Bloomberg New Energy Finance chief editor Angus McCrone had a sobering piece last week on the potential impact on renewable energy financial investments in the event of an increase in interest rates by central banks. And with news this morning that jobless claims hit a near 40-year low, the probability of a rate hike seems substantially higher than it did even yesterday. Higher interest rates from central banks, especially the Fed, would necessarily lead to higher cost debt for solar and other renewable project financings. It is a stark reminder how market and political uncertainties, well beyond the scope of solar’s ability to influence them, can have serious implications for investors and asset owners alike.
McCrone demonstrates the point with an assumed 2% increase in the all-in cost of debt:
Let’s look at the impact higher interest rates would make, compared to the H1 2016 LCOE estimates. If all-in costs of debt were to rise by 200 basis points, this would raise the LCOE of a U.S. solar project by $7, to $94 per megawatt-hour, assuming it was financed pre-construction with a debt-equity ratio of 70:30 and a 20-year loan… And by the way, if you think a 200-basis-point rise in debt costs sounds extreme, and therefore very unlikely, I would point out that this would only return all-in borrowing costs in northern Europe to where they were in 2012.
These estimated increases in LCOE, of 9 percent or so, would not kill renewable energy stone dead –far from it. But they would tilt the balance back towards coal and gas (and biomass), where the upfront capex is a smaller fraction of lifetime costs and where operating-stage expenses, notably the purchase of the fossil fuel feedstock, are a far bigger part.
I don’t have any particular insight on whether or not a 200 basis point increase in the near future is a real possibility. But given uncertainties in the market — particularly uncertainty surrounding the November U.S. presidential election — combined with an improving economic outlook, it doesn’t seem at all out of line.
What if there is an opportunity to shield against a 200 basis point increase? In a rising interest rate environment, all investors (both debt and equity) will try to maintain their rate premium above the risk-free rate, and therefore all forms of capital get more expensive. The scenario above assumes that a 70:30 Debt-to-Equity (D/E) ratio is a fixed assumption — but what if we could raise the D/E ratio to something closer to 85:15 or even 90:10? Although the cost of debt is higher, it would be offsetting substantially more expensive equity. Increasingly leveraged projects, even under increased interest rates for lenders, would still be preferable.
By our calculations, the LCOE of a project can actually be reduced — even with more expensive debt — simply by challenging the leverage assumption.
But how do we get lenders to lever up projects? The common view is that low advance rates are “just the way it is.” Lenders have appetite for solar risk, but they size to their downside and consequently assign very conservative coverage ratios for debt.
This is a challenge we’ve been working on at kWh Analytics. You may have heard last month that we raised a $5 million Series A. That part of the news got a lot of the headlines and we were obviously very excited about it. But also part of that announcement was the launch of a new production guarantee that we are now offering solar asset owner and lenders.
There are guarantees and warranties available to the average solar finance professional, usually offered by the EPC firm or the equipment manufacturers. What makes ours different, and more competitive than current offerings, is that it combines the industry’s most comprehensive database of historic project performance (that’s the kWh Analytics part) with the A-rated balance sheets of the global reinsurance market. We contribute a hefty dose of actuarial analysis to underpin the underwriting to enable a lender to wrap all of the disparate risks of a solar project into a single energy output figure.
Our re-insurance partners are so confident in the actuarial analysis that our data allows, that they are able to competitively guarantee up to 95% of the output of a solar project or portfolio of projects. For a lender evaluating how to think about the risk of a solar project, the equation is now much simpler. By transferring most of the production risk of projects to the global reinsurance market, lenders can confidently deploy more debt than the current 70:30 ratio up to as high as 95% and still be confident that their investment will be secure.
This would, assuming central banks do raise rates as posited by McCrone, mean that project developers are still paying a higher price for debt than under current conditions. But equity contributions would still be substantially more expensive. By replacing the equity contribution with more debt, the net result would still be positive for project financiers. And solar will remain more competitive than coal and gas.