To increase flows of finance toward transitioning sub-sectors, companies and projects, FIs need to innovate and design individually tailored products and services to facilitate that financing on a case-by-case basis. There will be unique transition pathways for each sector of the economy, so transition financing tools need to be adapted for every sub-sector, or, indeed, for every individual entity or project that is seeking financing.
Different personas across financial services including banks, insurers and asset managers will all face distinct concerns and differing practical challenges when it comes to financing transitioning projects and companies, but for all of them there are some common themes. Designing a well-structured product or service that can best facilitate and incentivize the transition means thinking across the lifecycle of an investment or loan, or underwriting process to identify where these incentivizing drivers can be inserted.
We have established a framework that delineates the different stages of an investment or loan at which FIs decision-making can drive transition incentives:
The below industry examples illustrate three major transition pathways:
- Shipping
- Renewables
- Electric vehicles
In each example, we will examine the unique challenges faced by FIs when considering how to approach each transition pathway, as well as the innovative solutions finance providers are using to overcome them.
Shipping
The pathway
The sector-level transition pathway for shipping has been designed by the International Maritime Organization (IMO), a UN agency with responsibility for the safety and security of shipping and prevention of marine and atmospheric pollution by ships.
The IMO first introduced measures to improve the energy efficiency and greenhouse gas emissions of ships in 2011 as part of the International Convention for the Prevention of Pollution from Ships. Since then the shipping industry’s transition pathway has developed in scope and ambition with initiatives to reduce the carbon intensity of new and existing vessels.
Important components of the transition pathway include:
- Shipbuilding
The Energy Efficiency Design Index (EEDI) was introduced in 2011. The regulation applied to new ships, requiring them to be 10% more efficient from 2015, 20% more efficient from 2020 and 30% more efficient from 2025. Since its introduction the EEDI has been developed to strengthen the requirements for certain types of ships as well as to better take vessel size into account. - Enhancement and modification
The IMO’s Ship Energy Efficiency Management Plan (SEEMP) is an energy management plan that aims to optimize a ship or fleet’s operational and technical performance to best conserve energy for new and existing ships. It includes best practices for fuel efficient ship operation and improvements and modifications which will improve fuel efficiency (e.g. new propellers, incorporation of new technologies, introducing hybrid fuel approaches on existing vessels). - Use
In 2018 the IMO set its Greenhouse Gas Reduction Strategy with a goal to reduce the carbon intensity of shipping by 40% by 2030 compared to 2008 levels. The organization introduced a Carbon Intensity Indicator (CII) to rate ships against a 2019 reference line. A vessel is awarded a CII rating from A-E depending on how efficiently it transports goods or passengers and per nautical mile. Under IMO protocols established in 2021, ships scoring D for three years in a row or ships that score E will need to take actions to improve their energy efficiency performance.
In the short to medium term, the shipping sector’s transition strategy is to reduce emissions using the measures above (better builds, modification of new and existing vessels and reductions in carbon intensity). New-build ships are beginning to use alternative fuels although this development is in its early stages. As of May 2021, only 12% of new builds on order are enabled for fuels other than diesel: 84% of them are still fossil fuels; either liquified natural gas or liquified petroleum gas. These fuels are viewed as a transition solution, other fuels will supersede these, over time.
In the longer term, the industry’s net zero strategy relies on the use of alternative fuels, predominantly methanol and ammonia, as well as hydrogen, biodiesel and biogas. Battery technologies form part of the picture, particularly for short haul shipping, although batteries are unlikely to be suitable for deep sea shipping routes.
The financing challenges
For financial institutions, shipping’s transition pathway presents two major challenges:
- Residual values
Vessels prices have been, at the best of times, a relatively volatile asset class from a pricing perspective; the transition prices will add further factors into the mix when considering price, particularly residual values. The need for ships to meet energy efficiency measures will begin to have an impact on residual values, and as the next generations of ships come on line, there will be further changes. The nature of vessels coming through for secondary sale will change over time (in the immediate term, vessels modified for energy efficiency will be coming up for secondary sale, those will be superseded by EEDI defined vessels over the next 5-10 years, and then superseded by LNG.LPG vessels in 10-20 years times, with those ships being superseded by alternative fuel vessels thereafter).
The problem
During the transition period, there are projected to be numerous changes to vessel types in the shipping industry over a relatively short period of time. Those changes present a challenge for finance providers assessing the extent to which they will ascribe residual value for collateral purposes against loans. The uncertainty is also posing a risk appetite challenge for FIs, with those who have historically had an appetite to finance secondary purchases (a wider net of finance providers than those which fund new builds), distancing themselves even further from new build financing.
- Structuring penalties and incentives
The IMO’s Carbon Intensity Indicator (which reflects operational carbon emissions performance) provides a potentially useful metric against which to structure bond covenants or ratchets (with positive grading and preferential pricing for operating at an improved CII level or a penalty for failing to deliver CII improvement).
The problem
It appears that FIs and counterparties in the industry have so far been reluctant to innovate in this manner. As with any new development in financing, there are associated risks for finance providers. Industry participants seem to favor gathering data regarding carbon pricing (e.g., the price of offsetting different CII outcomes) before giving any specific CII based penalty or incentive.
How FIs can overcome these challenges
- Collaboration
Insurers and banks: While finance providers grapple with the pricing impact of operating vessels with different CII levels they could work with insurers to make CII compliant operations a prerequisite for underwriting and for financing — and thereby encourage more rapid improvements in CII levels. - Primary and secondary finance providers
During the initial process of underwriting, primary and secondary finance providers could work together in order to give the primary finance provider a suitable "off-take" (a refinancing option from the secondary provider set out in indicative terms for a few years down the line) this would help to provide a refinancing, and with it a secondary ‘price floor’ thereby building confidence in the residual price of the asset. - Experimentation
Start to set margin ratchet step-downs (even at modest basis points) based on the achievement of certain emissions-related KPIs or adherence to better performing CII levels — and margin ratchet increases if these KPIs are not met. Introducing new CII-based ratchets will help to incentivize positive performance by borrowers, although lenders will need to develop their knowledge about borrowers’ transition pathways and their skills to monitor and evaluate borrowers against these KPIs. Experimenting now with innovative financial instruments will help these structures become more of a market norm.
Renewable energy
The pathway
The appetite for transition toward clean energy is huge — the IEA estimates $750 billion of investment in clean energy in 2021. Investments in renewables will need to increase substantially over time, the IEA’s 2021 global roadmap for Net Zero by 2050 estimates that investments in electricity generation and energy infrastructure will need to reach $2.5 trillion by 2030 to meet net-zero targets.
Renewables projects requiring financing currently fall into three broad categories:
- Development — early stage formation of projects
- Traditional construction — typical risk factors include project risk and country risks as well as weather-related risks (i.e., evaluating wind speeds for wind farm projects and solar irradiation levels for solar power projects)
- Newer and innovative construction — for example, colocation of clean energy production and energy storage capabilities (i.e., battery storage) enabling a more consistent profile of energy sale even if the production is more volatile
The financing challenges
- Power prices
Typically, finance is structured around the cash flows associated with a project (e.g., the operations and maintenance contract, power purchase agreements and power prices in the open market). Outside of country risks, the main financing challenge relates to the fact that while a lot of costs are predictable, the income can be uncertain given the volatility of power prices.
The following challenges emerge as a result of this volatility in liberalized power markets: i) forecasting power prices into the long term; ii) the impact of new construction (increasing supply) on power prices (“cannibalizing” existing pricing).
Pricing uncertainty (“merchant risk”) is therefore factored in by lending banks. Typically FIs evaluating projects and companies in the renewables space will take a ‘baseline’ power price forecast and structure financing and underwriting based on low power price scenarios. Financial institutions have little incentive to consider/underwrite against other, more optimistic power price scenarios. - Resilience
Any outage of a project clearly limits supply and revenues are also disrupted. The potential for outages further disturbs the certainty of cash flows. Climate change is increasing the likelihood and frequency of extreme weather events and therefore the potential for outages (e.g., extreme cold causing wind turbines to freeze, solar panels breaking with hail). A number of projects are looking to invest in resilience (giving a higher level of protection to their assets); however, this investment currently increases the cost profile and the benefit to cash flows is not necessarily seen commensurately by lending organizations to make this investment worthwhile. - Colocation
Investing in energy storage colocation projects may help regulate the supply of clean energy, with the renewable power generation asset producing energy when the weather conditions prevail and storing that output to deploy when weather conditions are less favorable — but power is still in demand. Producers are also able to smooth pricing and sell stored energy onto the market at optimum points. These abilities will give renewables projects much higher certainty of cash flows — however, the nature of colocation projects presents some challenges for FIs. Many FIs will view a clean energy asset and a battery storage unit as two projects with separate risk profiles, each with their own uncertainty — rather than one set of complementary risks. - New technologies
There are an increasing number of technologies emerging with high potential – including green hydrogen, green ammonia and others. However, technology risks and the lack of track record associated with new projects make securing finance a challenge for nascent technologies.
The aggregation of risks (project, country, merchant, physical and technology risks) typically results in pricing of conventional bank funding that is beyond that which operators would commercially seek to secure, and the lack of viable finance inhibits new projects.
How FIs can overcome these challenges
A number of measures have already been taken to address the power price challenge – in particular to remove some of the pricing risk associated with power price fluctuations. These measures include entering into Contracts for Difference (CFDs) and engaging in longer term power purchase agreements with corporates (in turn, renewable providers are helping a range of corporations achieve RE100 status and with it their net zero or carbon neutrality aims). The lower pricing risk should help enable financing.
A range of other innovations may also help provide cheaper financing:
- Developing in-house power price view
The discipline of power price forecasting is still improving and the data we have is from a relatively thin set of providers — establishing a broader panel of evidence, with a broader range of views will allow the responsible committees within FIs (e.g., credit committees) to better understand potential project outcomes and better discern whether to facilitate financing.
FIs will also look to establish an in-house macro view on new power developments likely to impact power pricing forecasts (e.g., in the UK the time horizon for power production at Hinkley Point) as a basis for their decision-making.
- Working across silos
For colocation projects (see above), FIs that foster collaboration across teams will be better placed to assess aggregate risk and therefore enable financing for colocation projects.
- Workforce skills
FIs working with renewables providers should invest in talent and workforce skills across their relationship management and/or underwriting teams to ensure they have the capabilities needed to appropriately evaluate the merchant, physical and technology risks associated with renewables projects (as well as the project and country risks which have perhaps been the focus to date).
Electric vehicles
The pathway
Surface transport accounts for roughly 20% of global CO2 emissions. More than a dozen countries around the world have announced plans to phase out passenger vehicles powered by fossil fuels, some countries also have plans to ban the sale of new petrol and diesel HGVs. The electric vehicles (EV) market needs to develop in line with those transition goals, and producers of components for internal combustion engine (ICE) will need to plan for a future in which there is decreasing demand for their products.
There are four key elements in the move to electrification:
- The battery ecosystem — Battery supply chains are becoming regionalized as EV battery manufacturing premises open in new jurisdictions. EV gigafactories will require upstream development of supply chains for the materials and minerals required for batteries and downstream development of recycling and reuse facilities.
- Fleet transition — Commercial and private vehicles fleets need to transition from conventionally fueled vehicles to EVs. Global initiatives such as the EV100, which seeks to encourage companies to transition their vehicle fleets and provide charging infrastructure for employees and customers will help to influence policy and increase demand for EVs, thereby accelerating change in the market.
- Infrastructure transition — Fleets transitioning to EV will need charging infrastructure available to them at sufficient scale and in the right locations.
- Supplier resilience through the transition — The move away from ICE vehicles presents risks for manufacturers across those supply chains. Those risks need to be managed to ensure that producers do not face “cliff edges” or risk becoming stranded assets. The requirements for components in EVs will remain the same for some suppliers (e.g., those making seats) but suppliers currently making components for ICE vehicles will need to pivot their production lines to make components suitable for EVs (e.g., different component shapes/sizes/purposes but same materials and processes). Some suppliers will no longer be relevant at all, particularly those making engine components (e.g., spark plug manufacturers). Only a small swing in demand from ICE to EVs will lead some traditional ICE suppliers to lose economic viability. Typical supplier production levels need to be 80%+ to break even meaning that we only need to observe a 20-30% swing toward EVs for some suppliers to go out of business (that swing is predicted to happen by 2024).
The financing challenges
- Residual values
A secondary market for both EVs and the batteries inside them is not yet fully formed enough to give underwriters confidence — banks are therefore simply not willing to take on residual value risk. There are several factors that will determine residual value levels but the mechanisms through which these can be measured have not been determined. For example, the way a vehicle is used will have an impact on the life of the battery inside it, in particular the number of charges a battery undergoes, and the type of charge used (e.g., fast charge versus trickle charge) will influence battery life and therefore residual values. - Who owns the supplier resilience challenge?
When suppliers fail in other industries OEMs may step in to rescue/finance them. However at the present time automotive OEMs are focusing their capital expenditure on the transition and do not have available funds to support failing suppliers. Governments may play a role in supporting suppliers; however, business failures may be seen as simply "the cost of transition." But ICE parts will still be needed until transitions are complete, so industry players will need some ICE suppliers to continue operating. FIs may be able to help ICE suppliers to consolidate to solve this challenge; however, consolidation efforts would require careful navigation from an antitrust perspective. Decommissioning finance is a tricky area for FIs, while an economic case can be made for it — especially as the “last man standing” in a given market can command higher prices during the wind down period — wind down risks are not easy for FIs to price attractively. - Reputation in sourcing and recycling
Batteries require a range of minerals (e.g., nickel manganese cobalt, lithium) and the sourcing of those is a process that needs to be understood for it to be carried out safely and appropriately. The same goes for end-of-life recycling of batteries. Battery technology is changing all the time and keeping up with these shifts — and the impact new battery technologies have on recyclability — is difficult for finance providers to analyze. Understanding the evolution of raw materials pricing is also challenging for financing teams.
How FIs can overcome these challenges
- Technology innovation to aid residual value (RV) assessments
Telematics are already widely used in the insurance industry to understand use of vehicles. Telematics and internet of things (IOT) technologies could be deployed by finance providers to keep track of EV use and charging and to understand the impact of that use on the health of the battery. That data can be used to help structure covenants, or to underpin a guarantee around RV, or to underpin dynamic pricing. - Collaboration
To solve the decommissioning and supplier resilience challenges noted above will require cooperation between big industry players, OEMs, governments and finance providers. FIs should seek to invest in their relationships with industry and with government to enable productive collaborations. - Workforce skills
To keep abreast of the fast pace of change in the dynamic EV, battery and battery recycling landscape will require FIs to develop deep sector-specific knowledge among personnel who work on financing for the automotive industry.