Environmental Audit CommitteeWritten evidence submitted by the Department of Energy and Climate Change (DECC)

Introduction

1. In response to questions on green finance raised by the Environmental Audit Committee, the Department of Energy and Climate Change (DECC) provide the following information.

2. In the wake of the global financial crisis, financial markets have seen significant restructuring, including reduced risk appetite, deleveraging and tightening credit and collateral requirements.

3. This restructuring has implications for project sponsors, in terms of the levels of debt and equity they can attract and for investors and lenders, in terms of what risks they will and will not take on.

Barriers to Entry in Green Finance

4. When looking at investment opportunities, investors will analyse the risks compared to the returns they may earn. Some of the major barriers to entry or risks they will encounter are:

Liquidity

5. Following the global financial crisis, long-term debt financing (on which many renewable energy projects, for example, have been dependent) has become much less attractive to banks to provide. The introduction of new regulatory requirements such as the BASEL III regime, and mounting pressure from regulators and shareholders has required financial institutions to meet more stringent capital, leverage and liquidity thresholds on their balance sheets to ensure their ability to meet their obligations over sustained periods of financial stress. Such obligations reduce appetite to hold long-term assets in banks’ debt portfolios and can mean that financial institutions charge more for their available capital.

6. Furthermore, since the financial crisis, the perception of risk that a counterparty may default has increased significantly. This is leading financial institutions to charge more relative to the interest rate curve for their available credit and impose stricter controls around the projects, counterparties and technologies to which they lend.

7. As a result, investors are unable to access the same financing or level of leverage as prior to the financial crisis and what they can access will be more expensive.

Required returns

8. The ability to attract investment into green finance may be reduced by the rate of return on investments, such as renewable technologies, that require higher upfront investment as compared to their fossil fuel alternatives (which have a lower upfront cost but higher on-going costs). This can disincentivise investment decisions in green projects, as the impact of higher capital costs (outlined under “Liquidity”, above) are factored in to investment models. The ability to attract investment or financing could be further reduced, given energy price volatility in recent years. This makes it difficult to model future returns or the ability to meet repayment thresholds from investing in the sector

Perception of political or regulatory risk

9. Investors are naturally averse to markets in which policy decisions or changes in laws impact on existing or future investment decisions. Investors and financiers require transparency and clear forward visibility of policy making and future proposed market developments as well as confidence that previously taken policy decisions will not be amended in retrospect. A number of European markets have seen changes in policy or regulation, in some cases retrospectively, which has served to undermine investor confidence more generally across the region.

10. In addition, the European Union Emissions Trading Scheme (EUETS)—the region’s primary measure to reduce carbon emissions—has suffered from repeated price declines, borne of an over-supplied market, which has done little to instil confidence amongst investors.

Asymmetry of information

11. New sources of capital are required for investment in green technologies, given the overall magnitude of investment required in the United Kingdom. A relative lack of information and expertise amongst such investors about green technologies, coupled with a lack of resource with which to acquire the necessary intellectual property, could be a barrier to attracting additional green investment.

The Main Drivers Behind Investors’ Decisions

In general investment decisions

12. Investors are accountable to their shareholders and finance providers. As such they will be constantly looking for a risk-reward ratio that makes economic sense and meets other non-financial criteria. Some of the main factors they will consider in making this decision are:

Consistent returns

13. Whilst some investors may still look to achieve supernormal profits across equities or other high risk investments, investors are increasingly turning to real asset classes to provide long term, consistent returns that enable them to meet their banking or investor covenants.

Low correlation

14. Investors will create a diversified portfolio with a low correlation between their various investment sectors (a diverse range of low-high risk investments, or a range of renewable technologies within one portfolio). This will create an offsetting effect between cyclical and sectoral trends allowing for a smoothing of returns across financial periods.

Proven track record

15. Investors will be cautious about new or unproven technologies. Whilst benefit may be gleaned from the first mover advantage in some cases, this needs to be balanced against the risk that the technology does not perform as expected. A proven track record of investment in the sector will help alleviate this concern.

Strong counterparty and/or conglomerate

16. Investors will wish to satisfy themselves that the counterparty, group of investors, developer and principal contractors who they are working with, will continue to operate as a going concern and have the necessary skills and balance sheet to fulfil their obligations.

In green finance decisions

17. Investments in green finance bring several nuances over and above that of general investment decisions. In particular, investors in green finance will be looking for:

Strong relative returns

18. An investor may be willing to offset some upside return for the “green” finance aspect, but the returns will still need to be sufficient to satisfy investors.

Reputational risk

19. Most investors and lenders want to ensure they are not associated with unduly controversial technologies or projects, for example where there are sustainable development concerns, over fuel or feedstock supply for instance, or where there is evidence of poor project governance mechanisms.

High marketability

20. A core consideration of investing in “green” is whether or not the investment can be used for public relations benefit. Increasingly, consumers will choose to buy products and services that are green with the costs and risks associated of investing offset through the ability to maximise advertising of the investor’s green credentials either via consumer driven channels or in annual reports.

21. Conversely, many investors will not invest in project types which they regard as contentious, due to concerns over the adverse publicity this may attract.

Reductions in volatility

22. Investors will look for reductions in input price volatility. A good example of this is fossil fuel prices, which have been hugely volatile for near on a decade. Most forecasters see this as an on-going trend and, as such, investors will look for projects where these inputs are reduced or excluded.

Actions to Stimulate Green Finance

23. DECC and HM Treasury have initiated a number of policy and programme measures to stimulate green finance, including:

Electricity Market Reform (EMR)

24. Under the EMR, DECC has developed a range of initiatives to address some of the barriers to entry that are affecting investors in green finance and create a stable, predictable market framework. These policy initiatives are currently being deployed in the UK market.

25. Provided below is a snapshot of these policies showing how they are actively working across investor segments (retail through institutional) to alleviate these barriers to entry, and helping to attract the required investment to the UK green finance sector.

Contracts for Difference

26. Contracts for Difference (CfD) provide increased revenue certainty over an extended period as generators will receive a fixed price level for the low carbon electricity they produce known as the “strike price”. This will smooth profits and allow generators to offset their higher capital costs resulting in an acceptable rate of return for investors.

Capacity Market

27. The Capacity Market will provide stability for the GB energy market by ensuring an adequate level of security of supply is forthcoming as we transition to a more low carbon electricity generation mix. It does this by providing a regular payment to providers of reliable capacity that are successful in capacity auctions. These providers include traditional sources of generation as well as other approaches such as demand side response.

Green Deal

28. The Green Deal overcomes mismatched incentive problems by providing a trustworthy framework of advice, assurance and accreditation for the energy efficiency supply chain resulting in a pipeline of energy efficiency measures for households. As energy efficiency measures are implemented, this will reduce household consumption of energy, and provide greater stability for consumers and help to keep energy bills affordable.

Tariff support for low carbon technologies

Feed-In-Tariffs

29. Feed-In-Tariffs (FITs) were introduced in April 2010 to encourage greater deployment of small-scale, low carbon electricity generation, particularly by those who would not have traditionally engaged with the energy market, such as individuals, communities and small businesses FITs allow those who install their own renewable electricity system (wind, hydro, anaerobic digestion or solar PV), up to 5 megawatts, to earn a generation tariff per kilowatt hour of electricity produced. An additional “export tariff” is paid for any excess electricity exported to the grid.

Renewables Obligation

30. The Renewables Obligation (RO) requires licensed UK electricity suppliers to source a specified proportion of the electricity they provide to customers from eligible renewable sources. Renewable generators are allocated Renewable Obligation Certificates (ROCs) for their renewable generation, and may sell these to suppliers to supplement their income from the sale of the electricity.

Renewable Heat Incentive

31. The Renewable Heat Incentive (RHI) tariff scheme incentivises businesses and households to install technologies such as biomass boilers, heat pumps and solar thermal to provide their heat. Participants are paid a tariff for each kilo Watt hour of renewable heat which is produced over 20 years. The scheme has been designed to reduce the UK’s reliance on fossil fuels.

Improving access to finance

Green Investment Bank

32. The Green Investment Bank (GIB) can deploy £3.8 billion to enable projects that are both green and commercial. It was implemented to actively seek opportunities where their capital, knowledge and reputation make the difference that enables a project to be successfully financed, with 80% of deployment occurring in priority sectors (offshore wind, waste recycling and energy from waste, non-domestic energy efficiency, and support for the Government’s Green Deal). The GIB is mandated to achieve this by “crowding in” investment ie by providing project enabling finance rather than shutting out existing investors.

Green Deal Finance Company

33. The Green Deal Finance Company (GDFC) is a not-for-profit company, established to minimise the set up and administration costs of providing finance across the industry and aims for Green Deals to be quickly and regularly aggregated and refinanced in the capital markets at high investment grade. Aggregating loans in this way provides access to liquidity for energy efficiency improvements that may otherwise not be available at the level or scale required by participating households.

UK Guarantee Scheme for infrastructure

34. In July 2012, the Government announced the UK Guarantees scheme to avoid delays to investment in major UK infrastructure projects that may have stalled because of adverse credit conditions. A key problem identified by the Government is that persons currently involved in providing infrastructure may find it difficult to obtain private finance, not necessarily because of the commercial or economic viability of the individual infrastructure projects but because the banking markets are currently constrained and providers of finance are taking significantly longer to approve lending to these projects. When they do approve financing, this is often for debt that is dated for much shorter periods (and is often not sufficient to cover the lifetime of the project). The legislation underpinning the Guarantee Scheme received Royal Assent on 31st October 2012. Guarantees for up to £40 billion in aggregate can be offered.

9 August 2013