12 September 2022
Renewables’ risk-reward trade-off: Perception vs reality
As is often the case when a new techno-economic paradigm emerges, an essential part of determining the new model’s risk-reward trade-off is to adopt the right framework to comprehend its new technologies and micro/macroeconomic characteristics – this process is only just beginning for renewables. Yet it is happening at pace – post-pandemic opportunities for investment are bountiful as countries enforce reduced emissions targets and energy demand grows.
According to the IEA’s World Energy Investment Report 2021, renewables dominated investment in new power generation. Renewable power was expected at the time of its publication (June 2021) to account for 70% of 2021’s total of USD 530 billion spent on all new generation capacity. China, the US, the EU and India are the greatest investors in renewables.
Undoubtedly the Ukraine crisis reinforced this trend in 2022, as the EU targets a 15% reduction in gas consumption between August 2022 and March 2023. At the same time, the Ukraine war has raised some questions about a potential revival of coal and LNG to deal with the sudden shortfall of Russian natural gas, and COP 26 commitments have proven disappointing in this context, yet the war will not lessen risk appetite for renewables medium-term.
Source: International Renewable Energy Agency 2019
Indeed, the risks of renewables investment are more than offset by handsome rewards, which are driven by two main factors:
- A structural shift in overall demand for ESG investment – especially from millennials looking for impact, and this is combined with corporate concerns over the avoidance of reputational and litigation risks, though not at the expense of commercial drivers
- Reducing operating costs – ten years of policy incentives creating economies of scale in renewables supply have resulted in average costs of photovoltaic solar energy falling by a factor of four in the last ten years. They are expected to continue falling due to economies of scale. Floating offshore wind costs have also fallen particularly steeply, with 2016 and 2018 being breakthrough years. Auction results suggest that projects commissioned from 2020 onwards could fall in the range of USD 0.06 and USD 0.10kWh, and many offshore wind projects are coming within the cost range of fossil fuels sold at auctions.
Falling costs are all the more noteworthy because Western risk assessment models inherited from Fordist times originally misunderstood the uniquely advantageous cost-risk structures of photovoltaic energy. This case exemplifies how crucial a robust framework for understanding renewables is. Without it, perception rules, and it is impossible to grasp the reality of the risk-reward trade-off.
It is undeniable that renewables are becoming a disrupting force in the market for electricity, as many renewable projects are now coming within the cost range of fossil fuels, particularly onshore wind and solar photovoltaic energy. The cost reductions have also resulted from a shift from fixed feed-in tariffs to auctions, as we explain below. Whether this trajectory continues going forward depends on the reliability of subsidy regimes in individual countries and the consistency of the operating environment and financing costs.
However, there are still risks involved. Headline risks include:
- Business risk – investing in relatively new, unproven technologies (although in the case of photovoltaic solar energy or biomass, the technology is largely mature in contrast with floating offshore wind turbines)
- Transport/construction and completion risks – construction is usually the riskiest phase of a project
- Operation/maintenance risks – the impact of extreme weather events on renewables infrastructure and the risk of terrorism are key here.
- Liability risks – including negative impacts on the local population
- Market risks – especially as renewables production is intermittent and market conditions change in the interim
- Counterparty risks – the low credit rating of the national utility is a major risk here, as are political interference risks
- Policy risks – concern those operating and investing in developed and emerging markets. In developed markets, the most significant risk is governments abandoning subsidy schemes such as feed-in-tariffs, which were initially introduced to reduce upfront capital costs but are cancelled due to their financial burden on the state. They are increasingly replaced by more competitive schemes where investors are more exposed to wholesale electricity markets. And auctions, whereby governments sign a long-term contract with the successful bidder, have increased from five in 2005 to 100 in 2019. The main risk involved in auctions for foreign investors with little knowledge of the local network is that local influence prevails over decision-making on allocation. In this changing context, risk management requires an in-depth knowledge of fiscal/political trends in individual countries to anticipate regulatory changes.
In our view, this kind of risk in developed economies, whilst hard to predict, pales in comparison with the same set of risks in emerging markets. Investors are increasingly shifting their attention to emerging markets - despite heightened risks. However, these risks are not always where one expects them. For instance, it would be logical to expect considerable risks associated with runaway inflation in certain emerging markets.
JP Morgan Government Bond Index EM Weighted Inflation, Total Vs Ex-Turkey
Source: Haver Analytics
Since renewables do not entail major operating costs, they are more resilient to inflation. Higher construction costs from a rise in raw material or logistics costs have little impact as they are locked in at the moment of contract signature; hence renewables remain the lowest-cost producer of electricity, even in emerging markets.
Conversely, the recent energy crunch has prompted many renewables investors to try to benefit from inflation – by ramping up exposure to the wholesale market through purchasing merchant solar and wind assets instead of entering long-term contracts because competition is pushing auction prices too low. Clearly, an investor’s risk/reward preference is highly individual.
A more problematic macroeconomic risk is currency risk, as violent swings in currency value or temporary market closure (as with the ruble immediately after Russia’s invasion of Ukraine) can take their toll on the unprepared investor, with risks including not just changes in the value of the currency, but also currency inconvertibility and exchange/transfer/repatriation risks.
Overall though, compared to macroeconomic risks, political volatility and arbitrary changes in the local investment regime are more of a concern, especially regarding expropriation/nationalisation risks. In the case of Centerra Gold’s Kumtor mine, which was seized by Kyrgyzstan’s government in 2021, this happened well after Centerra’s initial investment. There are countless examples of government interference in investor contracts once projects are operational and, critically, productive, either through outright nationalisation or by creeping expropriation through a series of measures that, over time, diminish the investment potential of a project.
Many markets where renewables projects (or where the mining of raw materials for the manufacturing of renewables components) need to be sited often have high levels of legal and/or regulatory risk – including varying levels of political corruption. This in itself presents investors with a range of challenges around contracting with a sovereign entity or state-owned counterparty.
Yet all of these categories of risk figure highly as a general risk of doing business for any emerging or frontier market investment, renewables-focused or not. Other considerations include the risks of capital controls or sovereign default. Combining these blanket risks with the array of risks specific to the renewables industry could constitute a particularly powerful disincentive for investors. For those renewables investors who are tenacious enough to see through this combination, prior knowledge of the macro and political risks of the specific market is essential.
Final thoughts
Finally, it’s worth flagging that perceptions of risk differ between public and private institutions. A recent survey by PWC on risk perceptions of stakeholders in the North African renewables segment, based on five areas of risk finds that the highest categories of risk as measured by private institutions relate to grid access, given concerns with the material adequacy of the grid to incorporate a growing share of renewables, and inflation. In contrast, public institutions highlighted independent power producer market access and exchange rate risk. While 60% of private stakeholders considered the availability of financing to be a major risk, only 39% of public ones agreed. However, political risk figures highly for both stakeholders, confirming it as the fundamental impediment to renewables investment in emerging markets.
Despite this long list of risks, it should not deter investors from renewables investment for two reasons. First, there are strategic means of managing risk, which mainly involve identifying potential risks, remembering that perception often differs from reality in this context. Insurance can be of great help here. Insurance can also be beneficial in assisting investors in navigating the gradual reduction in state subsidies to renewables investment while reducing the risks involved in the transition to a more volatile, market-based allocation of renewable resources.
Second, once the risks are mitigated, the rewards of investing in renewables are manifold. To begin with, if we start from the perspective that renewables are the defining energy source of this century’s new techno-economic paradigm, bypassing investing amounts to missing the greatest source of value creation in the coming years. Beyond that, the revenue stream from investing in renewables is significant given the growth prospects of demand for renewables, especially as insurance can also help prepare companies to capitalise on commercial opportunities in the sector.
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