Energy transition: power companies can't do it on their own

European Climate Foundation calls on policymakers to engage the financial community

Energy transition: power companies can't do it on their own

By Karel Beckman

European energy companies will not be able to finance the transition to a decarbonised power system on their own. They will need the help of institutional investors. But these investors will only become involved if the EU and member state governments become more actively engaged with them and reduce the policy risks associated with low-carbon energy sources. Those are some of the main conclusions coming out of a new report from the European Climate Foundation about how to finance Europe’s transition to a low-carbon economy. EER's editor Karel Beckman spoke with two of the report’s authors, Martijn Broekhof and Sean Kidney. "There has been too much emphasis on pushing risk on to investors."

“The utilities are not going to do it on their own. The scale of investment is to large for them to carry on their balance sheets and the risks too high.” The European Climate Foundation (ECF), world famous for its Low-Carbon Roadmap 2050 that came out last year, has a new, very clear message for European policymakers. The European energy companies, says ECF in a new report, ‘Financing for a Zero-Carbon Power Sector in Europe’, will not be able to finance the transition to a decarbonised power system. At least, not by themselves. “They do not have the funds”, explains Sean Kidney, Executive Chair of Climate Bonds Initiative (CBI) and one of the report’s authors. “The only way they will be able to do it is by getting assets off their balance sheets and getting outside investors involved.”

The ECF’s Roadmap 2050, which got a tremendous amount of publicity last year and is still regarded as one of the standard climate change policy reports in Europe, had an optimistic message. It said, yes, we can – it is technically possible and financially affordable to move to a zero-carbon energy system in Europe over the next four decades. So, in theory, the future looked bright. The question that remained, however, was: how can theory be turned into practice? Most of all: how can the huge amount of investment capital be found that is needed to build the new power generation and transmission systems for the “green economy”? Without this investment, the low-carbon dream will not become reality.

ECF has now come out with a follow-up report which addresses this question – for which, incidentally, they have not sought wide publicity. “We have not actively sought publicity for this report”, says Kidney. “Our focus has not been so much on getting the report out there as on getting projects going on the basis of it.”

Funding gap

The new report, which represents the findings from an extensive consultation process with the finance community, starts out by establishing what has by now become common knowledge: the dreamed-of green economy is faced with a funding gap – a ‘capital crunch’. This is mainly because renewable energy systems are highly capital intensive: they have low operational costs (they do not use fuel), but require large upfront investments. The same goes for other low-carbon systems, such as new nuclear power stations or carbon capture and storage projects. ECF estimates that just for the next 15 years €1.3 trillion needs to be invested in power transmission and generation systems – a doubling of the historical investment rate. This at a time when the economic climate is hardly conducive to large investments.

ECF notes that this amount of investment cannot be put up by the power companies on their own. “There is not enough capital available from the active actors in the power sector in the current system to meet decarbonisation targets”, the report states bluntly. This is not to say that the energy companies do not have a role to play. On the contrary, the report notes that “utilities are the primary actors who can really take on the large-scale complex generation assets, such as offshore wind projects and nuclear new builds.” But they cannot finance these projects on their balance sheets. “Much of their capital is locked-in and cannot be easily freed up to be reinvested. And many of the larger utilities are struggling to hold on their credit rating, which makes it harder for them to access low-cost capital.”

What this means, says Martijn Broekhof, co-author of the report and Power Programme Associate at ECF, is that utilities will have to change their way of working. They will increasingly need to change from owners into operators of assets. “In the current situation a utility will build a coal-fired power plant and will put it on their balance sheet until the end of its lifetime. That’s not the way you’re going to build the low-carbon economy. You need to have the utilities building assets, but making sure they get the assets off their balance sheet by refinancing, making them more nimble and flexible.”

Broekhof adds that this requires “a change of mindset” for the power companies. He concedes that it is not certain they are prepared to make this ‘transition’. “We talked to eight or nine utilities across Europe, but mostly to the most progressive people in those companies. There will still have to be a lot of internal convincing.”

Different beast

If power companies are expected to “refinance” projects, that means external investors will need to be brought in. That is indeed one of the key messages of the ECF’s report: there is "a need to find new ways to attract different types of investors to the power sector”. These will typically be institutional investors, such as pension funds or sovereign wealth funds. They are at this moment “under-exposed to the power sector” and “are increasingly interested in it”, notes ECF.

“We organised four roundtables for the financial community”, says Broekhof. “And there was a lot of interest to participate. Institutional investors usually talk to utilities one on one. Now they had a chance to talk to other investors in the supply chain.” Broekhof found that the investors were very interested in new investment opportunities. “They are always looking for better options. And they know Europe needs to shift to a green economy. They want more deal flow, more projects.”

In many ways the requirements of institutional investors are a perfect match for the renewable energy sector, notes the report. “They have a long investment horizon, which fits very well with the lifetime of power assets. Operational risks and costs are very low once the asset is up and running, and the returns are guaranteed for a long period – at least, when supported by a subsidy regime.”

Nevertheless, it would be a big mistake to assume that institutional investors will spontaneously rush in to finance the low-carbon transition, warns Broekhof. There are still many hurdles to be jumped before this will happen. The biggest hurdle perhaps is that there is a huge communication gap between the financial community and the climate policymaking community. Broekhof: “We found that the financial community is not part of the energy policy dialogue. They are not part of the conversation. Policymakers tend to talk with utilities rather than the financial community. They live in different worlds. Investors often feel misunderstood by policymakers.”

As an example Broekhof notes that policymakers tend to look at the financial community as one homogenous group. “But there are many different types of investors. You have equity providers, debt providers, pension funds, commercial banks. They react differently to incentives. You have to look at the whole finance supply chain”

“We told the European Commission they should go and seek out investors”, adds Kidney. “But they said investors should come to Brussels! I would argue that European policymakers do not sufficiently appreciate the importance of engagement with the financial community. They tend to be too preoccupied with internal politics. And this goes for national Treasuries as well. We were shocked sometimes by the lack of appreciation of investor issues in Treasury departments.”

According to Kidney, policymakers tend to feel that institutional investors should be prepared to shoulder a significant part of the risk of low-carbon projects. He thinks that’s a mistake. “There has been too much emphasis on pushing risks on to investors. This is a society-wide, externalised problem. A solution requires society-wide measures. We cannot expect individual players to carry a risk which is actually a society-wide risk. Policymakers need to look at how they can de-risk investments.”

Institutional investors, says Kidney, will only make investments in the power sector if they are “equivalent to investment-grade bonds”. This is certainly not the case now. There are still numerous practical issues to be resolved. For example, ‘deal-size’ can be a problem: renewable energy projects sometimes need to be scaled up (bundled) or down to fit within investor parameters. The attitude of rating agencies towards low-carbon projects is also important. Institutional investors also need to understand the market better, notes Broekhof. “They don’t always have the right expertise now to evaluate projects. They will need to be educated.”

Too complex

But all these risks can be handled, or priced in to the investment, says ECF. The only risk that cannot be controlled by investors is the political one. Policy changes are unpredictable and can have “unlimited effects” on the profitability of the investment, notes the report. An example is the recent decision by the Spanish government to cut solar subsidies retro-actively. “Even though the actual effect of this decision was limited, this completely spooked the market”, says Broekhof. “It sent ripples throughout Europe.”

Another example is the German nuclear phaseout decision. This not only impacts the nuclear power sector, it could also affect the renewable energy sector. ECF notes that a discussion has started in Germany about subsidisation levels. “Renewable energy adds one-third to the wholesale energy price for consumers”, the report points out.

Another risk that investors perceive is that they feel the decarbonisation agenda in Europe is being pushed by “Brussels” rather than at the member state level. In the eyes of financial players, “there seems to be a disconnect between EU-level ambitions and national policies”. In addition, the EU is viewed as fragmented and “too complex” – a “patchwork of different policy regimes”, but at the same time “highly interlinked”. Investors do not necessarily want a completely uniform or perfect market, says the report, but they do want to see a “durable pathway” for their investments.

Industrial planning

In the end, says ECF, it is up to policymakers to create the “investment-grade policy framework” that will induce institutional investors to make investments in the low-carbon sector. ECF has various suggestions that the EU and member state governments could follow. For example, they could offer some form of “political risk insurance” that would allow investors to insure themselves against the risk of policy changes, more or less on the model of export credit guarantees. Or they could help set up a “climate bond market”.

They could also intervene more directly in the market by offering warranties and ‘wraps’ through government-backed institutions, such as the new UK Green Investment Bank, the European Investment Bank (EIB) or the European Bank for Reconstruction and Development (EBRD). According to Kidney, governments in Europe should follow the example of the UK by setting up government-backed Green Investment Banks. “In Germany you have KfW which more or less functions as a green bank, and in France Caisse des Depots. In many other countries there is nothing. The EIB and EBRD could also be drawn in. They have a lot of expertise in the power sector already, but they are not focusing on low-carbon options. Indeed, in Slovenia they invested €770 million in a coal-fired power plant that did not even have any private sector leveraging. That’s where we don’t want to go.”

In fact, policymakers should go even further than merely offering financial guarantees to institutional investors, says Kidney. They should not shy away from forms of industrial planning. “We are not going to achieve the society-wide change required at the speed required unless we have a broad mobilisation of the various actors in society. At the moment we are edging around how to mobilise them. In Europe we have a better chance to do it than in the US, which is horribly hobbled by their bias against industry planning, despite the fact that two of their own most successful industries – defence and oil & gas – owe a lot to government planning. In Europe we have the opportunity to apply the American experiences in the defence industry and oil and gas industry to the clean energy industry. That’s the opportunity ahead of us.”