Financing Net Zero: Merchant Financing

Against a backdrop of ongoing developments in the energy market, the importance of unlocking future low carbon generating capacity continues to grow, offering rife investment opportunity.

On 11 October 2022, Shoosmiths hosted a webinar about financing net zero and managing renewal merchant risk. The panel of speakers comprised Lucy Dolton, senior analyst, assets and infrastructure - Cornwall Insight, Victoria Allen, head of onshore renewables development - Scotland RWE Renewables, Ross Driver, director - Foresight Group, and James Wood-Robertson, head of energy and infrastructure and commercial partner – Shoosmiths. The virtual event was chaired by Dan Atzor, research partner - Cornwall Insight.

Below reviews the key takeaways from the webinar:

Merchant Business Models for Renewables

• Merchant business models are typically referred to as the development of renewables assets, without direct support through policy or subsidy regimes. There is a question around whether they will produce zero costs to consumers or generate neutral costs over a lifetime.
• Each business model is case based on wholesale power market revenues, commonly referred to as ‘merchant generation’.
• Like other technologies, subsidy-free renewables have the potential to access other revenue streams. These include capacity markets, balancing services, balancing mechanisms, embedded benefits, and green certificates.
• Business cases also vary according to location, technology, size and scale, financing, and portfolio options.

Options and Considerations

A range of options and considerations come into play when it comes to merchants and renewables. These include:

• Asset Type (whether repowering extant renewables, or launching the deployment of new sites)
• Connection types (with concerns of transmission, distribution, and private wire)
• Revenue streams (including wholesale markets - the largest and most liquid revenue streams-, balancing mechanisms, balancing services, embedded benefits, capacity markets and green certificates)
• And different Routes to Market (such as self-trading, VPP supported training, PPA, CPPA)

Considerations: ongoing, current, and future

• There are ranges of macroeconomic uncertainty and low liquidity in forward wholesale markets, which has meant the future trajectory of wholesale revenue is uncertain. This creates significant levels of risk, which many parties do not have the appetite for.
• The Review of Electricity Market Arrangements (REMA) will aim to facilitate decarbonisation of the electricity sector by 2035.
• Legacy renewables will enable the end of subsidies.

Panel Q&A

On the one hand, high wholesale energy prices justify the financing. On the other hand, they raise the prospect of government intervention. Focusing on the price element, how would you assess the impact of current energy prices on the different routes to market (and on merchant financing) for renewable assets?

Ross Driver, director, Foresight Group: “From the perspective of the listed infrastructure space, none of us could have predicted that power prices would have risen to the level they had post the invasion of Ukraine - especially coming off the back of the pandemic in 2021 - when power prices were on the floor. Initial increases in prices, back to a normal level, were thus seen as positive at first. If not for the pandemic, we would have seen the real take off in a large level of investment in subsidy free solar in the UK, as well as wind and other technologies.” 

“Since the war in Ukraine and the rate at which power prices have risen, investors have sought certainty and a steady state. Renewables don’t need particularly high power prices for deals to go through. We knew rising prices would make for a hard winter for people, and Governments across Europe will have to step up as well. Lots of uncertainty exists in the market, and has done since May 2022 when the Chancellor refused to rule out extending the windfall tax. Investors are looking for certainty and reasonable levels of power prices to cover investor returns.”

Prices could trigger policy interventions such as revenue caps for generators. What are your thoughts on such a move, from investor and developer perspectives?

Victoria Allen, head of onshore renewables development , Scotland RWE Renewables: “The price caps are certainly coming. The renewable energy investment industry knows it can bring its part as well. Nobody expected these sky-high prices, we’re just looking for stable levels of return to give to our investors. Therefore, we could live with revenue caps if set at reasonable levels. They have to be higher than current, because strike prices don’t compare with generating portfolios, which cost more to develop, and legacy costs that are higher. Such levels crash investor confidence into the UK.”

Ross Driver: “The EU-wide cap is at 180 euros. Large disparities between the UK and EU will cause money to flow out of the UK into other jurisdictions. We want to invest more into UK renewables with stable structure to do so, but this probably will not be ready until the end of year – with the market being effectively closed to us at the moment.”

James Wood-Robertson, head of energy and infrastructure and commercial partner, Shoosmiths: “The government also have a role to play in this, the minimum they can do is create a stable development platform with stability for long-term investment. Currently the government is spooking a number of different markets at the same time with reactionary policies and decisions made under pressure. The last thing any market needs is a wobble.”

People are anxious to know the details, and better understand, those potential policy interventions. Do you think the price cap would affect private wire power purchase agreements (PPAs) with renewable generators?

Ross Driver: “This certainly depends on what the cap is and what the PPA price is, and how generators are targeted for the revenues they generate (on a per project or per company basis). We don’t know how this will apply. If resembling the current figures that were leaked by the Financial Times, it creates a position where inflating prices on private wire PPA increases development costs and the costs of borrowing. The alternative is a number of corporates looking to fix in, if the price is higher than it would have been a year ago. If prices being pushed up isn’t a pressure, and the impact pushes PPA prices down, then this would put negative pressure on prices of private wire PPAs.”

If the price cap in the UK is much lower than elsewhere on the continent, how would this affect the flow of generation?

Ross Driver: “The flow of generation must be considered in terms of interconnectors between the UK and Europe. If the price cap is twice as low in the UK than continental Europe, this would have multiple ramifications for interconnectors owing to the major imbalance between the two. It would also mean the UK loses the energy security we are so desperate for, thus flowing in the face of this goal.”

James Wood-Robertson: “Politically we are aligned with our neighbours at the present moment and this has probably been exacerbated by the current threat of war. Setting price caps will be a politically charged decision, as much as an economic one. This decision is also as much a challenge within the EU due to the flexibility that has been built in. States putting pressure on other states leads to the price cap problem presenting as a kind of political football. This is a time when we need co-operation more than ever.”

To what extent does the panel believe a revenue cap is a big stick to make the carrot on the voluntary contract for differences (CfDs) more attractive? Is its intention to migrate more towards voluntary CfDs?

Victoria Allen: “The voluntary CfD appears to be the longer-term solution whereas the price cap is something that can be done quickly and without too much damage. Making this look attractive might be a positive longer term silver lining to the way the price cap is currently being discussed.”

Ross Driver: “The CfD is too hard to implement in the time frames the government seeks to move on. It is also complicated by the amount of forward fixing of prices taking place.. From an investment point of view, CfDs exist as longer-term solutions and one the better solutions for funding renewables. Investors get the certainty they want, and the government gets the difference by making mor out of it than they’ve had to pay back - it is a win-win. We cannot say for sure, however, that this is a strategic shock factor or ‘stick’ to make CfDs more appealing.”

James Wood-Robertson: “The government is willing to intervene in the market. Not doing so voluntarily means the screws could be turned for instance on RO projects and move across to a CFD structure.”

Looking at the market as a whole and based on your research, which route to market has the most accessibility & liquidity in practice in the UK at the moment? 

Lucy Dolton, senior analyst, Assets and Infrastructure, Cornwall Insight: “Short term routes are much more liquid, with longer term deals in the PPA space are more challenging to price. Within the short term, there is a general market reluctance around fixed price deals around wind and solar due to imbalanced risks there. Challenges on the forward curve certainly impede longer term routes to the PPA market.”

With the current uncertainty, what sort of costs of financing and availability of financing are you currently encountering, or have stopped as you wait to see what happens next?

Victoria Allen: “The cost capital is increasing on the developer side of things. Merchant risk premiums will rise to account for the uncertainty in the market and political interventions we’re seeing. Everything is getting more expensive (commodity prices, bills, the cost of machinery). Immediately the opportunity presented by rising merchant prices, is to suck up lots of the increase. Capping this opportunity makes risk factors increase.”

Ross Driver: “UK guild rates are now at 4.5%, leading to risk premiums over and above that for investment in renewables.”

How are developers thinking about the market design changing? And what are your biggest concerns with merchant projects at the moment?

Victoria Allen: “As developers we are hoping the Review of the Electricity Market Arrangements (REMA) comes out and balances things better. Opportunities are opening up for big wind farms and offshore Scottish Wind to generate low carbon energy in Scotland. Making sure these match the energy policy is our greatest priority, so that we don’t end up with an imbalanced system that slows down investment or causes Scotland to be really expensive for generation.”

Ross Driver: “REMA needs to take place to shake up accommodation for new renewables and intermittent generation. It is not exactly on investors radars yet, but very much the next thing that’s coming. This is largely because the quickest we could enact any of this would be several years’ time. Careful consideration is needed for the messaging that goes with REMA about being investment friendly, otherwise uncertainty will drive away all potential and possible investment.”

What do you see of the potential impact of REMA on the market? More broadly, what could be the impact of upcoming market design reforms (such as the Review of the Electricity Market Arrangements) on the market?

Lucy Dolton: “REMA certainly introduces a lot of uncertainty, mainly because we don’t know the details or any of the miniature of it. This uncertainty makes the UK relatively less attractive for investment in renewables, which poses the risk for an investment hiatus. Stretching low carbon capacity deployment targets creates a significant risk in how we reach those. To reach net zero we need to double the growth in investment from where we are currently. Having the risk of uncertainty for investment in renewables, has a significant impact within that.”

Ross Driver: “We want to incentivise generators to be closer to the energy produced by them, and having more onshore projects cuts across this. Layering politics on top of designing a new market is a major risk.”

To what extent is the cost of energy increasing the appeal to onsite generation and CPPA for businesses?

James Wood-Robertson: “The appeal has been strong and significant for a while, and definitely growing. This has been witnessed across the board from everyone in the corporate space. Demand is outstripping supply. Large corporate PPAs are only suitable for the low percentage of large corporates that can carry them and make it work. The demand is significant, so much so that the delivery of right kind of projects cannot keep up.”

Conclusion

There is a lot of uncertainty at the moment in the market, with developers and investors seeking stability and reasonable levels of power prices to cover returns. Yet opportunities do exist with innovative ways forward, that we hope will improve the growth of investment in renewables.

Cornwall Insight will be launching their REMA portal W/C 17th October to provide regular updates in this space.

Click here to view the recording.