Carla Coghen: Project finance and profitability of renewable energy
How do you assess the profitability of a PV plant? What factors impact on pricing? What does it mean LCOE and why everybody is talking about it? Carla Coghen is our guest in Ogami Station to solve all of these questions.
Below you can read the notes and transcript of the episode. Also, here are links to the resources we cited:
- How the electricity market works and why, despite the price sometimes going to zero, it's hardly going to impact our bill (Xataka, 2021).
- The Essentials of Renewable Energy (Ogami Station, 2021)
This is the transcript of the original audio. To read the Spanish version, visit Project finance y rentabilidad de renovables.
Welcome to Ogami Station, a podcast created by RatedPower. As every month we bring you closer to the exciting world of renewable energies through interviews with relevant figures in the sector.
Good morning to all of you who listen to us and welcome to our second episode of Ogami Station, your renewable energy podcast. My colleague Gabi and I are here again, right, Gabi?
About Carla Coghen
You're absolutely right, Laura. The truth is that we are very excited, especially for the guest we have today. Carla Coghen is a consultant in international trade and investment and a corporate lawyer specialized in business law, but her true vocation is renewable energy, as it could not be otherwise. So more than two years ago she joined the RatedPower project leading the national and international expansion of pvDesign. How are you doing, Carla?
Very happy to be here with you. Thank you very much for inviting me.
Thanks to you for accepting our invitation and for participating in our second episode. Just to summarize a little bit. Today we will talk about the more financial part of renewable projects, how a project is structured, how it can be financed, how the profitability of the project is measured.
What is the LCOE and why is everybody talking about it?
Exactly. And to answer this and other questions, we have our colleague Carla. So she will tell us a little bit more. But first I would like, if you like, to make a brief introduction on how we got here. Well, in terms of renewables I mean. To answer this question, I think it is interesting to know the historical and political context in which renewables and traditional energy sources have played a leading role in recent years.
On the one hand, fossil fuels have dominated power generation, because until recently, generation was cheaper than electricity from renewable sources. To give you an idea, coal generated 37 percent of the world's electricity and gas 24 percent. But this obviously goes hand in hand with higher greenhouse gas emissions. Together, the two energy sources account for a total of 30 percent of emissions. Thank God this has changed somewhat and today renewables are cheaper than fossil fuels, thus changing the energy mix a bit.
How have we done this? Well, although we already talked a little bit about it at our previous podcast, let me tell you a little bit more in detail. And the fact is that energy prices are actually measured through the LCOE (levelized cost of energy). What is this? That we all wondered the first time we heard it. Well. Think a little bit from the perspective of someone who is going to build a plant and this person wonders what would be the minimum price that my customers would have to pay to make the power plant profitable over its lifetime. Well, the answer to that is LCOE, which is the cost of building the power plant, the fuel and operating costs over its lifetime.
And the LCOE is really a very important metric. Almost if you choose an energy source whose LCOE is higher than the price of the other alternative energy sources. Then it will really cost us to sell our electricity, because it will be more expensive than the rest. That is obvious.
And what has happened over the last ten years? Well, basically the price of electricity from nuclear power has gone up at the same time, the price of gas has gone down and the price of coal, which is the largest source of electricity in the world, has remained practically the same. However, in contrast, solar PV has become 89 percent cheaper, wind about 70 percent cheaper in the same period.
So it's that in the end, in summary, the price at which you have to sell your coal-generated electricity to get to break even is much higher than what you can offer in your electricity buyers if you build a wind solar plant. And why is the cost of this renewable energy cheaper?
The LCOE of non- renewables vs the LCOE of renewables
Let me give you a hand here, Laura. In the end, the costs of traditional sources, such as fossil sources and also nuclear energy, depend largely on two factors. First, the price of the fuel they burn, such as coal or gas. Secondly, the operating costs of these power plants. However, renewable energy power plants are somewhat different, as their operating costs are, of course, comparatively lower than those of traditional power plants.
Moreover, they do not have to pay for any fuel, because in the end it is the wind, the light that so far are free and then also what determines the cost of renewable energy is mainly the cost of the technology itself. So those panels and everything that we were able to talk about the other day, then, therefore, solar energy in this particular case is only as cheap as the technology that supports it.
So, as we have already discussed, the cost of technology has been reduced by more than 80 percent in the last ten years and there is an explanation for that. In the end, even when the cost of solar technology was high before 2000, it found a utility that, as we mentioned the other day, began to be used for satellites.
Then this utility, together with the subsidies that started to come from the governments, promoted by an ecological transition that became necessary and this transition towards clean energies, not only improved the production process, but also reduced the production cost and furthermore, the technology itself was investigated to make it a little more profitable. In the end, this led to a reduction in the cost of the technology itself, which made it possible to apply it to other types of applications, for redundancy's sake, such as industrial uses or more commercial uses, more on a large scale, which in the end also had a direct impact on demand, which increased and in turn led to a reduction in prices. So it is like everything is being re-fed.
Financial structure of a renewable project
Well, I think that's enough of this, don't you Gabi? If you like, let's take advantage of the fact that we have Carla here and let's see, the first question we have for you is that we would like to know how a renewable project is structured.
I heard in your previous episode that Felix had told you about the parts of a plant, right? Well, in order to know the parts of the plant, first we also have to know how it is built. We have to know the life cycle of a plant, which consists of three main phases: the design phase, the operation phase and then the end-of-life phase.
First of all, the project phase starts with pre-planning, where basic engineering, feasibility studies, permitting and financing begin to be structured. Then a more detailed design and engineering is carried out, and this is where the final calculation of energy production is obtained.
Subsequently, the construction or EPC process, known in the industry, begins, where the site is contracted, where the site is prepared, the land is moved, where the assembly and construction of the plant is done, and then it is connected to the grid as if you were plugging an entire plant into the Spanish electrical grid. During the exploitation phase, what is called operation and maintenance or OYM is carried out, so that the plant operates normally and for this purpose, monitoring and maintenance is carried out by the OYM manager. Then the end-of-life phase of the plant, as the word says, is when it has nothing more to give and it is dismantled and recycled.
I heard at the beginning you said that the project phase or the first phase is where you start to structure the project a little bit financially. So the question always comes up here, is this structuring complex, how do you finance a renewable plant?
It is complex to say the least. Let's try to break it down. But in short, we have to know first of all that there are two main types of financial structuring in renewable plants: Corporate Finance and Project Finance. As an elementary concept and in broad strokes. Forgive me for this oversimplification and especially if there is any financier listening to us, please forgive me.
Corporate Finance is when the promoter invests from his own pocket directly in the project, at his own risk, and the main idea of Project Finance is that the project financier, which to a greater extent is a bank, is leveraged in the project. In other words, the project risk is limited to the project itself. The project itself is the guarantee. This type of projects are carried out through SPVs or SPVs constituted ad hoc for each of the projects, i.e., every time you do a project you do an SPV.
So when would you structure a project with Corporate Finance and when would you structure a project with Project Finance?
It depends a lot on many factors. You have to see if you make a high investment, how long the life of the project is, the forecast you make of income and expenses, the technology you use or even the applicable regulation. In general, self-consumption tends to be financed by Corporate, because at the end of the day it is not a super investment that you make in self-consumption. On the other hand, in a utility or large-scale plant, it is normally financed with a Project Finance structure. After all, Project Finance is a slightly more complex financial structure that is tailored to each project and is based on the long-term predictability and stability of the cash flows generated by the sale of electricity generated in each project. Whatever the case may be, the aim is to find out whether the cash flows generated by this plant create value for the shareholder. That is to say, if they allow a remuneration of its capital without compromising the operational or financial sustainability of the same. In other words, without risks for the investor or minimizing risks.
CAPEX, OPEX and other renewable project’s costs
Hey Carla, a question that is coming up for me and maybe for our listeners as well. And that is how do you know if they create that value?
Good question, for that I think we have to be very clear and measure in detail. First of all, what are the revenue mechanisms. As you said before when you generate electricity, how do you create the money from the generation of electricity. What are the prices of that electricity going to be. How much are they going to give you, basically. What are the project expenses and investments going to be.
That is, the CAPEX, the OPEX, the license acquisition expenses, the land rental expenses, the insurance contracting and many more. And then the timescales you have available to generate those flows. At every point in the life cycle of the project, there are levers that generate value, i.e., that allow a good return on capital. If you do a good planning and a good design, or for example, if you execute the project well and use good technology, or even if you manage the maintenance of the plant well, then you will generate more value to the project. You have to be, I think, surrounded by a good team and good technology, either in the preconstruction houses or during the maintenance of the plant, will allow you to optimize the predictability of those cash flows that you want to get.
Very, very interesting. So how can I calculate those cash flows, how can I know if that project is profitable or not profitable? That is to say, I understand that it is about knowing when those flows are generated. At what moment, what is the amount of those flows, if that is going to allow me to reach the adequate remuneration that I expect and also try to reduce the risks of the project.
Yes, yes it is fair, it is just that. And it is very important, because the sooner you receive those flows, the shorter the investor's horizon and the lower the risk. After all, the future is always uncertain. So money in hand is much better and much safer than going into the future. For example, in inflationary contexts money loses value and purchasing power decreases. Let's also talk about the opportunity cost you have when you decide to invest in that project and decide not to invest in another project or even decide not to invest and have liquidity.
How to measure the rentability of a renewable energy project
Sure. Indeed. But since you are so to the point, Carla, you are explaining everything so well. I could ask you how you measure the profitability of a project.
Phew. What a question, Laura. Well, these are already financial concepts, but broadly speaking and without wanting to confuse people, I believe that the three main key concepts for measuring profitability are: the cost of capital, the NPV and the IRR.
First, the cost of capital, what it is, is the cost incurred by a company to finance its projects and investment through its own resources. Okay, this is basically that it represents the expected return that the investor has from investing in the equity of a company and the risk associated with that investment.
Then we have the NPV, which is the net present value, which is the sum of project cash flows discounted to the evaluation period using a discount rate that I don't think we need to talk about. When calculating the NPV, if it is greater than zero, the project generates value and if it is less than zero, it destroys value. In other words, the return on capital is not adequate and there is no need for the investor to get into this mess because it compromises his profit expectations. We already have two of the important things. We know what the cost of capital is and the positive NPV. Then we have to take into account the IRR, the internal rate of return. Which is a measure expressed as a percentage that indicates the profitability of a project. If the IRR is higher than the cost of capital, then we can invest in the project. In short, we have to have NPV greater than zero and the IRR is higher than the cost of capital. And once we have that, then we have to know which projects to invest in according to our aversion or our propensity to risk. In other words, if we have higher IRRs, we will have higher risks. If we have lower IRRs, then lower risk.
Perfectly explained Carla, thank you, but I have another question, this time a little more opinionated and it is: what factors will determine the financial success of my project? Tell us a little bit.
I think it's a little bit like we were saying before. I told you before about the value levers. Just as they have to be taken into account throughout the life of the project. You also have to take into account the risks associated with this life cycle of the plant. It is also fundamental for the recovery of the investment. From highest to lowest, where are the risks in the life cycle. They are mainly in the initial phases of the project, in the planning and design and in the construction. Other risks to consider would also be the risks associated with what technology you use, whether it is the right one or not, or for example, the quality control checks. And once, when you are operating the plant, because of the risks you have to do a good monitoring or manage your plant well, you see, everything is measured in detail.
And there is also a super important thing when we are talking about risks, and that is that apart from identifying and measuring them, many times we have to carry out mitigation actions and even transfer them to other people who are building or who are involved in the construction process or in the power generation process.
For example, in CAPEX, when you hire a builder or an EPC contractor, the risk that the plant is not built well or that it is built poorly is not something that you, as an investor, are going to bear, so you have to transfer it to the builder. And so on throughout the life of the plant. In short, this is a structure with greater or lesser complexity, but at the end of the day what we are looking for is to obtain the highest profitability at the lowest risk thanks to the flows generated by the production of clean energy.
Recovering investment: income from energy production
Okay, okay. So now we have a little bit of an understanding of how to calculate the profitability of a project. And then you've also told us a little bit about the risks that can be involved in these projects. Now what interests me and I imagine that many people are interested in, is how we can recover that investment and at the end, how we can make money with this kind of projects.
Of course, why else would you get involved in it, right? Well, first of all, as you say, we have to emphasize that when you carry out a project, people intend not only to recover, but to make it profitable. So there is part of the energy generated that when it becomes flow or money, it will go to cover or recover that investment or cover the operation of the plant. And then there is another additional part from which you will get the profitability. So, how to sell energy leads us to analyze three major remuneration systems.
The most common of all, or the one we are always familiar with, is auctions. What are auctions? Well, they are competitive, governmental, general concurrence processes to promote electricity generation from renewable energy sources. The typical thing that appears in the news "the mysterious up to 3000 megawatts of renewable energy", regardless of whether it is wind, solar or solar thermal. How to pay for this renewable energy will vary depending on the country's market. In other words, not all countries pay in the same way. For example, in Spain, until recently, the companies that won the auction were paid a specific amount of money per installed energy, regardless of whether they generated more or less energy. In other words, for the energy installed.
In addition, they earned extra income or higher income from the sale of energy in the wholesale electricity market, known as the Pool. However, this remuneration criterion is not very common among countries. In general, countries do not usually pay for the energy installed, but for the energy generated, which is what Spain is doing right now. In the last Spanish auction, which took place very recently, the new remuneration framework called the Renewable Energy Economic Regime, the REER, was launched, where participants participated by bidding a price for which they were willing to charge for energy generated.
It certainly makes more sense what you are telling us now.
But okay, so from what you are telling us now this remuneration, in the end it has a certain guarantee by the government or by whoever does the auction, and wouldn't there be other possibilities of different remuneration in which the government does not intervene?
Of course, there are. There are many alternatives and precisely all those projects that are not carried out through auctions are remunerated in another way, for example by going to the wholesale energy production market known as Pool.
In Spain it is managed by OMIE, which is the operator of the Spanish Iberian market. And the Pool is basically like the stock exchange, but for energy. It has a daily session, 6 intermediaries and a continuous intraday session. The daily session is where most of the energy is generally determined and traded. On the one hand, we have the electricity generators that present their daily sale offers for each of the hours of the following day. And then, on the other hand, we have the marketers or large consumers, who are the ones who are going to buy, who are going to make the purchase offers for the energy they expect to consume in each of those hours of the following day. Then, on an hourly basis, OMIE orders the generation offers from lowest to highest according to the sale price and from highest to lowest according to the purchase price.
The price of electricity and the amount of energy to be sold or bought by each of these agents will be determined from a point of equilibrium between supply and demand. The last offer that matches the demand is the one that will determine the price of electricity at a particular hour of the next day. As you can see this pricing system is quite complex, depends on several factors and is very volatile. So the market has a great volatility and it becomes very complicated to predict its behavior in the long term.
Of course, if there are so many interests, so many generators, so many demanders, in the end it is normal that it is a mess to organize the price of electricity. But then, wouldn't there be any method to ensure that price in a stable way over time?
Of course. In other words, there are alternatives. For example, there are risk hedges in the spot market. The spot market is the daily market, the intermediary we were talking about. And there are also the so-called PPAs or power purchase agreements. To put them in context, they are born as an alternative to these remuneration systems that are a little more volatile and are having a lot of success. Because from the point of view of supply, as we have seen in many countries a liberalization of electricity markets, allowing the entry of what are known as IPPs or independent power generators.
In addition, as you have said before, in your introduction there is a greater competitiveness of the price of electricity produced by just renewables and by the exponential decrease of the LCOE.
Also the end of the period of subsidies, in many cases to renewables, or the fact that many incentives are being paralyzed in many countries, has also created the need for a long-term alternative and also, mainly to cover the volatility of the wholesale electricity market we were talking about.
Also from the purchasing point of view, the PPA has been seen as a good system, because it has resulted in cheaper electricity prices, much more stable. And from a more ethical and moral point of view, there is also a greater awareness of the need to use electricity from renewable or sustainable energy sources. A PPI that is part of an efficient market.
The only way to hedge against this price volatility is through a derivative product. Whether it is the PPA or options or futures or synthetics, etc., there are several alternatives. In short, PPAs are bilateral contracts between a producer and a consumer whereby a purchase and sale price is fixed for a certain amount of electricity during an agreed period of time, which is usually long term. And there are several types of PPAs depending on the criteria by which they are measured. That is, if you look at the calculation of the selling price, there are Swap, Floor and Collard PPAs, which we don't even need to go into detail. Then, depending on the type of connection, i.e., if there is a direct assignment of the plant to the buyer, a physical assignment of what is the sale and purchase of energy between seller and buyer, or if there is a virtual connection between the two of them through the electricity grid, there are physical and financial PPAs.
And then depending on the contracted production, there are also Baseload, Pay as Produced, Synthetic PPAs. As you can see, it is a very complex subject, covering many issues and it is not closed either. That is to say, there are several remuneration structures that are being worked on now and have arisen from the needs we currently have, but there are millions to create and to evolve.
Sure, in the end we could have a day of PPAs alone, couldn't we?
And also, in terms of market evolution, the same. Now storage comes into play, which is going to be a factor that is going to change things a lot, because until now electricity was not a storable good. But you have to manage overcapacity in real time.
Totally, totally. When there is an exponential growth in the use of storage systems, this scheme is going to change completely.
And one thing of all the systems discussed, which one can be the most beneficial for an investor: PPA, going to the market?
You asked me the million dollar question, what everyone wonders. Well, it depends a lot on the project. At the end of the day, there are many factors to take into account. First, how you structure your project financially, the technology you use, the IRRs you are managing at the investor level, the context of the market you are in or the country you are in, what government incentives you have. Even Covid for example. So it has affected the prices of the conditions of the PPAs that we were talking about. Just the gas falls that have influenced the spot market and electricity futures. The good thing about all this is that these systems are often complementary, that is, they are not mutually exclusive.
And I believe that selling, for example, all the energy through a PPA contract allows you to eliminate all the risk you have of market volatility in the long term, but it also does not offer you the flexibility to take advantage of the moments when market prices are more favorable to you. On the contrary, if you sell all the energy adjusted to the Pool market price, then you do have this flexibility, but you are exposed to episodes of very low prices like the ones we are experiencing now. I believe that the key here lies in having a good strategy, whether it is first, that you are flexible, that you have good risk hedges and then that you have a very clear vision of the market in all horizons in the short, medium and long term. So, simplifying a lot, you will be able to sign a PPA when there is the possibility of doing it in advantageous conditions for you and go to the market when the prices are more favorable, and go to the futures market when there are attractive opportunities, like everything else.
Well, I think we can leave it here today, after this master class of our colleague Carla on projects, financing, profitability of our plants. In short, we have talked about a little bit of everything. So if it's all right with you, this is the end of our second episode of Ogami Station. We would like to thank Carla for her participation and her knowledge. We hope to have you back soon.
Pleasure, guys. My pleasure. I mean, I had a lot of fun and I'm at your disposal to repeat whenever you want.
Great. Of course, the truth is that it is always a pleasure to listen to a professional talk about something he knows with so much dedication and teach us, so that we can learn. We hope that our listeners have also learned something that is our goal: to bring the world of renewable energies closer to all of you.
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Thank you all very much and we'll be hearing from you soon!
We'll be hearing from you soon!
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