The UK Government promises to ‘Build Back Better’ and deliver the Ten Point Plan for a ‘Green Industrial Revolution’ to facilitate its 2050 Net Zero commitment with £12 billion of new government investment and measures to mobilise up to three times that much in private sector funding. But how much is the energy transition actually going to cost? December’s Sixth Carbon Budget by the Climate Change Committee stated that low carbon investment must scale up to £50 billion each year to deliver Net Zero so there’s a long way to go.
In the last of our series of articles on the energy transition provided by Freshfields, we consider how Net Zero might be funded in the UK focusing on subsidies, government support, sustainable finance products and brownfield investment.
Every project is individual, but, in general, the type of funding depends on the level of development of the relevant technology. The technology uncertainty levels from the Treasury’s December 2020 Net Zero Review: Interim report can be used to illustrate the possible different sources of funding:
Level 1: ‘Clear-enough future’ where the technology is commercially viable – this includes solar, wind and electric vehicles and charging infrastructure. These projects are attractive to the private sector and may be able to directly raise debt finance. However, they will still require significant equity investment and may rely on government subsidies and other support at the greenfield stage. Power generation projects at this level are low enough risk to create an active brownfield market and it’s reported that currently there is more funding available from infrastructure investors than there are sustainable projects at an investible risk level.
Level 2: ‘Alternative futures’ where the technologies may be commercially viable and have been piloted but a decision as to the favoured alternative has not yet been made – for example the choice between hydrogen and electricity for heating buildings. These projects are mainly funded from balance sheet by companies in the relevant sector or with debt from sustainable finance products. Government subsidies and support will be key to the viability of these projects. Institutional investors are more likely to contribute at the corporate equity level over time, rather than investing in individual projects.
Level 3: ‘Range of futures’ where the technology is not yet commercially viable and many pathways are still being explored – for example greenhouse gas removal systems. These are mainly funded off-balance sheet by corporate R&D budgets with significant government subsidies and support.
Level 4: ‘True ambiguity’ for technologies not yet invented. Very early funding will come from government initiatives such as the innovation fund announced in the Ten Point Plan and there may be venture capital money available too.
Public sector funding and support
State support schemes have been and remain major drivers for investment in energy transition projects and can be key at all technological stages of a project, including providing guaranteed income to make projects bankable for private sector investment.
Most countries apply a very diverse combination of support measures that include price-driven and capacity-driven strategies and instruments. This is often supported by tax measures and funding support. The sheer number of such support measures makes a diligent analysis in every specific investment and asset situation indispensable. A rough estimate is that there have been more than 1,300 support measures (economic, financial, regulatory, administrative) in relation to renewable power generation in place in Europe since 2005 with more in the pipeline such as Dispatchable Power Agreements (DPAs) – a CfD-like regime for the UK Carbon Capture, Use and Storage program. We illustrate how the subsidy regime for the UK has changed in the diagram below.
In terms of investment at the asset level, the variety of schemes means that every asset has its own legally allocated support scheme profile. Such profile determines a very significant part of the commercial viability of an individual asset. To prepare and take an investment decision, the specific asset must be characterised in detail and then classified within the existing (potentially grandfathered) support measures and schemes. Some of the factors relevant to identifying this profile are jurisdiction and location, technology and sub-technology, age and size.
Generous state support schemes have undoubtedly enjoyed great success in attracting foreign capital to renewables investments. The flipside is that, in the face of shifting political priorities or economic turbulence, some states have shown a tendency to renege on or rewrite established subsidy regimes. This risk, heightened in the economic headwinds of Covid-19, can fundamentally alter the returns from renewables investments in a particular jurisdiction and undermine the basis on which the investment was made.
UK Government support
The announcement of the new UK Infrastructure Bank and its policy design, published with the budget, should bring a welcome funding boost to UK energy transition projects providing £22 billion of financial capacity, consisting of £12 billion of equity and debt capital and the ability to issue £10 billion of guarantees. Following the sell-off of the successful Green Investment Bank and the large reduction in support from the European Investment Bank following Brexit, it is hoped that government
involvement and investment will mitigate risks and encourage commercial participants. However, following the abolition of PFI in 2018, there is still no clarity on which revenue support models will be used going forward and last year’s National Infrastructure Strategy states that the government remains open to new ideas from the market but will consider how existing models, such as the Regulated Asset Base and Contracts for Difference, can be applied in new areas. Investors will be wary of getting involved until such uncertainty has been removed.
Another initiative, following on from the Ten Point Plan and Energy White Paper, is the just-launched UK Centre for Greening Finance and Investment. Its aim is to provide data and analytics to financial institutions to better support their investment and business decisions by considering environmental and climate change impact and is led by an academic partnership. We look forward to seeing its output and how it conjoins with the UK’s green taxonomy.
Private sector funding
To be able to utilise project finance in energy transition developments, the projects need to be ‘bankable’. In the energy transition space, this currently only applies to the ‘Clear-enough future’ technologies described above such as wind and solar power generation. Bankability requires contractual certainty, suitable risk sharing arrangements, sponsor commitments and enforceable security over project assets and, although there will always be project-specific risks, the following are some key risks that must be mitigated to enable such investment:
- Revenue risk: The project revenue must be sufficient to repay any loans and secured for the term of the financing. In a power generation project, this would generally be achieved by entering into a long-term power purchase agreement. Establishing the revenue stream for less well-established infrastructure may be more difficult – for example in the electric vehicle charging space, pricing and customer use are not yet sufficiently predictable.
- Technology risk: Involving a technology partner as one of the sponsors in a project can ensure issues are more efficiently dealt with and may reduce the risk of claims and disputes. Risk of a technology failing to live up to expectations or becoming obsolete before the financing is repaid will affect bankability. Additionally, a new type of technology may mean there is not enough experience or skilled labour available to develop the project.
- Political and regulatory risk: A bankable project usually requires a stable and clear investment environment with an enabling policy framework. An history of successful infrastructure projects, a published infrastructure pipeline and established project initiation and facilitation tools are also helpful. These risks are lower in the UK than in developing jurisdictions but, as can be seen from the changes to the subsidy regime described above, there is still a risk of change in legislation/regulations even in developed economies.
116 financial institutions, covering the majority of international project finance debt, have signed up to the Equator Principles which is a risk management framework to identify, assess and manage environmental and social risks and impacts in projects – the financial institutions will not provide debt to a project which doesn’t comply. The Equator Principles 4 (EP4) came into force in October 2020 and now also apply to project-related acquisition finance and project-related refinancing. EP4 updates to the principles themselves include applicable standards in designated countries, increased human rights and social risk obligations, and new climate change reporting obligations.
Sustainable finance products
So, if your project cannot directly raise debt finance or you’d like an alternative to project financing, what can you do? Investors and companies working towards sustainability goals can use corporate sustainable financing instruments such as green bonds, loans and mortgages, sustainability bonds and climate bonds to raise money. Sustainable products continue to develop and the following are currently fashionable:
- Sustainability-linked loans and bonds where there is no restriction on use of the proceeds but the costs of the financing, usually an interest rate, are dependent on predetermined sustainability performance objectives. For example, we recently worked with Tesco on a £2.5bn multicurrency revolving credit facility and €750m ESG-linked notes which contain pricing adjustments depending on how Tesco performs against ESG targets relating to greenhouse gas emissions, the volume of renewable energy contracted by the group and food waste.
- Green bonds and loans, which must be exclusively used for financing or refinancing new and/or existing eligible green projects. Green projects include clean transportation, renewable power generation and energy efficiency and, to aid consistency, examples are listed in the Green Loan Principles and Green Bond Principles.
- Transition bonds which help issuers fund improvements in sustainability for projects that have a high carbon footprint and so can’t be funded by green bonds or loans. As an example, Shell has entered into a $10bn credit facility where interest payments are linked to progress in emissions’ reductions.
An issue with the use of sustainable finance products is lack of an agreed benchmark – it can be hard to compare how green the different products and providers are as there is not yet a global standard for sustainability criteria and the uncertainty as to whether the project is eligible can lead to accusations of ‘greenwashing’ by companies. For capital markets, the Climate Transition Finance Handbook, published by the International Capital Markets Association, provides guidance for issuers on best practice and required actions and disclosures.
The UK is developing a green taxonomy which should mitigate this, which will be based on the metrics and thresholds of the EU green taxonomy. The advisory platform for the EU taxonomy has been criticised for delays due to lobbying from some Member States and the seemingly vested interests of some participants; hopefully the UK equivalent, the UK Green Technical Advisory Group, can learn from this in its appointments and stick with independent experts.
Despite the coronavirus pandemic and the resulting economic challenges, there remains high demand from investors for stakes in energy transition-related companies and projects. Institutional investors, such as asset managers, infrastructure funds, insurance companies, pension funds, private equity and sovereign wealth funds, invest through ownership in relevant companies (both via debt capital markets and equity), acquisitions and refinancings, and project funds and pooled vehicles.
According to the IEA, institutional investors held approximately 25% of ownership in the top 25 listed energy companies (as ranked by market capitalisation in February 2020). As significant shareholders, often with their own sustainability pressures, there is a move towards activism on sustainability issues within these portfolio companies. Investors’ own sustainability pressures can come in various forms – from LPs refusing to commit capital to new funds which don’t have sustainability mandates, to some institutional investors now linking their investment professionals’ own compensation packages to portfolio company performance against ESG metrics. As a result, the nature and amount of investment in qualifying assets (and influence carried by that investment on environmental, social and governance matters in all assets) will only increase.
Brownfield investment, ie acquisition or refinancing of existing assets with low/no development risk, provides an opportunity for developers to recuperate capital and reinvest it in new projects whilst the investors get a stake in or lend to those existing projects with investments helping them meet their own sustainability goals. This has been more prevalent in more liquid brownfield markets (such as Europe and North America), although countries such as Brazil and India are making their way up the tables, partly due to incentives such as tax-exempt local infrastructure bonds and pricing pressure in developed markets.
A question increasingly asked is whether brownfield investment, particularly in offshore wind, has proved too popular? C-suite directors of major energy companies have cautioned that they believe valuations, often up to 25 times earnings, are “crazy” because of the short supply of appropriate assets and ever-increasing competition (including from SPACs in the last 12 months) – however, the pressures outlined above mean that market involvement can no longer be optional.
For institutional infrastructure investors with minimum equity cheques in the hundreds of millions, another challenge is finding energy transition investments of suitable scale. The hunt for ‘platform’ or ‘buy and build’ opportunities can ultimately unlock the minimum cheque size but require a much more time-intensive acquisition process and a management team prepared to step up to the plate. Some investors have successfully short-circuited this by teaming up with an operator or established energy company to spin off assets of scale over time, so building a reputation as a good partner to corporates has risen up the strategic agenda for those institutional investors who might otherwise be seen to have sharp elbows.
Vanessa Jakovich, partner: Vanessa advises on environment and planning issues, and the regulation of major energy and infrastructure projects.
She is focused on sustainability and innovation, guiding clients on issues including environmental governance, ESG strategy and climate reporting. She provides operational advice, as well as environment and planning support on corporate and real estate transactions across a range of sectors.
Richard Johnson, partner: Richard advises the world’s leading financial sponsors and multinational corporations, often in the infrastructure space.
He has experience across the corporate spectrum, with a particular focus on cross-border private and public M&A.
Caroline Gregson, senior knowledge lawyer: Caroline supports Freshfields’ global energy, infrastructure and transport team on project development, financing and the energy transition.
She has experience on a wide scope of projects and energy-related transactions including LNG and power projects, wind farm financing, energy company acquisitions, greenfield natural resources projects and reserve-based lending.