In my last post, I talked about the scale of the financing challenge to make a global shift to clean energy, and hinted at some of the obstacles to mobilizing private capital to meet that challenge. This post focuses on barriers inherent in clean energy projects.
There are two kinds of finance challenges for clean energy that apply no matter where the project is built. They are not the only challenges, but they illustrate why it is hard to finance renewables. First, it generally costs more money up front, per megawatt hour of power generation, to build a renewable power plant than a conventional power plant. Second, for solar and wind, you can’t always turn the power generation on when you want it – it is not “dispatchable”.
Costs. Economists who study electricity costs have an accounting device called LCOE, or “levelized cost of electricity”. An LCOE calculation looks at all the money you spend to build and operate a power plant over its lifetime and discounts the cash flows back to present value, then divides by the expected amount of power generated. The result is the LCOE for the power plant, which is usually expressed as a cost per kilowatt hour. A low LCOE indicates that electricity is being produced at a lower cost.
Now assume that you have a coal fired plant and a solar PV plant that have the same LCOE, can generate the same amount of power, and otherwise are equivalent for all purposes (this is unrealistic, but bear with me in this example). The solar PV plant costs more money up front to build than the coal plant, but costs less to operate because the fuel is free. Which plant does a financier prefer to finance?
All other things being equal, the financier likes the coal plant better because there is less capital at risk per megawatt hour of power generation. Even if the lifetime cost of electricity from renewables is equal to or cheaper than for fossil fuels, the higher up front cost to build a renewable power generation plant makes it harder to finance. In many developing countries, where the cost of capital is much greater than in developed countries, that higher up front cost can make renewables less competitive with fossil fuel generation.
Dispatchability and Uncertainty. Coal plants need coal to burn, and it sits waiting in a yard at the plant regardless of the weather. Wind turbines need wind to run and solar power plants need sun to operate. If there is no wind or sun, there is no electricity. Electric utilities have found ways to plan around this “dispatchability” problem, with a mix of different kinds of power generation sources.
But a financier who is financing a new solar PV plant has a problem – uncertainty – that he cannot solve so easily. The up front capital and operating costs of a solar PV plant are well defined. But, the plant makes money only when the sun shines. If there are storms for two weeks, the plant does not produce electricity and there is no revenue for two weeks. This is uncertainty, and financiers do not like uncertainty.
The finance solution to this problem, when the capital source is even willing to accept the problem, is to charge more for the capital. And this, like the greater up front cost problem discussed above, also tends to make renewables less competitive with fossil fuel generation.
As capital markets have gained experience with financing renewables, they have begun to understand that uncertainty of the revenue stream is not as great a risk as they initially thought. However, the uncertainty from lack of dispatchability still remains a problem for financing renewables.
Up front capital costs, and dispatchability and uncertainty, are not the only reasons why clean energy sources are harder to finance than traditional fossil fueled sources. Another important reason is that the bond markets, particularly the project finance market which typically finances large infrastructure projects, have not yet widely accepted clean energy projects as providing the long term stable low-risk cash flows that those markets require. We must face and solve these real business problems to get the capital markets to finance the shift to clean energy that is crucial to our future.
In my next post, I will turn to the special challenges that the enabling environment in developing countries pose to financing clean energy.
Larry Rodman is currently a 2016 Master of Environmental Management candidate at the Yale School of Forestry and Environmental Studies, focusing on clean energy and green growth finance. Prior to returning to school at Yale, he practiced law in New York City for 40 years, primarily in corporate finance. Larry is a graduate of Princeton University (Woodrow Wilson School of Public and International Affairs) and Harvard Law School. He is Chair of the Board of Directors of InsideClimate News, a Pulitzer Prize winning online publication devoted to climate and energy issues. Stay tuned for more blogs on climate finance from Larry on the Asia LEDS Partnership website.