Despite several landmark offshore wind deals attracting funding in the past year, there remain big question marks over both the appetite and the ability of banks to provide the large levels of debt required to fund Europe's offshore wind ambitions.
The UK, in particular, has a pipeline of programmes that could stretch Europe's project finance market to the limits. The country is already the largest offshore-wind generator on the planet with more than 1.5GW of capacity operational, and the UK government has set a target of 18GW to be installed and operational by 2020. With more than 2GW of capacity currently under construction, this still leaves around 14.5GW needing to be financed and built in the next eight and a half years.
Given average offshore-project costs at the start of this year were £2.6 million (€3 million) for each installed megawatt, the UK requires £38 billion of investment in offshore wind alone up to 2020. Infrastructure projects are typically financed on a debt-to-equity ratio of 70:30, so the debt requirement of these schemes will be more than £26 billion — £8 billion more than the total loaned across all renewable-energy sectors globally in 2010.
"The sheer amount of debt needed would swamp the project finance market," says Fintan Whelan, corporate finance director at European renewable-energy developer Mainstream Renewable Power. The long-term requirements of offshore projects make their financing needs even more challenging, he points out.
"The longer out project finance debt goes, the scarcer it is and more expensive it is. On the other hand, the bond market wants the long tenor and the steady cash flows."
This understanding that offshore wind — via vehicles such as project bonds —needs access to capital-market investors such as insurance firms and pension funds, is at the heart of the plan to create a green investment bank (GIB) in the UK.
The bank's timetable
GIB's mission is to accelerate private-sector investment in the UK's green economy. It has been promised
an initial capitalisation of up to £3 billion after it satisfies EU competition law. It will focus at first on three priority areas: offshore wind, energy efficiency and municipal waste.
In May, UK deputy prime minister Nick Clegg set out a timetable for its launch and scaling up into an independent financial institution. From its birth in April 2012 until it achieves EU approval — which could take up to two years — the GIB will be in an incubation phase and have £775 million available. The bank will have no borrowing powers at this time, spending will be controlled by government ministers and investments are likely to be small-scale and direct, similar to existing government grants.
Once it has EU approval, the GIB will evolve into a stand-alone institution offering financial products to support projects in its three priority areas. It will be given a further £1 billion already promised by the UK treasury and another possible £1.225 billion if the government can raise it through the sale of state-owned assets.
From April 2015, as long as public-sector net debt is falling as a percentage of GDP, the GIB will acquire borrowing powers, enabling it to scale up its operation to match the demands of the market.
With borrowing powers only potentially available from 2015 and a maximum capitalisation of just £3 billion before, there has been criticism that the GIB will amount to too little, too late for the UK's offshore wind ambitions.
Andrew Raingold, executive director of UK lobbying firm the Aldersgate Group, which has long campaigned for a GIB, argues that borrowing powers are paramount to its success and that the government should do everything in its power to bring the 2015 date forward.
"If you do want to mobilise investment at scale from institutional investors, then now is the time to do it because there is a huge amount of savings on the balance sheets of corporations in the EU — around €1.5 trillion stuck in bank accounts and not yielding returns," says Raingold.
"If you look at public banks in Europe — for example [Germany's] KfW — it is leveraged to a ratio of one to ten. For every €1 of public money it attracts €10 of private money. Without the ability to borrow you can't leverage to the scale [needed for offshore wind]."
It is also critical, he adds, that the borrowing powers are enshrined in legislation so there are no U-turns. The fact that borrowing powers as currently proposed are to be contingent on UK debt levels could, he fears, significantly restrict the GIB's impact on the UK's 25GW Round 3 of offshore projects, of which a large proportion is targeted to be completed by 2020.
Ben Caldecott, policy director at renewables investment-management firm Climate Change Capital, warns of the danger that the early stages of the bank could become subject to politicians' whims.
Before GIB is granted EU approval, it will not be able to appoint an independent board and will be controlled by ministers and officials, which could result in poor decision making, he says.
Caldecott believes, however, that the timing of the GIB fits perfectly well with the scaling up of Round 3. Climate Change Capital has been working closely with the government ever since George Osborne, the UK's chancellor of the exchequer, chose the firm — while his Conservative Party was in opposition — to lead his GIB Commission to investigate potential structures for the bank and the services it might offer.
The commission's 2010 report contained suggestions that have now been honed by the government. These include equity co-investment, a first-loss contingency fund for the construction phase of projects and a subordinated-debt fund to enhance the credit rating of operational assets. First-loss contingency is a way to provide insurance for the higher-risk opportunities.
For Whelan — whose firm Mainstream Renewable Power is in a joint venture with Siemens, known as Smart Wind, to develop the 4GW Hornsea zone off England's North Sea coast — the fact that a number of products more advanced than grants, loans or equity investments are still being considered for the GIB is reassuring. It means the bank has the chance to make the most of its initially limited means and potentially play a catalytic role in offshore-wind investment, he says.
"At first glance, the GIB may look under-resourced for the challenge, but it is worth a closer look," he says. If the GIB could provide guarantees for mezzanine debt at the construction phase, this could enable a substantial number of early-stage Round 3 wind farms to secure financing, he adds.
Assuming the first three 500MW of Round 3 projects each cost around £3 million per megawatt, the total funding requirement for these projects would be £4.5 billion. One could envisage, according to Whelan, the GIB supporting each of those schemes with a 10% facility for mezzanine debt (if a project goes bankrupt, mezzanine debt lenders are only paid after the main — or senior — debt lenders, making it higher risk). The 10% would make its total funding commitment £450 million. If, however, rather than loaning it directly, it simply offered a guarantee on those facilities and allowed commercial banks to actually finance the loan, the GIB could stretch its funds even further.
Whelan says the GIB needs to stretch its money as far as possible if it is going to get the required megawatts of offshore-wind capacity built. The above approach is far preferable to that of the European Investment Bank (EIB) or KfW which launched a €5 billion offshore-wind debt-and equity-investment programme in June. Both banks make direct loans to projects and require equal status to commercial banks — known as pari passu.
"The GIB would make its money go further if it was playing a first-loss role unlike the EIB or KfW, which like to be pari passu," he says. "The latter just solves a capacity problem, not an unacceptable risk problem. You need first loss for that."
Beyond the construction phase, Whelan says the GIB's role should be to bring in institutional investors to support the operating phase, as their interests are more in line with the GIB's than those of the banks. First-loss facilities would need to be one of a number of tools to bring in institutional investors at the operating phase.
Pension funds and insurance companies typically invest via bond issuances on the capital markets. Significant bond-market liquidity in Europe only really exists for credit ratings at BBB+/A- and above, but the underlying rating of most infrastructure projects — especially offshore wind — usually falls short of that.
As a result, the project bond market in Europe has been virtually non-existent since the decline of monoline insurers as a consequence of the financial crisis. They used to insure bonds against payment failures and thereby improve their credit ratings.
"The GIB could provide a credit enhancement much like what used to be available from the monolines,"
However, the UK government appears to be averse to this approach as there are no insurance or operating-phase guarantees currently among the proposed products for the GIB. Instead, it is looking at adopting a similar approach to that being used by several infrastructure-debt funds and the EIB's 2020 Project bonds initiative — using first-loss debt tranches to increase overall investor confidence.
As with the mezzanine debt tranches in the construction phase, these slices of debt act as first-loss components of any transaction and help to enhance the credit rating of the project by shielding the senior debt and equity from a certain amount of revenue risk.
Whichever way the GIB does it, both Whelan and Caldecott agree that bringing in large amounts of institutional investors' money into the sector will be the ultimate measure of the fledgling bank's success.