On July 5, in her maiden Budget speech as India’s finance minister, Nirmala Sitharaman said that India will be a $3 trillion economy by 2019-20. The Indian government has many ambitious goals and one of them is to achieve 175 gigawatt (GW) of renewable energy capacity by 2022. That is barely three years from today. This is a significant increase from the current level of 70 GW and will require an estimated $100 billion in financing. Furthermore, this figure would increase to $450 billion by 2030 (International Finance Corporation (IFC), 2017).
Assuming a typical 70-30 split of financing via debt versus equity, the debt funding requirements translate to $320 billion through 2030. While India’s clean energy sector continues to grow and attract significant investment, it is important to note that there can be serious challenges to this trajectory if capital deployed in existing projects is not recycled and/or if new sources of capital are not included to meet the increased future investment requirements.
It is, therefore, imperative that operational renewable energy projects access capital markets to recycle capital and attract new investor classes.
Debt capital market access remains limited for most small and medium enterprises in India:
A capital market is a financial market where debt and equity securities can be issued and traded. Such markets involve the participation of a wide range of retail and institutional investors, who can invest either directly in financial instruments or indirectly, through funds and investment vehicles. Note that investments from banks or NBFCs (non-banking financial companies), for instance loans, is considered outside the purview of capital markets.
In India, however, debt capital market is largely confined to the higher-rated government and corporate bonds and remains outside the reach of most small and medium enterprises. There are numerous reasons for this which are structural and legal in nature.
These issues have been recognised in the latest Budget, which has introduced a slew of measures, such as (i) Allowing AA-rated corporate bonds to be used as collateral for repo trading to improve liquidity of corporate bonds, (ii) Setting up a Credit Guarantee Enhancement Corporation to enhance the credit rating of lower-rated bonds, and (iii) Measures aimed at invigorating the Credit Default Swap market — mechanisms to transfer risk to third-parties, which will incentivize investment into corporate bonds.
AIFs offer a potential pathway:
As an industry matures, it is important to deploy structured finance and investment vehicle mechanisms to attract funding from capital markets. These types of vehicles are used frequently in Europe and the US, where capital markets are more developed, and thus they represent the logical next step for Indian renewable energy sector.
In this vein, new research by Climate Policy Initiative (CPI) shows that a specific type of vehicle, Alternative Investment Funds (AIFs), offer the best near and medium-term path to expanding renewable energy’s access to capital markets. AIFs are essentially managed pools of money that can invest in a pre-specified mandate. As the name suggests, they are alternatives to more mainstream investments and can deploy strategies or invest in securities that are beyond the purview of the more commonly deployed funds such as mutual funds.
Although AIFs allow for a multitude of investment structures, we propose a specific structure that would work well within the landscape of renewable energy financing. Such an AIF can be set up (or sponsored) by a financial entity such as IREDA, the government-owned institute focused on financing renewable energy projects.
This AIF would invest in debt securities (e.g. bonds) issued by renewable energy project developers, which are already financed by the sponsor (IREDA in this case). The bond coupon payments would be backed by cash flows from stable and operational projects. The developers issuing the bonds can retire loans they would have taken from the sponsor – thus freeing up capital for fresh deployment.
Benefits of this AIF:
For renewable energy project developers, such an AIF can possibly lower the cost of capital since operational projects are deemed to be less risky than projects that are yet to begin construction. Further, once the projects become operational and are refinanced through bonds, the developer may also be able to recover the entire capital outstanding at the time of issuance. This can help the developer unlock equity, which can be thereafter infused into new projects.
Similarly, AIFs also benefit the sponsor or the entity setting up the AIF. For IREDA, AIFs offer a way to recycle capital and thus extend fresh lending to existing developer (borrowers) — without breaching Reserve Bank of India’s (RBI’s) single borrower limits. This helps meet the aspirations of India’s renewable energy sector while conforming to RBI’s guidelines aimed at diversifying risk by preventing concentration of financing to a few borrowers.
Such an AIF will also lead to overall market development by showcasing demonstration effects. Once the AIF hits the markets, establishes track record, and instills confidence in investors about the economic viability of clean energy projects, there could be replication from other financial institutions. Initial success of an AIF could fuel the risk appetite of investors as well, and help more developers refinance and access capital markets.
Research also concluded that compared to other infrastructure focused investment vehicles, such as IDFs or InvITs, AIFs offer the least restrictions in terms of sponsor qualifications and commitments post launch, the proportion of assets that have to be mandatorily operational, whether or not the projects have to be mandatorily public-private partnership, and so forth. Thus, given the current scenario, an AIF can be an ideal platform to facilitate such transactions, whenever an opportunity arises.
Given the ability of AIFs to adapt to the needs and mandates of various stakeholders, they have been a success in India (though we are yet to see an AIF dedicated to renewable energy), attracting total capital worth Rs 134,200 crore ($20 billion) through March 2019, with these figures growing at a rapid pace (SEBI, 2019).
If India is to scale up its renewable energy sector, it will almost certainly require to transition from the existing debt-financing model, which is heavily reliant on banks and NBFCs, and instead engage deeper with capital markets. While CPI’s research acknowledges that AIFs may not fully address structural issues impeding the development of capital markets, they still offer a strong pathway forward in the near-term that could help the clean energy sector scale up and accelerate at the pace it needs to be.