And the Prices Keep Falling (part II)
In the first of this two-part post, And the Prices Keep Falling, Infrastructure Ideas highlighted the hugely positive side of this Summer’s remarkable solar auctions in Brazil and Portugal. With the price of new solar – and wind – generating capacity continuing to fall to record low levels, energy is getting cheaper for nearly all. And cleaner.
Yet there is a dark side.
Today’s post outlines some less positive consequences of these falling prices for two important sets of players. And we don’t mean the fossil fuel industry. Falling prices have downside for solar investors and lenders, and – surprisingly – for some of the countries who most need solar and wind power.
Falling costs (as distinct from prices) can affect industries in different ways. In some industries, producers are able to maintain previous price levels, or at least ensure that prices fall more slowly than costs. This drives higher profits, and is naturally the outcome to which most firms aspire. In other industries, prices fall as fast, or even faster than costs. This is the kind of outcome which disproportionately benefits consumers. As economists would frame it, consumers are capturing most – if not all – the benefits of falling costs. The solar and wind generation sectors are an example of the latter.
Why this should be the case is a good question, but one with a simple answer. Consumers, and consuming countries, have captured most or all of the benefits of falling solar and wind costs for one reason: competitive auctions. The across-the-board switch from older power procurement methods — negotiated contracts, and feed-in-tariffs – to competitive price-based auctions was pioneered in large Emerging Markets, notably Brazil and South Africa, in the early 2010s. now it is highly unusual to see utility-scale procurement on any different basis. A Bloomberg New Energy Finance analysis in 2016 found that the switch to auctions was responsible for as much of the price decline in countries which adopted them as were technology cost declines.
But what is great for buyers is becoming increasingly problematic for investors and lenders. Prices in recent PPA auctions are falling to such levels that little room is left for either unforeseen operational risks, or for the cost of capital. Already in mid-2018, UK consulting firm Cornwall Insight projected that unsubsidized solar projects would be unviable by 2030 (what happens when renewables eat their own profits?), in this case because of pushing wholesale prices in the UK down so far. Wood Mackenzie’s Emma Foehringer Merchant wrote back in January 2019 of a “finance bubble” in the solar industry. Looking at results of recent solar auctions, Merchant noted “A flood of new investors, like pension funds and insurance companies, now view solar as a stable asset. That “wall of money” going after a smaller pool of projects has created a market so competitive that many sponsors are willing to accept lower-than-average returns. Power-purchase agreement prices have also fallen to new lows, and contract terms have gotten shorter. Industry financial experts say, taken together, those trends have led to a mispricing of risk.” The chorus has become louder after this Summer’s below 2 cents/KwH auctions. A piece by Wood Mackenzie’s Jason Deign (Key to those record-low solar bids?) looked at the mechanics of bidders’ approaches to preparing these super-low priced bids, and concluded that bidders were offering very low prices for Power Purchase Agreements with the idea that they could sell power for higher prices in later years in merchant markets. An assumption which, given the recent history of how fast prices are falling, would seem highly unrealistic.
These emerging risk profiles for new solar and wind generation investments are getting further and further away from “traditional” electricity industry risk profiles, which assumed steady long-term revenues and predictably stable conditions for the life of 15 to 20-year loans. Normally lenders to such projects would adjust to higher risk and lower predictability by charging higher interest rates, but with prices falling so far and margins getting squeezed, new projects and owners have no room to accommodate higher rates – and indeed are strongly pressuring lenders to squeeze margins further down. A likely outcome? Lower profits and higher risks for renewable energy lending portfolios.
As solar becomes a larger and larger – and lower cost — market, one would think this is all good news for industry players, though we see it is not. And there’s another group for who one would think it’s all good news – but it’s not – or at least not for some of the group. This group? Low-income countries.
In principle low-income countries are the potentially biggest beneficiaries of low-cost wind and solar. Often the countries with the biggest electricity deficits, the highest costs of power, and the least money with which to add generation capacity, low-income countries stand to benefit disproportionately from plunging solar costs. And those that move to join those countries establishing competitive procurement auctions will do just that – benefit disproportionately. Their development and economic gains will be huge. The catch? Not all will manage to do so.
The difficulty for many low-income countries lies in organizing access to this new bounty of cheap solar (and wind). It will not happen by itself. Implementing competitive auctions is not an impossible task, but it does require organization, administrative competency, and ability to deliver on a process once it is announced. Many low-income countries face two important hurdles to achieve this. The first hurdle is weak administrative capacity to organize auctions. Auctions, after all, often differ radically from existing procurement mechanisms in many low-income countries, and a poorly handled process can significantly limit interest from solar companies – leading to less competition and unnecessarily high bid prices. This is a hurdle which can be surmounted, but often requires assistance from advisers who have done it before. The second hurdle is probably the higher. The second hurdle is the power of vested interests who benefit from existing arrangements – often high cost, inefficient arrangements. Foremost among these may be the national monopoly utility, and those in charge of supplying raw material – oil or coal – to the existing generation fleet. These vested interests may have significant political power and influence, enough to derail the implementation of administratively complex and novel competitive auctions for solar.
For countries which fail to overcome these two hurdles, the future is bleak. In a world where more and more countries are able to achieve lower energy costs through procurement of low-priced wind and solar generation, those countries whose energy costs are dominated by high-priced, “traditional” thermal electricity resources will become less and less competitive, and fall further behind their neighbors. Failure to join the low-cost renewable energy club will carry very high opportunity costs, both in terms of development, and of foregone economic competitiveness.
So cheer low cost solar. And encourage all not to be left behind.