76556 Financing renewable energy Options for Developing Financing Instruments Using Public Funds in collaboration with African Development Bank, Asian Development Bank, European Bank for Reconstruction & Development, Inter-American Development Bank, International Finance Corporation CONTENTS iii Contents Acknowledgments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix OBJECTIVE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix APPROACH. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix OVERVIEW. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix 1 Why the Choice of Financial Instruments Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 Identifying the Risks and Barriers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2.1 OVERVIEW. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2.2 FINANCING BARRIERS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 2.3 RISKS OF RET PROJECTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 2.4 THE SIGNIFICANCE OF TECHNOLOGY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 3 Financial Instruments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 3.1 OVERVIEW. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 3.2 GRANTS AND LONG-TERM EQUITY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 3.3 VENTURE CAPITAL EQUITY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 3.4 DEBT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 3.5 ASSET-BACKED SECURITIES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 3.6 GUARANTEES AND INSURANCE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 3.7 RESULTS-BASED FINANCING.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 3.8 CARBON FINANCING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 3.9 SMALL-SCALE PROJECT FINANCING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 4 The Role of Financial Intermediaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 4.1 COMMERCIAL FINANCIAL INSTITUTIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 4.2 FUNDS AND OTHER SPECIALIZED INTERMEDIARIES. . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 5 Selecting the Appropriate Financing Instruments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 6 Making it Work. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 6.1 INSTITUTIONAL CAPACITY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 6.2 POLICY AND PLANNING FRAMEWORK.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 6.3 SUPPORT MECHANISMS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 7 References and Further Reading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Appendix 1  List of Initial Case Studies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 iv FINANCING RENEWABLE ENERGY Appendix 2  Summary of Financial Instruments .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Appendix 3  Summary of Financial Intermediaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Appendix 4 Financing Instruments Appropriate for Addressing Financing Barriers and Project Risks.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 ACKNOWLEDGMENTS v Acknowledgments T he following paper and accompanying Web tool were developed by a World Bank team (made up of members of the Sustainable Development Network Financial Solutions and Energy teams). The team was led by Mustafa Zakir Hussain. Gevorg Sargsyan provided important inputs at all stages. Teuta Kacaniku and Ashaya Basnyat were core members of the team, and William Derbyshire of Economic Consulting Associates provided significant substance and drafting inputs to the paper. Federico Qüerio worked extensively on developing the accompanying Web tool. This paper and accompanying Web tool have benefited from World Bank review. Peer review- ers included: Mikul Bhatia (SASDE), Jeremy Levin (IFC), and Varadarajan Atur (AFTEG). Additional comments were received from Richard Hosier (ENVGC), Magnus Gehringer (ESMAP), Gabriela Elizondo Azuela (SEGEN), and Kenneth Chomitz (IEG). This work benefitted from support provided by the Climate Investment Funds (CIFs), through its Scaling Up Renewable Energy Program (SREP) in Low-Income Countries. It has also received comments and inputs from the other multilateral development banks working with the CIFs: African Development Bank (AfDB), Asian Development Bank (ADB), European Bank for Reconstruction and Development (EBRD), the Inter-American Development Bank (IDB), and the International Finance Corporation (IFC). In particular, Gregorz Peszko (EBRD), Claudio Alatorre Frenk (IDB), and Wesly Ureña-Vargas (IDB) are to be thanked. A draft version of this paper and Web tool was presented to borrower and donor government delegations during the annual CIFs meetings held in Cape Town in June 2011. vi FINANCING RENEWABLE ENERGY P R E FA C E vii Preface T o create new economic opportunities, increase energy access, and reduce carbon emissions, the governments of many low-income countries have embarked on the path to low-carbon develop- ment. But because funding from public and concessional sources is scarce, an engaged private sec- tor will be needed to make significant investments in renewable energy technologies (RETs). With an appropriate enabling framework, those investments should be forthcoming. The development of appropriate financing instruments—using public and concessional resources such as those provided under the Scaling-up Renewable Energy Program (SREP)—is one way to address the barriers and risks that presently hold back private investment. Using public and concessional funds to mobilize private financing rather than to pay the underlying costs of RETS offers the twin advantages of being more sustainable and minimizing the possibility of crowding out the private sector. This paper offers a framework for analyzing the types of financing instruments that are most appropriate for addressing prevalent barriers and risks. This is seen as particularly relevant in the context of international climate finance discussions. The experience to date has been that policy makers tend to go straight to the use of a particular financing instrument without necessarily ana- lyzing which instrument would be most effective for a given set of conditions. The paper and the accompanying Web tool (known as REFINe and available at www.worldbank.org/energy/refine) will provide information in a structured manner to allow policy makers to make fully informed decisions. Both the paper and the accompanying Web tool are designed for easy use. They focus on practi- cality and usability, rather than comprehensiveness, and are intended to be used more broadly than under the SREP alone. Associated case studies and reference lists will be updated and developed over time in the online version. In selecting instruments, efficiency is key. Policy makers should aim to use instruments that deliver the greatest amount of private financing for the least amount of public funds (thus achiev- ing maximum leverage). To do so, financing instruments need to be appropriate for addressing the specific barriers and risks specific to the RETs being planned. Different RETs have different degrees of exposure to the various identified barriers and risks. Barriers are created by underdeveloped financial markets. Examples of barriers include lack of long- term loans, high financing costs, high transaction costs, and poorly capitalized developers. Risks refer to the high risks and costs of RETs. They include cost competitiveness, technology risks, regulatory risks specific to making RETs competitive, and resource risks. The paper considers how well different financing instruments address different barriers and risks. The list of instruments covered includes grants, equity, debt, asset-backed classes, guarantees, and insurance as well as more targeted categories such as results-based financing, carbon financing, and small-scale project financing. Delivery mechanisms such as commercial financial intermediaries and funds are consid- ered separately. Evidence on the relationship between instruments and barriers/risks consists of 33 case studies, most provided by the World Bank, International Finance Corporation, African Development Bank, Asian Development Bank, European Bank for Reconstruction and Development, and the Inter- American Development Bank. Other case studies are expected to be added to the REFINe Web site over time to provide a growing and continually updated reference source. It is important to remember that there is no simple link between barriers/risks and the appro- priate financing instruments. More than one instrument could be suitable to address each barrier/ risk, or a single instrument could address multiple barriers/risks. This paper and the Web tool use viii FINANCING RENEWABLE ENERGY the case studies to suggest which types of instruments may be most appropriate for addressing par- ticular barriers and risks, with the aim of attracting significant additional investment. INTRODUCTION ix Introduction OBJECTIVE T his paper assists policy makers in low-income countries (LICs) to develop and apply financ- ing instruments (funded from public and concessionary sources) to scale up the deployment of renewable energy technologies (RETs). The paper has been prepared under the Scaling Up Renewable Energy Program (SREP) in Low Income Countries, one of the Climate Investment Funds (CIFs) administered jointly by the World Bank Group (WBG) and regional development banks. The findings here, however, are applicable more broadly than in the focus countries and areas of the SREP. The aim of the SREP is to pilot and demonstrate the viability of low carbon development pathways using renewable energy. Such viability is based on creating new economic opportunities, increasing energy access, and reducing carbon emissions. The SREP funds will assist LICs toward transformational change to low carbon energy pathways using their renewable energy potential. Transformational change in this context refers to a significant and sustained scale-up of RET invest- ment, delivering levels of RET capacity well above the business-as-usual baseline. Recognizing that the private sector has a significant role to play in promoting renewable energy, the SREP funds will be used in particular to help overcome barriers (especially risks holding back investors) to scale up investment. APPROACH This paper is intended to provide a short introductory guide to the use of public and concessionary funds to support the scaling up of investment in RET projects. It does not pretend to be a compre- hensive guide to the individual instruments described or to the full range of infrastructure project or RET financing issues. There are numerous other publications covering these topics in depth, many of which are referenced in this paper or noted in the reference section for further reading. Consistent with its purpose, this paper also does not consider construction and operating risks and barriers that are generic across technologies and that could be managed through, for example, standard practices such as warranties or turnkey contracting. It also does not consider in detail mea- sures to improve legal and regulatory frameworks for RETs that are better addressed through techni- cal assistance and capacity building, although some guidance on the need for enabling frameworks is provided. The focus of this paper is on the scaling up of commercially proven technologies, without nec- essarily assuming these are currently deployed in the country under consideration. These technolo- gies include those that harness photovoltaic (PV) solar, solar thermal, onshore and offshore wind, geothermal, and biomass power (through combustion, gasification, and digestion); small hydro- power used for electricity generation is also included. OVERVIEW The first two chapters of this paper discuss why the choice of instruments is important and what risks and barriers the types of publicly funded instruments discussed can address. The second part, x FINANCING RENEWABLE ENERGY comprising chapters 3 and 4, discusses the range of available instruments, illustrated by various case studies. In the third part, chapter 5 discusses how to select the relevant instruments and gives a more complete listing of case studies demonstrating the application of the various instruments against identified risks and barriers. The fourth and last part, chapter 6, considers the wider frame- work within which these instruments are applied. A list of the case studies contained in the paper is provided in appendix 1. Full write-ups of case studies as well as additional information on the financing instruments discussed can be accessed via www.worldbank.org/energy/refine. References and sources for further reading can also be found at this website. WHY THE CHOICE OF FINANCIAL I N S T R U M E N T S M AT T E R S 1 1 Why the Choice of Financial Instruments Matters A ny decision to use public or concessional funds to support renewable energy tech- nologies (RETs) represents a commitment of obviously, if these funds discriminate between particular technologies, locations, or develop- ers then there will be a concentration on those scarce public resources to fund investments. In projects that are most likely to attract public principle, the private sector should be capable financing, even if these are not the most effi- of funding such investments itself, given an cient option. If public funds are limited in the appropriate enabling framework; indeed, the total amounts available, the number of projects private sector does so in many countries.1 In to be funded, or the time period over which doing so, it increases the resources available to projects are funded, then rent-seeking opportu- other activities that may be far less amenable to nities will be created.2 private funding, such as health care and social Practical or legal constraints will rule out welfare. some instruments and favor others. But care Efficiency is therefore key to the selec- must be taken to ensure that such constraints tion of the appropriate financial instruments to are real rather than politically convenient. For support RET investments. The aim should be to example, if contingent liabilities do not need to use those instruments that deliver the great- be reported or funded, then there is an incen- est amount of private funding for the smallest tive to use guarantees rather than provide direct amount of public funds (thus achieving the financing in the form of debt or equity. The cost greatest leverage). of these guarantees will only become obvious Publicly funded financial instruments if and when they are called, while the costs of should target the barriers or risks that are direct financing are immediate and known. But constraining or inhibiting private investment, this does not necessarily mean that guarantees rather than simply being used to fund RET proj- are the optimal or most efficient instrument to ects in general. As well as being more efficient, mobilize investment in RET projects. this also reduces the risk of “crowding out� Instruments must be chosen with a view private investment. Under the assumption that to the capabilities of local agencies to manage public finance will generally be lower cost than them effectively and efficiently, and of local private finance, there will always be a prefer- financial markets to understand and use them. ence to use public funding even where a project Constraints are inevitably country specific would be more suitable for private financing. and will require investigation before decisions Consequently, private investors find themselves unable to finance attractive projects, which are 2 Rents result from the difference between the price and instead funded from public resources that could cost of a resource. For example, if public funds reduce the be better deployed elsewhere. costs of RET projects included in a quota but not those out- side the quota, while the price paid for their output reflects The use of public funding for RET projects the cost of those projects without public funds, then rents are also creates inevitable market distortions. Most created by the difference between the cost of projects receiv- ing public funds and the price. In turn, developers will seek to have their projects included in the quota to capture these 1 This paper does not consider the wider issues of the rents. Such rent-seeking behavior is largely a deadweight appropriate level of support for RET investments or the mar- loss to the economy, as it consumes time and effort but does ket failures that may lead to inadequate investments in RET not generate any additional wealth (instead, it redistributes projects. wealth in the form of rents among different developers). 2 FINANCING RENEWABLE ENERGY are made on which instruments to use. Some stakeholders to perform in ways that improve further discussion on institutional constraints is the eventual outcome of the intervention. This provided in chapter 6. is the basis for the use of results-based financ- It is also possible to use the selection of ing, as discussed later in this paper. instruments to help create the incentives for IDENTIFYING THE RISKS AND BARRIERS 3 2 Identifying the Risks and Barriers 2.1 OVERVIEW and expertise means a failure to develop a pipe- line of bankable projects, even where suitable Commercial deployment of renewable energy opportunities exist. In turn, the lack of such a technology (RET) projects faces numerous pipeline means that expertise and capacity in barriers and risks, helping explain the low rate RET projects cannot be developed. of take-up of these technologies in low-income These fundamental barriers cannot be countries (LICs). Perhaps most obvious is the addressed through publicly financed instru- high financial cost of RETs relative to con- ments alone—although they can contribute. ventional generation technologies using fossil Wider reforms in the policy and regulatory fuels. As long as energy prices fail to properly framework and in building institutional capac- internalize externalities and specifically take ity are needed. What financial instruments can into account the wider global and local envi- do is help overcome specific barriers and risks ronmental impacts of different technologies that can hold back the development of RET as well as their contributions to reducing the opportunities even where the overall framework price volatility of energy and increasing energy is supportive of these. security, many RETs will continue to cost more The barriers and risks that financial instru- than conventional technologies. Inevitably, this ments can target can be grouped into two broad will deter their use, particularly in countries categories. The first category comprises barriers where affordability is a major concern. Energy deriving from underdeveloped financial mar- prices also fail to reflect the other benefits that kets, making it difficult or impossible to obtain RETs may offer—notably the ability to diversify the types of financing required at reasonable the supply mix and reduce the reliance on fossil costs. While these barriers are not unique to fuels and imported fuels that may be subject to RET projects, but are common across most if large price changes or interruptions in sup- not all infrastructure projects in LICs, they are ply, and to locate generation nearer to demand exacerbated by the particular characteristics centers, reducing the need for large and costly of RETs. transmission infrastructure. The second category is that of risks more Lack of experience and familiarity with specific to RETs alone. An example includes RETs also forms a major barrier in many LICs. risks linked to regulation of the sector, Policy makers, financiers, off-takers (power pur- increased by the nature of a given RET. Risks chasers), and sponsors are unable to assess the associated with the performance of the technol- feasibility, viability, and risks of projects with ogy itself are excluded from this list—these are confidence and, consequently, are reluctant to generally better addressed through warranties develop these. This can lead to the creation of a and guarantees from suppliers and contractors low-level equilibrium “trap�: a lack of capacity than through the use of financial instruments. 4 FINANCING RENEWABLE ENERGY 2.2 FINANCING BARRIERS funding. In the absence of such long-term financing, investment decisions will be further Lack of Long-Term Financing biased toward conventional technologies that might be financially viable even with shorter RETs are generally characterized by relatively loan terms. high up-front capital costs and low ongo- Long-term financing is often difficult or ing operating costs, due to the nature of the even impossible to obtain in many LICs, which technologies concerned. This implies a need may be in part due to regulatory or other for RET projects to be able to access long-term restrictions on long-term bank lending. A lack BOX 2.1  ILLUSTRATIVE CASHFLOW PROFILES FOR RETS Illustrative cash flows for a 35 megawatt (MW) onshore wind project can be used to show the importance of obtaining long-term financing for RET projects. In these two examples, the only change is the term of debt available to the project. The result of a 5-year debt term is to push the project into deficit for the first 5 years of operations—for a total of $15 million in financing that would have to be made up by the sponsor—and to reduce the return on equity below the threshold of viability. $m 15-year Debt 40 Equity IRR 15.8% 20 0 -20 Sales revenues Debt service -40 O&M Loan Investment Net cash flows to equity -60 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 $m 5-year Debt 40 Equity IRR 12.5% 20 0 -20 Sales revenues Debt service -40 O&M Loan Investment Net cash flows to equity -60 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Source: Calculated using data from Projected Costs of Generating Electricity 2010, IEA. Note: O&M = operations and maintenance. IDENTIFYING THE RISKS AND BARRIERS 5 of experience with RETs means many potential comes from future project cash flows and financiers will feel unable to assess the risks where little or no up-front collateral is required, involved; there may also be a lack of matching although there will still be a need for a share of funding sources. Long-term financing is heavily the project to be funded from equity. Non- or dependent on investors looking for long-term limited-recourse funding of this type allows assets to match the profile of their liabilities— RET projects to spread their costs over the such as pension funds. In many LICs, such project lifetime, funding the high up-front cost funds either do not exist or limit investment from the positive cash flows generated during activities largely to the purchase of government operations. The alternative is to rely heavily debt owing to its low risk. on equity funding, payments to which can be In the smallest LICs, the major financ- delayed until the later years of the project. ing barrier may simply be a lack of capital RETprojects are more exposed to the market funds. Where financial resources are limited availability of project financing than constrained, these will inevitably be directed most conventional technologies, as the share of toward those investment opportunities offering capital costs in their total cost is much greater. the highest returns at lowest risk and in the Conventional technologies will also generally shortest time frame. RET projects are unlikely find it easier to attract equity financing and, to be included among these. potentially, corporate financing of investment costs as a whole. This is in part due to the Lack of Project Financing lower capital investment required by these tech- nologies, and also the much greater familiarity As well as long-term financing, RET projects of most potential project sponsors with conven- will also be looking to access funds on a project tional technologies. finance basis—where the security for the loan BOX 2.2  THE PROJECT DEVELOPMENT TIMETABLE FOR WIND A typical project development timetable for wind projects, shown below, illustrates the length of the development process. Even at the soonest, this would take 2 to 3 years to reach financial close; site identification and resource assessment in particular take time. Substantial preinvestment financing is needed to cover the costs up to the point where revenues are generated, and to allow for the risk of delays. At least 15 months 6–12 months 3 months for 2–3 years for large depending on multiple sites wind farms location At least 3 months , permits, Siting Wind Resource PPA and Site prospecting EIA and Assessment �nancing interconnection Construction Engineering, Commercial and procurement operation commissioning and contracting Ongoing Up to 1 month per At least 3 months turbine for engineering 9–18 months for turbine delivery Source: Bankable Wind Resource Assessment, Tetra Tech (2011). RET 6 FINANCING RENEWABLE ENERGY High and Uncertain Project BOX 2.3  TECHNOLOGY AND Development Costs PROJECT SIZE IN THE GEF PROGRAM While all major infrastructure projects will tend to suffer from slow, costly, and uncertain As an example of the sizes of investments project development and approval processes, in RET projects, the portfolio of projects particularly in LICs, these are again likely to be financed through the Global Environment exacerbated for RET projects for multiple rea- Facility (GEF) includes: sons. Such projects are often located in environ- • Concentrating solar power. Three mentally and socially sensitive areas. Land-use projects with total capacity of 70 MW requirements for larger solar and wind projects, and cost of $1.04 billion (average in particular, can be very significant. Renewable project size of $350 million or 23 MW). energy sources are frequently most abundant in areas at considerable distances from existing • Off-grid photovoltaic. Seventy projects transmission and distribution grids, resulting with total capacity of 124 MW and cost in lengthy negotiations over grid extensions of $3 billion (average project size of and the funding of these. A lack of experience $42 million or 1.8 MW). with RETs will slow the approval process as the • On-grid photovoltaic. Twenty-one concerned agencies will find it harder to assess projects with total capacity of 40 MW applications. The need to conduct assessments and cost of $1.76 billion (average of potential renewable energy resources will project size of $84 million or 1.9 MW). further lengthen the process (wind projects, • Wind. Forty projects with total capacity for example, need at least one year of reliable of 1 gigawatts (GW) and cost of site-specific data on wind resources to be able $2.15 billion (average project size to assess their viability). of $31 million or 25 MW). All this makes it vital that RET project • Geothermal. Eleven projects with total sponsors have access to significant amounts of capacity of 927 MW (electricity) and funds to cover the costs of project development cost of $1.8 billion (average project prior to reaching financial close. Such funds size of $160 million or 84 MW). will generally need to come from their own resources or from sources of risk capital3 such • Small hydro. Forty-four projects with as venture capital funds. The small size of most total capacity of 411 MW and cost of potential RET project sponsors in LICs means $1.5 billion (average project size of $34 that funding from this route is limited. And million or 9.3 MW) there is generally little availability of risk capital • Biomass. Fifty projects with total in LIC financial markets. capacity of 330 MW and cost of $2.3 billion (average project size of $46 Lack of Equity Finance million or 7 MW). • One project may include a number Linked to both the need for long-term project of individual subprojects, each of financing and limited access to preinvestment which represents a single generator. financing is the challenge posed by the lack Therefore, the average investment for of equity finance available for many if not each generator will be smaller than the most RET projects. While large numbers of project averages given above. 3 Risk capital is considered to be funds that are seeking Source: Investing in Renewable Energy: The GEF high returns and are willing to assume high levels of risk to Experience, GEF (2010). achieve these. IDENTIFYING THE RISKS AND BARRIERS 7 RET project developers exist, there are only While household, micro, and mini sys- limited numbers of large-scale project spon- tems are obviously far below these limits, even sors, particularly among those operating in larger grid-connected RET projects are generally LICs, with the ability and willingness to fund smaller than their conventional counterparts. RET projects on a corporate finance basis. RET As a result, they often struggle to attract fund- projects are generally smaller than conventional ing from larger financiers. These very small generation projects, and this is reflected in the systems also face the problem of lack of local size of developers. The high risks of invest- demand in rural areas, leading to underutilized ment in many LICs, whether inside or outside assets and worsening financial returns and the energy sector, will also tend to deter many attractiveness to financiers. larger energy companies based in more devel- oped economies. This lack of equity capital means that 2.3 RISKS OF RET PROJECTS project sponsors are often unable to cover the costs of development activities without external High Financial Cost assistance. But, as highlighted above, access to risk capital of the type required is limited in The high costs of RETs relative to conventional LICs. The lack of equity capital also increases generation technologies are a key risk to their the dependence on project financing, as spon- success. These higher costs are exacerbated by sors are unable to provide collateral for loans or the high cost of funds in many underdeveloped to put up large amounts of equity. As a result, financial markets (for example, borrowing costs loans have to be secured against future cash as high as 16–18 percent have been quoted for flows, given the absence of alternatives. Nepal and among other SREP pilot countries, lending rates of 16.5 percent and 15.1 per- Small Scale of Projects cent have been reported by the International Monetary Fund [IMF] for Ethiopia and The small scale of many RET projects cre- Honduras). The high up-front capital costs of ates significant problems in obtaining private many RETs compared to conventional technolo- financing. Economies of scale in due diligence gies further worsen their commercial position are significant, and many larger financial and make costs a concern. institutions will be unwilling to consider small For grid-connected projects, the high projects. Typical due diligence costs for larger cost of RETs can be overcome, at least in part, projects can be in the range of $0.5 million to through priority rights to dispatch and/or $1 million. International commercial banks are must-take obligations on off-takers. This generally not interested in projects below $10 means that these projects are effectively million, while projects up to $20 million will removed from having to compete for dispatch find it difficult to obtain interest.4 But lower with other lower-cost conventional technolo- limits may apply for domestic and regional gies. The higher costs imposed on off-takers banks operating in smaller economies, particu- of purchases from RET projects are gener- larly where these lack the resources themselves ally recovered from electricity customers as a to make large-scale loans. whole—either through the monopoly power of the off-taker or, where the electricity market is competitive, through some form of levy or 4 Scaling-up Renewable Energy in Developing Countries: universal charge. Finance and investment perspectives, K Hamilton (April But if costs are too high relative to alterna- 2010). Chatham House: Energy, Environment & Resource Governance Program Paper 02/10. (http://www.chatham- tives, affordability concerns may mean that house.org.uk/research/eedp/papers/view/-/id/874/). such priority treatment is not given. There may 8 FINANCING RENEWABLE ENERGY also be concerns whether RET projects that are High Exposure to Regulatory Risk more expensive than conventional alternatives will have commitments to pay them honored, While all energy projects face regulatory risk, whether governments will continue to make the RET projects are particularly vulnerable to necessary funds available to cover the obliga- changes in the regulatory framework. Their tions of publicly owned off-takers, or whether lack of cost competitiveness means that these attempts will be made to renegotiate these com- projects are generally dependent on a support- mitments on the grounds of affordability. ive regulatory framework to proceed—including Off-grid RET projects are more likely to be commitments to pay premium prices, priority competing directly with conventional technolo- access to electricity grids including support for gies, such as diesel generation. For these proj- the necessary infrastructure investments, and ects, if users are given a choice of technology, guarantees of purchases of their output. Severe RETs are unlikely to be selected unless their problems for project viability can arise where costs can be brought down to competitive lev- the regulatory framework changes. els. This is happening more as global oil prices rise. For example, the cost of solar photovoltaic Uncertainties over Carbon Financing (PV) modules fell by over 50 percent between 2008 and 2010. In remote locations and small The sale of Certified Emissions Reductions loads, this can make solar PV supplies competi- (CERs) through the Clean Development tive with diesel generation. Mechanism (CDM) is a widely recognized BOX 2.4 COSTS OF RETS The U.K. Government has undertaken a number of studies on the cost competitiveness of RETs, and in particular whether expansion of RET capacity is reducing costs to the extent where these are competitive with conventional technologies before any carbon costs are included. Though the United Kingdom is not a LIC, these studies provide good examples of the cost competitiveness of larger-scale RETs relative to conventional technologies. The most recent update, in June 2010, continues to show RETs as being uncompetitive with gas and coal generation, even for the most mature technology, onshore wind. Notable too is the high share of capital costs in total lifetime RET costs, amounting to 80 percent for wind projects compared to just 20 percent for gas projects. US$/MWh 300 Other costs Capital costs 250 200 150 100 50 0 Gas CCGT Coal ASC Nuclear Onshore Offshore Small Large Land�ll Gas PWR Wind Wind Biomass Biomass Source: UK Electricity Generation Costs, Mott MacDonald, 2010 (carbon costs ignored). IDENTIFYING THE RISKS AND BARRIERS 9 source of revenue for RET projects in LICs, and for the transformative purposes envisaged by one that can help reduce their costs relative to this paper. conventional technologies (in effect acting as a Geothermal projects face a particular risk form of subsidy). But unless some way can be in that the assessment of resources involves found to mobilize this potential revenue source the drilling of expensive exploratory test wells, up front, it is unlikely to help at the time of which may not succeed in finding adequate project development and implementation. resources. The costs of these wells are high There are significant uncertainties over the and the combination of this high cost and risk timing and amounts of revenues from the sale of failure may deter exploration of geothermal of CERs. The process for registration of projects resources in the first place. As a result, while is long and the outcome uncertain, particularly many countries claim that they have significant if a new methodology is involved. Prices can geothermal recourses, very little potential has also be volatile. The main benchmark price been developed so far. Even where an explora- is that set under the EU Emissions Trading tion program is successfully completed, there Scheme (ETS), which collapsed to almost zero are continued risks of resource adequacy during 2008. Finally, there is the uncertainty from the failure of production drilling wells over the CDM post-2012 created by the lack of and the degradation of the geothermal reservoir a replacement for the Kyoto Protocol, which over time. forms the basis for the mechanism. Uncertainties over Resource Adequacy 2.4 THE SIGNIFICANCE OF TECHNOLOGY Without high-quality assessments of renewable energy (RE) resources, the risks of RE projects Different technologies have different degrees are greatly magnified, and private financing will of exposure to the various identified barriers be correspondingly harder to obtain. Resource and risks. While all larger RET projects will assessments for wind, hydro, and biomass in generally require access to long-term fund- particular need to be available on a site-specific ing on a project finance basis, their exposure basis (that is, general assessments such as wind to other barriers and risks will differ. Project atlases are not sufficient for project financing) development processes and, therefore, the need and for an extended period (at least one year of to obtain preinvestment financing are likely to reliable and auditable data, for example). Even be most significant for hydro projects and less then, the risk remains that output—and there- so for other technologies that do not have the fore cash flows—will be less than expected, same impacts on land use and on downstream whether due to lack of rain or wind. communities. Project sizes—and therefore For solar projects, the problems are transaction cost barriers—are generally lower somewhat different. There are extensive data- for wind and geothermal projects that can be bases available on solar resources worldwide; developed on a greater scale than other technol- whether conditions are adequate for PV tech- ogies. While geothermal and small hydro can be nology can be estimated with a fair level of cer- competitive with conventional technologies and tainty. The situation is rather different for the wind energy is approaching competitiveness in use of concentrating solar power (CSP), which some countries, solar technologies in particular is only suitable in a limited number of locations remain a long way from achieving cost com- and where careful investigation of resources petitiveness, and so affordability remains a continues to be required. But CSP remains a key risk. Resource uncertainties are a problem much more immature technology, and therefore for all technologies, but in differing ways. For may not be suitable for most LICs or at least geothermal projects, the greatest risk comes at 10 FINANCING RENEWABLE ENERGY the time of resource appraisal, when expen- it can also be that the lack of long-term project sive drilling of exploratory wells is needed. For financing is actually less of a barrier to such biomass projects, the continuing availability projects—given their very small size, typically of affordable and adequate resources is more they would rely on corporate finance or on significant. Resource uncertainties also play a customer purchases. part in the extent of uncertainties over carbon A stylized representation of the signifi- financing—with those technologies likely to be cance of different barriers and risks to different more dependent on carbon financing to cover technologies is presented in figure 2.1. While their costs also being more vulnerable. inevitably subjective—it is extremely difficult The risks and barriers facing off-grid to conduct rigorous statistical analysis across projects also differ from those of on-grid RET very different projects in very different circum- projects. These projects are generally reliant stances—it provides an indication of which on sales of individual household or small-scale barriers and risks are likely to pose the greatest systems to rural communities. While technical challenges to developing RETs. challenges may be limited, affordability and Lack of market funds is not included in the financeability become key. Also, the very small figure. This financing barrier could affect any scale of such projects, down to the individual technology and is driven by the size of domes- household level, means transaction costs can tic capital markets, not the specific risks of any become an almost insurmountable barrier. But technology. FIGURE 2.1 TECHNOLOGIES AND BARRIERS AND RISKS FINANCING BARRIERS PROJECT RISKS High and Uncertain Project Lack Of Project Financing Lack Of Equity Finance Resource Assessments Small Scale of Projects Long-Term Financing Resource Adequacy Development Costs High Financial Cost Uncertainties Over Uncertainties Over High Exposure to Carbon Financing Regulatory Risk High Costs of Lack of On-Grid Wind Hi Med Lo Lo Lo Med Med Med Lo Med Solar Hi Med Lo Med Med Hi Med Med Lo Med Small hydro Hi Med Med Med Med Lo Med Lo Med Hi Biomass Hi Med Lo Lo Med Med Med Med Lo Hi Geothermal Med Med Hi Med Lo Lo Med Lo Hi Med Off-grid Solar/ Med Lo Med Hi Hi Med Lo Lo Lo Med micro-hydro Source: Authors. Note: Lo = Small or no impact (mitigation of risks is desirable); Med = Moderate impact (mitigation of risks is likely to be required); Hi = Significant impact (mitigation of risks is generally necessary if the project is to proceed) Lack of market funds is not included in the figure. This financing barrier could affect any technology and is driven by the size of domestic capital markets, not the specific risks of any technology. FINANCIAL INSTRUMENTS 11 3 Financial Instruments 3.1 OVERVIEW Figure 3.1 illustrates this. Instruments are or- ganized on the horizontal axis by their primary A wide range of financing instruments can be focus—whether to address underdeveloped applied in support of the scaling up of renew- financial markets, the risks and costs of RETs, able energy technologies (RETs). These can be or both. On the vertical axis, instruments are broadly grouped into those used to overcome organized by the level of risk and leverage financing barriers, those used to address the associated with their use. Pure grants are con- specific risks of RET investments, and those sidered to be the most risky, as these give the that address both simultaneously (as, for exam- public sector no control over the funds contrib- ple, where financial markets lack the sophis- uted and no recourse. Equity is next; although tication to offer risk management instruments it comes with control, shareholders are the last suitable for RETs). These various instruments to be compensated from the project. This is fol- can in turn be distinguished by both the level of lowed by debt in its various forms. risk assumed by the public sector entity fund- In general, the amount of leverage associ- ing the instrument concerned, and by the level ated with the different forms of financing will of leverage (the extent to which public funding follow the opposite pattern as the level of risk. mobilizes private finance) involved. But the selection of instrument must always BOX 3.1  LEVERAGE AND FINANCIAL INSTRUMENTS Leverage is the additional funding that is mobilized by the instrument concerned. For example, if the contribution of $1 in funding through the instrument leads to an additional $1 in financing from other sources, then the leverage will be two times as much. As an example of the leveraging that can be delivered with different instruments, assume that $10 million in public funds is available for RET investments. One option would be to inject these funds directly into individual projects. Another would be to offer guarantees for project investments. Assuming that the guarantee is for 50 percent of debt financing, and that debt represents 80 percent of the total project financing, then $1 of public funds would guarantee $2 of debt financing and $2.50 of project financing. The resulting leverage would be 2.5 times. Experience with World Bank guarantee instruments has shown even higher levels of leverage. During the period 2004–06, six guarantee operations were concluded for a total exposure of $444.5 million mobilizing a total of approximately $1.933 billion (that is, average leverage of approximately 4.3 times). Meanwhile, direct injection of funds may not deliver any additional private investment. While leverage provides a good measure of effectiveness, it may not be as useful in measuring the efficiency of interventions. For example, an intervention may achieve high leverage but does so by transferring private investment from other more valuable uses. An assessment of the choice of instruments must, therefore, take account of the risks of crowding out and of creating market distortions. Source: Authors. 12 FINANCING RENEWABLE ENERGY FIGURE 3.1  THE RANGE OF FINANCIAL INSTRUMENTS Source: Authors. Note: The risks and barriers are shown across the horizontal axis, with instruments shown below. Those instruments occupying the middle of the three columns are potentially suitable for addressing both risks and barriers. AMC = Advanced Market Commitments; OBA = output-based aid; OBD = output-based disbursement; PES = payment for environment service. take account of the particular needs of an indi- 3.2 GRANTS AND vidual project or program as well as legal and LONG-TERM EQUITY practical restrictions that may apply. Figure 3.1 also identifies three further cat- Capital grants fund part of the investment egories of instruments that have specific uses: costs of an RET project, generally in an effort funding delivered on the basis of results, instru- to reduce its ultimate financial cost to increase ments targeted on realizing potential revenues its competitiveness, or—where off-takers are from carbon markets, and instruments specifi- obliged to purchase its output—to reduce cally focused on the barriers and risks facing ultimate customer prices (the use of grants as small-scale RET projects and programs. part of a results-based financing mechanism is For further descriptions of individual discussed separately). Simple grants provide instruments, consult appendix 2 and no control over the project itself and create no www.worldbank.org/energy/refine. incentives on the project developer to deliver a FINANCIAL INSTRUMENTS 13 viable project (unlike a loan, where the project own problems in that, where a large grant is needs to generate sufficient revenues for repay- made, it may lead to the public funding agency ment), but they may be necessary as a means becoming the majority shareholder. Control by of reducing the costs of a project sufficiently to a public agency compared to a private devel- make it affordable. They also have the advan- oper creates the risk of the project suffering tage of being relatively simple to implement from the problems of many publicly managed and manage—the need for due diligence on projects: poor management of costs and perfor- the ability of the project to repay as well as for mance and high risks of political interference. ongoing administration of loans is unnecessary. A particular form of grant is the viability This does not, of course, eliminate the need gap funding mechanism, widely deployed in to ensure the project itself is well designed to India in particular. Under this funding, the meet the objectives that the provision of the government can provide capital grants for a grant is intended to further. share of project costs, where the project would otherwise not be viable due to the constraints GRANTS on user fees that can be charged. In India, the Uses viability gap fund administered by the central • Reduce project costs and provide long- government will pay up to 20 percent of a term finance (capital grants). project’s costs; sponsoring ministries and • Provide long-term finance (equity agencies can contribute a further 20 percent, holdings). requiring the developer to pay at least 60 per- Pros cent of the costs. • Relatively simple to implement. • Do not require ongoing administration. Cons 3.3 VENTURE CAPITAL EQUITY • High risk in terms of achieving objec- tives as they do not create incentives for Equity funding from public sources to support delivery. RET scaling up can comprise long-term invest- • If grants are made in return for equity then ments, as discussed above under capital grants, the public sector is involved in the control or venture capital financing, which represents of projects, which may lead to poorer per- equity investments intended to develop high- formance and the crowding out of private risk projects followed by exit. financing. Venture capital financing is generally • Low levels of leverage as it directly replaces possible private financing. targeted at new technologies and companies • No return on capital that could have been with a high growth potential. Financiers look used to finance further projects. to make their returns by exiting the investment, typically through an initial public offering (IPO) on the stock market or sale to a larger company Within the category of grants, we include interested in acquiring the business’s technol- capital contributions made in return for a ogy. Funding of this type is high risk, and the shareholding in the project company (that is, returns required reflect this. It also requires long-term equity investments). Public agencies sufficiently developed financial markets for the could, of course, also subscribe to shares in the initial financiers to be able to readily exit their same way as commercial investors. But this is investment through a sale of their shareholding not considered to represent any intent to lever- in what may still be a relatively small and risky age public funds to support RET investments, business. Given these requirements, such fund- and is therefore excluded from this paper. ing is unlikely to be well suited to RET invest- Capital contributions of this kind can raise their ments in low-income countries (LICs), unless 14 FINANCING RENEWABLE ENERGY these use particularly innovative technologies repayment of the loan principal may be made at that may make them attractive to an interna- the end of the loan term, reducing debt service tional investor. costs in the initial years of the project. A distinction can be made between direct loans EQUITY (VENTURE CAPITAL) to project companies and the provision of credit Uses lines extended through commercial financing in- • Funds preinvestment costs as risk capital. stitutions (CFIs) or other intermediaries. Credit Pros lines can create incentives for intermediaries to • Pays for itself. extend their own loans to RET projects along- • Strong incentives for project viability to side that funded from the credit line as well as enable potential gains to be realized. allowing blending of commercial and conces- Cons sionary loans to reduce overall costs. The choice • High returns are needed to compensate of intermediaries is discussed in chapter 4. for the risk. Since public financing can accept lower returns, it reduces incentives and makes it harder for private providers BOX 3.2  SRI LANKA RENEWABLE of equity to compete. ENERGY PROGRAM • Low levels of leverage as it directly replaces possible private financing. The World Bank is providing funding for • Developed financial markets are needed investments in grid-connected, mini-hydro, to allow exit from investment through an off-grid village-level hydro and solar home IPO or a direct sale of shares. systems (SHS). Funds are provided to the Ministry of Finance and Planning as an International Development Association 3.4 DEBT (IDA) credit. Participating credit institutions (PCIs) are responsible for lending to Debt, as used in this paper, refers to loans eligible projects applying their own due advanced to RET projects. Asset-backed securi- diligence. Loans may be made directly to ties are discussed separately. project sponsors or, for off-grid projects, to customers. Alternatively, PCIs may loan Senior Debt to microfinance institutions (MFIs) who on-lend to customers for the purchase Senior debt provided from public sources, of SHS. PCIs include development and whether in the form of a project loan or credit commercial banks and leasing companies. line, will take its place among the first creditors Once a loan has been made, PCIs may to be repaid from a project. It is primarily used apply to the ministry for the refinancing to reduce the costs of the project, by providing of up to 80 percent of their loan. The concessionary funds that may be blended with refinancing is made in local currency. more expensive commercial funding, and to The mechanism thereby creates strong offer longer-term debt than may be available in incentives for PCIs to conduct proper due local financial markets. Long-term loans from diligence by retaining their liability for public sources can also help establish credibility 20 percent of the loan and, where the among private financiers for longer-term lending project is not eligible, 100 percent of to RET projects. A wide variety of debt amorti- the loan amount. zation and repayment schedules can be used, Source: Case study #17: Sri Lanka—Renewable Energy allowing tailoring of debt service costs to project Program. cash flows. For example, a bullet (one-off) FINANCIAL INSTRUMENTS 15 SENIOR DEBT can also be used to extend the effective Uses term of loans, thus helping project cash flows • Reduces project costs. and viability. • Provides long-term finance. Pros BOX 3.3  USING SUBORDINATED • Obligation to repay creates incentives for DEBT TO EXTEND LOAN TERMS project viability. Subordinated debt is generally thought • Repayment of principal frees funds for of as a means of increasing the share of further support to RET projects. equity or quasi-equity in projects and, • Used as a means to increase CFI involve- therefore, attracting senior lenders who ment in RET projects (through provision as credit lines). require a minimum equity share in project Cons financing. But it can also be used to effectively extend the term of loans. • Need for due diligence to verify ability of project to repay loan increases transaction Repayment of the principal of costs. subordinated loans might only begin • Leverage is limited and may crowd out after an extended grace period or even potential private providers of debt. after all senior debt has been repaid. Subordination in this way improves the cash flows of the project in earlier years Subordinated Debt (Mezzanine Finance) and, therefore, reduces the risk to senior lenders of default. This can increase the For the purposes of this paper, subordinated willingness to lend and to accept longer debt is considered to encompass all forms of loan terms. mezzanine or quasi-equity finance, of which Source: Case study #4: Macedonia—Sustainable Energy Financing Facility. there are many variants. The key features these share in common are that repayment is subordi- nate to providers of senior debt (hence the SUBORDINATED DEBT name), and that the financier does not obtain (MEZZANINE FINANCE) a shareholding and thus control of the project Uses (although some forms of subordinated debt may be capable of conversion to shares or, as • Provides intermediate funding between equity and senior debt, which helps in the case of preferred shares, take the form of reduce risks to senior lenders while not equity but with lesser or no rights of control). taking control away from project sponsors. This higher risk is generally compensated for • By doing so, can extend the term and by a higher return than on senior debt. But a reduce costs of senior debt. public agency may choose to provide subordi- Pros nated debt at a concessionary cost similar to or • High level of leverage. below that of senior debt. • Crowds in senior debt by allowing projects Subordinated debt is extremely valuable to meet acceptable risk criteria for lenders. as a means of financing RET projects. It allows Cons project developers to reduce the risk to senior • It is generally custom designed for each lenders by reducing the share of senior debt project, implying high transaction costs. in total project financing, while still retaining • Significant risk transferred to public financ- control of the project. By doing so, it can make ing agencies, but with only limited ability senior debt less costly or even make it available to control these risks. where it previously was not. Subordinated debt 16 FINANCING RENEWABLE ENERGY 3.5 ASSET-BACKED SECURITIES ASSET-BACKED SECURITIES Uses Asset-backed securities are bonds or similar • Offer project financing through bond instruments, which are backed by the cash offerings rather than through loans. flows generated by a RET project or projects • Free public funds for future RET project (rather than being corporate bonds backed by development when completed projects the assets of a company as a whole). These are refinanced. cash flows form the security for repayment. The Pros process of raising finance in this way, secured • Longer tenor and possibly lower cost than against future cash flows, is frequently termed bank financing. securitization. • Ready means to refinance projects, freeing Asset-backed securities are generally used developer funds for further investments. for refinancing projects that are generating • Potential to bundle projects together in a single security can reduce risks and, there- positive cash flows, although they can also be fore, financing costs issued in the form of project bonds ahead of • Can be a good tool for expanding capital construction. Such refinancing offers a poten- market offerings given the relative low risk tial way to free up public funds that have been of some RETs (because of their guaran- committed for development and investment, teed offtake). thereby allowing these funds to be redeployed Cons to support new projects. • Sophisticated markets required to be able As well as freeing up development funds, to analyze and price the risk associated asset-backed securities allow the potential with this type of security. bundling of a number of RET projects by issuing bonds secured against the cash flows of multiple projects. By doing so, they can Asset-based securities require relatively increase the financing capabilities of CFIs. For sophisticated financial markets able to analyze example, if a CFI is required to hold reserves to and value the risks associated with such securi- cover the full risk of default, then—if lending to ties and, consequently, to price them. The expe- 10 individual RET projects, each of which has a rience with mortgage-backed securities in the 10 percent probability of default—it would need recent financial crisis shows how even the most to hold reserves equal to the original loans.5 sophisticated markets can get this wrong by, for If instead it purchased a bond secured against example, assuming past statistical relationships all 10 projects, then it need only hold reserves will continue to hold and by failing to properly equal to 10 percent of the total bond value, as understand the individual loans that comprise the probability of any one project defaulting the security. Their suitability for the vast major- remains at 10 percent. ity of LICs should be considered on a case-by- case basis. 3.6 GUARANTEES AND INSURANCE 5 This is an extreme and greatly simplified example Guarantees and insurance do not comprise used to illustrate the benefits of bundling. In reality, reserve requirements are much more complex than this example direct financing as such. Instead, by offering implies. It would also be unrealistic to assume that the risks protection to financiers against risks, they make of default of what would be very similar projects operating in the same market are uncorrelated and independent of one it possible to mobilize commercial financing for another. the necessary terms and at acceptable costs. FINANCIAL INSTRUMENTS 17 Individual Guarantees BOX 3.4 VARYING LOSS SHARES The figure below shows the sharing of An individual guarantee covers a portion of the losses under a guarantee of the type losses to the financier (for loans, this would described in the main text, where the typically be unpaid principal and collection share of losses borne by the lender costs, but not necessarily unpaid interest) if increases over time as its ability to specified events occur. A guarantee would not manage these increases. cover all potential losses as doing so would obviously remove the incentives on the finan- cier to conduct proper due diligence or to seek to recover unpaid amounts. The split of losses GUARANTOR might vary depending on the magnitude, for GUARANTOR example, to protect the financier against more extreme losses or to reflect expected improve- ments in the ability of the financed entity to LENDER manage their risks over time. As an example, LENDER a guarantee might split the first 10 percent of First 10% of losses Additional losses losses on the project between the guarantor and BOX 3.5 USING LIQUIDITY Both guarantees and insurance represent GUARANTEES an agreement by the guarantor or insurer to pay part of the costs or losses incurred by a An example of an innovative use of RET project in the event of a specified event liquidity guarantees to support a RET happening in return for the payment of a fee or project is provided by the funding of premium. The difference lies in the commercial part of the investment costs of the arrangements. A guarantee is a three-way rela- West Nile Rural Electrification Project in tionship with the guarantor offering the guar- Uganda. Under Ugandan regulations, antee to one entity (the financier) against the loans may not be provided for a term performance of another entity (that receiving exceeding 8 years. To allow for a longer- the finance). Insurance is a two-way relation- term loan, two separate senior loans ship between the insurer and the insured (typi- were structured. The first expires after cally the entity providing finance) without a 8 years when a bullet repayment of the need for the entity receiving the financing to be outstanding principal is to be made. involved. The financier would expect to receive This repayment is funded from a new the proceeds of any insurance payout to provide 7-year loan. The total period over which them with the necessary protection against the both the loans are repaid is, therefore, performance of the financed entity. 15 years. By their nature, guarantees tend to be A liquidity guarantee has been more one-off or bespoke in nature involving used to ensure that sufficient funds are the guarantor in extensive due diligence and in available to make the second loan after the design of the project, while insurance tends 8 years, thereby removing this risk for the to be better suited to more developed markets project developer. where insurers can offer standard products and Source: Case study #5: Uganda—West Nile Rural can assess the risks involved based on exten- Electrification Project. sive data. 18 FINANCING RENEWABLE ENERGY lender in a 75:25 percent ratio with subsequent between the financier and the guarantor while, losses being split 60:40 percent (a structure under a subordinated guarantee, the recovered illustrated in the accompanying box). Assuming monies are first used to repay the financier and the first losses would occur in the earlier stages only after this are any remaining amounts used of the project, this provides incentives for the to repay the guarantor. The latter obviously project company to improve its performance reduces incentives on the financier to recover over time before it starts to bear a larger share unpaid amounts, and affects risks to the guar- of any losses. antor and, therefore, the guarantee fee required. Guarantees might take the form of either Figure 3.1 also identifies two specific types a pari-passu or subordinated guarantee. The of guarantee. The first is a liquidity guarantee difference between the two lies in the treat- where the guarantor is guaranteeing that the ment of unpaid sums that may be subsequently guaranteed entity has sufficient funds to meet recovered. Under a pari-passu guarantee, recov- its obligations. For example, hydro projects ered monies are shared in a preagreed ratio may have very volatile revenues depending on rainfall in the year. In these cases, a liquidity guarantee can provide assurance that the proj- BOX 3.6  PARTIAL CREDIT ect will be able to service its debts in dry years. GUARANTEE (PCG) FOR The second is specifically targeted on the LEYTE GEOTHERMAL political or regulatory risks associated with many RET projects in LICs and takes the form The Leyte-Luzon geothermal power plant of political risk insurance (PRI) or a par- was implemented by the National Power tial risk guarantee (PRG). These are offered Corporation (NPC) and the Philippines by a number of multilateral institutions and National Oil Company (PNOC), both bilateral credit agencies, including the IDA, state-owned corporations. The NPC International Bank for Reconstruction and raised $100 million in project financing Development (IBRD), International Finance through 15-year bonds issued on Corporation (IFC), and Multilateral Investment international capital markets. The bond Guarantee Agency (MIGA) within the World issue was covered by a Partial Credit Bank Group (WBG). Such a guarantee will typi- Guarantee (PCG) provided by the World cally cover the risk that a project defaults due Bank. Under the PCG, bondholders have to the actions of government or public sector a “put� option to sell their bonds to agencies. These might include, for example, the World Bank on maturity in return for expropriation or a breach of contract that repayment of the principal. This option cannot be relieved by other means, regulatory provides the necessary confidence to actions that have severe economic impacts investors that such long-term bonds will on the project, or limits on currency convert- be honored when they become due at ibility. PRGs offered by the IDA and IBRD are the end of their tenor. The bonds were secured against a matching counter-guarantee successfully placed, despite the previous from the host country government (so that, if longest tenor obtained by a Philippines the PRG is called, the IDA or IBRD may then sovereign entity being only 10 years, and seek recovery of the costs of the guarantee from at a price of only 250 basis points above the government). This acts as a very power- U.S. Treasuries, which compares very well ful incentive for the host country government with previous bond issues. to meet its obligations. The MIGA by contrast Source: Case study #24: Philippines—Leyte offers an insurance product in that the PRI has Geothermal Partial Credit Guarantee. no counter-guarantee. FINANCIAL INSTRUMENTS 19 INDIVIDUAL GUARANTEES BOX 3.7  PRG FOR LAO PDR Uses HYDROPOWER • Guarantee a part of the losses incurred by a project in the event of a specified event The Nam Theun 2 Power Project is a occurring. $1.25 billion hydropower project. It • Guarantee ability to meet commitments on debt servicing / financing (liquidity reached financial close on June 10, 2005, guarantee). after mobilizing an unprecedented $1.17 • Guarantee policy and regulatory commit- billion in private capital. At the time of ments by host government (PRI/PRG). project preparation, the private sector Pros had indicated that the project would • Guarantees are targeted to specific risks only be possible with a risk mitigation deterring private investment, thereby package backed by the World Bank to minimizing the risk of market distortions contain the political and regulatory risks and being an effective means of crowding of investing in the power sector in Laos, in private investment. and the dependency on revenues from • A high degree of leverage as a rela- neighboring Thailand through exports tively small commitment of funds can of power. mobilize significant quantities of private investment. The WBG provided an IDA PRG of • No need for large up-front payment, mak- $42 million, a MIGA debt guarantee ing it easier to obtain political approval. of $91 million, and a MIGA equity Cons guarantee of $150 million. Additionally, • Generally are custom designed for each the IDA provided a credit of $20 million project, implying high transaction costs. to the Government of Laos. • Significant risk is transferred to public Source: Case study #33: Laos—Nam Theun 2 Project. financing agencies but with only limited ability to control these risks. • Appropriate accounting for and approval of the resulting contingent liabilities is Insurance would generally not be avail- required, which may be complicated by able for hydrology risk or for biomass projects. difficulties in assessing the associated Hydrology risk is very location specific making risks. it difficult for an insurer to assess the prob- • Ability to avoid up-front funding may ability of a dry year or to diversify this risk encourage excessive use of guarantees for against increased hydro flows in other insured political reasons and favored projects. sites. Insurance of the availability of biomass resources is also site specific and could create potential perverse incentives for the insured Resource Insurance RET project to minimize its efforts to obtain General insurance for business interruption, adequate supplies. damage to equipment, and similar risks is con- Even where insurance of this kind is avail- sidered to lie outside the scope of this paper. able, which may be the case in some more The RET-specific insurance covered in this sophisticated financial markets, there may still chapter is instead related to the management be a role for public agencies to support the of resource risks. For technologies that are provision of reinsurance (effectively insuring inherently dependent on uncertain resources, the insurers), which then releases the funds of wind and solar insurance can be used to pro- the insurers in a similar way to other mecha- vide coverage against unusually cloudy or nisms for bundling projects for the purposes of still periods. managing risks. 20 FINANCING RENEWABLE ENERGY RESOURCE INSURANCE 3.7 RESULTS-BASED FINANCING Uses • Insures against lost revenue in the event Payment against Outputs of lower-than-expected output due to lack of wind or sun (wind/solar insurance). Results-based financing (RBF) links the • Insures against costs of failed exploratory payment of funds to the delivery of specific out- wells (contingent risk insurance for geo- puts. There are many variations of such funding thermal projects). and many names used by different members Pros • Targeted on specific risks deterring private investment, thereby minimizing the risk of BOX 3.8  INSURANCE FOR RET market distortions and being an effective PROJECTS IN LICS means of crowding in private investment. • A high degree of leverage can be Substantial work has been undertaken achieved as a relatively small commitment by the United Nations Environment of funds can mobilize significant quantities Programme (UNEP) on the extension of of private investment. insurance offerings for RET projects in Cons LICs. This has helped lead to the estab- lishment of insurance4renewables, which • A large number of projects with diversity of locations are required for the insurer offers case-by-case coverage for RET proj- to be able to diversify their risk exposure ects including carbon delivery guarantees, away from any one project. carbon counterparty credit risk insurance, • A large database of historic performance and lack of sun/wind insurance. is required for insurers to be able to assess Source: Case Study #26: Global—insurance4renewables and price risks. • For these reasons, resource insurance Other insurance products previously tried either needs multinational insurers or include the GEF-supported GeoFund. large and sophisticated domestic financial This offered direct investment funding ($8 markets combined with large volumes of million), technical assistance ($7 million), existing RET projects. and geological risk insurance (GRI) ($10 million) for geothermal projects in Europe and Central Asia. The GRI window was used in Hungary in 2006-07 to insure 85 percent of the costs of drilling two A form of insurance specific to geothermal exploratory wells to support exploration of projects is that of contingent resource insur- these resources. In the event, both wells ance. Geothermal projects require the drilling were found to have insufficient pressures of costly exploration wells to assess whether to support geothermal applications and adequate resources exist. Contingent resource a payment of $3.3 million was made to insurance pays part of the costs of these wells the implementing entity. Although the where they prove unsuccessful. There has GeoFund initiative was later cancelled, been significant interest in the creation of such it continues to serve as a model for a schemes including the World Bank-supported similar mechanism being used to support GeoFund and the separate initiative, the African geothermal development in the Rift Valley Rift Geothermal (ARGEO) project supported in Eastern Africa. by the Global Environment Facility (GEF), for Source: Case study #10: Hungary—GeoFund. exploration in Eastern Africa’s Rift Valley. FINANCIAL INSTRUMENTS 21 of the development community to reference BOX 3.9  OUTPUT-BASED these variations. For the purposes of this paper, AID (OBA) FOR SOLAR HOME these are grouped under the term results-based SYSTEMS (SHS) IN BOLIVIA financing. RBF is based on the concept of shift- ing from funding of inputs (such as a contribu- Under the World Bank-supported tion to the capital costs of a project) to payment Decentralized Infrastructure for Rural for outputs or results (such as the successful Transformation (IDTR) project, 14 commissioning of the project) and, from this, medium-term service concessions (MSCs) the transfer of investment and operating risks for SHS installation have been allowed. from funders to implementing agencies. This The MSCs give exclusive rights to the concept of risk transfer is a critical element concessionaire for 4 years, during which that needs to be captured in the design and is period they receive subsidies for SHS instrumental in a number of benefits derived installations and are required to achieve from RBF. a given volume of installations. Subsidies A typical RBF approach involves a public are paid on an OBA basis with the entity providing a financial incentive, reward, following schedule: subsidy, or grant conditional on the recipient undertaking a set of predetermined actions or • Fifteen percent on acceptance of a achieving a predetermined performance or set prototype system compliant with all of results. Funds are disbursed not against indi- quality specifications. vidual input expenditures or contracts on the • Sixty-eight percent against input side, but against demonstrated and veri- achievement of installation targets fied results that are largely within the control • Twelve percent against meeting of the recipient. The recipient prefinances the annual visit requirements over the activity based on the certainty that, as long as 4-year MSC period. it delivers the pre-agreed service, it will receive payment. The credit worthiness of the fund- • Five percent at the expiry of the ing entity and the track record of the recipient MSC, provided all obligations have should allow the recipient to raise this prefi- been complied with. nancing either internationally or locally. But Source: Case study #32: Bolivia—SHS Medium-Term Service Contracts. where financial markets are significantly under- developed or project developers are small scale and have limited track records, this may not always be possible and RBF mechanisms may need to be combined with or supplemented by affordable user fee and a cost-recovery user fee, other financial instruments. for example, a consumption subsidy. OBA can There are several ways of structuring RBF also be used to support more efficient delivery mechanisms. These include the following: of services that exhibit positive externalities, Output-based aid (OBA). OBA specifically by tying payments for contracted-out services refers to delivering outputs for low-income to the achievement of specified service perfor- consumers. For the energy sector, OBA is typi- mance levels or outputs. cally used to increase access to energy services Significant work goes into the design of by the poor, by helping cover the difference OBA schemes. The subsidy is targeted for eli- between the full cost of supply and the afford- gible low-income consumers. This can take the able price to poor households. OBA subsidies form of geographic targeting (that is, consumers can either buy down the capital cost of invest- living within a certain area are eligible) or using ments or can cover the difference between an proxies for low-income consumers (such as 22 FINANCING RENEWABLE ENERGY activities. Unlike OBA, OBD is not targeted at BOX 3.10 AMCS FOR RURAL low-income consumers per se. ENERGY SYSTEMS IN RWANDA RBF also includes a range of mechanisms that aim to create sustainable markets by guar- The U.K. Department For International anteeing service providers—for a limited period Development (DFID) is supporting a of time—a price on their delivery of a pre- program of AMCs for biogas digesters defined output and/or a minimum number of and micro-hydro in off-grid energy units that they will be able to sell. This concept supplies in Rwanda. For biogas, the was known as Advanced Market Commitments, primary barrier that has been identified or AMCs, when it began in the health sector, is demand uncertainty, meaning a but is now being applied more widely to the reluctance among developers to enter energy and other sectors. Feed-in tariffs, which the market or to invest in sufficient scale guarantee the price for RET projects, can be to bring down costs. The AMC will help considered a form of AMC. address this by increasing the returns to Payment for Environment Service (PES). biogas investment, thereby increasing PESs are marketlike payment mechanisms interest and market size. It will pay a where the downstream beneficiaries of environ- cash incentive over 3 years to developers ment services (including reductions in carbon of biogas systems serving community emissions) pay for the continued supply of installations such as schools. The micro- these services by upstream providers. For hydro incentive focuses on ensuring the instance, an entity such as a bottling company sustainability of systems and will be paid pays another party, such as a rural community, against a combination measure including a fee to ensure the delivery of reliable and number of households served and of high-quality water supplies. The community new household connections. would commit to sustainable land and water Source: Case study #34: Rwanda—AMCs for Rural use activities to meet this requirement. PESs Energy. usually involve legal contracts and an adminis- trator who helps design, negotiate, and monitor the agreement. An example of RBF in action is the use of consumers with ration cards or without existing OBA to promote SHS. The mechanism makes connections to the distribution system). The an initial payment on evidence of the ability to size of the subsidy is also carefully determined deliver (such as approval of a prototype SHS), a based on third-party or competitive costing of further payment on installation of the SHS, and the works involved and the willingness and one or more additional payments at later dates ability to pay for surveys. Institutional arrange- dependent on the continuing operation of the ments such as independent verification agents SHS. By doing so, the mechanism creates incen- and funds flow processes are also determined at tives to install rapidly and to specification and the planning stage. The World Bank-managed to maintain the SHS following the installation. Global Partnership on Output Based Aid (www. There are tensions between such mechanisms gpoba.org) serves as a global center of expertise and other financing objectives—notably making for OBA design and monitoring. payments after installation implies the project Output-based disbursement (OBD). OBD company must have some means of funding involves payment of a subsidy to a service the up-front capital costs by itself. In some provider or a contractor against delivery of situations, this has acted to spur local credit improvements in the efficiency of service- markets. In Bangladesh, for instance, an OBA related assets, systems, or recurrent government approach to SHS installation has been heavily FINANCIAL INSTRUMENTS 23 reliant on the development of microcredit. The BOX 3.11 CONTINGENT PROJECT independent verification involved with OBA DEVELOPMENT FUNDING and the certainty of payments based on verifi- cation of effective installation have been seen The GEF provided a $4 million loan to as important to giving microcredit agencies the local utility, CEPALCO, to help fund confidence to lend for such activity. the development costs of a 1 MW solar RESULTS-BASED FINANCING (PAYMENT PV plant in Mindanao in the Philippines, AGAINST OUTPUTS) to be operated in conjunction with a hydro plant, thus greatly improving Uses dispatch control. The project was • Pays grants or subsidies against the deliv- intended to demonstrate the operational ery of a specified set of outputs. feasibility of this concept in anticipation • For RET projects, grants and subsidies are used to reduce the costs. of a fall in PV panel prices, allowing Pros future projects to adopt the same model without the need for subsidies. To • Linking payment of grants and subsidies to results creates strong incentives on provide incentives for the project to be developers to deliver. operated and maintained appropriately, • Availability of local credit to implementing the GEF loan converts to a grant if entities is boosted, if the funder of RBF the project is successfully operated payments is credible. for 5 years. • Crowding out effects are limited, as devel- Source: Case study #8: Philippines—Grid-connected opers must still arrange a large part of the solar PV—Hydro Hybrid Demonstration Project. up-front financing. Cons • The need for up-front financing by the developer means that results-based financing doesn’t necessarily overcome financial markets barriers—it may be dif- Public agencies can provide funding ficult to obtain loans against expected to help defray these costs. If the funding is future payments. provided as a loan, which then converts to a • For small-scale projects, the costs of verifi- grant if the project is successfully implemented, cation can be extremely high. then incentives are created for the developer to • Without careful definition of the required outputs, incentives can be distorted. pursue rapid implementation of the project. But there are obvious concerns as to how the devel- oper would repay a loan if the project didn’t succeed, as well as doubts whether further Contingent Project incentives to reach implementation would be Development Grants required. An alternative mechanism is actually the reverse, a contingent grant that transforms One specific form of RBF of particular applica- to a loan if the project is successful. This allows tion to larger RET projects is that of contingent development activities to proceed without the project development grants. RET projects, developer taking on loans that they may default particularly when the technologies are new and on if the project cannot be implemented for rea- unfamiliar, face significant risks of delays and sons outside their control, as well as providing increased costs of project development due to a source of funds through loan repayments that technological problems and extended permit- can then be used for future project develop- ting and approvals procedures. ment grants. 24 FINANCING RENEWABLE ENERGY RESULTS-BASED FINANCING providing guaranteed commitments to purchase (CONTINGENT PROJECT certified reductions in emissions on a standard DEVELOPMENT GRANTS) basis rather than negotiating individually Uses on a project-by-project basis, as is common • Provides preinvestment funding, either as at present. loans that turn to grants if the project is successful or grants that turn to loans. CARBON FINANCING Uses Pros • Allows projects to access expected rev- • RBF can leverage private financing by enue streams from CERs ahead of commis- supporting development of projects to a sioning or at start of operations. stage where private investors are willing to participate. Pros • The use of loans that will be converted to grants provides incentives to developers • A possible means of obtaining up-front to complete projects in a timely fashion. financing secured against carbon revenues • The use of grants that will be converted to (that is, project financing). loans means developers are more willing • Used to refinance projects, thus freeing to take on marginal projects, knowing that up resources for development of new the costs of preinvestment activities are projects. covered if the project is unsuccessful. Cons Cons • Only a small number of potential buyers of • The use of loans that will be converted to CERs exist. grants increases the risk for developers if • Significant risk is transferred to the public the project is unsuccessful. financing agencies, if purchases are made • The use of grants that will be converted to ahead of project registration (under the loans can reduce incentives to complete CDM) or if carbon revenues are uncertain. projects of marginal viability. • Process of realizing carbon revenues can be complex and costly, particularly for first-of-a-kind projects, and reliance on these may delay project development 3.8 CARBON FINANCING substantially. • Front-end loading of carbon finance Advance sales of CERs offer a way for project revenues has been difficult to realize in developers to manage the risks associated with practice given the regulatory and opera- tional uncertainties of these projects. the sales of CERs and, thereby, help mobilize • Financing only covers a part of costs funding. Such sales may be either made on the and amounts received depend on basis that the purchaser will be responsible for carbon prices. obtaining registration under the CDM (which will reduce the price offered) or that the devel- oper will do so. Various commercial entities A risk for any advance purchase of are already engaged in such purchases, and the CERs, of course, is that the expected volumes World Bank also administers a number of trust of emissions reductions will not be forthcom- funds for the purposes of purchasing CERs. The ing. To manage this, carbon delivery guarantees Carbon Partnership Facility under the World might be used, covering the losses resulting Bank will further enhance this capability as from actual emissions reductions being less well be a mechanism for post-2012 funding by than expected. FINANCIAL INSTRUMENTS 25 3.9 SMALL-SCALE PROJECT BOX 3.12  MICROFINANCING FINANCING OF SOLAR HOME SYSTEMS This category of financial instruments relates The UNEP-supported solar loan program specifically to small-scale RET projects, in par- operates in the southern Indian states ticular household and community-level systems of Karnataka and Kerala. The program is for off-grid electrification. Such projects are intended to provide access to affordable generally developed by small suppliers and microfinance loans for use by poor serve low-income communities with limited households to purchase solar home ability to pay up front. Consequently, they face systems (SHSs). The key component of even greater problems than other RET projects the program is the provision of subsidies in raising the necessary capital to make initial to participating banks to reduce the investments. interest rate charged to households. The instruments below are more specific The subsidy takes the form of a grant to small-scale RET projects, but other instru- (typically equivalent to 2-6 months of ments can obviously be used to support these loan repayments) paid to the borrower as well. In particular, the use of RBF can be at the end of the loan term. The grant effectively combined with appropriate busi- is sufficient to reduce the effective ness models to create appropriate incentives for interest rate paid while also providing developers. One example of this is the linkage security for lenders—the need to wait of payment of subsidies for SHS installations to for the grant provides an incentive for the continued operation of those installations, households to make all repayments, under an OBA model. This creates incentives while the bank can retain the grant in the for suppliers to provide continued maintenance event the household defaults. A payment for these installations to be able to collect the is also made to banks for each SHS full subsidy. loan concluded, reducing the effective transaction cost. Microfinancing Source: Case study #12: India—Solar Loan Program. One mechanism that has been pursued is that of channeling funds through microfinancing institutions (MFIs) to provide loans to house- of an exception). Loans are typically made at holds, either directly or via the equipment relatively high interest rates and for short peri- supplier, who can then use this to pay for at ods, to be repaid from the additional revenues least part of the capital costs of RET systems. generated by the investment or from the future The need to collect repayments also provides sale of crops. Longer-term lending for appli- an incentive for the supplier to maintain and ances where repayment depends on household ensure the continuing operation of the systems incomes, as is the case for the purchase of postinstallation. MFIs are characterized by SHSs, is therefore a change in business model their focus on lending to households and small for many MFIs. In Bangladesh RBF has been businesses—generally for productive invest- used in combination with microfinance activity ments (such as cottage industries) or to support to refinance MFIs after they have been verified agricultural activities (such as the purchase to have carried out appropriate installations, of fertilizers ahead of harvests). Most MFIs thus freeing MFI funds for further lending. have a relatively narrow focus in geographi- Public financing of such MFI initiatives can cal, product, and sector terms (the well-known be provided through a variety of instruments. Grameen Bank in Bangladesh is somewhat These can include the provision of credit lines 26 FINANCING RENEWABLE ENERGY to increase available funding and lower the PORTFOLIO GUARANTEES AND costs of customer loans, the provision of grants LOSS RESERVES or subsidies for a similar purpose (often on Uses a RBF approach), or the provision of guaran- • Guarantee a part of the losses incurred by tees to cover MFIs against part of the losses a portfolio of similar projects in the event they might sustain from loan defaults—either of a specified event occurring. directly or through the failure of Pros supplied equipment. • By grouping projects, the reserves required against default can be reduced as MICROFINANCING a result of the diversification of risk com- pared to individual guarantees, allowing Uses for a greater degree of leverage. • Provides customers with credit to pur- • Transactions costs for each project are chase RET hardware (typically SHS). reduced as any project meeting the Pros required criteria can be included in the guaranteed portfolio. • A means of allowing RET develop- Cons ers to receive payment on installation of systems, reducing need for up-front • Large number of similar projects are financing. required for this funding to be effective. Cons • Project developers may include inappro- priate projects in the portfolio, • MFIs may not exist or may be unwilling increasing the risk exposure of public to lend for purchases of RET hardware, financial agencies. as loan terms are longer than typical MFI • Ideally requires good database of similar loans and repayment is dependent on projects to be able to assess risk of guar- household incomes rather than revenue antee or reserves being utilized. generation. • As with other guarantees, requires good • Transactions costs are high, although MFIs accounting of contingent liabilities and are able to reduce these compared to may create scope for abuse. alternative financing arrangements. • Sophisticated institutional capacity • Microfinancing still requires RET devel- required to manage such programs. opers to find significant working capital to fund initial purchases of RET systems ahead of first sales. losses on the package of loans (or projects) as Portfolio Guarantees and Loss Reserves a whole. A “first loss� guarantee would cover part of the first tranche of losses—for example, Obviously there are high risks of default in 80 percent of losses up to a value of 10 per- lending to poor rural households for the pur- cent of the portfolio as a whole. A “second chase of electrical systems that do not (directly) loss� guarantee would cover a second tranche increase household incomes. One mechanism of losses—for example, 80 percent of losses for managing this risk is the use of guarantees. between 10 and 30 percent of the portfolio. First As projects of this kind typically involve large loss guarantees provide greater protection to numbers of similar individual loans, portfolio the financier. Second loss guarantees protect guarantees or loss reserves are appropriate against extreme events while also providing instruments rather than individual guarantees strong incentives for the supplier to minimize that might characterize larger RET projects. losses as it bears the first tranche of these. Portfolio guarantees cover a proportion of the A risk in any such arrangement is that the FINANCIAL INSTRUMENTS 27 guarantor has limited control over the loans Sri Lanka and Vietnam have both adopted or projects added to the portfolio. Although standard power purchase agreements and tariffs standard criteria might be defined, it is very dif- for small hydro projects, avoiding the need ficult to ensure these are followed in all cases. for these to be reviewed for each new project. Again, the recent experience with collateral- Another is to establish a dedicated financing ized debt obligations written against household intermediary that, because of the large volumes mortgages in the United States shows the high of similar transactions it deals with, can realize levels of risk inherent in relying on entities with economies of scale in their appraisal. Such an incentives to maximize the volume of loans intermediary could be a public entity or could covered by such guarantees to determine which be a CFI through which loans for RET projects loans to include in their coverage. are channeled. The role of intermediaries is Loss reserves operate in a similar manner, discussed below. except in this case the actual sums required to cover the guarantee are set aside rather than AGGREGATION simply being a promise to pay if the guarantee is called. Consequently, they provide greater Uses certainty that funds will be available to meet • Reduces transactions costs by bundling the guarantor’s obligations. They also allow for together similar projects that use standard the use of a guarantee without an actual guar- contracts and specifications. antor—the necessary loss reserves can simply Pros be paid into a special account for this purpose • Transactions costs for each project are at the project’s start. reduced as the standardization of docu- mentation means rapid review is possible. Aggregation Cons A major barrier to lending to small-scale • Large number of similar projects are projects is that of associated transaction costs. required for it to be effective These will rule out many RET projects from the • Commitment on part of developers, off- commercial financing market, even if they are takers, and financiers is required so they do not amend standard documents. otherwise attractive. Aggregation of projects is one way to overcome this barrier. Various forms of aggregation can be used. One approach is to adopt standard project specifications and A summary of the individual financial agreements so that each individual project can instruments discussed above, with their pros be rapidly appraised at low cost. For example, and cons, is presented in appendix 2. 28 FINANCING RENEWABLE ENERGY THE ROLE OF FINANCIAL INTERMEDIARIES 29 4 The Role of Financial Intermediaries A t its simplest, there are three main routes for providing public funds to renewable energy technology (RET) project companies: by multilateral organizations, such as the International Development Association (IDA) and International Bank for Reconstruction and Direct provision. This represents direct Development (IBRD) arms of the World Bank grants, equity contributions, or loans to the Group (WBG). project company. The original public financing Through a commercial financial institution agency is responsible for due diligence. Funds (CFI). In this instance, public financing is used may be given directly or on-lent by govern- to provide a credit line or guarantee for a CFI, ments, the route for most funds provided which is then responsible for providing funds to RET project companies—whether as grants, loans, or guarantees. The CFI might supplement BOX 4.1 USING CFIS AS the public funds with complementary funding INTERMEDIARIES IN from its own resources or blend public and its BURKINA FASO own funds into a single loan. The CFI is responsible for due diligence, following pro- Isolated grid projects in Burkina Faso cedures and processes approved by the public are undertaken by local communities financing agency. who establish electricity cooperatives for Through a fund or similar vehicle estab- this purpose. Funding for investments lished for the purpose. In this instance, public is provided by the Rural Electrification financing is used to provide the initial capi- Fund (REF) with 75-80 percent coming tal for the fund, which then provides this to as a direct grant and the remainder as RET project companies. The fund may either a 10-year loan on concessional terms be dedicated to RET projects or may have channeled through rural banks. The bank broader remits—for example, to support rural bears no risk but the expectation is that electrification. The fund is responsible for due administering the loan will create an diligence, following procedures and processes ongoing relationship between the bank approved by the public financing agency. and cooperative, so making it willing to This chapter briefly considers the respec- extend loans in future. The separation tive merits of using CFIs or funds as interme- also enables the REF to draw a clear diaries and provides guidance on the selection distinction between grants and loans in between these. funding. In practice, there are concerns that the REF has not insisted sufficiently on the need for loan repayments, while 4.1 COMMERCIAL FINANCIAL the bank itself has no incentives to INSTITUTIONS enforce these repayments. Consequently, the intention of building a track record In principle, the use of a CFI is preferred. A of reliability with the bank for the CFI usually has existing capabilities in due cooperative is being lost. diligence, borrower appraisals, and the adminis- Source: Case study #19: Burkina Faso—Rural tration of loans and guarantee products. It also Electrification Program. has established networks that can be used to identify and work with RET project developers. 30 FINANCING RENEWABLE ENERGY A CFI may also offer a more sustainable BOX 4.2  CHINA’S UTILITY- source of intermediation, as its continued BASED ENERGY EFFICIENCY existence is not dependent on one particular PROGRAM (CHUEE) group of projects or one particular funding source and it may be able to complement Under the CHUEE Program, the public funding from its own financial resources, International Finance Corporation (IFC) thus increasing the leverage benefits of provides guarantees to participating public financing. commercial banks covering part of the CFIs may have little or no previous experi- potential losses on energy efficiency ence in lending to RET projects. In these cases, loans. The loans are for a maximum public funds working with CFIs help them build duration of 20 years and borrowers must up their capacity in this area at low cost and pay at least 20 percent of the limited risk. Subsequently, as the CFI’s familiar- costs themselves. ity with the sector grows, they can increasingly Lending supported by the Program look to exploiting opportunities for commercial has expanded very quickly, to US$630 lending without the continued need for public Million by December 2010, of which $402 funding. Million was covered by loan guarantees. But working through CFIs can also have its The Program has helped established problems. One potential risk is that the use of an institutional setup for EE lending in public funds by CFIs will be directed by their partner banks, introducing loan products own commercial objectives rather than by the different from conventional practice wider public policy objectives underpinning the based on corporate assets and facilitate original provision of public funds. While out- access to finance for key market players – right redirection or misuse of funds is unlikely, ESCOs – through technical assistance for the example of China’s Utility-Based Energy building their capacity and by brokering Efficiency Finance (CHUEE) Program shows relationship with banks. how the conflicting objectives might make However, according to IEG’s public financing less effective than expected Evaluation of the Program, there are (see box 4.2). areas of improvement to increase the CFI procurement and accounting proce- level of additionality. The review found dures may also not comply with public sector that the Program should have focused requirements. In this case, much of the advan- more on market segments that did not tage of using CFIs to reduce administrative have access to other forms of energy costs may be lost, as the CFIs will need to learn efficiency finance already in place in these new procedures and to ensure that lend- China. In particular, it had focused ing of public funds follows them—effectively on large enterprises (cement, steel, separating these from the CFI’s own commer- chemicals factories) rather than the cial lending. SMEs, housing and commercial buildings Another risk is that CFIs become unnec- that were originally envisaged as targets essarily reckless in their lending, if they only recipients. IFC has launched in 2011 a bear a small part of the total risk of default. new CHUEE SME program targeting EE The CFIs then face a situation where there is a SME lending only. potentially high upside if the project is viable Source: Case study #9: China—Utility-Based Energy but only a limited downside risk it if defaults. Efficiency Program. If there is pressure on the CFI to disburse funds rapidly, as is often the case with public financ- ing, then this danger is intensified. THE ROLE OF FINANCIAL INTERMEDIARIES 31 The reverse to this risk is that CFIs will BOX 4.3  INDIA RENEWABLE fail to disburse public funds at all. It is possible ENERGY DEVELOPMENT that they may decide that the limited returns AGENCY (IREDA) available on lending to RET projects do not justify the additional costs and risks, particu- The IREDA provides an excellent larly where they need to develop new skills and example of a specialized intermediary. institutional capacity to appraise such loans. It was established as a government- Finally, it will inevitably be impossible to owned corporation in 1987, specifically involve all potential CFIs in a program of public to finance renewable energy projects. Up financing of RET projects. While this can create to 2003 the IREDA had funded around 30 competition among CFIs to manage such a pro- percent of all RET capacity installed to gram, it can also create significant risks that date. The IREDA receives funds from of market distortion. Selected CFIs are likely, a variety of international organizations if the program is working well, to develop as well as from the Government of skills and experience in RET lending that their India and its own borrowing (using competitors cannot match and, consequently, tax-free guaranteed bonds with a 7-10 to leave them with significant market power year tenor). Its nonperforming loan gained, in part, from public funding. The performance compares well with other involvement of multiple CFIs in a financing Indian lending institutions. In the longer program can mitigate this risk, but at the term, it is unclear whether the IREDA cost of reducing the resources available to can continue to effectively compete any one CFI, making the program less with commercial banks entering the attractive to them. RET market or whether it should refocus its activities to that of sourcing wholesale funds to be invested by other 4.2 FUNDS AND OTHER intermediaries and to providing risk SPECIALIZED INTERMEDIARIES guarantees. The alternative to using CFIs is to use a fund or Source: Case study #7: India—Renewable Energy Development Agency. other specialized financial intermediary—either an existing fund whose remit includes or can be extended to include RET projects or a new fund established specifically for this purpose. funds, if publicly owned commercial banks do While the use of CFIs is generally preferable, not exist or are not suitable intermediaries. it will frequently be unfeasible. Perhaps the Where a fund is established, sustainability most common reasons are that: (i) CFIs lack must be the key consideration. This will argue interest in lending to RET projects even where for the use of an existing fund where possible— public funds are available; (ii) particularly in as the fund’s continuing activity is not then the smallest economies, CFIs lack the financial dependent on a single sector or a single source and institutional capacity to implement any of financing. Where a fund is established large-scale lending program using public funds; specifically to support RET projects then efforts or (iii) the transactions costs of lending to RET must be made to obtain sources of contribu- projects—particularly for off-grid systems—are tions in addition to the original public financing so high as to make lending at any reasonable source. Failure to do so creates a high risk that cost nonviable for CFIs. It is also possible that the fund will largely cease active operations as legal restrictions on the use of public funds and when the original financing ends. While by private organizations may force the use of structuring a fund on a revolving basis (so that 32 FINANCING RENEWABLE ENERGY repayment of the original principal used to Government-owned funds also frequently establish the fund is not required and, instead, suffer from a lack of institutional capacity. repayments from RET borrowers are used for Remuneration is often low compared to that future loans) can, in principle, ensure a con- offered by CFIs and opportunities for career tinuing stream of income, the annual lending progression limited, making it difficult to attract capacity is inevitably reduced from the size of and retain qualified staff. There is also the risk the original financial contribution. Unless this of political interference with the fund’s opera- original contribution is, therefore, extremely tions, to favor particular developers, technolo- large or it is used to mobilize additional sources gies, or project locations. of finance channeled through the fund, the A summary of the pros and cons of using loan program of the fund will inevitably shrink CFIs or specialized funds as financial intermedi- substantially. aries is presented in appendix 3. S E L E C T I N G T H E A P P R O P R I AT E FINANCING INSTRUMENTS 33 5 Selecting the Appropriate Financing Instruments A lthough some financial instruments are clearly better than others for addressing specific barriers and risks to scaling up the That appendix cross-references the individual barriers and risks described in chapter 2 with the financial instruments discussed in chapter deployment of renewable energy technology 3 (and several of the financial intermediaries (RET), no simple or mechanical linkage can be discussed in chapter 4). The appendix is an made from barrier or risk to instrument and extension of figure 3.1. vice versa. More than one instrument may be Appendix 4 also identifies the case suitable for addressing an individual barrier studies (as numbered in appendix 1) that or risk, while a single instrument may be able are most relevant for each instrument. to mitigate or overcome multiple barriers and Detailed case study write-ups can be accessed risks. The barriers and risks are also unlikely at www.worldbank.org/energy/refine. to occur in isolation from one another—gener- These case studies are provided as ally, multiple barriers and risks will exist, and examples of good practice in the use of the a package of instruments will be needed to instrument concerned. Given that the circum- address them. The selection of instruments will stances of each country and project are unique, also depend on the environment within which it should not be assumed that the case study they are to be implemented and the specific can be directly applied to any individual situa- nature of the RET projects concerned. tion. Instead, the case studies are intended to This paper does not, therefore, attempt to illustrate possible approaches that might be fol- provide a definitive answer as to which instru- lowed as a basis for the design of an appropri- ment to use when—this would be an impos- ate instrument. Further literature on individual sible task. Instead, an illustrative indication case studies provides additional information to of which instruments can be applied to which assist in this process. barriers and risks is provided in appendix 4. 34 FINANCING RENEWABLE ENERGY MAKING IT WORK 35 6 Making it Work T he best-designed financial instruments will be ineffective in delivering a scal- ing up of renewable energy technology (RET) of these may be the most effective in terms of managing any individual instrument, but is also time consuming and runs the risk of fragment- deployment if this is not supported by the ing institutional arrangements with multiple wider enabling institutional, legal, and regula- agencies providing financial support through tory environment. This chapter discusses this different instruments using funds from wider environment. It is not the intention of different sources. this paper to define how this wider environ- In some instances, limitations on insti- ment should look and what steps should be tutional capacity may help determine the taken to enhance it; these topics are covered appropriate instruments to use. Where these in many other sources. Readers are referred, limitations are severe and improvement is in particular, to the Renewable Energy Toolkit unlikely or will only take place over a extended jointly developed by the World Bank and period, then it makes sense to bias the selection Energy Sector Management Assistance Program of instruments toward those that are simplest (ESMAP). Instead, this chapter looks briefly at to implement, and that can be implemented on the prerequisites for the application of different a one-off basis with external assistance rather financial instruments. than requiring ongoing management by local institutions. For example, a capital grant might be favored as an instrument that can be rapidly 6.1 INSTITUTIONAL CAPACITY delivered, with the help of external advisors working to identify appropriate recipients. Perhaps most obviously, the use of publicly Once the grant has been made, of course, it funded financing instruments requires that is no longer necessary for public agencies to public agencies have the institutional capacity continue to administer it. But they would be to manage such instruments in an effective and expected to monitor the performance of RET transparent manner. Institutions must be able projects receiving the grant, to gather evidence to effectively plan and prepare RET projects on its effectiveness and to help design future and programs for support, to implement instru- interventions. ments in a timely manner, and to follow all nec- An underlying assumption of this paper essary procedures and regulations (particularly is that a basic level of institutional capacity where donor funds are involved). exists. In the smallest and most fragile states, It may be possible to use commercial this may not be the case. Institutions may have financial institutions (CFIs) to deliver the limited functionality and may lack competent instruments (as discussed in chapter 4). If staff—or, indeed, any staff. In such cases, rapid this is not possible and if existing agencies adoption of financial instruments to support lack this capacity, it will be necessary to build scaling up RET deployment is unlikely to be it—either through support to existing agen- effective. Instead, initial efforts and external cies, the creation of new project management financial support should be directed to building offices (PMOs) within existing agencies, or the up capacity to a level where domestic institu- establishment of new agencies with a specific tions can manage a limited program of support remit to manage these instruments. The last to RET projects and programs. 36 FINANCING RENEWABLE ENERGY BOX 6.1  POLICY FAILURES IN HONDURAS In June 2007 the president of Honduras declared an “energy emergency.� Inadequate generating capacity, growing demand, a reliance on imported oil and diesel at a time of rising prices, high levels of system losses, and tariffs below costs all combined to leave the state utility, Empresa Nacional de Energía-Eléctrica (ENEE), unable to meet demand, even as it was losing money at an unsustainable rate. An intervention board was created, headed by the ministers of finance and defense, and a new energy commission to direct policy was established in 2008. The crisis had multiple causes, but a significant contributing factor was the failure of the policy and regulatory framework to deliver clear and consistent outcomes. Policy making in principle was undertaken by the relevant ministry and an Energy Cabinet, while regulation was the responsibility of an independent agency, Comisión Nacional de Energía (CNE). In practice, the lack of technical capacity and resources in both the Cabinet and CNE, and a lack of political commitment to CNE, led to ENEE being the de facto planner and advisor for the power sector. While private investment in generation did occur, delays in contracting, uncertainties in policy making, and the inability to raise tariffs to cost-reflective levels also led to developers favoring diesel generation, which could be installed rapidly, had low capital costs, and could be redeployed if necessary, despite the abundant renewable energy resources in Honduras. Reliance on such high-cost generation was, of course, one of the reasons for the ENEE’s financial crisis. Source: Honduras Energy White Paper, Institute of the Americas (2009); Honduras Power Sector Issues and Options, ESMAP (2010). 6.2 POLICY AND PLANNING will similarly be coordinated to avoid overlaps FRAMEWORK and gaps. This may be particularly challenging where responsibilities for RET projects are split The use of publicly funded financial instru- between national, regional, and local levels. ments to support large-scale deployment of RET An accompanying regulatory framework needs to be underpinned by an effective policy needs to be put in place. In particular, this and planning framework. Without this, there is will emphasize the use of appropriate support a high risk of funds being directed to ineffective mechanisms for RET projects. or wasteful uses. An effective policy and planning frame- work will identify which RETs are to be pur- 6.3 SUPPORT MECHANISMS sued, based on analysis of the relative costs and resource availability, the potential for scaling Support mechanisms for RET projects take up, and identification of priority technologies. many forms. For the purposes of this paper, Projects for support will be well defined discussion is limited to the use of mechanisms and realistic. Support will be coordinated and designed to ensure access to a viable market for duplication of effort avoided where possible these projects. Without this access any finan- (for example, where multiple competing public cial instrument is unlikely to be effective as it and donor-funded activities exist side by side). cannot, on its own, overcome the inherent cost The activities of different domestic institutions disadvantage of RETs. MAKING IT WORK 37 On Grid BOX 6.2  BIOENERGY FEED-IN TARIFFS IN SRI LANKA The key barrier to RET projects in accessing markets is their higher costs relative to other Sri Lanka has set a target of 10 percent technologies. There are two basic mechanisms of grid electricity to be supplied from to delivering subsidies to RET projects to RET sources by 2015. In support of this, a overcome this cost disadvantage.6 The first is three-tiered feed-in technology-specific to pay RET projects a guaranteed feed-in-tariff tariff for electricity sold to the state utility, (FIT) set at a level adequate to recover their the Ceylon Electricity Board (CEB), was costs (generally on a technology-by-technology introduced in 2008. The CEB has an basis). To ensure that projects are able to sell obligation to purchase all power sold their output at this tariff, they are given priority from RET sources with the difference dispatch rights and a must-take obligation is between its own costs and the FIT being imposed on power purchasers, requiring them made up by the government. to buy output from RET projects. To date, only two significant biomass The second basic mechanism is the use of projects totaling 12 megawatts (MW) a renewable portfolio standard (RPS). In this have been developed under the FIT. case, energy suppliers are obliged to purchase The first grid-connected biomass project a minimum share of their needs from RET in Sri Lanka is no longer operating. This is sources. Failure to do so attracts a penalty, reportedly because it was unable to take common across technologies.7 The existence advantage of the FIT due to the slowness of this penalty allows RET projects to charge a of the administrative process higher price than other technologies and still be to approve this. competitive, as long as the share of RET output But there has been more success with remains below the minimum established under small hydro and wind projects. Sri Lanka the RPS. has two decades of experience with There are obviously many variants on and small hydro projects and there are now combination of these basic mechanisms. In well-developed market chains in place. general, the experience has been that FITs are Wind projects, meanwhile, benefit from more effective at mobilizing RET investment a high FIT and the interest of a number but can also be significantly more expensive as of Sri Lankan corporations. As and there is no limit on the quantities of RET capac- when experience and domestic interest ity added to the system and, therefore, the total develops in biomass projects, similar costs incurred under the mechanism. This has success may be seen. The experience to been a problem in recent years in a number of date demonstrates the importance of the wider environment and the inadequacy 6 In some countries, RET projects receive a tariff based of setting a FIT alone. on the avoided costs of the electricity utility, which may or may not include an allowance for carbon costs and other Source: Case study #17: Sri Lanka—Renewable environmental damages. This is not considered to represent Energy. a subsidy to RET projects as it does not compensate them for costs above those of other technologies and is not discussed further in this paper. 7 This has proven to be a concern in the United King- dom, as it inevitably leads developers to focus on the lowest- European countries including Germany, Spain, cost RET (onshore wind). While this is an efficient outcome, it runs contrary to government objectives to promote a range and the Czech Republic, which have all been of RETs. This has been addressed by providing extra credits forced to reduce the level of FITs offered to under the RPS for higher-cost RETs, which are then able to earn additional revenues by selling these credits at the pen- solar projects in particular due to affordability alty price. concerns. The use of a RPS avoids this problem 38 FINANCING RENEWABLE ENERGY but can lead to unit costs that are higher than Off Grid FITs, as the subsidy provided is not as well targeted, and so low-cost RET projects can For off-grid RET projects, the need for support earn the same subsidies as higher-cost projects. mechanisms is somewhat different. High costs There is also the problem of the “cliff-edge� remain a barrier and can be overcome through effect where, as the level of RET output nears well-designed grants and subsidy mechanisms. the RPS requirement, the value attached to Small market sizes and project scales are also purchasing additional RET output collapses to barriers that can be mitigated through well- zero. In some cases, FITs have been combined designed financial instruments, including with a quota on the quantity of RET generation through aggregation and potentially the use eligible for these tariffs, but this requires some of results-based financing (RBF) instruments mechanism to efficiently allocate the rights to such as those that attempt to mimic Advanced participate in this quota. Market Commitments (AMCs). But there are There are also additional requirements if other barriers that financial instruments cannot these mechanisms are to be effective in their effectively address. In particular, these include application. Most obviously, the purchasers or the need to ensure that off-grid supplies are not off-takers of output from RET projects must be overtaken by grid extension. Where grid exten- sufficiently creditworthy to credibly commit to sion is likely to take place, the effects are two- the additional costs of these purchases com- fold. Potential users of off-grid RETs will prefer pared to conventional technologies. This may to wait for the grid, which is generally seen as require further financing mechanisms to be put a superior technology. And where investments in place, such as levies on electricity custom- are made in off-grid RET equipment, then this ers, which can be used to compensate off-takers may become “stranded� if the grid reaches that for these additional costs. Additionally, these location acting as a significant deterrent to sup- mechanisms rely heavily on the concept of pliers and users to invest in this equipment. priority dispatch for RET projects, which means For household-level systems, in particu- that these projects must have guaranteed access lar, a further barrier that cannot be directly to transmission and distribution networks, if addressed through financial instruments is such priority dispatch is to be meaningful. As uncertainty over the safety and longevity of many RET projects are located in remote areas, RET equipment. This uncertainty can lead to the costs of providing such guaranteed access potential users being unwilling to make large can be considerable and, if recovered from RET payments for equipment—particularly where projects alone, may well make them nonvi- they are unable to tell apart low- and high-qual- able. In such cases, mechanisms to fund the ity equipment. The regulatory framework can necessary network extensions and reinforce- help to overcome this by setting and verifying ments from other sources, including electricity technical specifications for equipment. RBF sys- customers generally, will be required. tems that require appropriate warranties from suppliers as one of the “outputs� used to trigger a payment have also worked effectively. REFERENCES AND FURTHER READING 39 7 References and Further Reading P lease refer to www.worldbank.org/energy/refine for an up-to-date list of references and further reading. This Web site can also be accessed for full write-ups of case studies and financial instruments. 40 FINANCING RENEWABLE ENERGY Appendix 1  List of Initial Case Studies REFERENCE TITLE 1 Thailand—Energy Efficiency Revolving Fund 2 Ukraine—Sustainable Energy Lending Facility 3 Central America—E+Co CAREC Mezzanine Finance Fund 4 Macedonia—Sustainable Energy Financing Facility 5 Uganda—West Nile Rural Electrification Project 6 Nepal—Power Development Project 7 India—Renewable Energy Development Agency 8 Philippines—Grid-connected Solar PV—Hydro Hybrid Demonstration 9 China—Utility-based Energy Efficiency Finance Program 10 Hungary—GeoFund 11 Uruguay—Wind Energy Program 12 India—Solar Loan Program 13 Bangladesh—Solar home program on Credit Sales 14 Africa—Africa Carbon Support Program 15 Sri Lanka—Power Fund for the Poor 16 Rwanda—AMCs for Rural Energy 17 Sri Lanka—Renewable Energy 18 Asia—ADB Clean Energy Private Equity Investment Funds 19 Burkina Faso—Rural Electrification Program 20 Egypt—NREA Wind Farms Financing 21 Central and Eastern Europe—Commercializing Energy Efficiency Finance (CEEF) 22 Thailand—Biomass Generation and Cooperation 23 Chile—Chilean Economic Development Authority Credit Lines 24 Philippines—Leyte Geothermal Partial Credit Guarantee 25 China—Wind Reinsurance Facility for China 26 Global—insurance4renewables 27 India—ICICI Securitization of SHARE Micro-Credits 28 Global—Carbon Partnership Facility 29 India—IFC Rain CII Carbon Ltd 30 Tunisia—Solar Water Heating Equipment Finance Program 31 Indonesia—Small Hydropower 32 Bolivia—SHS Medium-Term Service Contracts 33 Laos—Nam Theun 2 Project APPENDIX 2  SUMMARY OF FINANCIAL INSTRUMENTS 41 Appendix 2  Summary of Financial Instruments INSTRUMENT USES PROS CONS Grants Capital grants Reduce project Relatively simple to High risk in terms of costs and provide long- implement. achieving objectives term finance. as they do not create Does not require ongo- incentives for delivery. ing administration. If grants are made in return for equity then the public sector gets control of the projects, which may lead to poorer performance and crowd out private financing. Low levels of lever- age as grants directly replace possible private financing. No return on capital that could be used to finance further projects. Project preparation Fund preinvestment grant costs. Equity Venture capital Funds preinvestment Can pay for itself. High returns costs as risk capital. Potential gains to are required to be realized are a strong compensate for risk. incentive for project Although public viability. financing can accept lower returns, it reduces incentives and makes it harder for private providers of equity to compete. Low levels of leverage as it directly replaces possible private financing. Developed financial markets are needed to allow exit from the investment through an initial public offering (IPO) or a direct sale of shares. (continued on the next page) 42 FINANCING RENEWABLE ENERGY INSTRUMENT USES PROS CONS Debt Senior debt Reduces project costs. Obligation to repay Need for due diligence creates incentives for to verify ability of Provides long-term project viability. project to repay loan finance. increases transaction Repayment of principal costs. frees funds for further support to renewable Leverage is limited and energy technology may crowd out poten- (RET) projects. tial private providers of debt. Can be used as a means to increase commercial financing institution (CFI) involve- ment in RET projects (through provision as credit lines). Subordinated Provides intermediate High level of leverage. Generally custom debt (mezzanine funding between equity designed for each Can crowd in senior finance) and senior debt, which project, implying high debt by allowing proj- is able to reduce risks transaction costs. ects to meet accept- to senior lenders while able risk criteria for Significant risk is not taking control away lenders. transferred to public from project sponsors. financing agencies but By doing so, the term with only limited ability can be extended and to control these risks. costs of senior debt reduced. Asset-backed securities Asset-backed Project financing Longer tenor and pos- Sophisticated markets securities through bond offerings sibly lower cost than are required to be able rather than loans. bank financing. to analyze and price the risk associated with Refinancing of wwcom- Ready means to refi- this type of security. pleted projects to nance projects, freeing free public funds for developer funds for future RET project further investments. development. Potential to bundle projects together in a single security can reduce risks and, there- fore, financing costs. A good industry for advancing capital mar- kets, given that some RETs have guaranteed off-take and hence lower risk. APPENDIX 2  SUMMARY OF FINANCIAL INSTRUMENTS 43 INSTRUMENT USES PROS CONS Guarantees and insurance Individual Guarantee a part of Specific risks deterring Generally custom guarantees the losses incurred by private investment can designed for each a project in the event be targeted, thereby project, implying high of a specified event minimizing the risk transaction costs. occurring. of market distortions Significant risk is and being an effective transferred to public means of crowding in financing agencies but private investment. with only limited ability A high degree of lever- to control these risks. age can be achieved Appropriate accounting as a relatively small for and approval of the commitment of funds resulting contingent can mobilize significant liabilities is required, quantities of private which may be compli- investment. cated by difficulties in Lack of need to make assessing the associ- a large up-front pay- ated risks. ment can make it easier Ability to avoid up-front to obtain political funding may encour- approval. age excessive use of guarantees for political reasons and for favored projects. Liquidity Guarantee ability to guarantees meet commitments on debt service/financing. Political risk Guarantee of policy insurance (PRI) / and regulatory com- partial risk mitments by host guarantee (PRG) government. Resource insurance Insures against lost Can be targeted on Large number of revenue in event of specific risks deterring projects with diversity lower-than-expected private investment, of locations is required output due to lack of thereby minimizing for the insurer to be wind or sun (wind / the risk of market able to diversify their solar insurance). distortions and being risk exposure away an effective means of from any one project. Insures against costs of crowding in private failed exploratory wells Large database of his- investment. (contingent risk insur- toric performance for ance for geothermal A high degree of lever- insurers to be able to projects). age is achieved as a assess and price risks. relatively small com- For these reasons, it mitment of funds can either needs multina- mobilize significant tional insurers or large quantities of private and sophisticated investment. domestic financial markets combined with large volumes of exist- ing RET projects. (continued on the next page) 44 FINANCING RENEWABLE ENERGY INSTRUMENT USES PROS CONS Results-based financing (RBF) Payment against Pay grants or subsidies Linking payment of The need for up- outputs against the delivery grants and subsidies to front financing by the of a specified set of results creates strong developer means that outputs. incentives on develop- RBF doesn’t necessar- ers to deliver. ily overcome financial For RET projects, markets barriers and grants and subsidies Crowding out effects it may be difficult to are used to reduce the limited, as develop- obtain loans against costs. ers must still arrange expected future grant a large part of the up- payments. front financing. For small-scale proj- ects, the costs of verification can be extremely high. Without careful defini- tion of the required outputs, incentives can be distorted. Contingent project Provide preinvestment Can leverage private Use of loans that can development funding, either as loans financing by allowing be converted to grants grants that turn to grants if development of proj- increases risks to devel- project successful or ects to a stage where opers if the project is grants that turn to private investors are unsuccessful. loans. willing to participate. Use of grants that can Use of loans that can be converted to loans be converted to grants can reduce incentives provides incentives to to complete projects of developers to com- marginal viability. plete projects in a timely fashion. Use of grants that can be converted to loans means the developer is more willing to take on marginal projects, knowing that the costs of preinvestment activities are covered if unsuccessful. APPENDIX 2  SUMMARY OF FINANCIAL INSTRUMENTS 45 INSTRUMENT USES PROS CONS Carbon financing Carbon financing Allows projects to Means of obtaining Only a small number access expected up-front financing of potential buyers of revenue streams from secured against carbon CERs exist. Certified Emissions revenues (that is, Transfers significant Reductions (CERs) project financing). risk to the public ahead of commission- Used to refinance financing agencies if ing or at the start of projects, thus freeing purchases are made operations. up resources for ahead of project development of new registration (under the projects. Clean Development Mechanism, CDM) or if carbon revenues are uncertain. Process of realizing carbon revenues can be complex and costly, particularly for first-of-a-kind projects and reliance on these may delay project development substantially. Financing only incremental cost. Small-scale project financing Microfinancing Provides customers Allows RET developers Microfinance with credit to purchase to receive payment on institutions (MFIs) may RET hardware (typically installation of systems, not be operational solar home systems, reducing need for or may be unwilling SHS) up-front financing to lend for purchases of RET hardware as loan terms are longer than typical MFI loans and dependent on household incomes rather than revenue generation for repayment Transactions costs are high, although MFIs are able to reduce these compared to alternative financing arrangements Still requires RET developer to find significant working capital to fund initial purchases of RET systems ahead of first sales (continued on the next page) 46 FINANCING RENEWABLE ENERGY INSTRUMENT USES PROS CONS Portfolio Guarantee a part of By grouping projects, Large number of similar guarantees and the losses incurred by the reserves required projects is required to loss reserves a portfolio of similar against default can be be effective projects in the event reduced as a result of Project developers of a specified event diversification of risk may include occurring compared to individual inappropriate projects guarantees, allowing into the portfolio, a greater degree of increasing the risk leverage exposure of public Transactions costs financial agencies for each project are Ideally requires good reduced as for any database of similar project meeting the projects to be able to required criteria can be assess risk of guaran- included in the guaran- tee or reserves being teed portfolio utilized As with other guaran- tees, requires good accounting of contin- gent liabilities and may create scope for abuse Sophisticated institu- tional capacity required to manage such a program Aggregation Reduces transactions Transactions costs Large number of similar costs by bundling for each project are projects required for it together similar proj- reduced as the stan- to be effective ects that use stan- dardization of docu- Commitment on part dard contracts and mentation means rapid of developers, off- specificationsw review is possible takers, and financiers is required not to seek to amend standard documents A P P E N D I X 3 S U M M A RY O F FINANCIAL INTERMEDIARIES 47 Appendix 3 Summary of Financial Intermediaries INTERMEDIARY MAIN FEATURES PROS CONS Commercial financial Public funds are chan- Existing capabilities Use of funds driven by institutions (CFIs) neled through one or in due diligence and CFI commercial objec- more CFIs. administration of tives, not public policy loans and guarantees objectives. CFIs are responsible products. for due diligence and Procurement pro- management of funds. Established net- cedures may not works to identify and meet public sector work with project requirements. developers. CFIs may make overly Can complement risky investments as public funding their share of losses is from its own finan- limited. cial resources, thus CFIs may not disburse increasing leverage. funds due to high Can be used to build associated costs and up CFI experience risks/ with renewable energy Can distort the market technology (RET) by favoring some CFIs projects. over others. Specialized funds Public funds are May be only means to Sustainability is prob- channeled through overcome lack of CFI lematic—particularly if a government- interest. dependent on a single owned specialized time-limited financing Can develop spe- intermediary. source. cialized skills in RET The intermediary project appraisal and Difficult to attract and may be specifically financing. retain qualified staff. established to pro- Risk of public mote RETs or have interference. a more general remit (for example, Potential crowding out electrification). of CFIs. 48 FINANCING RENEWABLE ENERGY Appendix 4 Financing Instruments Appropriate for Addressing Financing Barriers and Project Risks (and Numbers of Pertinent Case Studies from Appendix 1) FINANCING BARRIERS PROJECT RISKS High and uncertain project Uncertainty over resource Lack of project financing Uncertainty over carbon High costs of resource Small scale of projects Lack of equity finance development costs High financial cost Lack of long-term High exposure to regulatory risk assessments adequacy financing financing Financing instruments Grants Capital grants 3 3 3 3 Project 3 3 3 3 3 preparation Equity Venture capital 3 3(18) 3(18) 3 Debt 3 3 Senior debt (1, 2, 3 (1, 2) 6, 20) Subordinated debt 3 3 (3) 3(3) (mezzanine (3, 4) (3, 4) finance) Asset-backed securities Asset-backed 3(27) 3(27) 3 securities Guarantees and insurance Individual 3(21– 3(9, 3(21, 3 3 3 3 guarantees 24) 23) 23) Liquidity 3(5) 3 3 3 guarantees Political risk insurance / 3 3 3 3 3(33) Partial risk guarantee APPENDIX 4  FINANCING INSTRUMENTS 49 FINANCING BARRIERS PROJECT RISKS High and uncertain project Uncertainty over resource Lack of project financing Uncertainty over carbon High costs of resource Small scale of projects Lack of equity finance development costs High financial cost Lack of long-term High exposure to regulatory risk assessments adequacy financing financing Financing instruments 3(11, Resource 3(10) 25, insurance 26) Results-based financing Payment against 3 (32) 3 outputs Contingent project 3(8) 3 3 development grants Carbon financing 3(14, Carbon 3 3 28, financing 29) Small-scale project financing 3(12, 3(12, 13, 13, Microfinancing 3(16) 15, 15, 16) 16) Portfolio guarantees 3 3 3 3 3 3 3 and loss reserves 3(17, Aggregation 30, 3 31) Financial intermediaries (17, CFIs (17) 19) Funds (7) (7) Source: Authors. 50 FINANCING RENEWABLE ENERGY