PFI: In debt capital markets, we at Thomson Reuters spend a lot of time tracking individual deals. That’s probably more straightforward than the equity markets. There are obviously public deals in the equity markets, but there’s also quite a lot of off-market fundraising. You can track if SSE does a bond, that’s a bond, but if there is equity that might be for a whole different range of purposes. You can track what Stephen’s fund does in terms of raising equity for renewables, but quite a lot of equity raising comes from all sorts of different places.
Moving onto technology risk and emerging markets. In Dubai it now costs 2.99 cents kilowatt-hour for solar. Is the risk not that your own technology won’t work, but that you’ll be gazumped by the next technology? How did you react to these incredibly low prices in the solar market and the impact that will have on various markets around the world?
Smith: From our point of view, it’s giving us more confidence as we see the price of solar drop, the price of wind power drop and the projections get better. In the beginning of the industry, a lot of consultants came in and gave numbers for how much wind would be generated and how much power would be generated in typical conditions. That projections methodology was very much in its infancy and it wasn’t necessarily very accurate. Now there’s more confidence in the projections of wind and there’s a very interesting drop-off in terms of the solar price. It will mean there will be more interest among banks, because they’re starting to see that there’s a track record of dependable data, and a lowering of the costs. For new projects that will work quite well. You’re right, there are some issues for projects that perhaps were there say six or seven years ago, which are running into difficulties because their prices will be higher than new entrants. And, of course, there’s been a big issue in Spain in terms of Abengoa, which is maybe more of a holdings issue than a project-by-project issue. But that does mean the new projects are going to be more attractive than the older ones if the same tariffs apply.
Mayhew: If you think about infrastructure investment, whether that be on an equity or debt basis, it has a longer term view – with the exception of the private equity model which is much shorter term. But, generally, we’re looking at longer term. So technology risk doesn’t necessarily chime with that. If you look into other parts of the infrastructure sector, people started talking about telecoms deals as being infrastructure and looking at towers and things. S&P came out very early and said there’s a technology risk in the industry and it would only look on an investment horizon of a maximum tenor of fourteen years, and an average life of seven years. As you bring technology risk across to other sectors, that is likely to have an impact on the length for which you can lend, and therefore by extension on the availability of debt versus the level of equity required for transactions.
It comes back to the sustainability of the price and the operating efficiency of that particular plant. There is a flipside the other way, because if you go into emerging markets and people are planning to do distributed solar you can get energy up and running relatively quickly, you don’t need to finance a whole distribution network. Oddly enough, a whole heap of investment is having to go into the distribution network in the UK, because if you look at the London electricity network, it was originally designed for about four entry points for big power projects. And now, how many people have a solar panel? The network has thousands of entry points now. So technology risk can work the other way as well, in needing to back solve on existing infrastructure to account for the rise of new forms of energy production coming in.
Lance: The good thing about renewables is that the EBITDA is very high. The main cost is capex but the operating cost is actually very low. So if we have new sources of energy, which are competitive and are going to compete more with gas or coal power, which have operating costs which are higher, that’s a good way of seeing it. You have competitive assets for the long run. And as soon as they’re amortised they are very competitive on the landscape. Breakthroughs with technology will probably cost a lot to install as well. It’s a very long cycle, in my opinion. It’s not going to come out in seven years, or probably longer than that.
Mayhew: Graham mentioned the point early on about export markets. The other aspect of technology is, does it help a country from its export market perspective? And actually, if we look at who are the major solar panel producers in the world now, it has very much shifted from those original countries to China. So the conversation becomes if a country misses the boat on one technology does it move onto the next one, such as tidal? Does this create an opportunity for a country to not only have renewable energy on its own, but also to build a supply chain and be able to export that? It’s good from an industrial logic perspective, but there are clearly risks to that too. When we were looking at solar transactions, most people thought that would tick an ESG box. But we weren’t allowed to consider things ESG until we’d also checked the labour practices in the manufacturing plants of the solar plant. You can take these things to an nth degree, but actually investors asked the questions and you need to be able to answer them.
PFI: Did you have to go to China?
Mayhew: When a TA visits manufacturing plants to check on production, they can check on labour practices at the same time. But otherwise you can say solar power is lovely, or renewable energy is lovely and it ticks all those boxes, but it was an interesting debate because the nature of the question shows you can take it to many, many degrees. If investors are asking us to justify how we are taking account of ESG while also achieving superior risk-adjusted rewards, we have to be able to answer those questions.
PFI: Stephen, any comments on technology?
Lilley: Not particularly, no. We buy operating assets, so I’m only bothered if it lasts for 25 years. If it falls apart after that point, that’s fine!
Berry: Technology risk increases regulatory risk. So if power suddenly became free, only assets that have FiTs and ROCs have high prices. It is a bit more risky than power not being free. So there is always a secondary impact or tertiary impact from these sorts of extreme scenarios.
PFI: David, you mentioned Egypt and various other emerging markets. Are they benefitting now from cheaper renewable prices?
Kerins: The picture is very mixed. Egypt is a reasonably well-developed market, actually, it’s one of Africa’s biggest oil and gas producers. Surprisingly, it has a rather high feed-in tariff. We see much lower feed-in tariffs in other markets like Morocco, where there would be a similar level of solar resource. So this opens up an interesting question about the cost of capital, political risk and the kinds of factors that are affecting projects in Egypt. But what we definitely see is the cost of renewables has come down. That’s absolutely real. We’re seeing more and more markets where projects can be developed competitively against a fossil fuel alternative.
Even with technologies like solar PV, go to a market like Burkina Faso. We looked at a project there a couple of years ago. Burkina Faso has no domestic energy options. It’s land locked, the road infrastructure is terrible. All the oil that it uses and burns has to be shipped in trucks across land. So energy is very expensive in a market like Burkina Faso. Solar is a great solution for a country like that. And we see this more and more. Lake Turkana, again, produces wind power. The cost of Lake Turkana – it’s half the price of the wholesale cost of electricity in Kenya. Renewables have incredible potential to compete. This has a huge impact on markets where they don’t have very many options.
But you have to remember the kind of perception of risk in relation to renewables, especially in some emerging markets. In Burkina Faso we visited the control centre and they use a pen and paper to dispatch. So it’s very old-school. They have a lot of technological development and for them a technology that varies is alien. They’re used to just running a diesel unit at maximum capacity until it breaks down, and that’s just how it runs. The market is much more developed in Kenya, which has modern control systems. They know that in Europe we’ve climbed the curve and they’re very interested in understanding how Europeans have come to terms with the risk of variability in their systems. Technical assistance is important. US Aid has done some really good work in Kenya, helping the Kenyans to understand how to run a system that has a lot of variable renewables.
In these markets, in the emerging markets, they certainly know that the technologies can work, they just don’t know how to make it work themselves. And that’s something they’re very interested in. And as the costs of renewables come down, this is a real challenge for them.
PFI: Moving to some more questions from the audience…
Audience Question: My name is Terry White, I’m from Alkebulan, an African focused advisory firm. Picking up on the conversation about the emerging markets and what Stephen mentioned before about the separation between development and operations, in terms of the financing. When we have operations in Africa, of course, the really big impediment is that the end users are local currency owners, spending local currency. Development finance is hard currency. The local currency bond rate in Ghana is 20%. That is incomparable with the development cost priced in US dollars. So I wanted to build on what Stephen mentioned earlier about passing the risks between the development stage and the operation stage, and ask Stephen what his experience has been in relation to the Western European model of getting a separation between those risks? Between development and operations from the financier’s point of view?
Lilley: We’ve predominantly separated them by only buying operating assets, so it’s an easy separation. I’m not sure there is any more complicated answer than that. I will give you a flavour of what that means, which will hopefully give you a sense of the mindset of a long-term owner.
Wind has two components. One is the actual wind coming up to your site and the other is the conversion of that wind into power. What do you produce? That’s the conversion factor. We either buy an asset that’s been operating for a year or we require the right to go and revisit what that conversion factor is and change the price if necessary. So if a wind farm is a year old, every 10 minutes you take data and therefore you know that if the wind blows at 10 metres a second from the South West, your wind farm will produce X and it will always do that. And so, in a year you have 50,000 data points and you can work out accurately what the conversion factor is. So for us, as a long-term operator, we want to know what we’ve bought.
Now we know that wind is a statistical phenomenon. Over 25 years it’s hardly volatile at all. But I really care about getting the conversion factor right, because if it’s wrong, it’s wrong for 25 years. So that’s our mindset as an operator, as opposed to a developer. Knowing what we have bought is a key component to us, to make sure that we’ve known what our wind farm will produce, precisely.
The next thing is going back to the three years of track record we have produced. The factor, effectively from wind speed to production, is 1.7 times. It comes from a normal distribution laid on top of the power curve. We produced 8% above production in 2013, wind speed on average was 5% up. So, tick, we got that right. In 2014, we were 3% below on production and wind speed was 2% below. In 2015, the first piece of information that we knew was that we produced 8% above production. Before we knew what the average wind speed was we knew it would be about 4.7% up and it was precisely that. So for us, it was really gratifying to know that we had understood what we had bought, we’d done our due diligence.
PFI: Have you ever heard of people buying things that weren’t quite what they were made out to be in terms? You’re buying an asset for 25 years, is it a science or a judgement in terms of how that turbine will perform in 15 years time?
Lilley: It actually goes back to what Raphael was saying: if the EBITDA margin is very high the capex costs are very low. So even if you’re 10% wrong on the operating costs – and actually we have been wrong because we’ve been too prudent – even if you get that wrong, your revenue stream does not change much. So actually in terms of operating costs, it’s precisely what Raphael said, it’s precisely about the amortisation of capex.
As I said, we have been too prudent on cost assumptions. We have seen a market that’s matured; we’ve seen service provision being much more competitive and some of that has partially offset power pricing coming off . The other thing that’s offset for us is over-production, because it’s been slightly windier.
Audience Question: I’m Martin McAspurn-Lohmann, I head the oil & gas and utilities business at Santander. My question is centred around COP21. We saw before and after the pledges from the various countries and zones coming in to reduce CO2 emissions and to get closer to the target – two degrees, which was then revised down to nearly 1.5. We saw quite a lot of interesting graphs coming out, where people were plotting what that actually now means, showing the pledges in comparison to the two degree target. It is a massive difference. Already renewable energies will see in the next 20 years an investment of around US$6tr, which means that we would repeat investments of what we saw in 2015 – well over US$300bn. We will see that now repeating itself over the next 20 years. And bearing in mind that one third came from China last year, it’s also an interesting thought. However, US$6tr and we’re not even close to the two degrees. If we believe the calculations, we have to double this type of investment up to over US$12tr, a huge number. Then we would get close to the two degrees. So my question to the panel is what do you think is going to be the catalyst that can get us to the US$12tr investment, from the US$6tr we are currently at?
Smith: It’s a difficult one. You’ve got to look at where the biggest emitters are. What the UK and Europe can do in terms of moving that dial is going to be small, simply because of the amount of carbon emissions we’re producing. If you look around the world you’ve got to look at China and India in particular as the biggest emitters. And that’s where the difference is going to come in reaching that two-degree C scenario. There has been a lot of discussion in the press, that we’ll be charged more in Europe for driving cars, for having inefficient televisions or hoovers or fridges, but Europe’s actions are not going to change the path the world is on. And you’re right, all the graphs show that’s where we’re supposed to go and this is how we must achieve that C change but it’s only going to be done by a generation of funds from the developed world, and passing those funds through to the developing world. That’s where we will see the biggest difference being made.
In the EU, at COP21, we were talking a lot about this idea of trying to mobilise capital and trying to get it into the developing markets. That’s where the banks are going to have the biggest challenge – and the investors too. They need to follow through if it’s going to happen.
Kerins: The biggest issue globally is pricing. What we see outside the EU is energy prices are subsidised across the board at the wholesale level and at the retail level. This encourages all sorts of waste and unnecessary consumption. We don’t see carbon priced properly either, which adds to the problem. Policy makers can get pricing right in the sense that they can pull away the subsidies and just put either a tax on carbon or a trading scheme. That will encourage a lot of the investment and end a lot of the kind of distortions that we see in the market. One easy thing for people to do if you look at say China is to move away from coal. But coal is priced at a very low level domestically, so they burn lots of coal. And if they import gas it’s slightly more expensive. But if you put a carbon price on fossil fuels it tilts things in favour of gas. You can make big changes very quickly by addressing pricing.
Audience Question: My name is Julia Eberdal and I have formed an advisory start-up. What do you see as the emerging markets? How much do you focus on it? In larger corporations especially people tend to be more risk averse, perhaps they focus on China and India, but how much business is being done in Africa, and whereabouts? And how much focus is there on the Middle East, for example?
Smith: HSBC’s focus is very much on the developing world and that focus, curiously enough, has actually strengthened in response to market flows. We’re very interested in flows of trade and investment, for example from Brazil to South Africa, and China into some of the other South East Asian nations. We’re interested in the One Belt One Road. We’re very interested in the Pearl River Delta. So for us the emerging markets is where the growth is going to be. Where we’re limited is we look at things like the corruption index and transparency. There are markets where those factors can be a problem for us, and we will consider if the reputational risk of doing business in those countries is too high. We do a lot of business in Africa, but we can’t do it across the board in all countries. We do a lot of business in Asia, but again not all markets meet our standards. The secret is to look at some of those indexes when you’re looking at developing markets. There will be places where you might find there is no bank financing available, unless it’s domestic, because the international banks will say that the risk of bribery and corruption is just too high. But the developing world for us is a big focus and we see it as a big driver of growth for the world and for our business.
There are some very interesting things happening in terms of new
Development Finance Institutions if you look at the BRICS Bank, if you look at the Asian Infrastructure Investment Bank, if you look at the Silk Road Fund. There are some very interesting funds coming through, it’s just they don’t necessarily have their headquarters in London, they might be in Beijing or Brazil or somewhere similar. If you look around you’ll find sources of financing. But there are some markets which are just too difficult.
Lance: We are currently working on one initiative which was a tender launch by the United Nations. We’re actually working with the EIB on developing a fund, which is called Land Degradation Strategy. The objective is to invest into wasted land, land that is not productive any more. It’s mostly an agricultural and forestry fund, from which we invest to rehabilitate land that is degradated to make it productive again. We’re working in Nicaragua on a project to replant coffee seeds, and then we would have an agreement with Nestle so it would buy our coffee for 20 years. That’s mostly active in emerging markets. Not only, but mostly in emerging markets. That’s our non-European focus at the moment and it’s going to be launched probably around this summer.
Audience Question: My name is Sailesh Patel, from BlueTech Advisors. We look at power and process in renewables as lenders TA and environmental advisors. There will be a number of transition type projects which may take a hybrid approach – say projects that combine power generation and storage, or more recently things like LNG to power. They have specific risk areas, which are different from packaging them separately. What kinds of risks and concerns do you see going ahead with these transition-type projects as investment vehicles?
Stergoulis: Can I just talk on the gas to power? Gas to power is not an example of a hybrid, it’s a very good solution for jump starting and dealing with a lack of infrastructure. I think we are going to see a lot more gas to power in the future. I think there are instances where people make the mistake of doing a hybrid, simply because they like the idea of a hybrid, but if you analyse it there’s no real need and the incremental benefit is not great. I agree there are grounds for scepticism about the true hybrids. But gas to power is in a totally different area. It is definitely a solution for lots of energy needs.
Audience Question: My name is Krish Kotecha, I’m involved in active lending in project finance, including renewables. I have heard a couple of interesting counter points today. One was there’s clearly too much money chasing too few deals and you’ve obviously got funds raising substantial amounts of money: the issue is not the ability to raise money, but identifying what assets to invest in. And then we’ve heard another argument, which says there are certain areas where there’s actually a funding gap, and perhaps there is a lot more that needs to be done than can actually be financed. My question is two fold: does the panel think that the renewables objective is a little bit overambitious, and perhaps too immediate for investors to be comfortable with – especially when they are being forced to invest in these assets because they are searching for yield in a low interest rate environment? And what actually needs to be done to better match the finance to assets where they’re actually needed? We’ve heard about regulation, but what else do you think needs to be done?
Mayhew: Some of us touched on the second element of that question about matching a bit already. There are funds or investors that have certain risk-return criteria, and if something doesn’t match that, either the investor has to change their return criteria (and for anyone who has spent time dealing with pension funds or insurance funds, those things don’t tend to happen very quickly), or you have to figure out what is it that makes that project not fit the criteria. Is there some way that you can plug that gap? That plug can sometimes come from another piece of capital somewhere in the capital structure. If it’s simply a kind of financial metric, there are ways to plug that, albeit it can flow through to the out turn price. Or you can pick up some of the things we picked up earlier – in Europe it may be the EIB and taking some risks in emerging markets, it may be the IFC or Multilateral Investment Guarantee Agency (MIGA).
But that’s where the overarching ambition needs to bring governmental or pan-governmental bodies with them. It isn’t the case that suddenly there will be a pension fund in the North of England that wakes up and wants to do emerging market infrastructure. That is a process that’s going to take some time, and you need to build blocks to lead them through that. There are many more public markets, emerging markets debt funds or indeed equity funds, because there is an element of perceived liquidity with those. If you move into the private markets, where many of us operate as well, the amount of finance for that falls off a cliff. But that comes down to people’s perception of risk and reward. And frankly if you are a pension trustee within a portfolio, there will be situations where you want to take risks and other situations where you don’t want to take risks. Do you want to take risks in a market you know, but go into private equity? Or do you want to take risk as a senior secured lender but in a market you know nothing about? Your return might be similar, but your comfort factor with it may be very different. Those are very individual choices each investor will make differently.
I think if you’re a pension fund trustee, you’re not, either by DNA or by the scope under which you operate, going to be a cavalier. You rely on entrepreneurs to be cavaliers. A pension fund trustee has a fiduciary duty to get good risk adjusted returns for their pensioners. But that does involve, as Ian said, making sure the money comes back. And yes, within a portfolio you’ll have bits where you take more risk and bits where you take less. That’s where maybe there are other pieces to fit the gap.
PFI: David, do we have too many targets?
Kerins: Someone in the audience commented earlier that despite all the targets, the commitments are still lower than the level of investment that’s necessary to achieve the ambitions. So maybe we don’t have big enough targets.
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