This new way of thinking has seen investors look to support more green initiatives not only to shield from risk but also because the road to net zero presents great opportunities.
Achieving the equivalent of an emissions yin-yang is no easy feat. This balance cannot simply be ‘struck’ but will require a significant amount of political and financial engineering.
Private debt financing, in its many forms – including asset and project finance, senior secured/unsecured corporate debt and mezzanine finance – has a critical role to play. Debt investors’ expertise in supporting large-scale, complex infrastructure projects will be of great value throughout the transition.
Whilst debt markets have demonstrated significant interest in environmental, social and governance (ESG) – as seen in the proliferation of dedicated funds – genuine green and sustainable projects and sectors still suffer distinct barriers to accessing finance. Thus, we are faced with the dilemma of debt financing net zero.
At Cyan Finance we specialise in funding authentically green and sustainable initiatives and are working to solve this dilemma. Every day we speak to companies bringing sustainable solutions to market. These companies are developing rapid chargers that can charge an electric car in under six minutes or cleaning wastewater with algae instead of harsh chemicals or even using artificial sea snake membrane to remove greenhouse gas from our oceans.
With such a diverse range of green and sustainable projects and sectors, debt financers don’t have a rule book to follow and they need to put their thinking caps on when it comes to achieving net zero.
Clearly defined credit criteria are essential to limiting lenders’ exposure to risk. However, following pre-determined, ‘one-size-fits-all’ criteria can act as a barrier to supporting projects that do not follow the status quo.
Debt financers need to start thinking outside the box when it comes to the contractual nature of project revenue streams. Currently, the availability of bank debt financing is largely dependent on a company securing a long-term “offtake” contract such as a power purchase agreement. More recently, there has been much debate and deliberation over taking merchant risk on energy projects with revenue streams tied to market prices.
However, these are but two financing methodologies – debt financers need to broaden their scope. After all there are only so many articles one can read about the pros and cons of taking merchant risk on a renewables project.
Many green and sustainable initiatives, both renewables projects and far beyond, are hybrids between asset and debt finance. Projects in this category will benefit from a mixture of significant project equity (and mezzanine), a level of contracted revenues (though typically not that long term) and asset security.
These projects require lenders who are prepared to take a holistic view of the overall project risks rather than applying specific pre-determined credit criteria. The development and expansion of the lender base to support these projects, in return for appropriate yield – including risk premium – would help to solve the UK net zero debt financing dilemma.
The second key issue debt markets must address is transaction size. Whilst adding a few extra zeros to every green mandate may seem like a simple solution to achieving net zero, this has not translated into real world impact. It is often much harder for smaller projects to get access to finance as it costs an investor the same amount of time and money to diligence a small project as it does a large one. With investors under pressure to allocate capital, they are incentivised to fund larger projects. If a project requires more than £50 million of debt financing, it will have significantly less trouble accessing finance than a project requiring less than £20 million.
This represents a great loss to society as smaller projects that make genuine contributions to a sustainable future are simply not being started, slowing down progress towards net zero. Furthermore, this market imbalance means that larger projects become inherently overvalued. Thus, by definition, they cannot deliver performance that will justify their price.
Government funding (including grants) has a role to play in providing more support for smaller projects, as do private debt markets. Private debt financers may find yields where there is market friction. Moreover, when small projects are appropriately structured and financed they present an opportunity for future large-scale rollouts. In order to achieve net zero it is essential to expand the pool of core lenders prepared to finance smaller projects, for yield, as well as promote an active “secondary” market. This will enable smaller projects to be aggregated into portfolios with larger projects to attract bigger investors.
The third issue relates to technological risk. The development and implementation of new technologies is key to delivering net zero in the UK. Not surprisingly debt lenders do not generally want to take risk on projects based on new and unproven technology and these will generally require equity finance. Some projects are based on well-established and proven technology, for example in waste to energy recycling, but may be perceived as having an element of technology risk until they are rolled out on an industrial scale. In these situations, the project sponsors will have to embed additional protections for prospective debt lenders (such as more sponsor and/or third party or supplier guarantees) as well additional equity yield.
Achieving net zero is far from a zero-sum game, there will be winners and losers. The climate emergency will continue to force debt financers to face myriad dilemmas and trade-offs. After years of unchecked growth, perhaps “balance” should not be our goal after all. When it comes to accessing finance it is clear that green and sustainable companies need and deserve an out-sized boost.
By addressing the challenges detailed above, private debt markets have the ability to provide this boost and accelerate our collective journey to achieving net zero.