The weight of capital in the price of renewable energies

Financing requirements for renewable energies

Renewable energies: colossal investment requirements

Renewable energies take many forms: solar photovoltaics, hydroelectricity and wind power for electricity; wood/biomass, geothermal or solar thermal for heat and cooling; and biogas to replace fossil gas, incorrectly called “natural gas”.

In 2023, renewable energies accounted for around 15% of France’s primary energy consumption. ¹ (and 22% of final energy consumption ² ): with biomass as the leading source, followed by hydroelectricity, heat pumps ³ and wind power.

While hydropower is set to remain relatively stable, growth estimates for other renewable energies are in the region of 5 to 10%/year, depending on the technology, according to the multi-year energy plan. ⁴ currently being drawn up by the French government.

Such growth requires considerable funding. For France, investment in renewable energies in 2021 was estimated at almost €15 billion/year. Given the expected growth in renewable energies, this figure should rise to €20 billion/year. ⁵ by 2030.

Almost all of these investments are made by private investors (individuals, companies with public or private capital). Solar and wind farms, as well as biomass boilers and some biogas plants, rely heavily on bank financing, so it’s essential that regulations and market conditions allow and encourage private investment in renewable energies.

Estimates for the development of renewable energies worldwide are also extremely high between now and 2050, particularly for solar and wind power, where growth rates are expected to be between +15 and +20%/year. The worldwide growth rate for batteries is expected to be around 30%/year over the next decade.

The financing structure for renewable energies

Renewable energies are “infrastructure” assets with the following characteristics:

• require a significant initial investment,
• operation over several decades,
• generate regular income over their lifetime.

In addition, most renewable energies have low operating costs, as they do not require any “pay-as-you-go” fuel.

These characteristics, once the technology is sufficiently mature (see box) and revenues are fairly regular and predictable, make renewable energies attractive for non-recourse project financing (see below).

In a typical financing scheme, the renewable energy project is held by a special purpose vehicle(SPV).

The financing of the SPV is based on :

• of the capital injected by the SPV’s founders (e.g. utilities such as EDF, Engie or Total, or specialist players such as Neoen, Voltalia, Valorem, etc.);
• bank debt which is “non-recourse”, i.e. lenders (banks) cannot demand compensation/additional capital injections from SPV shareholders if the renewable project runs into difficulty (see box above).

This type of financing considerably reduces the capital required from shareholders. For mature technologies such as solar and wind power, the debt-to-equity ratio in an SPV is around 70% debt and 30% equity (70-30), or even 80-20. Put another way, for a project requiring 100 million euros of investment, the shareholders contribute 20 million euros of equity and the SPV borrows 80 million euros from banks at the same time.

The debt-to-equity ratio depends on macroeconomic conditions and the project’s risks: the more mature the technology, and the more certain its revenues are and will be early in the life of the project, the higher the proportion of debt to equity (known as gearing or bank leverage).

Since the interest paid on debt is lower than the interest required on equity, non-recourse financing lowers the total cost of the project.

In some countries, more complex financing arrangements mean that, by temporarily moving away from the non-recourse model, a wind farm can be financed entirely by debt during construction. This delays the injection of equity capital and therefore, given the interest rate differential between equity and debt, reduces the total cost of the project. In the remainder of this analysis, we shall remain with the case of conventional non-recourse project financing.

The economic performance of renewable energies depends heavily on the cost of financing

There are several metrics for comparing the economic performance of energy production projects.

The Levelized cost of energy (LCOE ) compares the cost of an energy production project with the energy it is expected to deliver over its lifetime. This indicator can be used to compare different energy projects.

The cost corresponds to the price at which the energy produced must be sold throughout the project’s lifetime to ensure the profitability of the investment (taking into account the remuneration requirements of investors).

As we shall see, whatever the metric used, the cost of financing is a determining factor.

Impact of financing costs on the Levelized Cost of Energy (LCOE)

The LCOE is calculated by dividing the total project costs by the total energy production of the project. This calculation involves a discount rate, as the costs and energy production are spread over many years of the asset’s lifetime.

Costs include initial investment, fuel (where applicable), servicing and maintenance, dismantling and management of waste generated.

Energy production includes the project’s annual energy production (net of any energy consumed to operate the plant).

LCOE does not depend directly on the project’s financing structure: project costs are “physical” costs, and take no account of bank interest charges or return on equity.

The only potential “indirect” variability in LCOE relates to the nature of the project, through the discount rate: the riskier the project, the higher the discount rate should theoretically be.

The practical strength of LCOE is that it makes it easy to compare the economic performance of projects of very different natures: different energies, projects located in different countries, with different production profiles, etc.

If an energy project has high costs in relation to the energy production it generates, and therefore a high LCOE, it is a priori less attractive for the energy system than a project with a lower LCOE, and will therefore find it harder to be profitable.

This comparison is not free of bias. It does not take into account the “quality” of the energy produced for the energy system: is the production plant controllable (easy to start up or shut down according to demand)? Can it deliver high power at times? Can it react quickly or not when called upon by the grid operator? Nor does the LCOE reflect whether the energy produced is remunerated by virtue of favorable regulation or because it is sold directly to customers or on a wholesale market, etc.

The LCOE of renewable energies has fallen considerably over the past 10 years.

Today, it is competitive with fossil fuels. This decline is mainly due to lower manufacturing costs thanks to innovation and industrial massification (in China for photovoltaics).

This decline is likely to continue at a slower pace, given the high level of technological maturity and industrial massification already achieved.

It should be noted that the introduction of border tariffs, currently in force in the USA and India and under consideration in the European Union, has an upward impact on LCOE, since it increases the cost of equipment delivered on site. At the end of 2023, customs duties in the USA were 100% for Chinese panels, and LCOE was around €10/MWh higher than in Europe. This higher level does not, however, compromise the profitability of the installations.

Using LCOE, we can estimate the indirect impact of the cost of financing.

When a company calculates the LCOE of a project, the discount rate used corresponds to the weighted average cost of the capital invested (weighted average of financial expenses on debt and dividends on equity) that it envisages.

The simulation below compares the impact on LCOE between a financing structure with an 8% discount rate and an extreme case where the discount rate would be zero (no need to remunerate equity or pay interest on debt).

This simulation shows that in the extreme case, with no need to remunerate equity and debt, the LCOE would be half as high for renewable energies. On the other hand, it would only fall by around 25% for fossil energies (due to the lower weight of initial capital compared with operating expenses). This is, of course, a theoretical limit case.

Impact of financing costs on cost price

Cost price is another metric for the economic performance of an energy project. It corresponds to the price at which the energy produced must be sold throughout the project’s lifetime to ensure “sufficient” profitability. ⁶ of the investment. This “cost price” therefore includes the developer’s margin. In France, it is close to ⁷ of the price submitted by candidates responding to public tenders for the development of solar and wind power plants.

As with LCOE, the cost price depends on the weighted average cost of capital.

An investment of 100 million euros in a 100 MW solar farm will have a different cost price if the investment is made with 100% equity, remunerated at 10%/year, or if the investment is made with 80% debt and 20% equity, with a remuneration requirement of 4% and 10% respectively.

As the cost price depends on financing conditions, it is sensitive to macroeconomic conditions.

For example, a rise in the central bank’s key interest rates will have the following effects on new projects:

• increase in interest rates charged for renewable energy project debt: these are calculated according to a formula ENR debt rate = ECB risk-free rate + project-related risk premium ;
• Increasing return on equity requirements: since investors can earn more (than before the rise in key interest rates) by investing in risk-free debt, such as public debt, they will only agree to invest equity in a renewable energy project if the return on the equity invested increases;
• lower debt-to-equity ratio: the proportion of debt in a project’s financing structure depends on a number of parameters, including the project’s ability to repay debt in the event of a downturn (e.g., lower-than-expected production, or lower-than-expected production sales). The higher the profitability requirements for debt and equity, the greater the impact of downturns on debt repayment capacity, leading to a reduction in the proportion of debt in the project.

The sensitivity of the cost price of renewables to the cost of capital was highlighted by the aftermath of the invasion of Ukraine.

During the 2010 decade, the energy sector benefited from a highly favorable macroeconomic context (low key interest rates) and a steady decline in equipment costs.

These two factors led to a significant drop in LCOE and cost prices.

This period ended with the invasion of Ukraine, which was followed by a spike in inflation, particularly affecting ENR equipment. In response, the ECB sharply raised its key interest rates. From mid-2022 to the end of 2023, the feed-in tariffs requested in French calls for tenders jumped from around €60/MWh to around €85/MWh. ⁹ for ground-mounted solar and onshore wind power).

The fact that key rates have remained high in Europe makes it possible to study a real case where these rates – and therefore the cost of financing – are the only variable that changes. Comparing the tariffs requested in the 2023 tender with those requested in 2021, before the invasion of Ukraine, shows the impact of financing conditions on the cost price.

An analysis of the bids submitted to the French ground-mounted solar tenders shows that the electricity sales tariff (over 20 years) requested by the applicants has risen from €59/MWh in December 2021 to €68/MWh in May 2022, €73.5/MWh in July 2022, €82/MWh in December 2022 and €82.4/MWh in July 2023 and €79.3/MWh in August 2024.

A more precise analysis would naturally have to take into account the effects of anticipation. ¹⁰ as well as delay effects. ¹¹ It would also need to take into account the evolution of cost items (civil engineering, salaries of installation companies, etc.).

Despite this limitation, we can see that while the price of panels is close to the end of 2021 and mid-2023, the feed-in tariff applied for by the winners has risen by around €20/MWh, i.e. an increase of 30%. This increase is therefore largely due to the change in financing conditions, from a zero interest rate environment to a key interest rate of 4%.

Extrapolating from this analysis, a 1% change in the required return on capital translates into an increase in the price of renewable electricity from projects of around 7%.

Conclusion: the importance of lowering the cost of financing to guarantee the development of renewable energies

Given the urgency of the climate change situation, and the significant impact of the cost of capital on the cost price of renewable energies as described above, it is useful to consider the possible levers for lowering the cost of capital.

At the microeconomic level, a project’s cost of capital is linked to its risks. The more risks are minimized, the lower the cost of capital. French public authorities are already playing a role in this respect:

• securing project revenues through guaranteed prices for the sale of the energy produced for 20 to 25 years;
• by indexing these revenues to inflation and changes in interest rates between the time of application and the time of purchase of the main components (indexation implemented at the time of the 2022 inflation peak);
• by protecting the project against the risk of overproduction for 20 to 25 years: the investor is remunerated even if the park is temporarily shut down due to overproduction;
• by taking on part of the technological risk of innovative projects via repayable advances (loans to the SPV which are repaid only if the project is successful).

Generally speaking, the establishment of a stable regulatory and fiscal framework without retroactivity is an essential condition for the development of renewable energies.

At the macroeconomic level, public authorities can also intervene:

• via green taxonomy: the European Union has defined asset categories to guide/incentivize investors and lenders to favor green or decarbonized assets;
• by differentiating key rates according to the green nature of assets the European Central Bank could strongly favor these assets.