Consistent with the consensus commitments from the Paris Agreement, the Hydrogen Council represents yet one more step away from carbon-based fuel sources. It signals further technological advances driving the increasing options available for electricity generation. And it forms part of the continuing industry transition seeking to address the global energy 'trilemma' of security, accessibility/affordability and sustainability.
In recent years, trillions of dollars of investment have been raised for funding alternative energy projects. Large and small-scale projects have attracted financing on a vast scale. Investment has flooded into the full range of asset classes – from mega projects in the nuclear, offshore wind and concentrated solar plant sectors, through to smaller scale onshore wind farms, photovoltaic sites and biomass plants. Other less established technologies using tidal wave power or waste and biofuels feedstock, for example, are forming part of the energy mix. Even micro, off-grid renewable power solutions are starting to secure funding commitments as technology advancement in storage and battery systems, coupled with linked IT solutions, progresses at a startling pace.
The sources of this funding pool have been, and continue to be, varied. Key stakeholders have used their own resources and balance sheets. But they have also leveraged debt and equity capital markets. Equally, they have successfully tapped both private equity, fund and institutional capital. And, at the same time, they have attracted government, multilateral and development finance institutions money from a range of products covering equity investments, grants, soft loans, subordinated notes and tied export credit facilities.
Traditional project finance has played a significant part in this. But its approach to the growth of new technologies fuelling the energy sector has reflected the risk profile of project finance lenders. Consequently, this has meant that, in some cases, project finance funds have come later to alternative energy projects than the developer's and their shareholder's own funds.
What distinguishes project finance from other forms of finance is an acceptance by those funders of a credit structure with an increased risk of recourse. This is focused primarily, and almost solely in an operating phase, on the project assets being financed. In a project financing, these assets will be the only assets available to service the debt on an ongoing basis and (with the exception of certain completion risks), will be the only assets against which those funders can have any recourse to if things go wrong.
Hence, technology, sits at the very heart of a project financier's bankability analysis when testing a project's pre-cash flow completion risk and its post-completion operating risk. Will the technology allow the project to perform at a level required to meet its base case ratios for generating sufficient revenue to cover the debt service requirements? This then manifests itself in a detailed engineering and construction understanding of any range of hardware, from reactor types, turbine blades, solar panels and inverter efficiencies, buoys, boilers and digesters.
What do Project Financiers consider?
Project financiers are a fascinating type of banker. They are just as likely to be able to build and operate the generating facility being financed as they are able to administer the loans being made to the project vehicle.
Further, it is not just an understanding of the specific technology that is required. As a highly regulated industry, project financiers will be as fully versed in the minutiae of the Energy Act, and the multiple regulations made under that act for the various types of alternative energy assets, as they are the Banking Act, for example. And they will be as familiar with the positions of OFGEM as they are with those of the FCA.
The energy sector, and in particular the renewable energy sector, functions within a myriad of regulatory layers. From the global commitments formalised in the Paris Agreement, through to EU laws, domestic laws and enabling regulations, planning and environmental requirements, multiple licensing and permitting regimes, industry codes and regulator's guidelines, the sector operates under a legal framework against which risk can be assessed and investment decisions taken.
For renewable energy projects an additional layer applies. In recognising the risks and costs to developers associated with new technologies, and to attracted entrants into a new policy-driven investment landscape, government subsidies and incentives have become central requirements. The economics for alternative technologies that are now taken for granted in terms of electricity generation only work as a result of these subsidies and incentives, and thus policy and government plays as important a role as technology and regulation. As technologies have become more familiar and tested, and as capital and development costs reduce proportionately, subsidy and incentive review becomes a natural consequence.
Together with technology advancement, regulatory certainty (and the policy that generates the regulations) is central to the successful development and implementation of alternative energy projects. They both underpin a bankable risk allocation structure. And in the 101 of project finance, any likelihood of technology failure or the threat of regulatory or policy uncertainty or change in law, are immediate red flags for any credit committee.
In some ways, technology risk is more binary. Either the technology is tried and tested, as represented by empirical evidence of historical performance, or it is not. Project financiers have got themselves comfortable with many of the technologies now used in the energy generation mix. Some however, including battery and storage technology, remain in the difficult box, and whilst certainly not beyond the reaches of limited recourse finance they do pose challenges.
It is no surprise then that the participants behind the 'Hydrogen Council' represent some of the most recognised, established international corporates with extensive balance sheets. It should be assumed that material funding commitments will (as they already have been) sit on those balance sheets until such time as the project finance market feels fully comfortable with that technology.
But coming back to regulatory risk, this is in many ways a more complicated animal. The ability of a government agency, or an empowered regulator, to change policy and with it laws and regulations is always present. Political risk, as perceived by project financiers, is not just about governments forcibly expropriating assets from foreign owners, imposing exchanging controls and shutting down a country's ports and airports. In many of these instances, insurance will be taken out for these events, and will indeed be a requirement of any project financier in the face of commensurate risk to the project being funded. But in the context of alternative energy projects, the analysis around incentive and subsidy regimes can be much more complex. A reduction or withdrawal of the smallest subsidy may have a disproportionate effect on the viability of a project where operating margins are tight and leverage is high.
Changing tax and fiscal treatment too can have far-reaching implications for the economics of a project where large capital costs are sought to be amortised over a long period of time. And lastly, and most significantly in the context of alternative energy means, changing government policy can signal material problems for entire industries.
About the Author
Tom Eldridge is a Partner in the Banking & Finance practice at Mayer Brown.