Tapping into the superior financial performance of renewables in India
India has set ambitious targets for renewable energy, with a goal to increase the proportion of renewable energy sources in the country’s electricity generation mix to up to 40% by 2030. The total investment requirement for generation capacity addition is estimated to be INR 10.3 trillion during the period 2017–2022. The total fund requirement for the period 2022–27 is estimated to be INR 6.1 trillion.
This represents an opportunity for investors in the power sector. Policymakers need to design policies to reduce barriers to investment to be able to reach government targets for each technology. In a recent paper, we study and compare the historical financial performance and risk profile of the renewable energy and fossil fuel power sectors, to inform both investors and policymakers.
Further, renewable power has been a more lucrative investment than fossil power. Renewable power portfolios have historically shown more attractive investment characteristics including, on average, 12% higher annual returns, 20% lower annual volatility, and 61% higher risk-adjusted returns. Thus, a portfolio of renewable power companies would be deemed more efficient than a portfolio of fossil power companies, providing an investor with a given risk appetite higher returns in comparison.
We next examine the question: How does investors’ risk perception of the renewable and fossil power sectors differ?
We find that Investors perceive renewable power investments to be less risky than fossil power investments. The expected returns on debt to the fossil power sector is at least 80 basis points (bps) higher than the renewable power sector. The higher risk perception of the fossil power sector may be attributed to sourcing issues and import dependency for coal and natural gas, longer construction periods due to delays in obtaining clearances, and stricter water usage and emission standards.
Within the renewable power sector, solar is perceived as less risky than wind. The cost of debt for wind power investments is about 150 bps higher than solar power investments. This may be mainly due to the higher perceived resource risk for wind power over solar power, as also evidenced by the stricter conditions for assessing viability imposed by banks for funding wind projects over solar projects.
In the fossil power sector, coal is perceived as less risky than natural gas. This may be because there is higher resource risk associated with natural gas power due to insufficient domestic reserves, import dependence, high global prices, and lack of transport infrastructure in India.
We next ask the question: What factors contribute to the differing risk perceptions of the renewable and fossil power sectors?
We find that the main risk factors driving the risk perception of both renewable and fossil fuels are counterparty, grid, and financial risks. These risks together account for 50% — 54% of the total risk premium. Further, for the fossil power sector, the resource risk and power market risk are also significant, contributing to 26% of the total risk premium. Accordingly, policy and market interventions targeting the mitigation of barriers associated with these risks have the highest potential for reducing the cost of capital for investments, by up to 4% of the cost of debt of renewable energy investments, and up to 5.1% of the cost of debt for fossil nergy investments.
Counterparty risk, related to state distribution company (DISCOM) non-payment is the most significant risk, contributing to approximately one quarter (22–27%) of the risk premium for both renewable and fossil energy. This risk contributes to 50–100% more than the second highest risk. Long-term solutions like the Ujjwal DISCOM Assurance Yojana and short-term fixes like well-designed Payment Security Mechanisms may help mitigate this risk.
Grid/transmission risk contributes 14% to the risk premium for both sectors. This risk pertains to the inadequacy of the transmission infrastructure. There is no apparent short-term solution to mitigate this risk, and, over the long term, better demand-side planning as well as strengthening of the grid at the inter-regional and intra-regional levels should help alleviate concerns around this risk.
Financial sector risk, related to the inability of project sponsors to access sufficient equity and debt capital, is the third major driver of risk. The solution to this risk may be a combination of mitigating the other barriers to investment identified in this paper, as well as the introduction of innovative modes of financing such as InvITs, Green Bonds, etc. which can attract new investor classes to the sector.
To conclude, our findings have significant implications for investments in these technologies in India.
(This article is authored by Gireesh Shrimali, PhD; Precourt Scholar, Stanford University)
Originally published at https://www.thinkesg.in on March 22, 2021.
