Are renewable energy investors gullible fools?

Law firm Baker and McKenzie suggests owners of renewable energy projects will be financially ruined by the government's plan to cut the RET. But shouldn't they have seen this coming?

Look, we originated a renewable energy target. That was one of the policies of the Howard Government and yes we remain committed to a renewable energy target … we have no plans to change the renewable energy target. 
--Tony Abbott, September 29, 2011

There is a considerable consternation amongst the investor community about Industry Minister Ian Macfarlane’s announcement the government wants to cut the large-scale Renewable Energy Target by 40%.

Today the Clean Energy Council has released analysis by the legal firm Baker & McKenzie suggesting such a change would seriously undermine the value of $10 billion in existing investments, destroying investor confidence, and consequently “inflicting damage on Australia’s reputation as a safe place to invest”.

Is it really that bad?

Across a range of sectors of the economy -- particularly infrastructure -- investors need to put up large sums of money upfront on the basis of a government promise that will influence their future revenue from that asset. We see it in regulated monopoly assets such as gas pipelines, electricity networks, ports and telecommunications. We even see it in mining and oil and gas projects where governments around the world charge a form of tax in granting the rights for a company to extract these resources.

Now, the reality is that governments sometimes need to change the rules or revisit the nature of their promise due to changing circumstances.

Businesses are prone to scream “sovereign risk, sovereign risk!” whenever such changes reduce their financial returns, but this is just silly. Like most things in life, it is a matter of degree.

In evaluating what a government change of rules might mean for the risk associated with future investments, financial markets will consider things such as:

1) How significant is the change in rules and its effect on financial viability of the investment;

2) Could such a change be reasonably anticipated; and

3) Was there some major changes in circumstances that could justify government making such a change.

To explain, no investor could reasonably begrudge a government moving to ban a product if it was found that it was incredibly dangerous to human health. Imagine government allowing the continued sale of asbestos for fear of undermining past investments.

However, a change to the rules made by government that is not foreshadowed in advance, which dramatically reduces returns, and appears to be arbitrary or even made in malice rather than because of an overriding problem facing the community, is naturally one that will severely undermine investor confidence.

Could you reasonably anticipate the change?

Now there were plenty of people who, reading between the lines and knowing the background of the Coalition leadership, were deeply suspicious that the Coalition would scale-back the Renewable Energy Target once in government. But this was denied under repeated questioning.

Back in September 2012, I put the following question to the now Minister for Environment Greg Hunt:

Is the Coalition committed to a renewable energy target that maintains at least the same amount of gigawatt-hours worth of demand for renewable energy from 2013 to 2030 as contained in the current legislation?

His reply was generally reassuring that there would not be change but was a little tricky in avoiding mentioning the gigawatt-hours:

We are committed to the 20% RET and have no plans to change the current arrangements.

Naturally, I followed him up on asking whether a 20% RET might be one defined differently to gigawatt-hour target currently embodied within the legislation, to which he replied:

"We genuinely have no plans to change any definitions."

In addition, as late as June 2013 Hunt said on Sky News:

We … agree [with Labor]  on the renewable energy target. And one of the things we don’t want to do is to become a party where there is this wild sovereign risk where you are, where businesses take steps to their detriment on the basis of a pledge and a policy of government. And we’re very clear that that’s not what we want to be.

Now, maybe investors should have just assumed the Coalition were a pack of liars, but some chose to take them on their word. Indeed they took them on their actions, given the Coalition voted not once but twice in favour of legislation which set-out the gigawatt-hour targets.

Have circumstances changed recently that could justify a change of heart?

According to Ian Macfarlane reductions in electricity demand have occurred which mean renewable energy will far exceed the original intent of 20% market share.

But it was apparent in 2010 that renewables would exceed 20% share when the Coalition voted for amendments to the scheme. And you’d have to have been hiding under a rock to not know this by mid-2012.

Greg Hunt and Ian Macfarlane publicly acknowledged the drop in electricity demand well before they were elected, and meanwhile they continued to reassure people they did not intend on changing the Renewable Energy Target.

In addition, one has to ask what is the problem that is created by the RET remaining as it is, given electricity demand growth has declined.

Will it mean higher electricity prices? Not according to the government’s energy market modelling.

Does it result in reduced reliability of electricity supply? Not according to the Australian Energy Market Operator.

Will it reduce the environmental benefits of the scheme? No, it actually means CO2 emission reductions will be greater than previous thought.

The main change is that it will impose greater economic costs on the owners of other electricity generators – but most of these have been acquired since after the RET target was expanded and buyers would even have paid discounted prices for these generators reflecting the impact of the RET. 

So how significant is the government’s proposed change?

The Baker and McKenzie report observes:

Any substantial reduction of the RET will invariably lead to REC prices being sufficiently lower than prices modelled for operating projects and projects under development for the purposes of equity and debt financing. There is general consensus among energy market forecasters that REC prices will fall on average by between 10% - 30%.

That’s a pretty big hit. If we were to take ACIL-Allen’s modelling of electricity prices as well as REC prices, the government’s proposal will result in roughly a 10% reduction in overall revenue for large-scale renewables projects.

Such a large fall in the revenue of existing projects would probably leave equity funders extremely badly burnt.  

However, according to Baker and McKenzie the hit to equity financiers is likely to be worse than indicated by the reduction in revenue. This is because they believe such a significant change in the law will heighten bankers' perceptions of risk surrounding lending to such projects. Baker and McKenzie understand that the vast majority of existing projects will be up for refinancing over the period 2016-2018. Those projects will consequently face higher costs for debt relatively soon which will further reduce returns to equity holders beyond the reduction in revenue.

Baker and McKenzie concludes:

“Any reduction to the RET will trigger a set of review and default mechanisms in debt financing agreements which could lead to actual default and, potentially, an enforcement scenario. In such circumstances, equity will likely take a significant write-down (even up to 100%) on the value of their investment.”