By Ashay Abbhi
As per the estimates of the International Finance Corporation, India requires around $450 billion to achieve its 2030 climate change targets. This will include a debt component of $315 billion while the remaining will be financed through equity, assuming the typical 70:30 debt-equity ratio. While the traditional sources are expected to continue funding clean energy projects in the country, recycled capital from existing projects and alternative forms of financing also have a prominent role in meeting the objectives of India’s climate mitigation programmes. A recent study undertaken by the Climate Policy Initiative along with the Indian Renewable Energy Development Agency under the US-India Catalytic Solar Finance Program discusses the potential capital markets accessible to renewable energy projects in India. Renewable Watch presents a summary of the report titled “From Banks to Capital Markets: Alternative Investment Funds as a Potential Pathway for Refinancing Clean Energy Debt in India”…
Refinancing issues
In India, the primary challenges in renewable energy financing include a non-conducive policy framework, lack of risk mitigation mechanisms, and unavailability of structured financing tools to attract funding from capital markets. They prevent prevalent business models from scaling up.
India’s debt financing needs are largely fulfilled by banks and non-banking financial companies. According to CRISIL, the Indian corporate sector borrowed 2.7 times more from banks than it did from capital markets in 2016-17. In the developed markets, banks provide debt capital in the initial phase of project development. As soon as the project is operational and cash flows are stable, structured finance tools are deployed by banks to shift their loan books to capital markets. This helps unlock and recycle the capital for new projects. In India, however, such a finance mechanism is yet to take off, primarily due to an underdeveloped bond market. Therefore, debt capital in renewable energy projects can be tied up for the entire loan repayment period, which can sometimes go beyond 15 years.
Accessing debt capital markets
A capital market involves trading of debt and equity securities, wherein a range of institutional investors such as pension funds, mutual funds and insurance companies can invest in projects. For debt capital, bonds, debentures and asset-backed securities are most commonly traded. Capital markets bring a greater level of efficiency into the financial sector as large trading volumes and greater liquidity enable a better price of investment securities. Moreover, a wide base of investors and projects seeking funds helps maintain adequate supply and demand. Meanwhile, standard regulations regarding information sharing help reduce information asymmetry.
Capital markets have emerged as an alternative to bank lending, especially for renewable energy and climate projects that require low-cost capital. The financing requirement is huge, and banks are able to provide neither the scale nor the cost of capital needed. Capital markets can be flexible and provide bespoke financial arrangements for investors and fund seekers in terms of risk profile, tenor and liquidity of investment securities. Also, investments deemed risky by banks can be fulfilled through capital markets.
The renewable energy sector can access capital markets through two pathways. One involves shifting of loans by the lender to third-party investors through asset-backed securities and securitisation. The process of securitisation involves bundling several projects together into a single financial structure and selling their cash flows to third-party investors. The other path requires developers to approach capital markets directly and retire the existing loans. The developer can issue debt securities once the project starts generating revenue. Through this process, the money borrowed from banks can be repaid quickly, and can then be invested in new projects. Investors can participate by directly subscribing to bonds or by indirectly subscribing to funds that may invest in these securities. Funds may include mutual funds, alternative investment funds (AIFs), Infrastructure Investment Trust (InvITs) and insurance dedicated funds.
Roadblocks to access
In India, renewable energy projects do not achieve ratings higher than BBB or A, whereas bond trading requires AA or higher credit rating. According to the Securities and Exchange Board of India, more than 90 per cent of the bond trading in 2016-17 and 2017-18 took place for AA- and AAA- rated securities.
The market for credit guarantee has not picked up in India as the existing mechanisms do not provide an economic value proposition. These guarantees come at a cost, usually 200-300 basis points of the exposure. Therefore, the benefit of lower yield offerings is offset by the expensive guarantees. Meanwhile, only few credit guarantee facilities are available in the market and they do not provide enough value to enhance the rating of projects to AA rating.
As compared to the typical debt repayment period of around 15 years for renewable energy projects, bonds have shorter durations of a maximum of five years in India. Moreover, Indian institutional investors are not allowed to invest in securities rated lower than AA as per regulations. Therefore, the availability of long-term capital in the country is severely restricted.
The scale of renewable energy projects in India is still small. Therefore, developers are unable to issue big-ticket bonds. Smaller bonds incur high transaction costs, making the bonds economically unfeasible. Meanwhile, there is no incentive for developers to approach the capital markets while banks provide refinancing at more attractive rates once the projects are operational.
Solutions and recommendations
The corporate bond market in India needs to be deepened through structural reforms. This involves better investor protection in case of default. As liquidity and bankruptcy proceedings can take years in the country, investors usually shy away from investing in low-rated projects. Moreover, risk transfer mechanisms such as credit default swaps remain underdeveloped in India. Such instruments insure investors against payment defaults in financial assets like bonds. Reliance on credit ratings for project risk assessment needs to be reduced. These ratings are often inaccurate in capturing the level of risk for renewable energy projects.
It is important to develop aggregation mechanisms to achieve a greater scale of projects. Instruments such as alternative investment funds (AIFs) must be promoted to aggregate the cash flows of small-sized renewable energy projects to access the capital markets. Further, banks must be incentivised to move their loan books to capital markets instead of refinancing operational projects or holding loans till the portfolio matures. A strong asset-backed securitisation market will encourage banks to offload loan books to capital markets and realise upfront pricing gains.
Alternative investment funds
AIFs are instruments where capital is aggregated to be invested in a predetermined manner. These can be strategically invested in securities that go beyond the purview of the traditional financial tools. A renewable energy AIF requires a sponsor or originator such as IREDA. The AIF then invests the money in the securities or bonds of developers backed by cash flows from stable or operational projects. The capital received from bond issuances can be used by developers to retire the existing loans while freeing up capital for the originator to invest in new projects.
AIF would enable fixed cost debts and may be able to lower the cost of capital since the risks associated with operational projects are lower. Meanwhile, it is also beneficial for the market as it enhances the credit rating of renewable energy bonds. Since AIF can aggregate multiple projects, this will help overcome the lack of scale. Once the initial renewable energy AIF is successful, there will be greater confidence in these projects.
Conclusion
Achieving India’s long-term climate change and renewable energy targets will not be possible without engaging with the capital markets. While the underdeveloped bond market poses a huge challenge for clean energy projects, solutions and efforts to encourage the bond market are under way. That said, opportunities in the bond market may remain limited in the near term. Meanwhile, AIFs may be an attractive solution owing to their flexibility and their ability to circumvent the existing issues in the system.