By Angus McCrone
Bloomberg New Energy Finance
The last time U.S. interest rates were on a sustained upward trend was just over 10 years ago, in summer 2006. George W Bush was president, ‘Hips Don’t Lie’ by Shakira was at the top of the charts on both sides of the Atlantic, and no one had heard of Justin Bieber.
In the decade since, interest rates globally have plumbed depths never seen before – or even imagined. In the US, the Fed Funds Rate spent almost seven years at 0.25%. The main European Central Bank refinancing rate was cut to zero in March this year, and at one point earlier this month, the German 10-year bond yield (the rate at which investors are prepared to lend to the government in Berlin for 10 years) was minus 0.4 percent. The Bank of Japan benchmark interest rate is currently at -0.1 percent.
Amazingly enough, there is a chance that some central banks could lower rates further still. That was certainly the way the markets were thinking in the aftermath of the U.K.’s surprise vote on June 23 to leave the European Union. However, there are also grounds for thinking the trend might be about to turn, and wondering what the implications would be for the clean energy and transport sectors.
One is that U.S. rates have already been raised once (in December 2015), and may be lifted again after the presidential election in November, in response to signs of incipient inflation. Where the U.S. goes on interest rates, other countries tend to follow. Or at least that is what happened in other cycles.
Even in countries that have not matched the U.S. on economic growth recently, it may be that interest rates will be heading up – for the simple reason that current policies do not seem to be working. Many developed economies remain weak, and negative interest rates may be damaging, rather than boosting, the confidence of banks in Europe and Japan, and causing headaches for the pension system. Perhaps something new should be tried, so the thinking goes, to stimulate growth – maybe a combination of fiscal loosening, monetary tightening and structural reforms, or ‘helicopter money’ created by the central bank and used to fund new infrastructure programs.
The other reason interest rates might turn upwards is the Donald Trump factor. The U.S. Republican presidential candidate told the Economic Club of New York on September 15 that he would renegotiate the North American Free Trade Agreement, brand China as a currency manipulator, and if necessary impose import duties, in an attempt to “bring vast new jobs and wealth to America.” The Trump plan – if he wins the presidency onNovember 8 and if the plan is actually implemented (two big ‘ifs’) – might boost the U.S. economy in the medium term, or might not – there would be a period of great uncertainty. However, its logical economic consequence would be to substitute higher-priced, home-made goods for cheap imports, push up prices and wages, and so mean an end to the rock-bottom-interest-rate era in the U.S.
For the first few years after the financial crisis, while central bank rates dropped to near-zero, the actual interest rates paid by renewable energy project developers stayed stubbornly high. Banks had rediscovered risk premiums, and were using them to repair their balance sheets.
Over the past three years, however, those low rates started to be passed on, and clean energy has grown to like them. They have served to bolster investment in renewables in several ways. They have slashed the all-in cost of debt for projects, and the rates at which utilities can borrow from bond markets, improving the economics of technologies with high upfront costs and low operating-stage costs, such as wind, solar, hydro-electric and geothermal.
They have also brought new waves of money – from institutions and private investors – into renewables. They have been attracted partly because wind and solar have matured as an asset class and are no longer seen as high-risk, but also because those investors have had to look further afield for steady yields of 5-6 percent in the era of super-low interest rates.
Bloomberg New Energy Finance can claim to have glimpsed the low-interest-rate boost coming for renewables. In a VIP Comment article in August 2010, Watch the Debt Markets for Clues on the Next Twist for Clean Energy, we postulated that “we might be moving into a new phase of easier credit for project developers”. But we certainly did not foresee just how far it would go – in Germany, for instance, onshore wind developers in 2015-16 have been enjoying an all-in cost of debt of just 2 percent for new projects, down from 5 percent in 2010.
Impact on Costs
How would the sector stand if interest rates were to turn and, within a year or two, rise significantly above current levels? My analyst colleagues will soon be publishing BNEF’s latest Levelized Cost of Electricity estimates for all the main generating technologies. The results are likely to show electricity from onshore wind and solar photovoltaics falling in price yet again, with the global central estimates below the $81 and $99 per megawatt-hour shown in our first-half 2016 report, published in April. Offshore wind’s LCOE is also likely to be down from six months ago, reflecting aggressive pricing in recently announced projects, such as by Dong Energy A/S for Borssele 1 and 2 in the Netherlands and Vattenfall AB for Vesterhav Sud and Nord in Denmark.
Falling financing costs have played as much of a part in the long slide in LCOEs for onshore wind and PV as reductions in equipment costs, more efficient construction and installation, and streamlined operation and maintenance. The switch to tenders and reverse auctions has also caused all parts of the supply chain to address their overheads and trim margins, in order to enable winning bids to be tabled.
Let’s look at the impact higher interest rates would make, compared to the H1 2016 LCOE estimates. If all-in costs of debt were to rise by 200 basis points, this would raise the LCOE of a U.S. solar project by $7, to $94 per megawatt-hour, assuming it was financed pre-construction with a debt-equity ratio of 70:30 and a 20-year loan; and the LCOE of a Germany PV project by $9, to $112 per megawatt-hour, assuming an 80:20 debt-equity ratio and a 12-year loan. And by the way, if you think a 200-basis-point rise in debt costs sounds extreme, and therefore very unlikely, I would point out that this would only return all-in borrowing costs in northern Europe to where they were in 2012.
These estimated increases in LCOE, of 9 percent or so, would not kill renewable energy stone dead –far from it. But they would tilt the balance back towards coal and gas (and biomass), where the upfront capex is a smaller fraction of lifetime costs and where operating-stage expenses, notably the purchase of the fossil fuel feedstock, are a far bigger part.
Higher interest rates would have a similar effect on lifetime-cost comparisons between electric cars and gasoline vehicles. EVs have a higher upfront capital cost (although this differential is shrinking as batteries get cheaper), but lower running costs: recharging the battery is cheaper than filling the tank with fuel, and maintenance costs are much lower. Earlier this year, our advanced transport team predicted: “By 2022, the unsubsidized total cost of ownership of BEVs will fall below that of an internal combustion engine vehicle, assuming oil is between $50 and $70 per barrel.” However, this depends on interest rates also: a significant rise in rates would delay this ‘tipping point’, perhaps by another year or two.
Institutions and Utilities
Unprecedentedly low interest rates and bond yields have pushed institutional investors into playing a part in the financing of renewable energy. Starved of yield on corporate and government bonds, they looked first to property and general infrastructure in the years after the financial crisis, but when yields were pushed down in those markets too, they eventually turned towards the relatively steady income that ownership of a wind or solar plant can provide.
Bloomberg New Energy Finance figures show that commitments from institutional investors to European renewable energy projects were just $1 billion or so per year at the turn of this decade, but climbed strongly to reach a new peak of $7 billion in 2015. Institutions have been deploying their money in a variety of ways, including direct equity investment in projects (the Allianz approach), quoted funds (the European equivalents of yieldcos), private funds, platforms in which they invest alongside a financial player, and occasionally via project bonds. In the first six months of 2016, deals such as the financing of the 1-gigawatt Fosen onshore wind project in Norway, backed by German insurer Talanx and one Finnish and two German pension funds, contributed to a tally of nearly $3 billion.
This increased institutional interest has, in turn, created a nice opportunity for Europe’s under-pressure utilities to develop renewable energy projects and then sell stakes to institutions for a tidy profit. Dong Energy A/S, for instance, made a gain of 306 million Danish kroner ($46 million at today’s exchange rate) in the first half of 2016 “primarily on the sale of 50 percent of Dong’s ownership interest in the Burbo Bank Extension offshore wind project in the U.K.” to Danish pension fund PKA and the parent company of Lego. This ‘recycling’, as some utilities describe it, also saw British utility SSE PLC recording a 138.6 million pound ($183 million) gain in the year to March 2016 on the sale of a 49.9 percent stake in the 350-megawatt Clyde onshore wind farm to two U.K. pension funds and the quoted project fund, Greencoat UK Wind.
Energias de Portugal SA made gains of 60.9 million euros in the first half of 2016 on the sale of its Pantanal mini-hydro plants in Brazil, and 107.2 million euros on the sale of a minority stake in a portfolio of European wind farms. The first deal boosted profits, the second was booked as a gain to reserves and therefore to shareholders’ funds. EDP Chief Executive Antonio Mexia told BNEF last month that the company is already half way to achieving its 1.1-billion-euro target for ‘asset rotation’, less than a year into the five-year period it was supposed to cover. EDP said it looks for an internal rate of return in “double digits” when it invests in a project, but sells stakes to other investors at an average IRR of just 6.5 percent.
In the U.S., the trend of institutions putting equity into renewables projects has been most conspicuous via the ‘yieldco’ boom of 2013-2015. Last year, North American yieldcos sold $5.6 billion of equity to stock market investors. Although that equity-raising has slowed drastically in the last 12 months, asset transactions involving yieldcos are still happening – Nextera Energy Inc, for instance, selling 285 megawatts of U.S. wind power in July to its yieldco, NextEra Energy Partners LP for $312 million.
Higher interest rates would be likely to raise the IRRs that institutional investors require from renewable energy projects. Asset values would be likely to fall, and some institutions would be likely to trim their exposure to green power in favor of more conventional choices, such as corporate and government bonds.
Increases in central bank interest rates would not happen in isolation. In practice, many other things would be going on that could influence the impact on clean energy. For instance, it is possible that banks could decide to limit the impact of higher central bank rates on borrowers. Lenders are currently competing hard for the business of renewable power developers, and so they might opt to accept lower margins on the loans they make. Bank margins, even in Europe, have come down a lot in the last five years but, at about 180 basis points for onshore wind in France and just over 200 in the U.K. and Ireland, they are still far above their pre-financial crisis lows of 60-80 basis points. If banks accepted margins that were 50 basis points thinner than now, this would offset at least part of any central bank interest rate rise.
Second, politics could change the outlook in other ways than the interest rate effect. Trump has pledged to “lift restrictions on all sources of American energy production”, including abolishing the Environmental Protection Agency’s Clean Power Plan. His opponent, Hillary Clinton, supports the Obama administration’s policies on decarbonization, but has been back-pedalling on free trade. In the next few weeks, BNEF will be looking in detail at what the two candidates might do to U.S. energy.
One final thought: wind, solar and electric vehicles have all reached a point where cost comparisons are increasingly in their favor – very different from the position back in the summer of 2006. Given the risks of higher interest rates and political turbulence, it is just as well.
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