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Financing Renewable Energy Projects

Abstract

Financing of renewable energy (RE) projects is hampered by two systemic economic effects – market ‘externalities’ that make RE projects appear less attractive (versus fossil fuel development) than they should; and the effect of embedded interest in the cost of capital.

For a particular RE project, evaluating financing options can be intimidating. There would appear to be mileage in sharing understanding of the challenges across projects and jointly developing progressive approaches,

This article has been prompted by the incipient involvement of the Feasta Currency Group in the financial engineering of a specific wind energy project in Ireland, of which more in due course.

Market externalities

Orthodox economics may be a discredited pseudo-science but it has given us a number of useful constructs including the ‘externality’. An externality is a cost or a benefit that is not reflected in a ‘market price’. Quoted examples of externalities are usually negative – i.e. there are bad effects associated with the operation of the market that are experienced by non-participants in the relevant transactions. Sometimes though they can be positive and deliver benefits to ‘outsiders’; for example your house value may go up when a new school opens nearby.

In an RE context, a major negative externality – the costs of pollution, clean-up and subsequent climate change – is largely absent from RE projects but this is not reflected in the comparative economics of RE projects. The message can be (and is) used in prospectuses to ethically minded investors, but the bottom line return on investment takes no account of it.

The so-called ‘triple bottom line’ approach addresses this effect to some extent by attempting to quantify, and report on, ecological and social, as well as economic outcomes. It has been applied largely in the public sector. In the private sector Corporate Social Responsibility best practice also reports against ecological and social targets, and there are various organisations advising on ‘sustainable investment’.

But opinion is split between those seeking to refine, improve and make relevant the metrics that describe this real world/finance disconnect, and those who believe that ‘quantifying environmental bads’ is a well-intentioned but ill-considered line of action. Quantifying entities which should be beyond economic measurement, it is argued, implicitly encourages the progressive marketisation of goods which should be treated as commons.

Either way RE looks more expensive than it should.

As far as encouraging investment in RE projects is concerned, positive externalities, (such as the empowering community impact of locally controlled resources) should be (and are) articulated as part of the offering. Complex metrics seeking to add weight to the point may well over-complicate the proposition and confuse potential investors.

So, on this front, innovative approaches available may be rather limited. But on the financial engineering side there are definitely new ways of working to be developed.

The Interest Burden

Typically capital for RE projects is acquired by borrowing at interest. The overall excoriating effects of embedded interest (the ‘invisible wrecking machine’[8]) have been well described by Tarek el Diwany [1] and Margrit Kennedy [2] among others. It is unnecessary to repeat them here at length, though they do form a value-based backdrop for projects that aim to deliver maximum benefit back to the locality. In that context interest payments to absentee capital-renters represent leakage of money out of the community. Absentee lenders have ‘skin in the game’ to the extent that they risk their capital of course, but they will generally have no allegiance to the locality, (although the mainstream finance industry in Ireland has latched on to the potential ex-patriate investor community and is now offering ‘Diaspora Bonds’ [9]). Designing out the interest element is an attractive prospect to improve ROI.

FEASTA’s co-founder, the late Richard Douthwaite, envisaged a sort of halfway house in his paper on what he called Aggressive Mutuality [3]. In this model a proportion (he suggested 10% but it could be higher) of the capital needed was obtained from investment into shares by local consumers. Rather than distributing dividends, profits are retained to accelerate paying off the remaining bond-holder based finance. In this way, the interest burden is lessened.

To remove the interest burden completely we might look towards Islamic finance (see el Diwany above), full equity sharing or prepayment instruments. Equity sharing and Islamic finance are predicated on investors providing finance in return for a share of future revenue streams. Islamic finance is grounded in the religious prohibition of usury – an ancient wisdom whose time may yet come again. Here the equity share as well as having a local flavour is anchored to a stable and growing forward revenue stream from the sale of energy. As such it represents an attractive pension investment.

There are some echoes here of what is now being called ‘solidarity finance’ – for example the trade-union-driven financing innovations in Quebec which have resulted in employees pension funds being invested in projects with positive social outcomes [4] – a favourite ‘Real Utopia’ example of Erik Olin Wright [5].

Examples of equity finance models have been described in Feasta’s Fleeing Vesuvius [6] publication and elsewhere. Both equity finance and Islamic finance seem to require more active risk management by investors who are used to the capital-rental model which means they get their pound of flesh come what may (sometimes due to bailouts). But this syndrome – privatised profit, socialised risk – doesn’t really apply to new RE projects because the government isn’t going to bail out RE investors whatever the model. So good business planning, risk assessment and appropriate insurance are needed in all cases.

Of non-traditional approaches, prepayment instruments seem particularly suited to RE projects. Chris Cook, a leading advocate of this approach describes it thus: “Any community can create a pool of energy production which may be monetised simply through a community ‘custodian’ issuing prepay/IOU instruments returnable in payment for energy consumed.”[7] ‘Simply’ might be understating the challenge, but this is the prospect in a nutshell.

The innovation here is that the instrument is denominated in kWh rather than in euros. This means that the initial investment buys so many kWh and redemption is via payment at some future date against that number of kWh already consumed. If, as widely expected, energy prices continue to rise, the prepayment instrument acts as a hedge against price rises.

The design of such an instrument needs to address two particularly important parameters – whether the instrument is dated or undated; and whether it should be tradeable.

If dated, the instruments could possibly be issued in tranches which mature according to a schedule that matches the volume of expected electricity generation. If undated, attention needs to be paid to the generation and distribution partnerships of the community to provide some way of managing and fulfilling uncertain redemption demand. An individual RE project is generally subject to the classic RE criticism – that the wind doesn’t always blow/ sun doesn’t always shine. So partnerships with other electricity sources are needed in order to guarantee reliable supply to consumers. These would likely come from a PPA (power purchasing agreement) with an electricity license holder providing for both supply and sourcing – the so called ‘top up and spill’ agreements.

A further exciting possibility is the linking of investment instruments of this sort to a community-sponsored exchange currency. The prepayment instruments could be held in reserve by the sponsor to back a mobile phone based digital currency, easing liquidity in the locality. While sourcing affordable capital funding is the overriding priority, a local exchange currency is high on many communities’ wishlists.

References

[1] Tarek el Diwany: http://www.theproblemwithinterest.com/about_pwi.html

[2] Margrit Kennedy: http://www.youtube.com/watch?v=1Ixgt4syL9U

[3] Richard Douthwaite: previously unpublished : www.feasta.org/forum/files/aggressive_mutuality_plus_101.doc

[4] http://www.open.ac.uk/oubs/socialinvestmentseminars/pics/d97691.pdf

[5] Erik Olin Wright: http://realutopias.org/

[6] http://fleeingvesuvius.org/

[7] Feasta Currency Group: www.facebook.com/groups/designercurrencies/

[8] John L King: quoted by Kennedy

[9] http://www.economist.com/node/21526324

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