February 2011

RENEWABLE ENERGY: hard times ahead

windfarm2_410Across Europe and the US, governments have been keen to promote “clean” technologies by providing both financial and regulatory support. But are such incentives artificially distorting the market? Ilya Golubovich at I2BF takes a look A recent survey by the Cleantech Group and Norton Rose on private equity (PE) and cleantech investment shows that private equity and venture capital investment in the cleantech sector has increased. The research showed that in the second quarter of 2010, investment in clean tech, totalled $2.02bn across 140 companies.

This is up an impressive 43% from the same period a year ago. The number of deals recorded was down from a record high of 192 in the first quarter, but the number is still high in historic terms.

The same research shows Europe as offering the greatest incentives for clean tech investment. There is substantial government support, both political and regulatory, and the financial incentives offered encourage innovation. These factors are crucial for the continuing growth of the sector.

While this is positive in that it is attracting investment and bringing about a much needed sea change in how energy is provided in Europe, there is a view that such incentives are distorting the market and leaving it vulnerable as cuts come into play. It is argued that investing in the clean tech and renewable sector should not have different criteria to other sectors.

Investors should go where the dollars have a bigger impact and ultimately, better risk-adjusted returns.

This is particularly true as the fall out of the economic difficulties begin to affect public finances across Europe. The sector is beginning to experience some volatility after it had weathered the financial turmoil endured by others over the past few years. As governments, especially in Europe, look to cut back on subsidies, investors and the sector as a whole will experience some difficult times. This adds to the woes suffered by the sector due to a slow and painful couple of years in bank loans and project finance. This has also had a detrimental effect on the clean energy sector, which typically entails massive up-front capital outlays.

The effects are already becoming visible. Over the summer of 2010, large renewable energy companies in Spain had to broker a deal with the government, which resulted in lower-than-expected cuts to subsidies. However moves to reimburse Spanish utilities for approximately €16bn worth of tariff deficit (the difference between the cost of renewable-generated energy and how it is sold to the consumer) have been ignored.

There have also been question marks over smaller scale renewable energy projects in Spain such as solar PV and thermal. 

The global solar industry, a sector which has already suffered the effects of an incentive-distorted market (solar module cells lost 50% of value when the market crashed in the financial crisis in 2008), is also likely to face fresh difficulties as European subsidy cuts come into play next year.

The sector has had an excellent year as customers ordered stock ahead of these cuts and as a result, suppliers have increased capacity. However, exposure is geared towards Germany and other countries such as Italy and Spain, all of which are looking to cut public spending over the next few years.

In the UK, the coalition government recently called for PE to provide the capital for the country to meet its carbon emissions reduction targets. However, a reduction in subsidies may well put these investors off.

Meanwhile, in the US, there are questions about the expiration of the 30% investment tax grant for wind projects.  Even as some of the traditional providers of tax equity return to profitability and new entrants such as Google emerge, many believe the moribund tax equity market will take a while to recover.  This, along with the upcoming November elections, is having a chilling effect on incremental investment.

Uncertainty surrounding regulation and government financial incentives may make investment too risky. Investments in renewable energy projects and assets, such as those in energy efficiency, energy storage and smart grid, have the potential for significant returns, but without greater policy certainty, investors will be reluctant to provide funds.

One third of the international private equity investors polled by the Cleantech Group and Norton Rose cited the absence of a clear regulatory framework as a major barrier to entering the market, while 45% said that government support and related financial stimulus was the key factor when deciding which region to invest in.

This is, I believe, the difference between venture capital investors in the sector and their relationship with government subsidies.  Venture capitalists operate with different rules to PE investors and therefore are more insulated to the volatility of government regulations. PE funds operate with reference to these incentives therefore are more likely to get caught out when there are changes to them.

In my view, volatility is precisely the right characterisation.  The great irony of the incentive programs is that they actually increase the volatility in the sector rather than decreasing it.  Witness the intense volatility in the wind sector in the US from 1999 to 2005 as the incentive program fluctuated wildly and forward visibility dropped to zero.

It makes sense, therefore, to incentivise venture capital investments in the renewable and clean tech sector with a one-off grant, loan, or guarantee. This framework appears to provide a more efficient system for governments than the commitment to pay a feed-in tariff (Fit) over the next ten or 20 years.  The US has addressed this somewhat by allowing wind farm developers to take the Fit upfront rather than over the life of the project.  The American Recovery and Reinvestment Act has also instigated a shift away from Fits to manufacturing incentives.  Despite the inherent accounting and budgeting conflicts at the national level, it’s great to see some progress on this front.

We make these investments with the belief that the best product will find its own market – be it in Spain, Italy, the US, China, or elsewhere.  At the same time, as investors, we do not have a crystal ball to know where the regulatory arbitrage will be greatest in the next three to five years. Therefore, we do not expend a lot of energy trying to figure it out.  We are not fundamentally “tariff chasers”.  We are drivers and promoters of technological advances,
which ultimately obviate the need for government incentives. Ilya Golubovich is the founding partner of I2BF ©2011 funds europe

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