PFI Project Finance and COP21 Roundtable 2016: Part 1

PFI: Good morning ladies and gentlemen and welcome to our Project Finance COP21 Roundtable sponsored by HSBC. The fact so many of you are here shows the level of interest in our subject this morning. COP21, the 21st Conference of the Parties, was the UN backed climate change conference held in Paris last December. Whilst not legally binding on nation states, as was the case with the Kyoto conference in December 1997, COP21 does require countries to publish their own national plans on how they will combat client change. In New York in April, 171 countries formally signed the COP21 agreement. So for those of you who are keenly looking to find new deals, there are 171 national plans to read. The impact of the conference has been very positive, with few, if any, after-party rows. After all, the US rejected the Kyoto Treaty in 2001 and, of course, at the Copenhagen Climate Change Conference in 2009 there was no agreement at all before, during or after.

Focusing on COP21’s impact on the market for funding projects, there has been a real feeling of up-surge and interest in renewables this year. Like the results of the conference itself, this is more of an emphasis than a fact. But there have been some key moments worth pointing out. We can highlight four.

Firstly, competition in the solar market has become as hot as the sun itself. Bids for the 800MW solar PV tender in Dubai recently reached a new global low of US$2.99 cents per kilowatt hour. In Mexico they got down to US$3.5 cents. Bids in other countries such as India, while not as low, have certainly been highly competitive. And yesterday the lowest bid for a solar PV in Morocco came in at US$4.8 cents.

Secondly, Moody’s issued an interesting sovereign rating report on Morocco in March highlighting the benefits of the Masan renewables programme on the country’s finances. Normally, renewables are seen as a drain on national budgets but as costs fall this is changing.

Thirdly, new renewable energy programmes are being launched by countries across the world. Today in Algiers, for instance, the EU is sponsoring its own roundtable on building 22GW of renewables in Algeria.

And fourthly, just after the COP21 event in the developed world, the US Congress passed a five-year extension of the production tax credit and a seven-year of the solar investment tax credit. In Australia, anti-renewable energy policies have been reversed. Not that all is rosy, of course. The UK has been cutting back. But even here three massive UK offshore wind farms have been financed in the last six months, raising £5bn in project finance debt.

Power prices in Europe have been falling across the board, undermining revenues and making some investors nervous. Yet the prospects for the renewables market have never been brighter.

We have here a range of experts from the debt and equity investment communities to talk about the most, and perhaps least, attractive opportunities.

Graham Smith: I am one of three green champions in the project finance area of HSBC. One is based in New York, one in Hong Kong and myself in London. My specialisation is actually around transport, but I’m the HSBC focal point for the green climate front. We were accredited with the Green Climate Fund in March this year, which is obviously a route for the developed world to pass funds to the developing world for investment in sustainable projects such as sustainable energy. I’m also the focal point for HSBC with the Catalytic Finance Initiative, which is a group of banks, multilaterals and investors looking at the funding and financing of sustainable projects around the world.

PFI: Could you elaborate on those two initiatives?

Smith: The Green Climate Fund is an interesting initiative and it’s received pledges of US$100bn so far from a range of governments. In effect, all the countries related to the UNFCCC have signed up to it. At the moment the fund is probably in its infancy, having started approving projects only over the last six months. It will fund mitigation projects and adaptation projects, but its real interest is in the developing world, with a focus on Africa and Asia, small developing states and highly indebted poor countries. The fund arguably has a much more altruistic angle than most institutions. It looks at the impact on communities, on gender, the social benefits projects will deliver, as well as the actual climate change benefits. It should become a way of producing very low cost, very long-term funding for projects in the developing world. It is principally funded by grants – I believe the French government has put loans into it, as opposed to full grants. But it should become a very interesting route for financing sustainable projects. To give you a rough idea, by its statutes it can lend up to 35 years and can agree up to 15 years of grace for projects.

The CFI, the Catalytic Finance Initiative, is a group of investors, banks and multilaterals looking in to invest some US$10bn into sustainable projects between now and 2022. The idea of the CFI is that the partners will work together to deliver something as a group, or as a club, that they couldn’t do individually. That may be due to limited appetite, the need to syndicate or the need for an investor to wrap some elements of the project. But the idea is that the investors and the multialterals and the banks work together to produce solutions that they couldn’t do individually.

Stephen Lilley: I run Greencoat UK Wind, which is a listed wind utility, hopefully a member of the FTSE 250 in due course. We listed in 2013 and have a market cap of £650m, focusing entirely on operating UK wind farms. Our very simple aim is to produce a stable and attractive yield and grow capital on a real basis. It’s very straight forward, matching long-term assets with long-term investors in the equity capital markets. In some ways I was slightly amused to be invited to a forum by Project Finance International because the first thing we do when we buy an asset is remove the project finance.

We’ve been very pleased with our development to date. We started with six investments in 2013 and we now have 18. We have 400MW of capacity, producing power for 360,000 homes – so we own about 3% of the operating UK wind market. We think there is a huge opportunity to add to our portfolio of operating wind assets, predominantly from utilities. The market is probably worth between £30bn and £60bn, and we’d expect to buy some of that, at a steady rate.

So a lot of what we do is selecting and acquiring attractive assets that will last for 25 years, and probably have some potential for life extension, and putting those investments into a format that is attractive to private individuals and institutions.

PFI: How did you find the fundraising market? You were recently in the market and completed your fundraising last week.

Lilley: It is difficult to tell. We’ve fundraised five times now, including our IPO. At the IPO stage we set out the story and made predictions about what we expected in terms of production. But three years in we can now point to a real track record. We can say in the first year we’ve produced 8% above budget, in the second year it was 3% below and in the third year 8% above. That makes it easier for people when weighing up investment decisions. And then we can say the dividend cover should be roughly 1.7x, and in the first year it was 1.8x, in the second year it was 1.6x and in the third year it was 1.7x, matching the increased production in the first and third year. So that certainly makes it more straightforward.

In terms of the most recent fundraise, we made sure that our March Net Asset Value was published before fundraising. We also launched the fundraise as soon as we possibly could because we were concerned some investors might not invest with the upcoming Brexit vote. The aim was to come out as soon as we could.

Overall, I think the fundraise was pretty well received. Some of our larger investors chose not to invest more, some of which was due to concerns about Brexit. But that is okay. We want to grow on a steady basis and don’t believe in revolutionary growth or in in doubling our size overnight. And so we’ve done things very steadily and fundraising is part of that organic process. Revolution is not easily compatible with infrastructure. Hopefully investors understand our preference for steady growth.

So it was harder than it has been in the past but we’ve got a pretty good story and track record three years after IPO. So we raised what was required and are pleased with the outcome.

PFI: Harder because?

Lilley: There’s a bit of volatility in the markets. Some of it is Brexit, though I think most of it was general market volatility as opposed to Brexit. We did, this time, put a programme in place, allowing us the flexibility to return to market a number of times without having to put another Prospectus together. That was predominantly to allow us to build scale where necessary, but also to manage those concerns around volatility by having greater flexibility and being able to move faster.

David Kerins: I have a dual role at the EIB. On the one hand I’m very much involved on the transaction side, supporting the transaction teams and the deal teams. I’ve worked on some of the very large private sector transactions like Galloper and Beatrice in the UK and big deals in Africa like Lake Turkana Wind Power. I work on funds, on public sector debts. So its a bit of everything on the transaction side. I’m also heavily involved in the Bank’s policy side. Back in 2013 I developed the Bank’s renewable energy and energy efficiency policies, to try and boost the Bank’s lending in those sectors. More recently I’ve been involved in the Bank’s climate action strategy, which our Board approved last year. The key target is to try to achieve a minimum of 25% of our lending volume in climate action projects, with a target of 35% of that to be outside the EU. These are very substantial targets for a bank like the EIB, which as you know is the European Union’s policy bank. In the last four years we signed about €50bn to energy. It’s a very big business and is very important for the Bank, constituting about 20% of our overall lending. And, of course, renewables and energy efficiency play a huge role in the Bank’s climate lending, because it accounts for about 40% of our lending to that sector last year.

Our involvement in the COP21 goes back to 2013, when the European Commission started to develop the 2030 climate and energy package, committing to the 40% reduction in greenhouse green emissions by 2030. This generated a raft of policy measures, a lot of which are in development at the moment. So we won’t have great clarity until probably next year about the shape of the Renewable Energy Directive, the Energy Efficiency Directive and the New Market Design Directive. But what we do know is that it will drive substantial investment: the IEA estimates it will be worth £13tr up to 2030. So that’s about US$850bn a year, every year up to 2030, which is huge.

PFI: In the EU?

Kerins: No, that’s worldwide. Within the EU we’re a bit more modest, but we still have rather large targets. The Commission estimates that about €210bn a year will be needed up to 2030.

From the project finance perspective we can look at the different sectors and the first interesting point to note is that energy efficiency plays a huge role in all of this investment. It’s responsible for about 50% of the overall numbers, so half of the investment needs to go into energy efficiency. And this is one of the most difficult sectors. At the Bank we have a number of dedicated teams, such as a banking team and a technical team trying to boost lending numbers. I can assure you it’s not for want of trying, but it’s a very difficult sector to boost numbers, and the projects are small. The barriers are well known and I won’t go into them now, but given the scale it’s not a very suitable sector for project finance. Finding a business model that works that can capitalise that investment is very challenging.

Elsewhere it is mostly about power generation and here there is a business model that’s not too difficult. The trick will be to support the new technologies that are needed. Look out to 2050 we can’t just rely on onshore wind and solar PV, we need to think about tidal, concentrated solar power, floating offshore wind farms, carbon capture and storage. There is a whole range of technologies that aren’t really developed yet that we need to support and finance, and the Bank is working on that. We have a small facility for demo projects, it’s only €100m but it attempts to bridge the huge gap we see in the market between the prototypes of projects and their development on a commercial scale.

Ian Berry: We manage about a quarter of a trillion dollars, with infrastructure representing probably a few percentage points of that. Our focus is to invest on behalf of pension funds and insurance companies across Europe, including Aviva, in long-term assets, usually for those who want to match liabilities, pay dividends or pay distributions. A lot of our activity is in renewable energy. We are also active in more difficult areas like energy efficiency. We are active in the debt side of the business – senior debt and traditional project finance – on a substantial scale. We are also involved in the equity side of the business, although our approach is a little bit unusual because our basic approach is to be unleveraged. We think of it as being almost debt but with a bit more upside.

Raphael Lance: Mirova, for those who don’t know, is an affiliate of Natixis, created about three years ago to put all the group’s socially responsible investment activities into one single fund manager. Today, it has about €6bn under management. We propose sustainable solutions to clients by various means such as listed equities and green bonds. We have a green bond fund and an infrastructure fund, including social infrastructure and renewable infrastructure. In renewables we have close to €500m under management. We invest mostly in Western Europe, in existing technologies such as solar and onshore wind. We develop in partnership with industrial companies and typically we like to take projects out of the ground. So we invest mostly in greenfield projects. In recent years we’ve seen this is an attractive proposition for investors and we’ve seen growing interest in renewables.

Is it a COP21 effect? I don’t know. Most likely it’s an interest rate effect, as one of the key drivers is the prospect of good returns. But the willingness to invest into the real economy has been another key driver. There are some initiatives, such as the French requirement that investors publish their carbon footprint which came out within the last year, that have been important drivers. And the intrinsic quality of the assets is also crucial. Industrial risk has declined a lot in this sector, and it has become increasingly competitive. There is lots of liquidity in our market I would say.

Evan Stergoulis: Watson Farley is a global firm, active in the US, Europe, the Middle East and Asia. We’re very heavily sector focused, mainly in energy and transport. And in energy, last quarter we were number one globally in renewable deals in terms of value. Our client base comprises lenders of all types, sponsors and institutional investors in both debt and equity, with the latter group growing.

Our clients are embracing COP21. I saw the Asian Development Bank last month and although four fifths of its lending is sovereign lending, it’s very keen to increase its direct lending, especially into renewables. It is doing a big push and is looking for opportunities where there is sufficient scale for it to make a direct investment. There is lots of money out there, but not many can do execution, so a lot of transactions are hamstrung by the lack of institutions that can do the deals, rather than money. Institutions like the Asian Development Bank and the African Development Bank are there to stimulate the market but gaps still remain. And there is also saturation in the market. So it’s about finding the right opportunities.

John Mayhew: M&G, for those who don’t know, is a European fund management business, managing funds on behalf of insurance companies and pension funds across Europe, as well as for our parent, Prudential Plc. We manage around a quarter of a trillion pounds of assets, so not unlike Aviva, and have been a longstanding investor in infrastructure in its broadest sense, with Prudential making its first such investment to a hydropower project in the 1930s.

We’ve been investing in private debt quite consistently for around the last 20 years, but the teams I look after look across both public and private markets. So we also provide a lot of financing to the large utilities who actually do a lot of renewables by themselves, on their own balance sheets. We look at things from a project finance perspective and from a more normal corporate structure.

The driver has always been relative value. While we talk now about COP21 and environmental, social and governance (ESG), a lot of those elements have often been implicit in investment decisions through the years.

Good governance structures, good engagement in a social context and the backdrop of the environment are becoming more explicit across the industry as we find more of our investors asking us upfront about how we address these considerations, both at the onset of transactions and over time.

I completely agree that COP21 faces challenges around execution and it remains too early to predict how it will play out. Each government will have to decide its own plan of action, in terms of how it will address renewable energy and energy efficiency, and its attitude to nuclear power, which will be a big swing factor. There are some generation gaps coming up in various countries and using gas can be a transitional measure, even if it is not consistent with a long term approach.

Most of our investors are looking for long-term investments to match the long-term liabilities that they have. We invest through the capital structure on the debt side, including in junior debt.

But the vast majority is well structured, senior, secured, investment grade debt, to provide long dated, steady and often index-linked returns for the pension funds and insurance companies whose money we manage. And trying to bring that long term debt in when you’re looking at either transitional environments or newer technologies represents an interesting challenge as we move forward.

PFI: As a pension fund manager, is there a conflict between return and ideals? When a fund trustee, for instance, comes to you with a mandate, what’s the mix between seeking maximum returns and an idealistic renewable approach?

Mayhew: It’s an interesting question. A couple of people have already mentioned interest rates aren’t exactly high at the moment. But even setting that factor aside, pension scheme trustees have a fiduciary duty to seek returns. While they may, in and of themselves, have a desire to invest in an environmentally conscious basis, they can’t necessarily to so at the expense of returns. There are some recent changes to UK Charities guidance which will help those investors, but they’re a relatively small piece of the pie.

It comes down to how you interpret reward and return. A lot of the conversation post COP21 has highlighted that institutional investors on both the debt and equity side need to engage with companies. They need to ask whether those coal mines and oil reserves they own are actually stranded assets, how they should be valued on the balance sheet and how they are going to be accessed going forward. Some of the people agitating for change are trying to move the dialogue in that direction, because otherwise a pension fund trustee has a fiduciary duty to seek the highest risk adjusted return across the portfolio. They can’t accept returns that are 1% worse than they might otherwise have been just because they are environmentally friendly.

PFI: On the bank side, Michael Bloomberg is working on some guidelines for banks which could have a similar impact.

Smith: It’s the same idea. It’s very much looking at the mix you should have in your portfolio and trying to reflect what government and society need to tell the financial services industry. But at the same time the financial industry is concerned with supporting its clients. I don’t think things are going to change overnight because it isn’t possible. I think around 70% of the world’s population relies on coal-fired power, so you can’t just switch this off. So there is pressure and there will be change, but it will be a gradual change.

PFI: Picking up on Evan’s point about Europe and COP21. Has COP21 has been a game changer in Europe? What are the major deal opportunities that people see at the moment in the renewables space?

Smith: Obviously renewable energy is going to be an interesting and growing market in Europe. Another angle is going to be energy efficiency, smart meters and smart lighting. There is a new awareness that smart cities provide interesting opportunities for financing, both in Europe and around the rest of the world. If you look at the way population growth is moving, more and more people around the world are moving into cities, meaning they will represent an increasing share of emissions. In Europe there is going to be activity around smart cities, with smart meters, smart lighting and smart power grids, which will help energy efficiency. These are areas where European countries are strong. We see this becoming an export market, with European cleantech increasingly being exported around the world. That’s another business opportunity around the sustainable financing area.

Lilley: Is COP21 revolutionary? I don’t know the answer to that question yet, but it does at least show people want to limit the increase in temperature to less than 2%. It shows political will, which is a very good thing.

But how is that going to work in the UK? We’ve already got targets in the Climate Change Act so it probably doesn’t have much of an effect there, even in the medium term. Since Paris the UK Government has changed its language around ‘expensive’ renewables, onshore wind in particular, which it made a lot of noise about when the Conservatives came into power last year. In reality though, the presence of grace periods means little has actually changed. Since Paris, the negative rhetoric has died down, which is a good thing.

One of the biggest issues that we’ve had in the UK is that the cost of capital for renewable projects is quite large compared to other parts of Europe. I believe that the Government is partly responsible for this, especially with the Conservatives seemingly wanting to tinker fairly regularly. That probably has led to investors worrying about change. In other European countries the cost of capital is a lot lower and there is greater comfort that policy is not going to change. In Germany they have even arguably overdone it.

So is COP21 a game changer? If it means that the Government is slightly more silent that is a good thing.

Kerins: COP21 doesn’t actually kick in until about 2021 so we still have to wait and see the ultimate impact. Before it starts there’s a lot of legislation and policy that needs to be agreed and decided upon – at the EU level, and outside the Union too. A lot of the deal flow we see in the market today is still really driven by the 2020 target. At the EIB we see an awful lot of very big offshore wind projects. It’s a sector that the Bank can play an important role in. We see a lot of projects in the UK, and Germany, and the Dutch and French rounds should be coming soon as well. So there are a lot of things happening in the offshore wind space across Europe.

The other sector in the EU where we see a lot of deal flow is in smart meters, especially in the UK. Smart meters are very much on the agenda for 2020 and many member states are trying to roll out programmes. So we see a lot of activity there.

In the 2020 time frame we are seeing a shift from investment within the EU to outside the EU. We saw a bit of a bubble around 2012, mostly driven by photovoltaic (PV) in Europe. That investment has dropped off a bit and it hasn’t really picked up again. We haven’t really got back to those very high levels of investment in the EU, but we have seen a big shift outside the EU. We talk with a lot of EU businesses now that are active in markets like Uganda, Kenya, Egypt, Morocco – all over North Africa and Asia – trying to develop projects. So they’re bringing that European expertise that they’ve developed under the 2020 targets and they’re bringing that to new markets.

PFI: The UK has moved ahead in terms of smart meters with other counties catching up?

Kerins: It’s difficult to say because the UK model is so different to everywhere else. Typically meters are a regulated business in distribution companies. It’s a very dull business: you put in a meter, it sits there for 25-plus years, then you replace the meter. But in the UK you have a very different structure which allows for project financing. We see these meter asset providers capable of bringing in new sources of finance, bringing down the cost of capital, and it’s actually quite exciting.

The overall approach really sets the UK apart. Typically we would see smart meters as essentially just digital meters – they’re not that smart. But in the UK they’ve put a lot of thought into the process, with home area networks attached to the meter. This opens up all sorts of possibilities in terms of passive participation in energy markets, if fridges ever advance to the right stage. There’s a lot more possibilities for things to happen in the UK. I don’t really see that approach being replicated anywhere else in the EU at the moment.

PFI: Evan mentioned gaps in the market in terms of new technology. Do you think there are gaps in the market?

Kerins: The issue with new technology is scaling up the demonstration scale. In the UK we see quite a bit of activity, especially in the tidal space. The UK is far ahead of many other markets in that respect and there are some very interesting projects. They need some kind of regulatory scheme to support them. It’s a little tricky at the moment with the auction approach that you have in the UK, which doesn’t encourage them to roll out quickly. They also need to secure some bank finance, which is tricky for a lot of these technologies as they’re not proven and banks aren’t typically attracted to unproven technology. This is a challenge. We have a facility that allows us to invest in unproven technology, called the InnovFin Energy Demo Projects, which has a guarantee from the Commission. But it will be a real challenge to attract financing to support these new technologies.

Berry: It’s early days for COP21. The sorts of things that we finance or buy are the same things that we saw six months ago, or even twelve or twenty-four months ago. The difference is the price, or price aspirations. We still see lots of things to do.

Evan made a point before about the problem is actually the people. There aren’t enough people wanting to create the kinds of investment opportunities that the end investor actually wants. There is a lot of mismatch. Put simplistically, there is a lot of debt and equity chasing big deals, but mostly renewable energy efficiency schemes are not big deals. That is a challenge.

I don’t want to be critical but it’s relatively easy to deal with offshore wind farms, because they’re big. But the real difference is going to be made by people in their homes, in their businesses and in their cars, doing things differently every day. Financing that is really tricky, and that is a big part of what COP21 is trying to do.

PFI: Does that mean you have to look at things that are slightly riskier? Or deals that are slightly more challenging?

Berry: The challenge is then matching risk with appropriate return. There was the Green Deal idea some years ago, that was something that really interested me on behalf of my investors. But the price that it interested me at was too expensive for the householder to bother to do it, so it fell apart. That is fundamentally the challenge, and that’s why, at least to begin with, you need the regulation, or the feed-in tariffs, to kickstart these new sectors. Some of the things we’re talking about here feel as if they’ve been around forever, but they haven’t, they’ve just had that kickstart that means there is now £60bn of onshore wind, which means you can buy a proportion of them.

Stergoulis: On and offshore.

Berry: Sorry, and offshore. But there are loads of other sectors too. I don’t think anyone has mentioned heat yet, but that’s a very obvious one where it’s quite tricky to know what to do. We are trying to be active, or proactive, but it’s never going to be a project financing because even the largest heat networks will be relatively modest in size: perhaps £5m, £10m or maybe £20m. I am focusing on the UK here but there are plenty of heat networks around the rest of Europe, in particular, that are already a substantial size.

Lance: There is still a great need for capital among the mainstream renewable energies. We still have a lot of onshore wind farms and solar PV plants to build for our 2020 objectives, requiring about €50bn per year. So there are still a lot of opportunities in Europe.

Energy efficiency is an interesting topic because the project finance community has not yet figured out how to finance projects that deliver negative income. It’s mostly financed through corporate investments. So the development of green bonds, for example, is a very interesting way to finance energy efficiency.

Another sector that we look at that is increasingly interesting and competitive is storage coupled with renewable energy production. It will be crucial in the fight against intermittencies. Storage technology is becoming really competitive: prices have halved in the last couple of years and it’s going to continue.

We also think bringing biogas to the grid will be very important in the future, as an ecologically friendly way of recycling waste. Traditionally, biogas has been mostly used for coal generation, but now there are ways to mix it with the natural gas in the system. France has an objective to have 10% of its gas coming from biogas by 2030, which is going to require a lot of investment.

And then there is ecological transportation. Electric cars are becoming increasingly popular, but there is not yet much infrastructure. A lot of investment will be required in that sector.