How to stimulate investment in clean energy

20 August 2014

Wind turbine installation on Grouse Mountain in British Columbia, Canada. Photo by Neil Openshaw

Clean energy finance has gathered speed this year, but it is still far short of what the IEA publication Energy Technology Perspectives 2014 (ETP-2014) calculates is needed to refit the energy sector so that average global temperature does not rise more than 2 degrees Centigrade.

Bloomberg New Energy Finance (BNEF) reports that global clean energy investment surged 9% in the second quarter from the like quarter in 2013, adding to the 10% gain for the first quarter. The USD 63.6 billion invested in the second quarter was the most in two years, bolstered by USD 3.8 billion in new financing for the 600 megawatt Gemini wind farm in the North Sea off the Netherlands, as well as outlays for wind farms in China and Mexico and a solar-thermal project in Israel. In its BNEF 2030 Market Outlook released last month, the financial analysis firm forecasts USD 5.1 trillion in investment in renewables by 2030 out of total spending of USD 7.7 trillion on new generating capacity.

While BNEF’s advisory board chairman said the firm foresaw greater spending than some other outlooks, ETP-2014 this year warned that the energy sector will need an extra USD 44 trillion in investment by 2050 to decarbonise sufficiently to limit climate change.

But the spending outlined for the 2 Degree Scenario in ETP-2014 will generate more than USD 115 trillion in fuel savings, and even at a 10% discount rate, the return in net savings exceeds USD 5 trillion.

So why isn’t there more investment in decarbonising the energy sector?

The problem for the power sector, ETP-2014 explains, lies with how investors assess the risk and return of decarbonisation.

New ways of looking at generation investments

To close on the financing of any project, a project developer needs to convince financial investors of one thing: that they will be able repay the debt and the interest on the debt while also remunerating shareholders for the capital mobilised.

For investors, financing low-carbon projects is relatively new territory, fraught with uncertainty.

To assess whether the cash flows of a new project are sufficient to reimburse the investment and capital costs used to finance a project, investors calculate the net present value (NPV). NPV calculations are based on expected electricity prices and take into account their variation and uncertainty over time. A negative NPV implies that the project will not deliver sufficient return, and thus is unlikely to proceed.

But while a positive NPV is a necessary condition for being financed, even this is not sufficient. Investors also appraise projects with other financial ratios, such as the internal rate of return, the payback period or debt coverage ratio under stress conditions to capture other dimensions of financial viability, and to inform investment decisions. Investors need to feel assured that a project with higher perceived risk is going to deliver a higher rate of return.

Low-carbon investments, whether large and financed by sophisticated large utilities or small-scale and financed by households, cannot escape this financing constraint. Before deciding to spend USD 10 000 for a rooftop solar PV or USD 5 billion to USD 10 billion for a nuclear power plant, investors seek to assess whether they will be able to get their money back and get a return.

Challenges to financing decarbonisation of generation

Low-carbon projects, like other power plants, face regulatory risks such as licensing delays and problems of public acceptance plus the danger of construction delays and cost overruns. Then once the plant is up and running, private investors face operational risks.

For new technologies, accurate operations and maintenance costs can be known only when operations are under way; some installations of a given technology type can prove to be less reliable and with a lower availability factor than others. For wind and solar power, initial estimates of the quality of the resource can also be a source of risk, and yearly weather variability can affect cash flow.

And renewable projects have the added risk of uncertain load factor, resulting from possible curtailment of their output due to grid integration challenges and in the situation of excess generation.

Finally, if a carbon price exists, it lifts wholesale electricity prices, thereby increasing the profitability of non-emitting power plants and providing incentives for their construction – but then low-carbon projects must factor in carbon price uncertainty.

How to stimulate investment in a low-carbon future in the power sector

Attracting private investment in low-carbon electricity generation requires that governments learn to think like investors, ETP-2014 finds.

To reassure investors, governments may need to spread related risks and associated costs to taxpayers and consumers. Governments need to become more transparent when using such support mechanisms.

To date, low-carbon investments have been driven by support schemes, including feed-in tariffs, output-based subsidies and quota systems. Governments need to assess whether these mechanisms remain relevant or need to be replaced with new options.

ETP-2014 finds that current conditions suggest that it may be necessary to continue supplementing competitive markets to secure the low-carbon investments needed to decarbonise the electricity sector by 2050. The IEA technology publication details various options to promote investment return, including direct capital subsidies, individual plant regulation and public procurement, plus feed-in-tariffs, quota systems and of course carbon pricing. But the book concludes that no single option should be regarded as the perfect solution. Some are better for the uptake of technologies, but need to be replaced as technology matures or if progress is made on implementing carbon prices. Other options fit well for distributed generation that can be installed quickly, while large and long-term low-carbon projects may need long-term commitment by governments.

Governments should carefully apply the best option from their “basket” of instruments.

Focusing on the end goal of mobilising investment

Caveats exist for all the options available to supplement markets, ETP-2014 notes. Each can have different implied costs of avoided carbon emissions. Most of the options are technology-specific, yet inefficiencies can arise when governments pick the winners. Promoting too-expensive technologies too early may be unsustainable in the long run and may increase the cost of climate change mitigation. Also, every option can have distortive effects on wholesale electricity markets, again to different degrees.

The key to stimulating investment in decarbonisation, ETP 2014 concludes, is to supplement electricity markets while seeking to minimise distortions, and efforts should rely on market mechanisms for mature technologies while minimising costs through timely technology deployment.

To learn more, order Energy Technology Perspectives 2014 by clicking here.

Creative Commons photo via Flickr