Calculating The Risk Of Renewable Energy Investment

by Anandita Ketkar

The Importance Of Renewable Energy Investment 

To finance the renewable energy expansion, financial resources must scale to meet the challenge of scaling up investment in clean energy at three to four times its current level [1]. The diversity of investors in renewables has increased as returns from renewable energy financial assets are attractive; having stable cash flows and no fuel price risks, returns may be at best weakly correlated or entirely uncorrelated to those of the major asset classes [1].  For portfolio investors, this reduces measured risk of a given portfolio [1]. Hedge funds, private equity firms, insurance companies, pension funds and endowment funds are now regular participants in renewable energy investment as the energy sector now encompasses privatised companies, although state-owned companies remain tangible players [1]. 

Types Of Renewable Energy Investment 

As the diversity of investors in renewables has increased, there is a pre-existing range of investment opportunities in renewables:

1. Investors may buy shares in publicly traded renewable energy companies (equities).  
2. Investors lend directly to clean energy projects (fixed income).  
3. Investors have ownership in manufacturing and production facilities (real estate). 
4. Investors speculate on the price of outputs such as electricity, liquid fuel or emissions allowances (commodities) [1]. 

Thus, renewable energy is not an asset class in itself but is a sub-category within several asset classes [1]. The characteristic of investors having ownership in “real estate” offers lucrative opportunities: at times, this sub-category does not offer the necessary scale or liquidity that many investors need to adequately manage an investment portfolio, as the return on investment is capped by the size of a single project (e.g. an offshore wind farm) [1]. Asset backed securities (ABS) are financial assets whose income is generated from a collection of real assets [1]. The conversion of renewable “real estate” such as geothermal power stations, biofuel refineries and solar energy facilities into financial assets can be achieved through the mechanism of ABS [1]. Renewable energy assets may be used as collateral to create real estate investment trusts (REIT), C-Corporations (Yield Co) and sector-specific debt securities (e.g. climate bonds) [1]. 

Calculating Risk 

Investors use risk and financial return as their primary criteria for deciding whether to invest in renewables and other asset classes [1]. Asset pricing models are aimed at answering the question: does the price at which the asset is trading today offer a good prospect for capital appreciation? The Capital Asset Pricing Model (CAPM), used to calculate risk and financial return, encompasses a measure of investment risk which varies according to a single “Beta” term. The Arbitrage Pricing Theory (APT) places no restrictions on the number of risk factors to be used [3]. 

Renewable energy is distinct and consequently poses a direct competitive threat to the conventional utility business plan [2]. Calculating risk is inherently complex owing to the absence of fuel costs (with the absence of biomass), leading to complex price interaction with fossil fuel technologies in marginal cost-driven markets [1]. Renewable power sources generate commodities that may be costly to transport or store [1]. They comprise a broad range of unique technologies for which risk may be unknown [1]. Each technology is at a different level of commercial readiness and at a different level of reliance on centralised energy networks [1]. Non-fossil fuel projects are capital intensive, requiring much of the life-cycle investment costs to be made upfront, thus increasing the initial sunk cost risk on investment [1]. 

Nevertheless, numerous  factors alleviating renewable energy risk are emerging. Other than in India and China, large-scale green investments in the developing world are yet to achieve their full potential owing to regulatory volatility [4]. Larger Energy and Power (E&P) companies are familiar with managing risks in this terrain within the oil & gas sphere and their skills may be able to develop large scale renewable projects in complicated, higher-risk settings [4]. 

References:

[1] Donovan et al, 2015, Renewable Energy Finance: Powering the Future, Singapore: World Scientific Publishing Company, 9781783267781, https://www.google.co.uk/books/edition/Renewable_Energy_Finance_Powering_The_Fu/G923CgAAQBAJ?hl=en, accessed on 23/02/22[2] Gillis, J., 2014, “Sun and Wind Alter Global Landscape, Leaving Utilities behind”, 2014, The New York Times, https://www.nytimes.com/2014/09/14/science/earth/sun-and-wind-alter-german-landscape-leaving-utilities-behind.html , accessed on 23/02/22 [3] Ross, S. A., 1976, “The Arbitrage Pricing Theory of Capital Asset Pricing”, Journal of Economic Theory, 13, 341-360, https://doi.org/10.1016/0022-0531(76)90046-6 , accessed on 23/02/22[4] Financial Times, Big Oil can play big role in frontier markets’ energy transition,

  https://www.ft.com/content/90c4f600-b035-4800-be68-d28fd0c4e3ee, accessed on 23/02/22