Many renewable energy project investments and exit valuations would have taken a negative hit in the past 10 years if we were dealing with today’s interest rates; some projects would probably even have been aborted during development.
This is particularly given the fact that, historically, the region was in the nascent stage of energy transition, and most stakeholders were in the design phase of what could and could not work to catalyse the growth of renewable energy infrastructure.
Important benchmarks have now been set, along with experience and established processes having been transferred from other regions—so the question is, has the market evolved enough to allow investors to mitigate interest rate risk?
Exhibit: Interest rates have increased at a rapid pace in the past year and a bit
Recent developments
The renewable energy sector has seen tremendous growth over the past decade, with renewable energy sources accounting for an increasing share of the world’s electricity supply. That said, according to IRENA, “the average annual investment in renewable power capacity in ASEAN should scale five times from now until 2050 compared to the 2019-2021 average” ($15 billion/year to $73 billion/year).
Rising interest rates can have a negative effect on the cost of capital due to higher debt costs and that can ultimately threaten the profitability of projects. This in turn increases the risk, making it more difficult for developers to obtain project financing. Lenders, when faced with increasing risks, incorporate project finance terms with more protective covenants and ultimately shift their risk to the equity sponsors. In many cases today, whether based on commercial terms or legal covenants, single project financing for construction may not make sense until the project has been de-risked through construction.
At the other end of the project lifecycle when project developers/investors are seeking to monetise the operating asset, higher interest rates increase the discount rate and lower the valuation. This is a serious problem for private equity and other investors alike, who must work within relatively short timeframes to realise their investments.
The inability to hold, continue scaling and wait for a more attractive valuation scenario again is a structuring shortfall.
What can companies and investors do?
While rising interest rates could have a negative impact on renewable energy investment, there are strategies relevant today that companies and investors can use to mitigate these effects. Here are a few examples:
More robust project screening and review. If the working assumptions change, review the profitability and if necessary, recut the economics or stop the project. Experienced management teams are key when faced with critical decisions of when to change course or say abort!
Diversify financing sources. Especially in developing markets without precedent, project finance for new wind and solar projects could take one to two years to put in place. Concessional finance is a possible alternative in the developing markets, but companies had to approach the debt capital markets to fund OECD project portfolios. Green bonds were notionally feasible but for many investors the potential portfolio was not diversified enough, or the market risks were still too great. Companies like Vena Energy and AC Energy that were able to scale their portfolios, have successfully issued green bonds, so look at their transactions for reference. Alternatively, with larger investor commitments, all equity could be a differentiator for the project developers over the next few years.
Focus on execution and operational efficiency. In-house expertise is a key driver with the knowledge and network of relevant service providers to deliver this optimisation and increase margins. It can include doing both your own project design and engineering or equipment procurement instead of relying on a turnkey EPC solution. Again, scale is critical here, with many early mover project developers being small entrepreneurial teams with limited financial resources, hence too small to put this in place. Investors today should be mindful of whether and how this approach can be incorporated and funded.
Instead of just investing in projects pre-developed by relatively small domestic project developers, larger investors who are prepared to take early-stage risk are creating new regional management teams, within corporate structures, who have a combined breadth of experience to implement strategies highlighted above. Now regularly referred to as platform businesses, these entities are multi-country, multi-sector, multi-project entities with the equity commitment in the hundreds of millions if not more. This way they can diversify their risk, choose when and how to incorporate leverage, optimise execution and operation, and ultimately have more flexibility and control over when and how they monetise their investment.
When it comes to monetising the investment, platform businesses with operating assets and a pipeline of projects under development are valued on a combination of the operating cashflow in addition to growth prospects. The additional premium buyers are willing to pay for future growth could more than offset the effect of higher interest rates. This would not necessarily be the case when trying to sell a single operating project. The best reference point in the region in the past five years to support this approach is the sale of Equis Energy to Global Infrastructure Partners, now operating as Vena Energy.
Walking the tightrope successfully
Rising interest rates could potentially make it more difficult for companies to finance new renewable energy projects and reduce the profitability of existing ones, but there are strategies that companies and investors can use to mitigate these effects. It is more effective to implement these strategies with a diversified scaled portfolio, so investors and developers that can, should focus on platform partnerships.
It is good news for both investors as well as developers. Asia has a growing, experienced talent pool of teams coming together and equity investors should focus on finding the right platform to back. The easier money has been made—low interest rates, high government subsidies, lack of competition from low cost of capital utility companies and the like are in the past. One shouldn’t underestimate how easy it could be for margins to be eroded and losses to be incurred; take the time to make sure your strategy fits with current market conditions. By carefully considering these structures and strategies, renewable energy infrastructure should continue to expand, even in the face of rising interest rates.
Andrew Affleck
Andrew is the founder and managing partner of Armstrong Asset Management, an institutional private equity firm investing in renewable energy infrastructure in Southeast Asia. He was formerly the CEO of Low Carbon Investors Ltd, a dedicated European clean energy fund management group. Prior to joining Low Carbon Investors in 2008, Andrew worked throughout Asia in various capacities. He has 32 years of asset management and investment banking experience, and specialises in renewable energy investments for the last 16 years.
