Renewable Energy: Bumpy Road but the Ride Continues

Grappling with an uncertain macroeconomic environment, the last two years have been challenging for the renewable energy industry, particularly for wind, driven by supply chain constraints as well as increasing project development costs (construction and financing). These challenges have been amplified for offshore wind development, which is especially capital intensive and involves extremely long development timelines. Despite these recent challenges, we believe the renewable energy industry has a long runway of growth ahead.

There are several long-term challenges that risk throttling back the growth of renewables, such as the need for investment in the power grid to build out transmission lines, cumbersome project approval (permitting) processes, dependence on continued policy and financial support, and optimization of various power generation technologies, including the development of new technologies, such as battery storage, to ensure grid reliability.

From a credit perspective, project finance-structured renewable power projects are typically supported by various project agreements, including construction contracts and long-term power purchase agreements (PPAs) that make the credit risk for these projects manageable. The recent challenges faced by the industry underscore the importance of well-structured project agreements.

Construction risk is generally mitigated by allocating it to the construction contractor through a fixedprice, date-certain engineering, procurement, and construction (EPC) contract protecting the project from cost or schedule overruns. The operational phase of projects is generally supported by long-term PPAs, which normally afford several protections, such as partial or full indexation to inflation, force majeure clauses, and generation curtailment protections (in the event of economic (price-based) curtailment). In the absence of a fixed-price, date-certain EPC contract and/or a PPA that contains inflation protection mechanisms, a project may be exposed to economic shocks that could be highly detrimental to its financial viability. A PPA with a balanced, risk-sharing mechanism that allows for price adjustments associated with macroeconomic-related cost escalations during a long development and construction period is paramount for future predictable growth in the renewable energy industry, particularly so for offshore wind development.

Renewable Energy Growth Projected to Continue
Support for the renewable energy industry remains strong as policymakers across the globe have set ambitious targets to decarbonize electricity generation and help tackle climate change. Based on International Energy Agency (IEA) projections, renewable energy will continue to grow on a global basis, with China leading the charge.

From a technology perspective, solar power is forecast to lead the growth in the near to medium term, largely driven by lower input (module) costs offsetting higher project development costs and buoyed by subsidies through government initiatives, such as the 2022 U.S. Inflation Reduction Act (IRA). Onshore wind is also expected to continue to grow, albeit the industry is facing challenges amid supply chain constraints and increasing project development costs. Offshore wind has experienced significant technological advances over the past decade, with turbine sizes and towers reaching new heights, helping to bring costs down until the recent inflationary period shocked the industry. In a more stable macroeconomic environment, offshore wind development is likely to get back on track and provide strong growth going forward.

Renewables’ Transformative Journey
Looking back at the last 15 years, the renewable energy industry has come a long way and is now a key part of the energy transition, underpinned by government policy support, improving technology, operational acceptance, cost competitiveness, substantial investment, increasing corporate support, and changes in consumption behavior.

Technological efficiencies have increased, helping to significantly reduce the overall cost of developing renewable energy projects. Although some wind development costs have increased in the last two years because of recent macroeconomic shocks, overall costs are expected to resume their downward trend as the industry’s supply chain capacity expands and further technological advances are made.

As an illustration, solar project development costs have seen a dramatic drop and project efficiencies have materially improved.

Challenges Remain
There are a number of long-term challenges that could impede the growth of renewable energy.

Investment in Developing Grid Infrastructure and Streamlining of Permitting Process
One of the key obstacles to sustained growth in renewable energy development is the need for continual investment in the expansion and modernization of the power grid to accommodate renewable energy projects. Maintaining, expanding, and modernizing power grids is extremely expensive. According to the European Commission, investment of approximately EUR 584 billion in grid expansion will be needed to achieve European Union (EU) renewable targets of 42.5% by 2030. The permitting and approval process can also be extremely lengthy. There are numerous environmental and regulatory factors that can delay permitting resulting in increased costs. A streamlined permitting’ and approval process can go a long way to accelerating renewable energy growth.

Continued Policy Support
There are several key elections in 2024 around the globe (U.S., India, UK, etc.) that could create considerable policy risk and may result in changes to existing renewable energy subsidies and targets. Policy support has been a key driver of renewable energy development globally and continued support is imperative for growth to continue. For example, the U.S. IRA provides benefits to the renewable energy industry; a less favourable regulatory environment or a change to the tax incentives may alter the growth trajectory for future renewable energy development in the U.S.

Government support through subsidies continues on a global basis. The U.S IRA includes a 10-year extension of the Production Tax Credit (PTC) and Investment Tax Credit (ITC), as well as solar projects being able to benefit from PTCs for the first time. The PTC provides tax credits based on the power generated, whereas the ITC enables project investors to claim a one-time tax credit of 30% of a project’s value. Given that the cost of solar projects is decreasing relative to the value of the power overtime, the inclusion of PTC benefits might provide a lucrative alternative to investors.

Further, the recent guidance on transferability of federal tax credits to third parties for cash (i.e., monetization of tax credits) has the potential to expand avenues of financing renewable projects by increasing the investor base from what has been a relatively small pool of market participants (mostly large financial institutions and certain corporations that had sufficient tax liabilities to use the tax credits). Through the new transferability rules, smaller corporations with limited experience in the space can now participate in renewable project financings.

In October 2023, the EU announced the European Wind Power Action Plan to accelerate the growth of wind power. This initiative focuses on improving several areas, such as the permitting process for wind energy projects, electricity market design to incentivize renewable energy development, manufacturer’s access to financing, protecting the EU manufacturers from unfair trade practices, and skills development. The motivation stems from the EU’s target to achieve 42.5% energy consumption from renewable energy sources by 2030, implying a growth in installed capacity for wind energy to more than 500 gigawatts (GW) by 2030 from 204 GW in 2022.

Earlier in 2023, the EU unveiled its Green Deal Industrial Plan to scale up net zero manufacturing capacity in the EU through a series of initiatives directed at the simplification of the regulatory framework. The plan called for improving access to rare earth materials key to net zero technologies, improving access and speed for financing of renewable energy projects, and upskilling human capital. One of the key outcomes of the plan is the recently announced EUR 5 billion package of counter-guarantees from the European Investment Bank (EIB) to help wind energy equipment makers achieve financial close. According to the Green Deal Industrial Plan, the EIB plans to double its lending to wind energy companies, which would result in the mobilization of around EUR 150 billion to finance wind power projects over the next five years.

Policymakers are taking action to alleviate the challenges faced by offshore wind developers because of the importance of offshore wind power in realizing clean energy targets. For example, in November 2023, the UK announced it would raise the maximum price offshore wind farm developers can secure in a contract auction by 66% to GBP 73/megawatt hour (MWh; in 2012 prices) from GBP 44/MWh previously. This action is in response to the UK government’s failed auction in September 2023, which saw no bids from offshore wind developers; development costs had increased significantly, yet contracted power prices remained stagnant. The new terms are expected to result in more successful auctions going forward, with likely 10 GW of projects to be awarded at the UK’s next auction in March 2024.

Similarly, in the fall of 2023, New York State Energy Research and Development Authority (NYSERDA), the public benefit corporation leading the coordination of offshore wind opportunities in New York State, announced a new, streamlined process for developers to try to negotiate higher prices as part of NYSERDA’s fourth competitive offshore wind solicitation. This was successful and put some high profile, late stage offshore wind projects back on track.

Optimization of Various Power Generation Technologies
Electricity markets have naturally been designed to rely on traditional sources of power, such as coal, hydro, natural gas, and nuclear energy. Baseload generation from these power sources are available around the clock.

One of the key concerns with renewable energy is its variability. For example, wind projects tend to have peak power generation at night when demand is typically low. Finding a proper use of this excess electricity either through development of technologies like battery storage and/or being able to curtail electricity from facilities in real time will be extremely important in the future. As the proportion of renewable energy to the overall mix of generation increases, managing the grid will become even more complex. The creation of smarter grids will be essential in maintaining robust electricity systems in the future and scaling up renewable energy.

The Path Forward
The renewable energy industry has come a long way. The benefits of clean power are undeniable in helping to combat climate change. The last couple of years for the industry has been trying and several long-term challenges remain. However, technological advances have helped to drive down costs, making renewable energy more cost competitive versus the traditional forms of power generation. We believe further advances will be made and the renewable energy industry will continue to receive government support so policymakers can achieve their clean energy targets. Project agreements, including construction contracts and PPAs, will play a key role in managing credit risk for renewable power projects. The importance of a balanced PPA structure that creates value for both the project developers and electricity ratepayers is vital in ensuring predictable renewable energy growth.

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