As mentioned in "Why investors retreat from US and European offshore wind sector?", 70% of the financing in offshore wind and many other renewable energy projects come from bonds. As free interest rates rise, wind farms will have to bear higher interest costs. This article explores reasons why low interest rates are conducive to renewable energy development and how higher rates challenge wind farm financing.
How lower rates attracted capital to the renewable energy industry?
Since the 2008 financial crisis, the world had remained in a low-rate environment for 14 years. The benchmark interest rate in the U.S. was only slightly higher than 2% before the pandemic broke out in 2018, and the main refinancing operations (MRO) of the European Central Bank (ECB) sustained at 0%. Low interest rates squeezed the bank's profit from borrowing activity due to less interest from stable sources, such as government bonds and investment-grade cooperate bonds, forcing them to seek new loaners.
Renewable energy projects were considered a low-risk option that delivered a reasonable return. Although offshore wind construction was relatively difficult at that time, it was gradually maturing. According to WindEurope statistics, the gap in interest rates between the borrowing costs for offshore wind and the London Interbank Offered Rate (LIBOR) dropped from 325 basis points in 2011 to 150 basis points in 2019, an obvious indicator of the market’s confidence in the decrease of risks in offshore wind power investment.
Institutional investors (e.g. pension funds, sovereign wealth funds, and insurance companies) have been focusing on public utilities or transportation systems that provide continuous cash flows. With a pool of capital on hand, they invest in rarer targets but see inferior returns on investment (ROI). Therefore, they turn to alternative assets, including offshore wind power. which brings regular cash flows (some contracts for difference are coupled with CPI, mitigating inflation risk). Additionally, the huge funding gap of tens of thousands of dollars and ROI two times higher than that of conventional infrastructure construction attract myriads of institutional investors. For example, the Government Pension Fund of Norway, the world's largest sovereign wealth fund, purchased a 50% stake in Ørsted's Borssele 1 and 2 offshore wind farms in 2021, yielding a return rate of 5.1%.
To sum up, low interest rates are favorable to the development of renewable energy because renewable energy projects have high debt ratio, high capital expenditures (CapEx), and low operating expenditures (OpEx). High debt ratio allows renewable energy projects to reduce the overall weighted average cost of capital (WACC) by increasing leverage. In addition, renewable energy is in line with the ESG investment trend and has superior ROI than conventional targets such as infrastructures. High CapEx and low OpEx enable renewable energy projects to generate better returns than conventional energy projects in a low-rate environment. This is because the operating cost of buying fuels drives up the cost of conventional electricity generation, and the lower the interest rate, the lower the discount rate, making conventional energy projects less appealing to investors. Consequently, the levelized cost of energy (LCOE) of renewables is more susceptible to interest rates than fossil fuel energy. That is, renewable energy has higher interest rate elasticity than conventional energy. Therefore, a low-rate environment is more suitable for the development of renewable energy.
Impacts of high interest rates on offshore wind: higher capital costs and more uncertainties
Rampant inflation forces governments around the world to raise interest rates, affecting financing in the renewable energy industry. First, the cost of financing, whether through bonds or shareholder equities, will rise. Figure from WindEurope shows that when ECB's MRO maintained at 0% in 2018-2019, the cost of debt (CoD) of onshore wind energy struck below 4% in most countries, and as low as 0.8% in less risky markets, such as France and Germany. The cost of equity (CoE) came in at 4-13%, and Germany even had a record of 2.8%. Latvia had the highest CoD of offshore wind at 5.0%, while the UK had the lowest at 1.2%. Latvia had the highest CoE of offshore wind at 21.0%, while the Netherlands had the lowest at 5.5%.
The Fed is very likely to raise the terminal rate above 5%. To avoid capital outflows, central banks across the globe will try to reduce interest rate spreads, and the CoD and CoE will rise accordingly. By then, the high interest rate elasticity of renewable energy becomes a disadvantage as its LCOE will increase more significantly than that of conventional energy. Additionally, high interest rates will result in less capital supply, thus capital costs may rise faster than interest rates.
High interest rates may also slow down offshore wind development and energy transition. Higher interest rates mean: 1) investors and lenders obtain decent ROI in fields or regions they are familiar with, 2) in riskier regions and emerging markets, fundraising for offshore wind is more difficult, and 3) the ROI investors expect wind farms in developing countries to generate may increase faster than that in advanced countries, which is unfavorable to the investment of capital-intensive offshore wind farms in economically disadvantaged areas. Additionally, high rates increase financing costs of Feed-in Tariffs (FIT) and other subsidies, dampening the strength of the incentives.
Second, uncertainties during rate hikes will affect institutional investors' willingness to invest. Institutional investors, especially pension funds and insurance companies, are risk-averse. Currently, subtle risks of bank failures disrupt the pace of rate hikes of central banks, stoking uncertainty about future rate hike decisions. The interest rate elasticity of renewable energy is relatively high, and its sensitivity to rate changes amplifies the uncertainty brought by rate hikes, which is likely to dissuade risk-averse institutional investors, reduce the inflow of funds into the offshore wind industry, and underscore the advantage of developers with good balance sheets in wind farm financing.
Now is the first time for the offshore wind industry, even the entire renewable energy sector, to face a high-rate environment, where financing costs increase due to the end of excess capital supply. Still, most climate economists are optimistic about the impact of high interest rates on energy transition. According to a Reuters survey, 75% of the 68 respondents believe the impact to be mild. The main argument is that higher borrowing costs are only temporary, and current inflation rates in most economies are still higher than the benchmark interest rate, so the real interest rate is negative. Thus, renewable energy is not more expensive than fossil fuel.
Providing preferential interest rates for renewable energy is an option for the government to ensure sources of funding, accelerate carbon market improvement to facilitate manufacturers' energy transition, and bring more demand and liquidity to the PPA market to clear some doubts among institutional investors. Many developers choose to suspend development and wait for the pressure of inflation and rate hikes to ease or renegotiate PPAs. From developers to supply chain members, all parties are under the pressure of rising costs. The absolute annual declines in LCOE the industry expected are put to question.