its use by a project will show up as a liability on the public sector balance sheet.
There are other potential forms of comfort. Investors in greenfield renewable energy projects may be able to source export credit agency support that includes political risk cover. And those that co-invest with a development bank may feel that, if something goes wrong, the latter will exert influence in the corridors of government.
Each country tends to offer its own particular snags. A recent BNEF note, by Luiza Demoro, (client links: web | terminal) discusses the specific risks in Chile, Kazakhstan and Thailand, as examples, and lays out a framework for considering clean energy investment opportunities in emerging markets more broadly.
Of course, in developed markets, there are perils too – retroactive tariff cuts were a painful one earlier this decade, and counter-party risk as a result of signing corporate PPAs is the new kid on the block. You could argue that, because electricity is in short supply in many emerging economies, and often produced expensively, investors in new wind and solar are likely to be welcomed by host governments, making them perhaps not as exposed to harsh treatment as subsidized renewables were in the rich North in 2010-2015.
Outlook
So will the vaunted “wall of money” arrive from rich economy investors and finance the hoped-for build-out of solar and wind capacity in the developing world?
“Walls” are famous for not moving easily. Governments in both developing and developed economies try to help – although sometimes it seems that they speak klingon and investors speak vulcan. Among their efforts are the pledges in the Paris Agreement on the part of almost all developing countries to shift toward low-carbon generation; and the Green Climate Fund, which was set up to channel developed-country money to projects in poorer countries, supposedly “catalyzing” funds from private sector institutions.
While platitudes and efforts to save the world are nice, investors tend to move capital when the risk-reward ratio is to their liking. If and when the wall of money does move, it will more likely be because investors have decided they can earn the returns they need.
One argument is that, where the biggest battalions start to go, smaller and more timid institutions will eventually follow. Justin DeAngelis, partner at Denham Capital, which has made $2 billion of equity investments in international power, said: “The largest pension funds in the world are already active in or are seriously looking now at investments in Brazil, and they are already active in Mexico. I think that will ‘crowd in’ other players. The largest direct investors will move first, partnering with people because they have not previously been active in the region. Then, once they get comfortable, they will invest directly themselves. And there is a bigger pool of institutions that don’t have direct programs and so will do their investments through asset managers.”
Maurizio Bezzeccheri, head of South America at Enel, sees a different virtuous circle. “There is an element of chicken and egg. Interest on the part of institutional investors helps to encourage governments to take the right steps. In many countries, the right regulations are already in place, but there needs to be confidence in the rule of law, the presence of a strong local supply chain, and increased interconnection between countries.”
It makes sense that many institutions will prefer to spread their risks via a fund structure, rather than having a lot riding, for instance, on one large solar project in Africa. That implies that, of the four main conduits discussed above for institutional money reaching renewables, the private fund and quoted fund options will come first and most of the direct equity investments and bond issues significantly later.
Last week Copenhagen Infrastructure Partners said it has raised $700 million from four Danish pension funds to invest in renewables in “new markets in Asia and Latin America”. Its ‘build-and-exit’ strategy suggests that CIP expects other investors with risk appetites that are somewhat lower, but still significant (because these are developing markets) to be on hand to buy their completed projects.
What could financiers do that would help to speed institutional capital into developing-country renewables? BNEF looked recently at how capital from the World Bank’s Clean Technology Fund has been deployed either into the most risky nations or to back the riskiest technologies, in an effort to lay the groundwork for more risk-averse investors to follow. This summer, we will dig deeper into the question of how and when institutional investors might get involved.
However, one idea might be for development banks to offer a new type of ‘first-loss’ capital that would shield holders of ordinary equity from temporary problems such as tariff payment delays or interruptions to construction. Like every other form of cover, it would come at a price. A second might be for a body like the Green Climate Fund to subsidize political risk insurance.
A third might be for multilateral lenders and agencies such as MIGA to put together a standardized package that could be bolted onto renewable energy investments in those developing economies that qualified. It could include multilateral approval of a local auction process with hard-currency tariffs, as has happened with the Scaling Solar program in Zambia and other parts of sub-Saharan Africa, together with standardized political and counter-party insurance.
It does feel as though, step by step, institutions will come to renewables in developing countries. The road is unlikely to be smooth, because it will only take problems with an investment in one location to affect confidence more generally. But the prize of lower-cost capital is coming into view.
Just mind those scorpions.