Understood, thanks! A follow up if you don't mind, I find the finance side very interesting: How much of the initial investment cost is equity, how much is debt and at what rate? Do rates differ by type (wind, solar, pv)? And how are battery storage assets financed since cashflows are slightly different?
Hi Jérôme – you describe the renewables business as "structurally a low margin business - as a cost of capital play, they should never be very profitable". I think I agree with you but have trouble squaring it with my mental model. In my mind, I've always likened renewables to a real estate play (cashflows become very predictable via PPAs), where the money is made on the leverage. Is that what you mean by describing renewables "as a cost of capital play"?
Given that cashflows are (or can be, with the right tariff design) highly predictable, both debt and equity can actually be cheap. Projects will be highly leveraged, but the return on equity will still be compressed because the risk remains low. There is structural pressure on the overall cost of capital (debt plus equity) as the cost of electricity is essentially driven by the cost of capital (as all the investment is upfront and power is then generated for 20-30 years or even more, with very low operating costs) - so to be competitive you also need to have cheap equity.
Thus the typical deal structures where developers start, sell down to a first industrial player that contracts and builds the project, and then it is sold to a pension fund - and refinanced.
Hi Jérôme, happy to catch up in person again, now that the city cools down a bit ;-)
Seems worth to also have a look at the different business models behind OFW, i.e., selling the mere electron vs. integrating the production into a broader portfolio, allowing for added value. Better (i.e., more reliable since less intermittent/volatile) products deserve better prices and allow thus for better margins.
Hence: it’s not „merchant“ and „ever increasing power prices“ alone that do the trick, but the alternative - only relying on guaranteed offtake for an intermittent electron - surely will always remain a low margin business as risks are limited.
To some extent that enters under 'regulatory arbitrage', if production from another asset gets access to a tariff. If you mesh production, you just mix the business case of two (or more) assets and it's not certain that it's better than if they were managed separately.
From a system perspective, it is almost always better to manage the different production profiles as an aggregate rather than having individual parties doing partial aggregation at their level. Of course, this is very theoretical, and parties with large, flexible portfolios can capture value away from smaller, less flexible ones without hurting the overall system efficiency.
But I stand by my point hat parties that bet on merchant can only do so with more expensive capital than those that rely on a CfD, and thus they make the power they produce more expensive as a result, and that can only be profitable by capturing something else.
Very good Jerome. I’m curious, you describe oil majors as having a high cost of capital. Can you substantiate that? What qualifies as ‘high’ and how does it compare to PE (at one end) and institutional investors (at the other)?
It's definitely higher than pension funds or infra funds, and not far from private equity.
Their general business model is to take relatively high risk bets for relatively high returns (but also relatively short maturities) - and they are quite good at that.
In renewables they would be a good fit for development work, but that's typically too small amounts for them.
Understood, thanks! A follow up if you don't mind, I find the finance side very interesting: How much of the initial investment cost is equity, how much is debt and at what rate? Do rates differ by type (wind, solar, pv)? And how are battery storage assets financed since cashflows are slightly different?
You can check my report on financing offshore wind - read about it here: https://jeromeaparis.substack.com/p/financing-offshore-wind
In general, construction finance will be 80:20 (debt equity) for offshore wind, and can reach 90:10 for onshore wind and solar, with some variations
Hi Jérôme – you describe the renewables business as "structurally a low margin business - as a cost of capital play, they should never be very profitable". I think I agree with you but have trouble squaring it with my mental model. In my mind, I've always likened renewables to a real estate play (cashflows become very predictable via PPAs), where the money is made on the leverage. Is that what you mean by describing renewables "as a cost of capital play"?
Hi Felix
Given that cashflows are (or can be, with the right tariff design) highly predictable, both debt and equity can actually be cheap. Projects will be highly leveraged, but the return on equity will still be compressed because the risk remains low. There is structural pressure on the overall cost of capital (debt plus equity) as the cost of electricity is essentially driven by the cost of capital (as all the investment is upfront and power is then generated for 20-30 years or even more, with very low operating costs) - so to be competitive you also need to have cheap equity.
Thus the typical deal structures where developers start, sell down to a first industrial player that contracts and builds the project, and then it is sold to a pension fund - and refinanced.
Interesting. Though I don't understand why oil companies would like to put their cashflows into renewables rather than into dividends or buybacks.
They are being pressured by investors (at times) and activists, and politicians responding to the same. That pressure is not even...
Hi Jérôme, happy to catch up in person again, now that the city cools down a bit ;-)
Seems worth to also have a look at the different business models behind OFW, i.e., selling the mere electron vs. integrating the production into a broader portfolio, allowing for added value. Better (i.e., more reliable since less intermittent/volatile) products deserve better prices and allow thus for better margins.
Hence: it’s not „merchant“ and „ever increasing power prices“ alone that do the trick, but the alternative - only relying on guaranteed offtake for an intermittent electron - surely will always remain a low margin business as risks are limited.
Stefan
To some extent that enters under 'regulatory arbitrage', if production from another asset gets access to a tariff. If you mesh production, you just mix the business case of two (or more) assets and it's not certain that it's better than if they were managed separately.
From a system perspective, it is almost always better to manage the different production profiles as an aggregate rather than having individual parties doing partial aggregation at their level. Of course, this is very theoretical, and parties with large, flexible portfolios can capture value away from smaller, less flexible ones without hurting the overall system efficiency.
But I stand by my point hat parties that bet on merchant can only do so with more expensive capital than those that rely on a CfD, and thus they make the power they produce more expensive as a result, and that can only be profitable by capturing something else.
Very good Jerome. I’m curious, you describe oil majors as having a high cost of capital. Can you substantiate that? What qualifies as ‘high’ and how does it compare to PE (at one end) and institutional investors (at the other)?
It's definitely higher than pension funds or infra funds, and not far from private equity.
Their general business model is to take relatively high risk bets for relatively high returns (but also relatively short maturities) - and they are quite good at that.
In renewables they would be a good fit for development work, but that's typically too small amounts for them.