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Cost of Capital: European Renewable Energy Projects

The content of this blog is based on the findings of an EU funded DIA-CORE project (1), published on Feb 10, 2016(2).

When judging the financial viability of a renewable project within the 28 EU countries the following criteria are applied in order of importance and hence they are at the core when the cost of capital is determined in each country;

  1. Generic Country Risk (accounts for up to 6% difference)
  2. Design and reliability of the renewable support scheme (accounts for up to 2% difference)
Source- Shutterstock

This causes an identical renewable project to swing from being hugely profitable to breaking-even or totally uneconomic when moving between the member states.

Taken across Europe, 2015 saw wind generated energy grow by 12.8GW and Solar by 8GW in 2015, with wind now accounting for 44% of all renewable energy. However, this European average conceals huge differences between the countries as almost half of all this wind is taken up by Germany whilst the growth in solar of 15% after three years of decline is in first instance reflecting UK activity.

On-shore wind was taken as an example to indicate that the factor most responsible for the differences is policy. The reasoning being as follows: renewable projects are highly capital intensive and the return investors ask to make money available to fund this capital expenditure increases as the overall business risk is perceived to be higher. The level of this return, also referred to as the weighted average cost of capital (WACC) is often the decisive factor as to whether a project goes ahead or not. If the policies are considered not to reduce risk sufficiently, the WACC will be higher, making it less likely that the project will materialise.

The 2014 weighted average cost of capital (WACC) ranges from the Greek 12 % to the German 2.5%. Let’s put this in context. Say we have a 20 year wind project with a stable revenue stream increasing by inflation each year and two potential investors A and B with differing WACCs of 6% and 9% respectively. Investor B would need electricity prices or revenues to be about 28% higher than investor A before he would invest. Comparing Greece and Germany reveals even more extreme results. An investor in the former would need prices or revenues to be more than 120% higher than in Germany!

This explains why wind projects can be financially more interesting to investors and hence more will materialise, in a country with relatively less favourable wind conditions (Germany) compared with countries with more promising wind environments (Spain and Portugal).

With secure and good “policy design” taking the top position as conditions precedent for a stable investment platform, “administrative risk” is next (permitting can take between 2 and 154 months), followed by “market design and regulatory risk” and “grid access”.

In addition there are some clear European regional top-3 differences:

Northwest: social acceptance / South: financing / Eastern Europe: sudden policy changes.

If looked at in more detail, the WACC is a percentage which reflects two elements: the cost of debt (banks etc…) and the cost of equity (investors). Not only are both of these separate costs cheaper in, for instance Germany, but also the different weightings given to them favours that country. Where the average project will see a 70:30 debt:equity (D:E) split, German projects can obtain a 80:20 D:E ratio, hence providing more weight to the, cheaper, portion of debt. This ratio can tip to 50:50 in the South East of Europe. The cheaper debt levels appear as a direct result of the competition between German banks, keen to fund wind projects, in addition to a perceived, lower overall country risk level, thereby pushing the rates down.

Although based on a small sample, the ideal support scheme appears to be found where a good balance between risk and return can be found and when six member states (The Netherlands, UK, Denmark, Finland and Italy) discussed the ideal Feed In Tariff scheme at length, they designed and use the sliding scale of the Contract for Difference. Hereby generators obtain a guaranteed minimum, but also capped return as the public sector will top up the market price if needed. When market exposure and the cost of capital go up, the support by the taxpayer and ultimately the consumer, goes down.

The overall conclusion is that policymakers should “look at renewables as an investment in a value chain that triggers industrial development”.

 

(1)Directive 2009/28/EC lays the policy framework for renewable energy sources (RES) until 2020. The aim of this project is to ensure a continuous assessment of the existing policy mechanisms and to establish a fruitful stakeholder dialogue on future policy needs for RES in all sectors (electricity, heating & cooling and transport). Thus, DIA-CORE shall facilitate convergence in RES support across the EU and enhance investments and coordination between Member States (MSs).

 

(2)Report for the European Commission published on 10 February, 2016. The “DIA-CORE” project was carried out by a consortium of researchers from Ecofys (lead author David de Jager) (NL), Fraunhofer ISI (D), eclareon D), Unversiteit Uthrecht (NL), the National Technical University of Athens (EPU-NTUA) (G), Deutsches Institut fuer Wirtschaftsforschung E.V. (D), Centre for European Policy Studies (B), the Technical University of Vienna (TU Wien) (AU), AXPO (AU), and the Lithuanian Energy Institute (LEI)(LI). It was paid for by the Commission’s Agency for Small and Medium Enterprises (EASME).