Show me the money: capital for a renewables future
Wind and solar energy have caught investors’ attention over the last decade. Improved economics and increased gigawatts deployed have attracted significant pools of capital. So how much capital is likely to be deployed going forward, and where will it come from? And what role will this play in the energy transition?
Principal consultant Prashant Khorana shared his view.
How much capital will be deployed across renewable energy generation technologies worldwide?
We estimate that the capex spend for wind and solar combined will be around US$165-190 billion per year. That’s more than double the current spend for US unconventional oil and gas.
Our calculation is based on realistic growth scenarios, and project development at an average cost of around US$1.0 per watt.
Do you expect consistent capital deployment each year? And in each region?
There are significant variances in development costs by country. For example, solar projects can be developed for US$0.4 per watt in Spain or Portugal, compared to US$1.5 per watt in Japan. However, the global average is around US$1.0 per watt for onshore wind and solar, and US$2 per watt for offshore wind. This translates to capital deployment of around US$190 billion in 2019.
Over the short-term we expect this to decline slightly, to US$160 billion by 2025. This is due to the combined impact of policy changes around the world, and ongoing reductions in equipment costs.
After 2025, the capex pool will rebound. We predict it will return to US$190 billion by 2035 as cheaper unit economics and favourable regulatory changes make new markets more attractive.
How should investors perceive renewable energy generation assets?
One way to quickly evaluate risk is to consider debt financing and leverage rates available from large banks.
An onshore wind or utility-scale solar PV project can currently be financed with 75-85% of leverage at a 100-130 basis point over LIBOR (for investments in BBB credit-rated countries). This is very close to the lending rate a large bank would provide for a highway or an airport. So, in many cases these assets are bankable, investable, and considered to be comparable to other high-quality investment opportunities on the risk-return curve.
What type of firms will deploy capital in renewables?
Due to the de-risked nature of wind and solar power generation as an asset class, unlisted and listed funds currently deploy around 45% of the US$190 billion spend.
Utilities, legacy players in the power generation value chain, come next with roughly 25% of the annual spend. Pension funds and oil and gas companies, relative newcomers to this asset class, deploy 3-6% each.
The fragmented nature of utility-scale development in many countries – such as Germany, Netherlands and parts of Spain – means that small developers also maintain a meaningful share (18%).
How will this change over time?
A significant share of capacity (100-120GW of 170GW) is still expected to be awarded under fixed remuneration auctions through 2030. The role of passive and low-WACC investors, such as pension funds, is likely to increase over the long term as a result. Even a 1% increase in pension capital could provide an additional US$15-20 billion for renewable energy projects. As countries scale their auction plans, small developers are likely to consolidate their portfolios. Their share would decline.
Large oil and gas companies, eager to join the energy transition, are likely to increase their allocation to 10-15% of their annual capex plans. Galp Energia, for example, made this commitment in October 2019. Oil and gas players are also likely to have the appetite to pursue higher-risk opportunities to meet shareholder return targets. This might include emerging market project development, distributed generation and behind-the-meter generation.
Utilities will likely maintain their share at 25%. It remains to be seen whether large utilities will spread their capex across a variety of opportunities or focus on specific technologies or activities. Ongoing transformation plans of prominent utilities suggest that there is no one-size-fits-all model. Many are trying to focus on niches that capitalise on their unique competitive advantages.
How would a transition to ‘merchant’ models impact this story?
A move from fixed remuneration to merchant models would expose assets to power price volatility. Passive sources of capital would find it more difficult to deploy capital in fully-merchant or unhedged projects.
However, over the next five to ten years new hedging instruments are likely to become more robust and liquid, allowing asset owners to continue to deploy capital in a flexible way. So the transition to merchant assets is a short-term headwind for an asset class with a long-term tailwind.
What effect will capital deployment have on carbon targets?
The incremental capex pool expected to emerge from the power generation sector might seem significant. But it barely gets us close to the 2-degree target agreed upon in Paris in 2015.
Hypothetically, to swap the world’s entire coal power plant fleet by 2030 would require an additional spend of US$200 billion a year. This (highly optimistic) scenario would significantly step up our efforts towards a cleaner and emissions-free world, but would only contribute an additional 13% towards the global Paris target (including non-power sector emissions).
The reality is that far more needs to be done to help us cut back from 51 billion tonnes of CO2 to 35 billion tonnes by 2050.
Is this the whole investment picture?
No. These calculations focus on renewable energy generation. The other side of the story is the additional investment needed in transmission, energy storage and other areas that complement growth in renewables. Based on our recent analysis of the US market the investment requirement could more than double, depending on the technology choices made.