Considering political risks when investing in renewable energy
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Considering political risks when investing in renewable energy
As the post-pandemic economic recovery focuses on “building back better”, many countries around the world are seeking to reduce the share of electricity generated from fossil fuels. At the same time, many investors are looking to make their portfolios more sustainable, and renewable energy source (RES) projects are perceived to offer such investment opportunities. This article looks at some of the key political risks associated with wind and solar investments and how investors can mitigate these risks at the different stages of their investment decision-making.
Investments in RES projects and companies are booming. The International Energy Agency forecasts 10% year-on-year growth in RES investments in 2021. Some estimates forecast more than USD 3.4 trillion new investments in renewables over the next decade, including USD 2.72 trillion in wind and solar. While regions dominated by developing and emerging economies attracted only around 15% of RES investment before the pandemic (see IRENA graph, below), over the next two decades these regions are expected to generate a larger share in additional renewable capacity than Europe and North America, according to the IEA.
Three factors are driving a rise in RES investments: demand, technology and values.
- As the global economy recovers from the pandemic, a combination of growing energy demand and increasingly more ambitious (and enforced) emissions reduction targets are encouraging renewable investments in advanced, emerging and even more frontier markets.
- Significant technological improvements have resulted in a dramatic reduction in the costs associated with green electricity. Further technological breakthroughs are expected in transportation and heating technologies and in the production of green hydrogen, thus improving the prospect of good investment returns. In many regions the cost of renewable energy is now below its fossil fuel-based alternatives.
- Public support for more decisive climate change mitigation action is changing consumer behaviour and increasing pressure on investors – including limited partners and public investment funds – to make the funds they invest in and their own portfolios greener and more sustainable.
These three factors will continue to shape the investment environment and guide investment decisions into the next decade and beyond, offering investors many opportunities to change the profile of their portfolios and to meet decarbonisation or sustainability targets.
Political risks on the rise
As renewable technologies expand around the world, so do the risks investors face, particularly as they shift their attention from advanced economies to emerging markets. China remains the world leader in new wind and solar capacity; Indian Prime Minister Narendra Modi aims to increase renewable energy generation from the current 90GW to 175GW by 2022 and 450GW by 2030; and Brazil is aiming to expand its wind energy capacity to nearly 27GW by 2027, and solar generation in the country is expected to expand even faster.
Financial returns will remain the key concern for most RES investors. However, rapidly evolving regulations and the politicisation of wind and solar projects mean that assessing political risks is becoming an increasingly important step in the investment decision-making process. We have identified three categories of political risk that can play a decisive role in the evaluation of renewable energy investment opportunities – not only in emerging markets but in many more developed economies in Europe, Asia and the Americas:
- Volatile regulatory environments: Governments around the world are upgrading their climate change mitigation targets and rolling out new incentives (and constraints) for attracting FDI in RES projects.
- Public procurement processes: Governments increasingly rely on competitive auctions for distributing additional renewable energy capacity to foreign investors. In countries with less developed – and at times corrupt – public procurement systems, investors need to navigate complex decision-making processes while managing financial crime and reputational risks.
- Community relations: Investors need to take into consideration local residents’ concerns about the social and environmental impacts of large-scale RES projects. There is also potential for such projects (and local concerns) to become politicised at the regional and national levels, posing new risks to investors.
Responding to changing regulations
One of the key challenges for investors is how to navigate the rapidly changing regulatory environment for wind and solar projects. Understanding the regulatory context is critical for evaluating the return profile of an investment. It is also one of the main factors for selecting where to invest among the growing number of countries looking to attract FDI in renewables.
In recent years, more developed markets have seen extensive regulatory changes in the sector. In Europe these include both EU and national regulations as member states adopt more ambitious emissions reduction targets, and more EU funding is allocated for energy transition purposes under the bloc’s COVID-19 recovery fund. However, further significant regulatory changes are expected in the next decade as the EU implements its comprehensive decarbonisation plans. In emerging markets regulatory changes are primarily aimed at land acquisition for projects, localisation requirements and investors’ access to FDI incentives, which can be offered not only by national, but also local governments.
Subsidies start to subside
The most significant regulatory risk for investors relates to the stability of subsidy regimes. For many years, European governments subsidised RES projects to ensure their financial viability and attractiveness to private investors. However, growing financial burdens from these subsidies and technological advances that made renewable generation cheaper are compelling governments to abandon subsidy schemes – such as feed-in-tariffs (FITs). They are being replaced with other market-based competitive schemes where investors face greater risk exposure to wholesale electricity prices. In China, the government has phased out wind and solar PV subsidies and from 2021 new projects will be subject to long-term tariffs, which are fixed at provincial benchmark electricity prices set by the government.
As these changes are often driven by national and local politics, investors need to understand governments’ track records in supporting and implementing subsidy policies and the outlook for future policy changes in this area as a result of election outcomes or changes in fiscal and environmental policies.
Broadening compliance challenges
Changing regulations also impact operational and compliance strategies for renewables investments. European and US investors increasingly have to comply with new ESG requirements covering not only their projects, but their global supply chains. Renewable energy investors may soon face new sanctions risks, as the US administration has threatened to target some equipment suppliers for solar PV projects. Other countries are taking steps to regulate the production and export of rare earths and minerals that are important components in renewable infrastructure and supply chains. Finally, renewable energy investments are increasingly subject to foreign investment screening laws in the US and Europe, particularly if these investments originate from non-Western jurisdictions.
Beyond one country or one sector
All these developments indicate that in order to mitigate risks effectively, investors need to analyse their exposure to regulatory changes beyond a single country jurisdiction, as well as across a range of sectors.
Hydrogen is an example of how risks and rewards in renewables are indirectly affected by regulations in a range of other sectors. Policymakers will set thresholds for CO2 emissions when defining what constitutes “clean (green) hydrogen” under the EU taxonomy, which in turn will impact renewable energy required for its production. Such thresholds may change or vary country to country. Other examples of sector regulations indirectly affecting renewables include electric vehicle (EV) subsidies and energy efficiency requirements for buildings.
Investors can mitigate regulatory risks by conducting policy-focused due diligence and country-specific scenario planning at the early stages in the investment cycle. In addition to understanding the existing regulations (and comparing them across different regions), it is important to assess how these are likely to be impacted by elections, high fiscal deficits in the wake of COVID-related recessions, and the potential for political instability.
Navigating government contracts
With technology continuing to drive down the cost of renewable energy and with the share of variable renewable energy (wind and solar) increasing, governments are adapting new forms of state support to maintain stable and attractive investment environments, while ensuring the long-term reliability of the energy system and its cost-effectiveness. As a result, renewable energy projects are often the subject of competitive government procurement processes.
Auctions to procure a particular capacity of solar PV- or wind-generated electricity have become the preferred option to provide incentives to investors. After evaluating price bids, a government signs a long-term power purchase agreement with the successful bidder. According to the International Renewable Energy Agency (IRENA) the number of countries that have adopted renewable energy auctions increased from five in 2005 to more than 100 in 2019. The European Bank for Reconstruction and Development (EBRD) has issued guidelines for such auctions that offer a summary of best practices.
However, these auctions could be challenging for investors with little on-the-ground experience in a particular country, or when their ability to travel is limited. In many emerging markets with weak public procurement legislation, practices and oversight, decisions can be politicised or prone to corruption due to nepotism, poorly enforced property rights, and the lack of a functioning competitive market in the energy sector. Although auctions often award long-term contracts to investors, some investors may still face pressure to renegotiate their contract conditions or may encounter difficulties in securing land and other permits to effectively implement their projects.
Know your stakeholders
It is important that investors understand the dynamics around who is making decisions over contracts and how they compare to their competition. Sector-specific stakeholder mapping can help to understand networks of influence around specific procurement decisions, which often involve relationships between governments, landowners, and powerful energy sector lobbies.
Local influence also a factor
Local governments can also have a considerable influence over projects – both positive and negative. While they often offer additional incentives to investors and a good overall investment climate, they can put up barriers that pose significant challenges to project implementation. In India, power producers, including renewable companies, in states such as Andhra Pradesh and Punjab have suffered significant payment delays and tariff rate renegotiations because of changes in government at the state level.
Managing community relations
The environmental and social impacts of projects on their local communities pose some of the most persistent and high-profile risks for investors – not just financial but reputational. It is therefore important for investors to understand how their projects impact local interests and to engage with key opinion-makers, officials and activists throughout the entire project life cycle.
Greenfield projects face increasingly common challenges around land acquisition and community relations. In emerging markets, local communities often contest large land acquisitions for renewable projects (with underdeveloped land property rights and complex land use regulations). In more advanced economies, large-scale renewables projects face not-in-my-backyard activism from local residents.
And it’s not just human residents that create challenges for project implementation. The Supreme Court of India in April 2021 passed what is perceived as a landmark judgement asking wind and solar companies to take their power lines underground to avoid potential danger to wildlife in the vicinity of power plants. Activists across the country are coming together to underscore the serious threat the renewable sector can cause to the environment. Koyna Wildlife Sanctuary in Maharashtra, for instance, has one of the largest wind farms, which has impacted biodiversity. Wind farms in the Gulf of Khambhat in Gujarat threaten to impact marine biodiversity. Andhra Lake Wind Farm, close to Bhimashankar Wildlife Sanctuary in Maharashtra, has led to the felling of trees and diversion of forest land.
Wildlife welfare concerns – including behavioural changes, impact on habitats and direct mortality – are also increasingly causing delays to RES projects in European countries. Planning permission for solar projects, which commonly need large plots of land, and for offshore wind projects, which impact bird migration and habitat, often require complex and lengthy assessments. Onshore wind projects have attracted considerable public backlash in many European countries, including Germany, because of some residents’ perceptions about the noise they generate or their negative impact on the countryside landscape and tourism.
Who holds the power?
In order to manage community relations effectively, project developers need to understand local power dynamics to assess which groups are likely to be most affected by the project and which groups exert most influence with local governments and regulators. It is also important to start community engagement early to avoid potential conflicts, which can leave a lasting legacy.
An overall strategy required
These at-first-glance local issues are increasingly being politicised at the regional and national level, which means renewable energy investors and operators need to start to think about how to manage these issues not just in relation to individual projects, but in developing their overall market and ESG strategies for individual countries, and in conducting and resourcing their government relations.
Informed and engaged
Interest in investing in renewable energy and other sustainable sectors will only grow as concerns about climate change lead governments, companies, and individuals to choose the more environmentally friendly option. And investors will need to remain informed and engaged to try to stay ahead of the broad range of political risks – from changes at the government level to individual residents’ complaints.