Renewable Energy Finance: Sovereign Guarantees

Overview

With less than two decades to achieve significant carbon dioxide emission reductions, as outlined in the Paris Agreement, global efforts aim to limit temperature increases to well below 2°C, ideally 1.5°C, above pre-industrial levels. Meeting these climate goals requires substantial energy investments, estimated at USD 110 trillion by 2050, or roughly USD 3.2 trillion annually. Sovereign guarantees, traditionally vital for making renewable energy projects bankable, are becoming harder to secure, prompting the exploration of alternative risk mitigation tools. While public funds are critical, they alone cannot meet climate targets, necessitating greater private sector investment. Despite available capital, private investment in renewables faces barriers due to complex risk perceptions, particularly in less-developed countries where higher risk premiums or additional safeguards are often required.

Investment Trends in Renewable Energy

Global investment in renewable power has surged from under USD 50 billion annually in 2004 to approximately USD 300 billion in recent years, outpacing fossil fuel power investments by a factor of three in 2018. Hydropower remains the largest contributor to renewable capacity (50% in 2018), but solar and wind power dominate new installations and investments, accounting for 90% of renewable power investments in 2018. A notable shift has occurred toward emerging and developing markets, which have attracted the majority of renewable investments since 2015, representing 63% of 2018’s total. Key markets include China (33% of global investments in 2018), India, Brazil, Mexico, South Africa, and Chile. However, regions like Africa, the Middle East, South-East Asia, and South-East Europe still have significant untapped potential.

Emerging business models, such as green bonds, corporate renewable power procurement, and pay-as-you-go systems for small-scale renewables, are diversifying investment vehicles. Despite these positive trends, current investment levels fall short of the USD 110 trillion needed by 2050 to limit global warming to 1.5°C. Renewable power alone requires USD 22.5 trillion, or roughly USD 662 billion annually—more than double current levels. De-risking projects and creating bankable pipelines are essential to attract sufficient capital.

Financing Public-Private Partnership

 

The Role of Sovereign Guarantees

Achieving financial close for renewable energy projects requires managing risks to satisfy all stakeholders. In emerging markets, country-specific risks—such as non-creditworthy off-takers, changing legal or tax environments, or tariff adjustments by new governments—deter investors. Sovereign guarantees, where a government ensures obligations are met if the primary obligor defaults, have historically addressed these risks. They are commonly used to attract independent power producers (IPPs) in countries with negative risk perceptions, covering:

  • Non-payment by state-owned off-takers.
  • Breaches of power purchase agreements (PPAs).
  • Unilateral tax changes.
  • Termination clauses.
  • Currency inconvertibility or transfer restrictions.

These risks are often under government control, making sovereign guarantees a logical risk allocation tool. For example, off-takers may lack creditworthiness due to government-set electricity prices, subsidized fuel costs, or inadequate infrastructure leading to high transmission losses (20% on average in Africa, up to 50% in some cases). Sovereign guarantees, typically issued by the Ministry of Finance and reviewed by the attorney general, provide recourse to a more creditworthy entity, reassuring investors and lenders. However, obtaining these guarantees is increasingly challenging due to:

  • Arbitration cases where IPPs successfully invoked guarantees, raising government caution.
  • Fees charged by Ministries of Finance to off-takers for issuing guarantees.
  • International Monetary Fund (IMF) treatment of guarantees as contingent liabilities, potentially increasing national debt ratios and limiting borrowing capacity.
  • Doubts about governments’ ability to honor guarantees, as defaults can trigger secondary economic effects.
  • Long-term PPAs (often 20 years) spanning multiple election cycles, risking challenges to prior commitments.

Alternatives to Sovereign Guarantees

As sovereign guarantees lose their universal appeal, several alternatives have emerged:

  1. Letters of Comfort/Support: Issued by the Ministry of Finance, these documents provide reassurance without the binding nature of a formal guarantee. Some include enforceable commitments, while others are less definitive.
  2. Preferred Creditor Status (PCS): Multilateral institutions, such as the World Bank or African Development Bank, leverage PCS, where governments commit to compensate for losses caused by their actions. PCS can apply broadly or to specific transactions, with governments informed in advance to align with national priorities.
  3. Put and Call Option Agreements (PCOAs): Replacing traditional PPA termination clauses, PCOAs allow IPPs to sell a project (structured as a special purpose vehicle) at a pre-agreed price if the off-taker or government defaults. This transforms a contingent liability into a commercial transaction, reducing perceived risk for IPPs.
  4. Bilateral Treaties: Agreements between governments protect transactions from political risks, often enforced by export credit agencies (ECAs). These are effective when the investor’s home country has strong diplomatic ties with the host government.
  5. Regional Programs: For instance, a Pacific Renewable Energy Program provides guarantees and loans for renewable projects in Pacific Island countries, addressing fiscal constraints. It includes partial risk guarantees, direct loans, letters of credit for liquidity, and technical assistance to streamline small transactions.

Recent Developments

  1. Improving Off-Taker Creditworthiness: Structural reforms, supported by large financial institutions aim to recapitalize utilities, enhance management, and align revenues with expenses to reduce reliance on guarantees.
  2. Partial Risk Guarantees (PRGs): Issued by multilateral institutions, PRGs are triggered by specific events and backed by government guarantees. Rarely called, they rely on the issuer’s bargaining power to resolve issues.
  3. Local Currency PPAs: To address currency risks, some propose PPAs in domestic currency, easing off-taker treasury issues. This suits local investors like pension funds but requires further study.

Opportunities for Engagement

  1. Risk Assessment and Mitigation Platform: A database of risk mitigation providers (insurers, guarantors, banks) offers alternatives to sovereign guarantees, detailing products, eligibility, and processes.
  2. Knowledge Sharing: Information on bankable project solutions, innovative financing, and risk mitigation tools is freely available, supporting IPPs in achieving financial close.
  3. Transparent Procurement: Guidelines for renewable energy auctions promote transparency, reducing risks of future government challenges compared to feed-in tariffs or single sourcing.
  4. Open Solar Contracts: Standardized contractual templates for solar projects balance risk allocation, enhancing bankability and reducing disputes.
  5. Regional Investment Forums: These platforms share trends and solutions, fostering technical assistance programs tailored to regional needs.

Conclusion

Sovereign guarantees remain a key tool for unlocking capital for low-carbon investments, particularly in high-risk markets. However, their declining availability has spurred innovative alternatives that effectively mitigate risks and drive renewable energy adoption, ensuring progress toward sustainable development and climate goals.

Glossary

  • Contingent Liability: A potential obligation triggered by an uncertain event, like a payment default.
  • Escrow Account: Funds held by a third party until transaction conditions are met.
  • Export Credit Agency (ECA): Institutions financing exports, insuring against political and commercial risks.
  • Feed-in Tariff: Long-term pricing for renewable energy based on generation costs.
  • Financial Close: The point when financing conditions are met, and funds are released.
  • Investment Grade: A rating indicating strong financial reliability (e.g., AAA to BBB-).
  • On-Demand Guarantee: A guarantee honored upon request without justification.
  • Political Risk: Risks like expropriation, currency inconvertibility, or government breaches.
  • Power Purchase Agreement (PPA): A contract for purchasing renewable electricity.
  • Special Purpose Vehicle (SPV): A legal entity isolating a project from parent company risks.
  • Stand-by Letter of Credit (SBLC): A bank guarantee ensuring payment if a client defaults.