Tightening Credit

This is the second in a two part series examining the effect two recent trends - falling energy prices and tightening credit- are having on the market for cleantech and green buildings.

Last time we discussed how falling energy prices make the returns from renewable energy projects less attractive. Today we will focus on how tightening credit is negatively affecting renewable energy project finance.

As I mentioned last time, the standard method of underwriting and valuing investments in clean energy projects is as follows:

1) Calculate the upfront capital cost
2) Calculate the future savings from avoided energy use- this is the income stream of the investment
3) Compute an internal rate of return (IRR) and decide if it meets some hurdle rate. If so, invest. If not, throw it out.

Tight credit means banks and other financial institutions do two things that hurt IRRs for equity investors in clean energy projects: require more equity and charge higher interest rates.

Banks are now requiring investors to put up more equity up front. At last week's US China Green Tech Summit in Shanghai, Shawn Qu, CEO of Canadian Solar, said that before the credit crunch began, banks would typically require investors to put in 15% of the total project cost and finance the rest. Now, banks are requiring 20-25%. This makes it harder for projects to meet their IRR hurdle rates and therefore more projects are "thrown out".

Banks are also charging higher interest rates thanks to the general aversion to risk in the market now. Higher interest rates reduce the free cash flow, or the savings from the avoided energy minus the financing costs, making the future income stream and the overall investment less attractive.

Luckily, several other equity investors at the Green Tech Summit said they see tight credit and lower energy prices as a blip on the radar screen. It will negatively affect clean energy investment in the short term, but likely won't significantly affect it in the long term. Also, Shawn Qu also mentioned that prices of silicon and other parts have been dropping, lowering upfront capital costs and helping make investments look more attractive.

One option for helping to reduce the dampening effects of tight credit is for governments to offer loans to clean energy project investors. I suspect that Obama's energy/ economic stimulus plan will include something like this.

Another related option is for sovereign wealth funds (SWFs) to start investing in clean energy loans. SWFs are gov't run, opaque pools of capital and can essentially invest in whatever they want. Several countries with big SWFs like Norway, Abu Dhabi and Australia, are increasingly interested in sustainability and might be good candidates to invest significant funds in clean energy project debt. China might also consider investing in clean energy projects. This could help provide its growing number of wind and solar manufacturers find markets for their products, and likely produce significantly better returns than their investment in Blackstone, which is down ~80%.