Getting WACC’d in Latin America: How renewable energy policies affect cost of capital

Summary: Every Latin American government designs policies and establishes market mechanisms that address different risks, looking to minimize them and therefore the weighted average cost of capital (WACC) of renewable energy investment projects. This article outlines various policy risks and gives examples of individual country successes and failures.

Carlos St James closeupAbout the AuthorCarlos St. James is an advisor to energy investors and developers in emerging markets. He founded the Argentine Renewable Energies Chamber in 2005; has been a board member of the Latin American & Caribbean Council on Renewable Energy since 2010; founded the Middle East-Americas Energy Council in 2014; and publishes the Latin American Energy Review in his free time.

He was recently named Summit Chairman of the upcoming LAC-CORE Finance Summit in Miami, Florida in September 2016.

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Renewable energy (RE) projects require large upfront investments. This frontloaded capital risk leads investors to require a higher rate of return, which in turn affects the overall weighted average cost of capital (WACC) of a project. WACC is defined here as the rate a project is expected to pay for all its capital sources: equity, bonds, bank financing, etc. A lower figure, expressed as a percentage rate, reflects less risk.

In its simplest form, WACC blends the higher cost of equity (last in line to get repaid, if at all) with the lower cost of debt (first in line and collateralized): thus, more leverage in a project’s capital structure results in a lower WACC. In Germany and the US, typical RE capital structures are 25% equity/75% debt. The riskier the country the more equity demanded by lenders, so in emerging markets like Latin America a 30/70 or even 50/50 split is closer to the norm.

WACC is more important than abundance of natural resources

The abundance of natural resources like wind and solar radiation are often touted as a reason to consider investment in Latin America. It shouldn’t be. Country risk sometimes raises capital costs to the point of futility, so the first thing to understand is that WACC trumps natural resources and always will. The Argentine Patagonia has far superior wind capacity factors to anywhere in Brazil – but Brazilian projects have a WACC of around 10%, half that of Argentine deals. The end result is that Brazil has close to 7000 megawatts (MW) of installed wind capacity and Argentina a mere 150 MW.

“WACC trumps natural resources and always will.”

The goal of government policymaking is to reduce uncertainty

Government policies for renewables play an important role in mitigating risk and therefore reducing WACC, as was recently demonstrated in a study that analyzed this for the European wind energy market.* The risks include (in no particular order):

POLICY DESIGN RISK: one of the key roles of government is to create frameworks that promote and support nascent industries. Some instruments entail a higher exposure to market and regulatory risks (like quota obligation schemes) than others (feed-in tariffs). Policy designs that include tax incentives as straightforward as (a) acceleration of depreciation or (b) value-added tax (VAT) reimbursements can play an important role in lowering total WACC.

  • Chile, for all its commendable success in attracting investment, has had its delays and could have been far more successful had the government taken less of a laissez faire approach and nurtured the industry by supporting long term power purchase agreements (PPAs), something Uruguay has done to great effect.
  • Argentina has had a number of missteps in policy design:
    1. it built its export-driven biodiesel industry on a controversial Differential Export Tax scheme and became the world’s largest exporter – but ended up in a legal battle with its biggest customer, Europe, that has all but killed the industry;
    2. it badly misjudged Counterparty risk in the 2009 GENREN renewables tenders. PPAs were to be signed with government entities whose balance sheets and reputations were extremely weak, resulting in less than 100 MW of the 895 MW worth of approved projects ever getting built — despite very attractive pricing of $127/MWh for wind and $572/MWh for solar PV projects.

FINANCING RISK: Not only does there have to be availability of bank financing, but its cost and regulations have to be efficient and competitive. Besides project financing, a solid market needs to develop a sound equities market, venture capital, and long-term pension capital markets.

Here Chile shines as having the best capital market in the region, with Venezuela typically at the bottom (among the region’s larger economies). Brazil, for the all the muscle and outsized lending over the last decade provided by BNDES, the national development bank, is still slow and lacking in transparency.

TECHNICAL & MANAGEMENT RISK: The availability of human capital to execute all aspects of a project, from design through financial exits cannot be understated.  You need talented, experienced, ethical professionals to successfully pull off long term investments of this magnitude.

  • Argentina, despite not having a renewable energy industry, has graduate and engineering degree programs for renewables; many of their graduates have emigrated to neighboring countries and gathered hands-on experience and are likely to return if and when that market comes to life.
  • On the other hand, Central American and Caribbean countries struggle with this risk and it is a decidedly clear factor increasing the WACC of a project in that part of the region.

ADMINISTRATIVE RISK: Many permits need to be obtained in order to build a power plant. Using one well known parameter – the number of days it takes to incorporate a business taken from the World Bank’s database – Brazil reveals itself as highly bureaucratic at a frustrating 83 days, while Chile and Mexico are the fastest at six business days. Those countries than can design speedy and transparent permitting mechanisms can help reduce a project’s WACC. Time is money.

MARKET DESIGN & REGULATORY RISK: this refers to government energy strategy and energy market liberalization, ideally showing a fair and independent regulatory scheme. A country (and an investor) needs to know where it stands on these issues and be consistent in its energy policymaking.

  • Venezuela’s policies have proven to be ineffective and a tragic societal breakdown is now taking place before our eyes.
  • On the other hand, Mexico’s much-touted energy reforms were created by one administration and are now being executing by the next and from a different political party — and yet remained consistent. The reforms are tremendously ambitious and there have been a few contretemps, but the fact is that few markets are as exciting.

GRID ACCESS RISK: projects need to have clarity on the availability and dependability of the grid and the procedures to grant access. Grid connection represents around 10% of the total cost of a project, so uncertainty regarding grid access results directly in higher risk and cost of capital.

  • This is Colombia’s Achilles heel. The country is admittedly challenged by not one but three separate mountain chains running through the country, effectively forcing independent grids.
  • Central America is making great progress on interconnections between countries in the region, creating a larger and more stable market and aligning grid-related issues to the benefit of all — and lower WACCs.

 SOCIAL ACCEPTANCE RISK: Conflict with local communities for environmental or Not-In-My-Back-Yard (NIMBY) problems can have devastating effects on the cost of capital of a project. Battles with indigenous communities in southern Chile, in Central America and in Mexico make clear that it increases risk for a project. Respecting the rights of local people is very important – it just needs to be known before investment decisions are made.

SUDDEN POLICY CHANGE RISK: Investors hate nothing more than surprises. The obvious case study is Spain, which not only cancelled its very appealing feed-in tariffs in 2012, but also made them retroactive. This was a shot damaging enough that the ripple effects were felt around the world with resulting higher WACCs everywhere. The Latin American industry is young enough that this hasn’t happened yet but the risk is always looming. If any one country does an about-face, the effects will certainly be felt regionwide.

I would love to hear from readers and improve on my examples – and suspect I have drawn blanks on the Sudden Policy Change risk.

 

* The impact of risks in renewable energy investments and the role of smart policies, February 2016, www.diacore.eu.

© Latin American Energy Review 2016

About the Author:

Carlos St. James is the founder of the Argentine Renewable Energies Chamber (CADER, by its initials in Spanish); board member and was elected the first President of the Latin American & Caribbean Council on Renewable Energy (LAC-CORE); founder and chairman of the Middle East-Americas Energy Council (MEAMEC); and founder and publisher of The Latin American Energy Review. His private sector background is focused primarily on finance and bringing together stakeholders so that deals get done. He advises governments on renewable energy policy, counsels private equity firms seeking to enter the region; and brings together stakeholders, including investors, for new energy projects.

He obtained his undergraduate degree in international economics from DePaul University and his masters in international relations from the Fletcher School at Tufts University.

 

 

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