Tuesday, November 29, 2011

Risk and Return : Key Factors in Renewable Energy (Part 6)

 This is the continuation of the article: Private Funding of Renewable Energy
Key Features of Funds Providing Equity (Part 5)
Venture Capital, non-public Equity and Funds (Part 4)
The monetary Institutions– what they are doing (Part 3) 
Introduction – Finance basics (Part 2)
Private Funding of Renewable Energy (Intro)

This section illustrates, what financiers consider when investing in RE assets on the ground; this would typically be the case in a project finance, fund and private equity context. There are a range of variables that impact project success and many that will change over the project lifespan: these need to be understood and managed or mitigated. Prior to investing both debt and equity providers will undertake a detailed assessment of these risk factors, which is known as due diligence. Technical experts and advisers will be brought in during this process, where specific technical knowledge or insight is needed. This is where RE and energy policy fit in, as covered in more detail below.

Typical risk assessment will include:

Country and Financial Risks

• Country risk – this is a broad term and covers a range of economic and political risks including government stability, status and maturity of the legal system, transparency of business dealings and currency risks. It also includes general instability due to wars, famine and strikes.
• Economic risks – inflation, local regulation.
• Financial risks – interest rates4, refinancing risk, insurance (business interruption, asset rebuild), asset liquidity.
• Currency risks – exchange rate risks, currency controls, devaluation. Exchange rate risk, for example, is faced by investors in emerging markets if revenue is generated in local currency and loans are to be serviced in hard currencies. In this situation, the lenders are likely to require the project to ‘hedge’ the risk using a financial contract, but in many emerging countries these contracts can be expensive and for short durations. Equally, a UK or US investor buying plant or equipment in Euros finds project costs rise as a result of the falling sterling-euro or dollar-euro exchange rate. Often purchasers will arrange a concurrent currency hedge with the supplier or a bank at the time the supply contract is signed to manage this risk for an individual project.
• Political risk – this incorporates not only the stability and durability of political regimes but also the risk that for example tax laws are suddenly changed, central bank rates are increased etc. directly affecting project viability. Policy and regulatory risk are subsets of political risk.
• Security risks – can the lender actually take possession of a plant if there is a default on the loan, and will it be permitted to operate the plant and maintain the revenue generation? Although in most developed countries the right to security over an asset has a solid legal basis, this is not always the case in some emerging markets and can add significant complications.


Policy and Regulatory risk

As the policy or incentive mechanism may be a key part of making RE project economics attractive, changes to these factors pose a risk: a long-term, stable policy regime with a sound legal basis is essential for serious investment to occur. Regulatory risk is also considered in depth for the permits, authorisations and licences required to plan, construct, operate and decommission RE projects. A sound track record of stable and consistent regulation, well managed price or other reviews, and clarity over the development of regulations or policy to implement new RE legislation, would be sought. This is covered in more detail in the section below.

Technical and Project Specific Risk

Typically this will include a review of the technology, its suitability for the proposed conditions, operational track record, source and accessibility of spares, a feedstock/energy resource assessment and a capital expenditure cost review for a construction project. These factors are generally assessed by a technical expert on behalf of lenders and investors.
• Construction risk – this will cover the risks involved with the build, the interfacing of different contracts, the degree of protection from liquidated damages for project delays, other damages, build timing.
• Technological risk – each RE technology will be assessed in the light of its maturity, operating history, fitness for purpose and warranties. The assessment will be undertaken by appropriate specialists often working closely with the technology supplier.
• Environmental risk – environmental and social risks associated with the project, often subject to legal requirement for an impact assessment.
• O peration and Management risk – once a project has been commissioned the plant will need to be properly maintained and staffed to ensure optimal performance. An assessment will be made of staffing and costs, as well as contracts required during the operational period and provisions required for decommissioning.

Market Risk

These assessments are typically provided by market specialists who report on topics including future electricity prices, future green subsidy prices, future carbon prices, and the prospect of new competitors.
The boxes below show finance and contractual arrangements for a wind power and biofuels project. These illustrate differences in the RE subsectors, and the kinds of issues financiers will examine.

Box 2. Structure of an Operational Wind Power Project

This diagram sets out the typical contractual structure for a wind power project. Technical studies of the wind resource, a review of the proposed technology and the construction, operations and maintenance will have been completed. The construction contract may well feature multiple contracts, in which case detailed analysis of how the contracts interact will be completed. Legal due diligence including all land title will be reviewed. If the project is only viable due to the power and green attributes it sells, a thorough review of the offtake contract and subsidy regime will be performed.
Box 3. Structure of a Biofuel Plant

This example of a biofuel project highlights some challenges project promoters often face, not including policy risks linked to the sustainability of feedstock.
Issues include:
• Stable feedstock supply: if multiple contracts with suppliers are involved the actual ability of the plant to produce the biofuel at a forecast production capacity carries a greater risk.
• Sales contracts: on the output side, producers will want to find sales contracts for biofuels that line up with long term project finance debt. This can be challenging.
• Lack of correlation between the prices for the feedstock and the final product being sold (associated with the commodity markets and the oil markets respectively). This can mean that the biofuel plant can be squeezed in between two separate markets.

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1 comment:

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