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Merchant risk in energy storage project financing makes compelling case for traditional players

By Charles Lesser

At first glance, renewable power generation has created, in the eyes of traditional industries, an investment nirvana. By understanding how these better-capitalised companies view renewables’ merchant risk, we can identify where future energy storage projects should seek finance partners, says Charles Lesser, a partner at Apricum – The Cleantech Advisory. 

UK energy storage funding is rapidly improving with £270M (US$337 million) of funding announced in November 2020 alone for two players, developer/integrator Zenobe and investment fund Gresham House Energy Storage Fund in two landmark transactions, and further milestones pending announcement. But funding remains challenging. By understanding how better capitalised companies view renewables’ merchant risk, we can identify where future energy storage projects should seek finance partners.

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At first glance, renewable power generation has created, in the eyes of traditional industries, an investment nirvana: a promised land of low engineering risk, low operational risk, guaranteed revenues, low opex, unsated demand, cheap capital, and social value. The relative technical challenges of a solar farm are not comparable to a high pressure/high temperature, subsurface, offshore, emerging market gas field. However, every one of these advantages is efficiently valued in the low project returns acceptable to its financiers – 'mid-teen' IRR energy companies cannot win shareholder support to participate: they are as competitive as champion weightlifters on an athletics track.

The unacceptably low project returns can only be mitigated by layering further risks that crowd out traditional renewable finance: the primary three are venture risk, sovereign risk and merchant risk. Venture risk is the early risk of proving a project (or technology’s) commerciality and is best suited to renewable project developers with a track record or to venture capital. Many energy incumbents have therefore established venture funds. Sovereign risks are country level risks, relating to macro-economics, tax and policy. They are highest in emerging markets where primary energy companies have long operated and they will leverage this familiarity by pursuing renewables opportunities in emerging markets. In this article, we focus on the merchant risks (price and volume), which torture post-subsidy renewables, but are the most manageable for traditional energy corporates.

Eight reasons why this market can suit traditional energy companies

Why should traditional energy companies (utilities or oil & gas companies) target owning the merchant risk of renewable energies? We see eight principal reasons.

Merchant returns are compelling

The aversion of infrastructure finance to merchant risk escalates the additional return available, known as the risk premium. To take a distilled form of merchant risk, such as energy storage, many UK developers now claim new UK project returns are settling in the mid-teens. If deliverable, not only are these returns vastly superior to the oil & gas industry's pre-pandemic five year average Return on Capital of 5.1% (or utilities’ 7.6%), but they are derived from lower risk projects: so on a risk-adjusted basis, these returns are both numerically superior and deliverable on a lower cost of capital (as we will see). That renders them compelling. 

Pre-existing vertical integration

Large companies and utilities have long used vertical integration to mitigate price risk across the enterprise. Where they already own end customers (e.g., residential energy, C&I vehicle forecourts, energy distributors), this remains an option. Upstream project merchant risk can be acquired and self-hedged through downstream demand ownership, with the risk premium secured as profit. Indeed, the phasing out of ICEs could facilitate a fuel forecourt price advantage if the retailer owns upstream electricity generation exposure, bypassing the mark-up of a fixed price utility contract.

Financial market expertise to manage price risk

Since the 1980s, energy companies became adept at exploiting the growing liquidity of commodity markets to manage portfolio price risk and these operations have became lucrative. There are both barriers to entry and economies of scale in these trading businesses that allow energy producers and utilities to acquire unwanted merchant risk and, where it is not hedged by portfolio construction, it can be cheaply, competently, and potentially profitably hedged, with the risk premium pocketed as profit. It is currently unlikely that any renewables developer will develop the same proprietary hedging expertise. 

Merchant risk has board and shareholders support

A risk that is endemic to the business model, familiar to its stakeholders, and has proven monitoring and mitigation tools, does not trigger internal convulsions as it may in a fund mandate. Shareholders of oil companies have traditionally owned them in part because of the merchant risk, which mitigated energy price risk elsewhere in their portfolio. Boards are therefore comfortable acquiring price and market risk. This ease of ownership is an easily overlooked advantage. 

Balance sheet scale to manage volatility in returns

Infrastructure balance sheets are not configured to manage volatile returns, but to minimise the cost of capital: commodity producers' balance sheets are tailored to cyclical volatility. Merchant risks bringing volatility of returns are suited to commodity producers who will withstand volatility of returns, so long as these exceed the investment on a full-cycle basis. This appetite for volatility creates space for traditional energy companies to participate (although their balance sheet strength is admittedly dissipating). 

Bespoke merchant risk lending products

The financial services industry developed sophisticated lending products tailored to accommodate simultaneous uncertainty of both price and volume for commodity producers, such as accordion facilities, reserve based lending, redeterminations, etc. Volumetric risk in energy storage is more modest than in a subsurface reservoir: the principal risk in energy storage is price (or volatility). While adapted lending products have not yet fully emerged, once the commercial opportunity in energy storage lending is large enough to support a scalable product, merchant risk-adapted lending products may well be developed by large energy companies’ existing lenders to support them in energy storage.

Merchant risk can reduce the cost of capital

Portfolio theory states that revenue diversification, uncorrelated risks and the resulting stability of returns can reduce the cost of capital, by reducing portfolio volatility. An upstream oil producer, developing material earnings exposure to intra-day electricity price volatility driven from solar and wind exposure, should see greater cashflow stability across the portfolio. This should reduce its cost of capital in both credit markets and improve its equity valuation (i.e., cost of equity): uncorrelated merchant risk exposure is therefore attractive. 

Best available option

Most employees seek purpose and pride in their work. Commodity industry employees generally believed they were nurturing access to energy and its economic gains (employment, political stability): western societies have condemned their work, and their careers are uncertain. If their skills can be profitably deployed in markets that restore personal and social pride in their labour, this will be embraced from the board down.

Delivering an energy transition without risking it all

So, we see several conceptual reasons why some of the challenges of post-subsidy renewables finance might be solved by traditional energy companies.

Of course, the practical realities are more complex. First, most of these opportunities lack the scale to be material: it may require the emergence of aggregating niche champions to grow portfolios large enough to interest energy majors. Second, the engineering intensity per unit of return is significantly higher in renewables: these projects can, at least in the development stage, require more staff hours for less portfolio impact: adapting to this requires an uncomfortable shift in a corporate culture accustomed to the high impact returns of an exploration well or off-take agreement. Third, the low returns in traditional renewables projects can depress blended project returns such that traditional companies can only justify accessing the concentrated merchant risk: if that structure forfeits the ESG reporting benefits prioritised in shareholder checklists, they will be deterred from participating. So further steps are required to unlock the participation of traditional energy companies in the energy transition. But that work can be done.

Looking through the other end of a telescope creates an unfamiliar and remote view, as we have done here, but distance can create valuable perspectives. From the other side of the telescope, merchant risk is not just the obstacle but the opportunity. The finance industry's raison d'être is the efficient allocation and pricing of risk.

True energy bankers should therefore be helping both renewables and legacy industries to allocate risks in the delivery of the energy transition. To this end, Apricum has expanded its banking teams in both equity and project finance to facilitate this allocation and pricing of merchant risk and render the undoubted opportunity of energy storage and further renewables penetration. 

Cover image: It's time to unlock the full force of traditional energy industry players like Shell in an energy transition based on forward-thinking but sensible decisions about investment, financing and risk. Image: Shell Energy.  

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