Merchant risk a rising issue in green power auctions: Q&A

By Bryony Collins, BloombergNEF. This interview first appeared on the Bloomberg Terminal

The “sliver” of exposure that bidders have to merchant electricity prices is becoming a key issue in renewable energy auctions, said Nico Escallon, Mexico City director at private equity firm Actis, in an interview with BloombergNEF.

The private equity house is preparing to bid in Mexico’s fourth renewable energy auction on December 4. Escallon expects bids to be low in the auction due to increasing competition and the fact that Mexico’s energy market is “becoming somewhat standardized”, he said.

Falling prices in auctions for wind and solar power in Latin America mean that projects are increasingly selling excess energy on the spot market, making exposure to merchant risk more relevant, Escallon said. This is a “key element of risk” assessed by the Act is team when looking at the economics of participating in auctions.

Renewables account for 9 percent of Mexico’s 73 gigawatts of installed capacity, according to BNEF data. The “marginal” role played by wind and solar so far shows the potential for new projects to be built, Escallon said. The country’s strong wind and solar resources, combined with energy regulation in support of renewables, makes it a favorable destination for clean energy investment, he said.

Q: Andrés Manuel López Obrador, or AMLO, will take office on December 1 in Mexico. How could the incoming presidency impact renewable energy?

A: Not only in Mexico, but across the region, the success of renewables whether through auctions or otherwise is not under discussion anymore.

All governments see it from afar, and say – we have to get in on that, both from a decarbonization perspective, but more importantly from a cost perspective. You’ve seen it pretty much everywhere now – Chile, Peru, Brazil, Mexico, Central America, and probably the last one to jump on was Colombia. Everybody’s now seeing it as something that has to be done and has to be an intrinsic part of the network. Mexico is no different.

You’ve seen it pretty much everywhere now – Chile, Peru, Brazil, Mexico, Central America, and probably the last one to jump on was Colombia. Everybody’s now seeing it as something that has to be done and has to be an intrinsic part of the network. Mexico is no different.

Q: Mexico’s energy sector liberalization was started in 2013 and will be fully implemented this year. However renewables still only account for less than 10 percent of installed capacity. Is there room to install more wind and solar?

A: Yes. The entire matrix in Mexico is around 70 gigawatts, and around 1 to 2 gigawatts has been auctioned in each of the four rounds so far. That’s still a marginal part of the system overall. In Chile, they are reaching roughly the same capacity – about 4 gigawatts – but with a system that is [around a third] of the size. So the potential to do more [in Mexico] is obviously there.

From a resource perspective – Mexico is great – we have a lot of sun and two very windy areas. One in the North East and another in Oaxaca in the South. There the system will have to start to pay attention to transmission bottlenecks. There is already need to build out big transmission projects to high wind-resource areas.

Q: Does it concern you that there may not be sufficient transmission?

A: It doesn’t, because the Mexico regulator and operator are very diligent in planning ahead of time. I think the Mexico system will continue to be resilient and operating well.

Q: How does the Actis infrastructure work in Mexico?

A: We have the energy funds and we are on our fourth fund there. Zuma Energia is a portfolio company in fund 3. In fund 4 – we have two companies that are in Mexico. One is Atlas, which [operates across Latin America], and then we have a separate business called Saavi Energia in the combined-cycle gas turbine space. We bought that earlier this year.

Q: Is Actis looking into the next auction round to be launched December 4?

A: We’ve been looking at it closely. Our teams do competitive analysis to determine the supply of projects and the characteristics of each project, [in order] to understand how competitive it’s going to be. Then we work very diligently on the structure of the project – from optimizing the financing, to how we optimize procurement of equipment so we can be the most competitive bidder. Prices have been coming down over the last auction cycles. A lot of that is in response to technology costs coming down, but also competition. At the beginning Mexico was a new market and people didn’t know how to finance it. As it’s becoming somewhat standardized, you see more and more capital coming to the space and more competitiveness.

You have to look at that and make an assessment on where you want to be. One element that we are watching is that as your contracted price comes down, and these projects sell a sliver of excess energy into the market – your relative exposure to the merchant side also becomes more relevant. So that’s a key element of risk that you have to assess when you look at the economics of participating in auctions.

Q: Are you prepared to take on more exposure to merchant power prices in Mexico?

A: It’s all relative to the price you pay and your expectations around that. It’s not necessarily inherently risky to be exposed to the market, assuming you’re underwriting an investment with very conservative assumptions and the price you’re paying to build the asset is conservative. We’ve seen the merchant story play out in other markets in not such a nice way [so we are learning from experience]. Many assets have been built in Chile with expectations of spot prices north of$100 [per megawatt-hour] and that has come down, and those projects are not well situated.

Q: So you expect to be active in the 4th round?

A: We are preparing for it. The bidding decisions will happen later – right now it’s looking at the competitive landscape.

Q: Do you expect the submitted bids to be low?

A: Yes, they will be low because of capital costs and competition. The volume of energy to be auctioned is 1 terawatt-hour, and the capacity will depend on how much is allocated to wind or solar power.

Q: Do you expect these annual auctions to continue, given that the government wants to build much more renewables?

A: We are three auctions in, and we are going for the fourth one. The first projects are starting to reach financial close just now, so the government will want some type of feedback about how long it takes for projects to get built, and how many of those projects are not getting built for some reason. They will calibrate the right pace for [upcoming] auctions [based on feedback from the first set of auctions].

Having visibility about auctions down the line is very helpful for setting up a factory line that will consistently deliver those projects.

Q: Do you expect interest rates to stay low and remain conducive to investment?

A: The majority of our assets in Mexico are U.S. dollar – linked, whether it’s from the auctions or bilateral PPAs [power purchase agreements]. So we’re looking more at dollar debt, where we’re exposed to the risk on the U.S. side, and then there’s an element of Mexico credit risks that fluctuates up and down, depending on whether emerging markets are in favor or not. So we’re monitoring all of that continuously, but we see it favorably.

For our acquisition of Saavi – [Intergen’s Mexican 2.2GW portfolio of gas assets later rebranded as Saavi] – we did an international bond with investors from the U.S. and Europe that had very good reception. We got 17-year debt in a bond structure with them. [Actis bought Saavi for $1.3 billion in April.]

Q: Why was that particularly successful internationally?

A: Saavi has a portfolio of over ten assets with long-term contracts with counterparties like CFE [Mexico’s state -owned utility], in dollars. So you have portfolio diversification, dollars and good offtakers that are long – term. A lot of what investors are offered in other markets – whether it’s Peru, Colombia – don’t have all those components. Either you have a single asset that is well contracted, or a portfolio that has short-term contracts in local currency. So that unique combination was very attractive to investors.

Q: Will the auctions succeed in driving down power prices across the country?

A: Yes – you look at the results and it’s there – it’s incredible how much prices have come down.

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