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Identifying Energy Efficiency Risks: Key for Treasurers

  • By Michael Wilkins
  • Published: 1/13/2016
panels1Mounting pressure from governments to cut energy consumption and limit pollution has implications for corporate finances, as companies must increasingly look to new technologies and energy-saving strategies to comply with new regulations.

Of course, realizing energy efficiency measures requires considerable financing. In fact, one study conducted by consultancy firm Accenture and Barclays Bank found that the EU will need to invest around €2.65 trillion in energy efficient infrastructure by 2020 if it is to meet its goal of a 20 percent reduction in energy consumption.

One way to attract the necessary financing is through green bonds, which are designed to fund environmentally friendly investments. And because these bonds are tax-exempt, investors find them highly attractive and we have witnessed a strong growth in corporate uptake over recent years. For example, in October, German electricity distribution company Schneider Electric issued a €200 million green bond to finance research and development programs dedicated to carbon-reduction technologies.

For smaller companies—without the means to issue expensive bonds—power utilities are increasingly offering energy-efficient services accompanied by financing solutions. For instance, under ‘energy performance contracts’ a provider will identify the potential savings before supplying and implementing energy saving technology. After the upgrade, all costs are paid back by the guaranteed savings sourced from the reduction in energy consumption. This way, companies do not need to provide any financing upfront, making it affordable.  

Challenges remain

Despite growing incentives and new financing solutions, there is still some way to go—mainly because the productivity benefits and operational efficiency savings can take time to be realized.

Of course, the payback period of projects varies depending on company size, power consumption and technologies involved. For instance, low-energy lighting fitted with movement sensors can result in considerable energy savings in less than three years. But upgrades to heating, ventilation or insulation equipment can have a payback period of a decade or more.

What is more, the need to prioritize core business payments can often see financing for energy-saving measures sidelined—meaning energy efficiency initiatives sometimes struggle to take off in the first place.

And the historical lack of a standardized system for measuring energy savings has only added to uncertainty. A case in point is the failure of the UK government’s 2013 Green Deal scheme to finance energy efficiency improvements.  Project complexity, alongside high interest rates, meant investors were uncomfortable with the risk and the scheme closed after two years.

Accounting for risks

Certainly, developing new technologies, funding projects which involve contracting third parties, and dealing with energy price fluctuations involves considerable risk. In this respect, Standard & Poor’s have identified four key areas of credit risk that companies would do well to consider so that they might better manage their exposure.

First, is construction risk—the stage at which projects are most likely to default. Companies should ensure that adaptation or installation of new technology, equipment and material is kept on schedule, under budget, and to performance requirements. In fact, one way to mitigate risk here is to use fixed-price contracts, which account for any potential construction costs and time delays.  

A second important concern is counterparty risk, since reliance on third parties—for revenues, construction, equipment supply, operations and maintenance—is a common feature in energy efficiency projects. Here, the focus is on the level of exposure the project would suffer should the counterparty become insolvent—so the amount of available liquidity is key.  

Third, operational or performance risk must be taken into account. Here, developing standard procedures for proper measurement and verification of cash flows is essential to generate reliable savings. This assessment will depend on the complexity of the operations and technology involved—from simple energy saving lightbulbs, to advanced heating system technologies.
And fourth, market risks should be considered. In the energy sector, price fluctuation is always a possibility. Therefore, it is important to ensure that measures, such as financial buffers, are in place to cope with these changes.

Clearly, the need to factor energy efficiency investments into financial planning is too significant to ignore. By keeping up to speed on the risks and market trends, companies can reduce their energy consumption, cut costs, and ensure long-term sustainability which will have benefits for all.

Michael Wilkins is Managing Director, Head of Global Environmental & Climate Research, Infrastructure Finance Ratings, Standard & Poor’s.

A longer version of this article will appear in an upcoming edition of AFP Exchange.

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