- Renewables came into their own during a long period of low rates. That’s over, but lenders and borrowers can take steps to soften the impact.
According to Bloomberg’s article published on November 10, 2022, at COP27 this week, negotiators and executives will address the urgent need for trillions of dollars of climate finance to help the world through what the UN organizers call a “polycrisis era.” On Wednesday, the summit’s Finance Day, there was a session devoted to lowering the cost of green borrowing. For good reason: Current financial conditions, and interest rates in particular, have changed drastically from the period when clean energy came into its own.
Since COP14 was held at the end of 2008, much of the world has enjoyed very low government lending rates. Europe has had years of sub-zero rates. Japan has had zero or negative rates for almost this entire time as well. Although the US stepped rates up prior to the Covid-19 pandemic (to a level that was still historically low compared to the 1980s or even 2007), the eurozone and the UK never had rates above 2% during any COP gathering in the past decade.
But as inflation grips Europe and the US, government rates are soaring. In the US, Fed fund futures point to a terminal rate above 5%, about where it was before the global financial crisis.
This interest-rate environment is obviously not unprecedented, but for renewable energy in particular, it is certainly unwelcome. We can also say that it is unusual, in a sense. Since 2004, almost $4.4 trillion of renewable energy assets have been financed, with most of that funding coming from long-term debt. Of that asset financing, more than $3.6 trillion flowed during the very low-interest-rate period of 2009 to 2021.
Low rates, in other words, have been the base expectation for renewable energy asset finance to date.
Central bank rates are about as exogenous a factor for asset finance as possible. Any company developing new assets right now must take rates as a given. But that doesn’t mean there is nothing the world can do to soften the impact on the energy transition. There are a number of options within structured finance itself.
Developers of wind and solar assets, or EV charging infrastructure, do not actually borrow from the Bank of Japan or the US Federal Reserve; they borrow from commercial entities that anchor to government rates but then add a series of premia to create the final cost of debt for a borrower. Those premia may include a term swap, for converting from shorter- to longer-duration debt; credit insurance, to reflect risk; and finally a spread for the project itself.
So while neither borrower nor lender can affect the Fed’s decision-making process, lenders can still work to mitigate the ultimate cost of capital. Term swaps are probably not a component with much room for negotiation, but others are. A big one is the term of an asset-backed loan. For any given amount borrowed, a longer loan term corresponds to a lower fixed payment. Risk premia, too, can be adjusted if lenders see zero-carbon assets as less risky than other comparable investments.
Longer debt terms, however, are particularly challenging for projects in emerging markets due in part to political risk, as the energy journalist Amy Harder has reported, citing findings from the Rockefeller Foundation.
Enabling longer loan terms requires coordination as well. Lenders are usually reluctant to extend payment terms beyond an asset’s contracted life, and in fact usually limit loan terms to several years prior to the end of a contract (a solar project with a 20-year power purchase agreement, for instance, would likely receive only an 18-year loan). So those purchasing power can do their part, too, by extending contract terms that can in turn allow longer loan terms.
There are other financially related moves to make. One, proposed this week by the CEO of wind turbine maker Vestas, is seemingly simple but fairly profound in its implications: acknowledging that clean electricity might not always get cheaper every year. Henrik Andersen, the Vestas CEO, says that the industry brought this perception on itself. At the same time, rising wind energy prices have never out-competed coal and gas more than they have.
And in specific markets — such as Nigeria — solar power is both competitive with grid power (where it is available) and five times cheaper than power from a diesel generator. Rising rates are not going to erase a five-times price gap in favor of renewables.
Another move is to renegotiate. If a project signed its agreements in a different macroeconomic environment, and those agreements are no longer viable because of current conditions, then they should be renegotiated. It is perhaps not the most pleasant process, but it is truthful.
The example worth watching in the northeastern US, where offshore wind developer Avangrid has asked the state of Massachusetts for a one-month suspension of its existing power purchase agreement for its Commonwealth Wind offshore project. The company’s reasons are a litany of relevant factors: “historic price increases for global commodities, sharp and sudden increases in interest rates, prolonged supply chain constraints, and persistent inflation.” All of those, again, are largely or entirely outside the developer’s control. If a company needs to address those factors through adjusting its contract — and still out-competing other power sources — then it is probably better to adjust terms than to break a contract.
Clean power development is facing a financial headwind not seen in decades. It is undoubtedly challenging, but fortunately there are tools, both highly quantitative and somewhat subjective, that the world can deploy to keep decarbonization in the money.
