Prospects of Investing in the Long-Term Debt Securities for Funding Renewable Energy Projects in Emerging Economies
By Dr. Babu Ram
The emerging economies are adopting new and innovative approaches to expand their renewable energy portfolio with the assistance of private sector participation in their projects. The innovations happen in both demand and supply side. The approaches on the supply side are renewable energy portfolio standards (e.g. green certificates), net metering, renewable energy feed-in tariffs, and auctions for procurement of MW / MWh. Renewable Portfolio Standards and net metering are in use in the US and Europe. Renewable Energy Feed in Tariffs are widely used in developing countries. According to IRENA report, 30 developing countries out of 44 countries used auctions as of early 2013.
The experience of emerging economies such as South Africa in the use of procurement auctions is worth the discussion with the objective to understand challenges and opportunities in terms of exploring alternative sources of financing of renewable projects utilizing solar and wind. Finding the alternative funding instruments is imperative because the supply of funds from conventional debt channels namely, commercial banks, is reaching limits or even expected to decline, toward funding renewable energy projects.
The electricity supply in South Africa is dependent on coal and the country is committed to progressively displace the use of coal for power generation. It is investing in clean coal technologies. It has prepared an atlas of carbon storage sites. Its potential for solar energy and wind energy is well documented. Its electricity transmission grid is healthy and is capable of absorbing 5000 MW renewable energy projects without any additional investment.
The renewable energy development began with the announcement of feed in tariff in 2009 but it was abandoned in favor of procurement auctions because the procurement based on the feed in tariff was not in conformity with the national procurement laws. The country launched procurement auctions in favor of feed in tariff in 2011. It has successfully conducted three rounds of auctions to source renewable energy projects under the South African Renewable Energy Independent Power Producer procurement program (REIPPP). In round 1, 28 bidders were qualified to produce 1416 MW of renewable energy. The round 2 generated 19 preferred bidders to supply 1045MW and round 3 the 17 preferred bidders to produce 1470 MW. The three rounds of auctions together contributed to 55% of the targeted RE capacity addition by 2020. The fourth round auction, furthermore, yielded 1121 MW new renewable energy projects capacity additions.
The key outcomes are: the offered unit electricity price has progressively declined from the round 1 to round 3 in regard to wind energy, solar photovoltaic and solar CSP. The round 3 also picked new renewable energy projects, namely a landfill gas-to-power project and a biomass project. Local content in the renewable energy projects has increased; South Africa invested US $10 million to prepare bidding documents, conditions of contract and evaluation of bid which is a big amount for a small Sub-Saharan economy.
The implementation modalities for developing the selected projects are: the renewable energy projects developers sign a PPA with the state utility ESKOM, which guarantees a payment for power generated at an agreed tariff, based on a “take or pay” for at least twenty years. The Department of Energy provides investors a second line of defense and offers recourse to government if ESKOM fails to honor its commitments subscribed in the PPA. These dispensations make the PPA a credible instrument enabling developers to raise funds for project development purposes.
On the basis of these PPAs, selected bidders raise equity (30%) and debt (70%) to implement renewable projects. The resultant preferred bidders of the three rounds have already secured the financial closure status. The debt has been financed from major local commercial banks and equity by institutional and domestic investors. However, Soittec Solar, a company selected for a solar PV project, secured $111 million of debt finance through issuance of a rated bond in 2013. The project was expected to be completed in 2014/15. The bonds have been purchased by South African institutional investors such as insurance companies and pension funds. This shows that the debt financing is possible through renewable energy bonds.
There are two pertinent questions in regard to raising debt in emerging markets: (1) what should we do so that the experience of Soittec is emulated by other companies in emerging economies? (2) What should be done to attract the international institutional investors to purchase long-term debt securities in the emerging economies?
To investors, a bond is a fixed income security. A bond is characterized by an annual interest rate, called coupon and bond duration. For example, coupon rate could be 5% per annum on the par value of a band. The bond issuer pays to investor an yield based on the coupon and face value of the bond. The bonds after issued are listed on the stock market, can be bought and sold by investors. The real bond value fluctuates with macro-economic variables such as rate of inflation and interest rate of economy. If the market interest rate is higher than the coupon, the present value of the bond reduces and investors loose. On the other hand, stable macro-economic conditions such as low interest rate, low inflation and well developed stock markets offer investors a higher yield than assured by coupon interest rate.
The project developers need to study the macro-economic parameters of a country and credibility of the stock markets. It should take the help of noted transaction advisers to develop a bond prospectus for investors. The prospectus defines, among others, coupon, maturity and rating of the bond. The bond needs to be rated by an international rating agency. The bond rating should be an investment grade in order to inspire investors to invest in the bonds. The investors avoid the junk rated bonds. The bond prospectus needs to be approved by the stock market regulator. The project developers need to appoint smart investment banks to market these bonds to institutions investor such as insurance companies and pension funds. The institutional investors try to match duration of their assets and liabilities.
There is no doubt that opportunities are big for investors in renewable energy bonds to be issued by private project developers in emerging economies. However, the international investors view emerging markets purely from the risk perspectives. Such risks as political upheavals, labor strikes, large unemployment level, policy reversal risks, policy paralysis risks and two digit fiscal deficits make the international rating agencies weary and they down grade sovereign bond rating. Downgrade of sovereign bond rating might have impacts on current and future projects due to rising debt service cost. It might lead to increase in the infrastructure service supply cost. Therefore, infrastructure projects must be implemented within the time schedule and budget.
Moreover, there is need to improve the macro-economic policies (a) accelerated economic growth with jobs, (b) stable interest rate, (c) stable exchange rate of national currency with US$ / Euro in view of the expected US Treasury’s tapering of the quantitative easing, (d) prudent fiscal management and (e) monetary policies to control inflation. In the current situation, the international investment in renewable energy bonds is likely to lag behind other sectors, in emerging economies. However, renewable energy bonds could be given some sops such as a tax free status to attract international investment in the long-term debt securities.