Renewable energy (RE) is the answer to a number of questions, including those regarding battling climate change as well as ensuring geopolitical energy security. However, the answer to promoting fast RE growth rests on ensuring that RE has no shortage of private-sector financing. This is because the private sector has been the vanguard of power production since the late 1980s. Therefore, securing the necessary financing for private RE generation will determine the speed with which the global community achieves environmental sustainability.
Importance of finance in the green-energy sector and the investment deficiency
Financing is a very important element in promoting the growth of RE. Investment in renewable energy can come from public or private sectors. Many times, investment by the public sector has induced investment from the private sector. In addition, government financing for exploratory RE projects is also justified on the basis of basic research being a public good.
Within private investment, venture capital enables the deployment of RE technologies. Specifically, venture capital helps RE technologies surpass the “Valley of Death”, which involves transforming a new technology from proof of concept to a commercial entity. Of course, non-finance objectives also influence financing decisions in RE projects.
However, with all of these dynamics, there are a number of obstacles to growth for green-based power firms. Removing these obstacles will ensure faster growth for RE and hence a more sustainable planet in the long-run.
Fixing the issues in green finance
The financing challenges for renewable energy stem from internal and external sources. Internally, certain characteristics of RE add new challenges for investors. These internal issues are compounded by a number of external factors, such as policy uncertainty and banker bias.
Starting with internal factors, RE facilities must contend with a number of new issues that don’t affect traditional non-renewable-energy power production. These include weather risk, shape risk and price risk.
Weather risk relates to the fact that many renewable-energy technologies depend on variable factors, such as cloud cover and wind speed. Both of these factors vary a lot within a day. Climate change will further exasperate these risks due to unpredictable local effects. Weather risks can be reduced through national efforts for standardized and better collection of weather data.
Shape risk refers to the time difference between generation and sale of contracted energy. Renewable-energy delivery varies, according to the weather. Yet in a merchant market, the producer is often contracted in advance for the supply of energy. Therefore, the power producer always faces the risk that weather variation will compromise its contractual obligations.
In addition to shape risk, the RE producer also has to contend with price risk. Price risk relates to the nature of pricing in a merchant market. Within a local area, the price set in the market will depend on supply and demand. Simultaneous massive supply by a number of producers will naturally depress the price. This is a very common phenomenon in RE, when all local producers—e.g., wind power—simultaneously supply power. Due to this factor, RE producers face the risk of low prices, which will not guarantee positive returns on investments.
Weather risk, price risk and shape risk can be mitigated through the use of proxy revenue swaps. A proxy revenue swap replaces a fixed payment for the variable value of the project’s revenues. Proxy revenue swaps are offered by the insurance industry. In a way, this financial structure is a means to pool the risks for the whole industry.
Externally, RE power producers often face challenges from the various economic agents in the economy. They include the government as well as financial institutions, such as banks. Specifically, RE producers face significant risks from unclear government policies and biased behavior from financial institutions.
Banks have a number of issues with renewable-energy projects; a number of factors stop RE financing from meeting its potential. First, the size of investment required in capital-intensive RE plants is much larger than venture capital’s maximum ability (B. Gaddy, V. Sivaram, F. O. Sullivan, “Venture Capital and Cleantech: The Wrong Model for Clean Energy Innovation,” MITEI Working Paper No. 2016-06). Similarly, banks find RE projects to be too risky for their comfort. This increased risk comes from the uncertain nature of the fuel as well as the lack of long-term data regarding renewables. Furthermore, financial institutions also find the low scale of investment to be unattractive.
Addressing these concerns requires that certain actions be taken by central banks and governments. Central banks can help fix problems by creating projects with concessional interest rates. These funds will create an information bank that can be used by future financiers in assessing the risks for future RE projects. In addition, central banks can also allow innovative financing mechanisms such as crowd-funding.
Governments all over the world have assumed RE financing to be an important part of its future energy mix. This support has been given through fiscal and financial measures. However, these comprehensive efforts have a few chinks in their armor relating to both fiscal and monetary concerns.
Fiscally, governments need to have a more diverse investment portfolio. Although governments have been at the forefront of funding solar and wind renewable-energy generation, they need to fund other avenues of investment as well. This refocusing is justified on two grounds. First, having a wider portfolio minimizes exposure to research failure in any one technology. In addition, a diversified RE-investment portfolio will enhance system resilience.
Apart from tapping different types of technologies, governments also need to ensure that they invest in different stages of RE development. Studies have found that there is a dearth of investment in the deployment phase of RE projects [European Commission, Technology Assessment Commission Staff, Working Document No. SWD(2013) 158 final]. By investing in the deployment of RE projects, governments can ensure overall higher rates of return for RE projects. This is because the deployment phase better leverages the investments made in the research and development (R&D) stages.
On the policy front, governments can perform course correction by taking two steps. First, they need to reduce the uncertainty regarding their policies; a medium-term framework for policies will reduce uncertainty for investors as well as financiers. Furthermore, governments need to make sure that there is no major split between the power policies of the center and the provinces/states. If that happens, investors will start to approach the country as different markets. This market segmentation will cause businesses to act in an opportunistic manner. Therefore, governments need to ensure adequate policy synchronization and compatibility between the provinces and the center.
RE is the closest thing to a silver bullet when it comes to battling climate change. In addition, RE investment also guarantees energy security. However, there are a few obstacles to RE financing that need to be urgently addressed. These hurdles emanate from external as well as internal sources. Internally, risks come from the nature of RE power generation. External sources of risk, on the other hand, come from public and private sectors. Addressing these concerns will ensure that RE financing meets its potential.