Aug-2024

Powering tomorrow: Financing the energy transition

Governments, private investors, and lenders all have important roles to play in commercialising emerging energy transition technologies.

Rishabh Agarwal, Joe Selby and Conrad Woodring
Bechtel

Article Summary

The pressing need to address climate change is forcing us to rethink how we produce and consume energy. Renewable electricity sources such as solar and wind technologies are leading the way in decarbonising our economy. From 2010 to 2022, global installed solar capacity increased 25-fold (ourworldindata, 2023) while wind capacity grew five-fold (ourworldindata, 2023b), (Lazard, 2021). This rapid scale-up and commercialisation was made possible largely due to supportive regulatory policies, which allowed this market sector to develop. In turn, this rapid development has led to an enormous improvement in levelised costs, making wind and solar economically viable.

Unfortunately, renewable energy has limits and cannot alone fulfil the Paris Agreement’s ambitious net zero by 2050 target. Of the nearly 35 billion tons of CO₂e (total CO₂ and CO₂ equivalents for other greenhouse gases [GHGs]) emitted in 2020 (ourworldindata, 2024a), only ~45% originated from burning fossil fuels for heat and electricity production (ourworldindata, 2024b). The remaining emissions arise from activities such as transportation, manufacturing, and agriculture. Eliminating these emissions will require a comprehensive set of emerging technologies, including renewable and low-carbon hydrogen, biogenic fuels, energy storage and carbon capture, collectively called energy transition technologies.

However, energy transition projects are largely based on unproven technologies and/or relatively nascent markets. For example, hydrogen electrolysis has never been deployed on a large scale or run exclusively on renewable energy. As a result, securing the financial backing to commercialise these technologies and construct commercial-scale facilities is a significant hurdle. Estimates suggest that a massive $75 trillion (ourworldindata, 2024b) of investment, or 50x the UK government’s spend in 2022-23 (IFS Taxlab, 2024), is required for the global economy to reach net zero emissions by 2050. With such formidable capital requirements, effective policy frameworks and risk mitigation strategies that support and enable large-scale energy transition projects are crucial to de-risk and attract capital to projects. In this article, we delve into the complexities of financing energy transition projects and the roles of different entities, from governments to commercial banks to EPC companies.

Financing avenues
Commercialising emerging energy transition technologies requires a range of capital sources, each playing a unique role in supporting the energy transition. Early-stage technology development is typically funded through high-risk venture capital investments, internal R&D budgets of private sector companies ranging from Alphabet to Shell, and government grants such as the US SBIR/STTR programme (SBA, 2024). Such capital sources are vital for driving innovation and maturing energy transition technologies from the lab to the field.

Once these technologies are successfully field-tested, they become ready for scaling up, establishing manufacturing capabilities, and market adoption. Building out the infrastructure requires capital several orders of magnitude greater than for early-stage funding. To secure the necessary capital, energy transition project developers or sponsors often turn to multinational corporations, private sources, public funds, and commercial banks.

Private sources
Energy multinationals and others raise capital by issuing equity or borrowing against their balance sheets. This approach allows them to leverage their financial muscle, accelerate transaction speed, and spread all the risks of an individual technology over a large global asset portfolio. Additionally, private equity (PE) funds such as CIP and BlackRock can invest significant capital amounts for proven technologies. In 2023, venture capital (VC) and PE funds alone contributed nearly $50 billion towards advancing the energy transition (BloombergNEF, 2024). Additionally, privately owned energy transition technology companies can access capital markets by raising an initial public offering (IPO), which could help finance technology or project development.

Public funds
Governments can support energy initiatives through various means such as grants, tax credits, low-interest loans, and sovereign loan guarantees. These public avenues help de-risk emerging technologies, which makes projects more attractive to investors. For example, the US Department of Energy’s Loan Programs Office was authorised to underwrite up to $400 billion in loans (Plumer & Friedman, 2023) for energy transition projects. Public funds also play a role in making clean energy more accessible. The Green Climate Fund, created by the UN in 2010, is focused on directing resources to developing countries, supporting them in reducing emissions and adapting to climate change (Green Climate Fund, 2023).

Project financing
The bulk of the $75 trillion required to achieve net zero by 2050 will likely come through debt offerings from commercial banks. Commercial banks differ from other private investors, such as energy majors and PE funds, as they typically have a significantly reduced risk appetite. A commonly used approach by banks to finance large infrastructure projects is called project financing.

Project finance is typically characterised by non-recourse lending, where the creditworthiness of the project, rather than that of the project’s owners, is used to determine financeability. This approach democratises access to capital and reduces barriers to entry for smaller developers, which can lack the financial strength of large companies. In order to lend to a project, banks need to get comfortable with key factors such as the project’s costs, certainty of product offtake, operational performance, environmental and regulatory approval process, technological readiness, and the EPC contractor’s reputation. Collectively, these elements constitute the ‘bankability’ of a project.

However, crafting a project finance deal is a complex endeavour. Project developers must negotiate across multiple parties, such as lenders, operators, insurers, contractors, suppliers, and even governments, to allocate risks equitably. This requires a rigorous feasibility and risk analysis to determine which party is best suited for each risk. The complexity can be better understood by a chart (see Figure 1) that maps out the intricate web of relationships needed to execute a standard project financing transaction.

A project finance transaction typically starts with the developer setting up a special purpose vehicle (SPV). This SPV then executes agreements with various stakeholders, including the engineering, procurement, and construction (EPC) contractor, a product offtake agreement with the product purchasers, a feedstock agreement, and so on, to distribute various project risks. A successful project finance transaction tries to balance the risks and rewards while aligning incentives for all participants.

In addition to large commercial banks, a project can also raise project finance debt through taxable or tax-exempt bonds, export credit agencies (ECAs), multilateral agencies, private placement debt, and other sources of funds. Furthermore, debt providers also require a project to raise equity, which can come from energy companies, strategic investors, investment funds, operators, off-takers, and even host governments. Different funding sources are essentially different ‘capital pools’ with different risk appetites and eligibility requirements. Large projects often raise money from a wide spectrum of financial institutions and stakeholders to achieve financial close.