The Dark Arts of Financial Modelling

There’s a common perception that a financial model is a black box – numbers go in and numbers come out, but what happens in between is a complete unknown and only to be understood by an elite few who dabble in the dark arts. It is certainly true to say that some financial models do meet that description, but a good financial model should not.

A good financial model should be easy to follow and transparent in its structure. A lot has been written about the importance of clear formulas, but where there is far less focus on models is in the structure of the model itself.

I like to think about this in terms of a marble run. For the lucky people out there who haven’t experienced the joy of a marble run, the basic idea is to drop a glass marble in at the top and watch it descend through all the various traps and tricks you have built before finally coming to rest under the fridge or equivalently inaccessible place. So what does this have to do with models? I think of the marble as an input, its journey as the workings of the model and its final resting place as the result.

A good marble run is largely the opposite of a good model. It is complex, does a few wholly unnecessary loop the loops and produces random results, but there are some similarities. If you put the marble in at the top and it doesn’t go anywhere or gets stuck, it’s not much fun. In the same way, we see plenty of models with excess marbles (sorry, inputs) that are redundant or don’t contribute to the derivation of the results. This is no fun either and, at its worst, can lead to a significant error.

A good model represents the most simple and boring marble run. The marble should go in at the top and clearly work its way through the system. The system should be designed so that it is easy to add more inputs and more sections, but that so that there is no doubt the overall flow will be unchanged. In the diagram above, another input ball can be added and its journey is clear. It will not skip a section, come out the side or move over to another section. This is the transparent art of financial modelling.

At Elgar Middleton we can build some great marble runs, but we also know how to build good models.

Elgar Middleton completes the financing of a solar portfolio in the Republic of Ireland

Elgar Middleton is delighted to have advised Neoen and BNRG on the financing of three solar PV farms, totalling 58MWp, in the Republic of Ireland.

The three projects will be among the first large-scale solar projects to be installed in Ireland, and will benefit from Irish State support through a CFD mechanism until 2037.

Elgar Middleton advised Neoen and BNRG in their successful participation in the RESS-1 auction and throughout the financing process, allowing the projects to secure over €30 million of long-term non-recourse debt and ancillary facilities from Société Générale.

How to Avoid A Climate Disaster: A Book Review

Introduction

In a recent FT interview, the bestselling author of “Homo Deus” and “Sapiens”, Yuval Noah Harari remarked that the COVID pandemic is no longer a natural disaster but a political one. Furthermore, it has revealed the inability of national governments and institutions to coordinate and act in unison to prevent a global disaster. And while we are still battling one disaster, another one is unfolding beyond a tipping point: climate change.

In the next few paragraphs, we will attempt to zoom out of the current M&A and financing transaction frenzy keeping us busy and briefly assess the high-level context renewable energy projects on the path of decarbonization.

To do this we have selected a few key insights from Bill Gates’ latest book: “How to Avoid A Climate Disaster”, published earlier this year.

A long story short: Summary

The book makes a meaningful contribution to the current climate change action debate in at least two distinctive ways.

Firstly, it provides a simple and clear overview of the relative contribution to global CO2e emissions from several areas of our lives (electricity, construction, transport, etc.). Secondly it provides directions of how emissions can be reduced over a 30-year horizon and what action stakeholders can take to address an obvious shortage in climate technology innovation.

The main theme is that avoiding a climate disaster is a combination of two factors: adaption and mitigation, with 80% of the chapters focused on mitigation. The fundamental message is that all efforts should be focused on eliminating approximately 51 billion tons of C02e (equivalent emissions) p.a. from today’s emissions by 2050.

The author makes a clear point that efforts to (only) reduce emission by 2030, such as replacing coal with gas generation or petrol cars with diesel/hybrid, are in fact counterproductive as they are not only insufficient to enable humankind to achieve a full emission elimination but represent a different social and technological trajectory than decarbonization by 2050. Therefore, decarbonization focus and targets should be assessed on the basis of their contribution to the “zero emission by 2050” target and not merely a reduction effort.

The below paragraphs will summarize several of the book’s chapters but omit a significant part of insightful advice provided in the book on adaptation / government policy and personal contribution. We consider the practicality of those ideas both highly relevant and relatable.

What are the consequences of delayed action?

Before we provide a short list of the what the social and economic costs of a delayed response might be, let us first consider what the impact of COVID-19 related economic curtailment is. It turns out CO2e [1] emission levels have reduced [2] by approximately 2-3 billion tons or just less than a 6% reduction in required levels.

This is not encouraging at all, in particular given that the increased economic activity projected for 2021 is already expected to compensate for some of those saved emissions.

A lot has been said about the consequences of pandemic related, cause-effect relationships, so here is a reminder taken from the book, of some social, political and demographic consequences, which hopefully resonate even more in a post-pandemic world:

How can the financial impact of climate change be quantified?

The book puts forward a simple model that approximates the impact of climate change [3] to the US economy to be roughly equivalent of the effect of one COVID-19 pandemic once every 10 years. This is equivalent to a reduction of approximately 1-1.5% in US GDP per annum or an approximate GDP reduction of USD 2-3T every 10 years.

Considering the scale of the potential financial impact, what part of this cost is already priced in by the global equity and debt markets?

It seems the answer is “not much” – at least according to PGIM’s David Hunt and Taimur Hyat. In “Megatrends- Weathering-Climate-Change Spring 2021” they consider the possibility of a “climate change Minsky moment”, leading to a sharp and disorderly repricing across all asset classes at an approximate cost of USD 20. Their estimations are that the equity and bond premium in many sectors are inadequately reflecting the associated (local) climate risks. In particular municipality / state (Miami / Florida) and sovereign debt rating (e.g. Bangladesh, California) seem to be non-representative of the impact of local weather events. To what extend might a major repricing of sovereign bonds, even if it doesn’t result in non-payment defaults, lead to cross contamination of global fixed income markets remains to be seen. Historical references (e.g. “Asian Contagion”, “Russian financial crisis”) might offer insights. Equity asset repricing risk, according to the authors is high, with additional equity market discount of approximately -200bps for Indian equities and -50 bps for Chinese equities not captured in current stock prices.

These estimates also ignore all the significant economic cost associated with increased inequality, humanitarian cost of deaths.

What needs to be done?

So, if the target is to remove 51B tons of CO2e per year, Bill Gates’ team suggest that there are two ways to achieve this. One seems plausible and the other less so, but let’s start with the easy answer first: Direct Air Capture (“DAC”).

DAC is a largely unproven technology for capturing CO2 directly from the air and currently pegs at a cost of USD 200 per ton of captured CO2. Capturing approximately one C02 molecule out of 2500 air molecules is less efficient compared to direct point capture, which can result to up to 90%, but CCS (carbon capture and storage) technologies have hardly been a success story historically and more importantly, only energy generation emissions can be subject to CCS point capture.

So, removing 51B tons per year at USD 100 (50% lower than the current cost) will be equal to USD 5.1T per year. For reference this is the GDP of Germany (3.86T) and Spain (USD 1.4T) together. Joe Biden’s “American Jobs Plan” infrastructure plan envisages spending USD 2T over 8 years, funded over tax increases over 15 years!

Even if it was technologically feasible the cost might be prohibitive.

Let’s move on to the second – also difficult – but more realistic option: emission reduction. Where do most emissions come from?

The next sections will focus on a few ideas on how to tackle three of them

How we make things (Manufacturing): 31% of total emissions

Having such a high proportion of emissions attributed to one sector might be considered good news as progress should be quick. Unfortunately, the ability to decarbonize the production of cement, steal, plastic and aluminum is rather complex.

Making cement contributes approximately 1 ton of C02e per ton of cement, and with approximately 5Bn metric tons produced in a year it responsible for the same emission intensity as steel production which is twice as intensive at 1.8t CO2/ 1t. Both together contribute more than 10Bn tons of CO2 emissions per year (approximately all the CO2 emissions of China p.a.).

Steel and aluminum production can be zero carbon if electrified (for example via molten oxide electrolysis) and so can plastic production – if produced from captured carbon and added heat.

There is potential for reduction of cement emission of up to 70%, but it comes at a relatively high premium. One approach might be to add captured “recycled” carbon  to calcium oxide in the cement production process. Another, more theoretical one, is the production of cement from seawater, but even those would not enable 100% clean cement.

How much higher will the cost of these goods be if we need to decarbonize immediately:

    • Plastic – Cost increase: +10-15% to USD 1115/t
    • Steel premium – Cost increase: +16-29% to USD 850-1000/t
    • Cement – Cost increase: 75-104% to USD 220-300/t

How we plug in (Electricity): 27% of total emissions

Not surprisingly a transition to low carbon generation seems to be key and for most developed nations (such as the US & EU) a transition to a 100% green grid will come at an increase of 15-20% (or USD 13 a month) in power bills per household per year. The problem of course is the rest of the world and developing countries in Asia (India, Indonesia, Vietnam, Pakistan) and Africa. Their Green Premium Costs at the moment are disproportionally higher, hence their slower ability to decarbonize. On the other hand, if they follow China’s coal energy generation path, a climate disaster will be unavoidable.

The book goes very briefly into dealing with the intermittency of renewable generation, but the author admits that its more the seasonal intermittency that’s problematic.

Also, unsurprisingly, the book mentions a technology that the author has been supporting for at least a decade: nuclear fission (not to be confused with nuclear fusion). We should mention that fission reactors are 15x more efficient in using construction materials (cement and glass) than solar and 10x more efficient than wind and approximately 400x less deadly than coal and 40x less deadly than gas. Could and should nuclear be a fundamental part of the energy mix of the future? According to Bill Gates, the answer is a resounding “Yes”. Many might disagree.

Herewith, the solutions proposed for reducing emission in energy generation are rather straightforward: a) more investment in interconnection and distribution networks, b) more offshore wind/solar, storage, cheap hydrogen / thermal storage and in the meantime, carbon capture, and, last but not least, c) reduced energy usage and ramping up of energy efficiency measures.

How we get around: 16% of total emissions

Transport is only the fourth biggest contributor of emissions but is currently receiving a lot of attention. The emission breakdown is as follows:

Gasoline’s “Green premium” of USD 2.43/gallon to USD 5/gallon is equivalent to a 100% increase if we replace petrol with advanced biofuels or USD 8.2 (350%) if we employ electro fuels (hydrogen + carbon). Trucks, buses and planes are subject to approximately the same premiums.

Container ships currently have a fuel cost below USD 1.29/L so an equivalent fuel increase of 326% / 600% increase might suggest why they will decarbonize last.

Quick word on electro fuels, which are produced from (clean) hydrogen with added carbon and include biodiesel, methane and butanol. These are obviously interesting as a carbon recycling idea but considering the immense cost of producing clean hydrogen and carbon capture, it seems like electric vehicles (“EV”) or hydrogen itself will be much more efficient.

So, the solutions here seem to be to drive less or failing that, encourage more EVs  and increase effort to improve biofuels or electro fuels to lower the green premium.

The role of innovation and R&D

Unsurpisingly, almost all of the proposed solutions rely on upgrades in technology or significant improvements in industrial or manufacturing processes. The speed of these improvements depends to a large extend on the priority and incentives these types of technological innovations receive from policy makers at state/federal or local level.

The message from the book is that efforts in developing technological solutions are currently insufficient and more public support is required both to increase the supply and demand for innovation in clean technology in the following areas:

Conclusion

The above summary captures only about half of the book. To gain the full picture including the areas of heating, cooling, agriculture, adaptation and government and consumer behaviour changes, we do recommend getting a copy of this well researched and very readable book.

We found the high-level breakdown of C02e emissions combined with the impact of different solutions to be straightforward and helpful in contextualizing the effort required to reduce emissions and reduce the impact of climate change.

A clear theme explored through the book is that electrification of different sectors (transport, industrial processes) combined with sufficient cheap green energy generation is one the most viable ways to decarbonize the global economy by 2050. The continuous reduction in LCOEs we’ve observed over the last decade is a significant contributor to this, but so is the application of lessons learned from the early days of wind and solar in Europe and the US.

Sometimes we might have the tendency to think that the future ahead of us is deterministic, i.e. renewables will displace coal, EVs will replace petrol cars, and the planet will avoid a climate disaster. Such deterministic confidence is often a product of hindsight bias and probably highly inaccurate. Hopefully it is a product of our “stubborn optimism” [4] and not complacency.

These positive future outcomes of the world we must create are indeed very much determined by the actions of companies, communities and individuals today, as well as their alignment with the task to narrowly steer away from a global scale climate disaster within our lifetime. The stakes and our responsibility to avoid a climate change disaster could not be any higher.

On Elgar Middleton

Elgar Middleton have been involved in the global transition to a low carbon economy for over 10 years. During this time, we have helped our clients raise over £3.5 billion of senior debt for the financing of renewable generation assets, as well as working on over 50 acquisitions and disposals. Our experience encompasses all the renewables sub-sectors and we assist our clients across Europe and Australia from our London and Sydney offices.

Footnotes

[1] CO2e (equivalent) here will refer not only to C02 emissions equivalents but also include nitrous oxide and methane. In the case of methane, a greenhouse gas 120x more potent than CO2
[2] Period from Q1 2020- Q1 2021
[3] By the year 2050
[4] See “The Future We Choose” by Christina Figueres and Tom Rivett-Carnac

Elgar Middleton completes sale of a commercial rooftop solar portfolio

Elgar Middleton is delighted to have advised Innova Capital on the sale of their commercial rooftop solar portfolio to Octopus Renewables.

Innova Energy (“Innova”), a private equity-backed solar energy company, managed by Innova Capital, has completed the sale of its commercial rooftop solar portfolio to an investment vehicle managed by Octopus Renewables (“Project Astrid”).

The portfolio comprises 57 rooftop-mounted solar PV assets in the UK, representing 3.7MWp of installed capacity, all of which benefit from Feed-in-Tariff government subsidy.

Elgar Middleton Infrastructure and Energy Finance LLP (“Elgar Middleton”) was Innova’s exclusive financial advisor on the transaction.

Innova was also advised on the sale by TLT and PKF Francis Clark. Vendor due diligence was carried out by Morgan La Roche, TLT, RINA and Corylus Planning and Environmental.

JLEN signs new £200m ESG-Linked Revolving Credit Facility

Elgar Middleton is delighted to have advised JLEN Environmental Assets Group (“JLEN”) on their refinancing of an existing RCF with an ESG-linked facility.

JLEN has successfully signed a £170m multicurrency RCF with an additional £30m accordion facility.

The RCF provides an increased source of flexible funding, with both Sterling and Euro drawdowns available at lower rates than the existing facility. The interest charged in respect of the renewed RCF is linked to the Company’s ESG performance, with JLEN incurring a premium or discount to its margin and commitment fee based on performance against defined targets. Performance against these targets will be measured annually with the cost of the RCF being amended in the following financial year. These targets include:

  • Environmental: volume of clean energy produced
  • Social: contribution to community funds
  • Governance: number of work-related accidents

The new facility was provided by a group of five banks: HSBC, ING, NAB, NIBC and RBS.

Exploring the correlation between the carbon intensity of the UK’s electricity and the wholesale price

There is much debate in the mainstream media about the cost of generating electricity from renewable sources. The underlying belief often being that green = expensive. But is this necessarily true? In light of this debate, William Evans looked at daily data from 2020 and in his article below, explores the relationship between wholesale electricity prices and the carbon emission intensity of the UK’s electricity production.

The results are clear, green (by which we mean low carbon intensive) electricity was in fact the cheapest electricity delivered to the grid network no matter which month you review.

But does this tell the whole story and are we in fact already seeing the start of supply & demand forces driving prices down when renewable generation peaks? Whilst this may be good for the consumer it raises some immensely difficult questions for these low carbon generators that need addressing, otherwise they may quickly witness a collapse in their underlying economics.

How to determine what is green electricity?

A great deal of data exists in the public domain about the UK’s electricity generation. Two of these data sources have been used as the basis for this analysis. The first is the carbon intensity of the UK’s electricity, the second is the price that electricity is sold by the generators to the grid network.

    1. Carbon intensity – data produced by National Grid provides the CO2 emissions on a half hourly basis. The data is presented in units of gCO2/kWh, essentially telling you how many grams of carbon dioxide are released for every kWh of electricity produced in the UK. The lower the better; with high solar and wind generation it is <100; whereas when gas and coal is predominantly being used it is often >300. In reality, the value is somewhere in the middle due to the blend of different generators being employed at any point in time.
    2. Wholesale price – the price paid by the grid to a generator can be broken down into half-hourly segments and is measured in £/MWh. For clarity this is the wholesale price paid to the generator and should not be confused with the price paid by a consumer, the differences include government subsidies (as summarised in this article’s footnote), grid costs and the costs assumed by the retail supplier. The wholesale price is dictated by classic supply & demand forces, with over-supply of power driving the price down and conversely a lack of supply will result in a power price spike. To account for this many gas and coal powered generators are on standby and only generate when prices climb (often as it would be uneconomical to run with a lower price) thereby helping to balance the supply.

By comparing the two data sources outlined above you can determine if there is any relationship between the wholesale price paid for the electricity and its CO2 emissions. Elgar Middleton’s analysis is based on a daily average for each data source. The average is not weighted and is based on the ‘mean’ of each day’s data.

UK electricity production in 2020

The chart below plots the two variables for all 366 days in 2020. Carbon intensity on the left-hand axis, wholesale power price on the right-hand axis.

At first glance it is hard to see any patterns as both lines experience substantially short-term volatility. That the power price (red line) is higher in the winter months than summer is to be expected as more lighting and heating is required at these times. Trends in the carbon intensity (blue line) are however harder to immediately see.

To try and clarify this, the data can be viewed in a different way, namely by smoothing out the volatility using a 7-day average. This simply takes the ‘mean’ average wholesale price & carbon intensity for the past 7 days. The results are displayed below, note that the axis have the same units but a different scale to the chart provided above.

When viewed in such a way it appears that there is a correlation between the two variables. Namely that the UK pays a higher wholesale price for electricity that has a higher carbon dioxide output. Conversely it is clear that in months such as May 2020, the power was not only low in carbon dioxide emissions, but this was also the month with the lowest power price. This correlation is not just on a macro scale of monthly trends, but is also witnessed in short term peaks and troughs.

Determining the correlation

Whilst comparing lines on a chart is a useful visual aid we can also test our intuitions mathematically, for instance by measuring the correlation between two variables. A strong correlation between cheap power and green may not prove that they always occur together but would get us over the first hurdle of demonstrating that they are related to some degree.

A ‘correlation coefficient’ measures if two variables are positively (both move in the same way) or negatively (move in opposite directions) related. This is represented by a value denoted ‘r’ which ranges from +1 to -1. As the earlier charts suggest a positive correlation, we shall just consider the r values above 0. These are expressed as follows:

The correlation coefficient was calculated for each month’s data based on the daily values (i.e. the data presented in the initial chart). This means that each r value is based on 29-31 data points for the two variables (noting 2020 was a leap year). The outcome was as follows.

This analysis shows us that in 11 months of 2020 the correlation between movements in the wholesale power price of electricity to the carbon intensity of that same electricity was “Strong”. The only month where this did not occur was in July, but even then, the r value was 0.69, meaning it was at the very top of the “Moderate” range.

This confirms that there is a strong correlation between the electricity wholesale price and the carbon intensity of the electricity generated at that point in time and conversely that low-carbon electricity comes with low-cost electricity.

Green power is cheap power, but is that actually a surprise

Is it then right to conclude that low carbon electricity should be regarded as delivering the cheapest source of wholesale power to the UK grid network? This looks reasonable, at least in the wholesale markets; the correlation is strong and is backed by a strong narrative – that much of the low carbon electricity that finds its way to the grid is generated at almost zero marginal cost, and it should come as no surprise that power that is cheap to produce is also cheap to consume.

There can also be no doubt that knowing that, when we generate the lowest carbon intensive electricity wholesale prices are also at their lowest, is anything but positive. It is a message that is crucial in further strengthening the relationship between the renewable energy sector, the general public, as well as the political class. It is undoubtably therefore a message that should be widely shared and celebrated.

But there is another side to what this data is telling us. As noted before, the power price is driven by supply & demand forces. Focusing once more on the supply side it has long been recognised that the supply of electricity from renewable sources is volatile and dependent on external forces. For wind turbines it is the strength of the wind, for solar it is the passage of the sun (creating daily fluctuations) as well as the length of the day (seasonal fluctuations). It is therefore no great surprise to see that periods with low carbon output are the same periods with low prices. All that is happening is we have lots of wind and sun … which generates lots of power at essentially zero marginal cost … which pushes the market price down.

The steady increase in the UK’s low carbon generation has made this supply & demand relationship ever more volatile. We now have a situation on particularly sunny and windy days where the power price has been driven so low that it is turning negative, meaning a user of power can actually be paid to consume electricity from the grid, an almost unheard-of concept only a few years ago. This over-supply of power from renewable sources will only become more pressing as we continue to connect more offshore wind farms and more solar installations onto the grid.

The challenge and the potential solutions

To some, the idea of power prices being pushed even lower will be seen as fantastic news. But sadly it isn’t that simple. The higher the proportion of power generated by low carbon sources is, the greater the inherent volatility will be in our grid. The resulting spikes and troughs in wholesale prices each have their own issues:

    • The power price spikes – when low carbon power is not available, the supply drops and the wholesale price rises. This is when existing back-up generators kick in. As these back-up generators are typically based on the combustion of gas and coal, the carbon intensity climbs and the spikes are aligned. This is bad for the general public’s wallet and their health.
    • The power price troughs – As noted earlier, high output from renewables increases the supply and drops the wholesale price. But developing renewable energy plants is an expensive business and is dependent on stable long-term power prices to service the considerable levels of finance required upfront. If the wholesale power prices decrease too far, the economics can fail and renewable energy generators can face financial ruin. Added to this is the risk than no additional renewable energy facilities will be developed as the revenues no longer support this business case. In short, the pace of our continuing transition to a low carbon economy would slow and potentially stall altogether.

The solution to this lies in our ability to ‘balance the load’. Essentially storing excess electricity when low carbon electricity generation exceeds the demand, and then releasing it when the demand exceeds the supply. This can be short term (such as daily fluctuations) as well as long term (suppling low carbon power in the extended periods of low wind speeds). The ultimate aim being to create a permanent supply of low carbon power, and by extension low power prices, without volatility. This not only restores the economic building blocks required for the future development of more low carbon generation, but also means that the UK will no longer need to rely on gas and coal to switch on when low carbon supply is not available, thereby removing the horrific spikes in CO2 emissions witnessed in early 2020.

Thankfully the renewables industry is well aware of this challenge but has yet to settle on the best answer. Some have turned to batteries – good for short term balancing, but not a solution for more than a few hours and the raw materials in batteries are far from being environmentally friendly. Others are looking at pump-storage – extremely expensive and very reliant on relatively rare geographical features, but a 100-year solution. Green hydrogen and compressed air are other options being considered. However, it is becoming increasingly clear that all of these are likely to be needed to meet the challenge of delivering a stable supply of low carbon electricity.

Elgar Middleton

Elgar Middleton have been involved in the UK’s transition to a low carbon economy for over 10 years. During this time we have helped our clients raise over £3.2 billion of senior debt for the financing of renewable generation assets, as well as working on over 50 acquisitions and disposals. Our experience encompasses all the renewable sub-sectors and we assist our clients across Europe and Australia from our London and Sydney offices.

We recognise that whilst the UK has achieved so much in the last decade, much remains to be done. The need to ‘balance the load’ is just one of these challenges and is one that we are already playing a role in. The solutions outlined earlier are all ones that we have extensive knowledge of and are actively working with clients to deliver.

Footnote – A word on subsidies

Whilst this analysis demonstrates a clear correlation between the carbon intensity of the power being generated to the wholesale price paid for that electricity, it should be noted that this is not the full picture. To say that green power is cheap wholesale power is a different statement to saying that it is the cheapest power for the retail consumer. The missing part being the subsidy support that many generators of low carbon power receive. For solar and onshore wind, this takes the form of either the Feed in Tariff or Renewable Obligation Certificates, where in both cases the generator is paid a pre-determined subsidy for every kWh delivered to the grid on top of the wholesale price received for that same kWh. For offshore wind a Contract-for-Difference is used whereby the subsidy guarantees a fixed wholesale price that the generator receives per kWh, so they are in effect topped-up when the wholesale price dips below the agreed ‘strike price’ although they also pay a rebate when the wholesale power price exceeds this level. This traditional (transitional) approach of relying on these government subsidies de-risk projects for the generator but serves to increase the cost differential between the wholesale power price and the retail power price.

However, these subsidies no longer apply to new onshore wind and solar installations as the costs of construction have decreased to such an extent that the projects are financially viable without any subsidy support. This does however mean that these new installations are fully exposed to the volatility in the wholesale power price demonstrated in this article and hence the need for load balancing to dampen these peaks and troughs is a crucial component for their successful deployment.

The economic case for green hydrogen as a transport fuel

In view of the vigorous debates constantly being conducted on the best use for green hydrogen in the UK, Edward Elgar decided to review the underlying data. The results are summarised below, with transport coming in as the clear winner.

Green hydrogen

There is now little doubt that green hydrogen has a major part to play in humankind’s drive to decarbonise our fuels. This is not a seismic change but an evolution. Fossil fuels themselves are hydrogen carriers. It is the hydrogen in fossil fuels which combines with atmospheric oxygen to produce water vapour and power. The problem with fossil fuels is that when we use them to create power, they release things we do not want – CO2 and noxious gases. Pure, green hydrogen, created by renewable electricity, gives us the convenience benefits of fossil fuels without the unwanted combustion gases. In short, humanity is in a process of cleaning up its hydrogen – the question now is where is best to deploy this green fuel?

Transport fuel or heating fuel?

Work is underway to examine how green hydrogen can decarbonise heating by blending it with the natural gas / methane in our gas distribution network. Alongside this, advances have been made with fuel cell cars, trucks, buses, trains, and aeroplanes which offer the opportunity to transform transport to a largely carbon-neutral activity.

But which of transport and heating is most likely to succeed first? It is transport that has the financial advantage by a street and a mile. The reason is based on the economics of substitution (i.e., the point at which it becomes economic to replace the incumbent fossil fuel with green hydrogen). The cost of green hydrogen is dropping fast as the cost of renewable electricity falls and the production of electrolysers move from bespoke production in high-cost economies to production lines in low-cost economies. It will become increasingly easy for green hydrogen to substitute the fossil fuel alternative. Economic substitution is close with transport but remains a long way off with heating.

We have used costs and prices from the UK to (roughly) illustrate this point:

  • Transport: In the UK, transport fuel hydrogen retails at £10 per kg (plus VAT) at the pump. The price is set at this level because it is approximately equal to the substitution price for petrol and diesel on a km driven basis. Elgar Middleton’s own calculations support a substitution sale price close to this amount confirming that green hydrogen as currently priced is an economically sensible solution when compared to the fossil fuel alternative.
  • Heating: In contrast, the substitution price for hydrogen as a heating gas is approximately £0.5 per kg. This is the product of the wholesale value of natural gas (the cost at grid entry which is approximately £0.015 / kWh) times the number of kWhs in a kg of hydrogen (approximately 33) giving a substitution value of £0.495 per kg. This is twenty times less than the substitution price for transport fossil fuels and, consequently, substitution for natural gas / methane will only happen when the cost of green hydrogen has fallen significantly further.

 

* Ratio of the energy contained in 1kg of hydrogen over the energy contained in 1m3 of natural gas. Source for the calorific value: https://www.claverton-energy.com/wordpress/wp-content/uploads/2012/08/the_energy_and_fuel_data_sheet1.pdf
** Ratio of the fuel consumption per km for a petrol car (Vauxhall Insignia) over a same category fuel cell car (Toyota Mirai). Sources for the fuel consumption values are the car manufacturers’ websites.

Battery electric or hydrogen fuel cell?

120 years ago humanity had a choice between battery electric vehicles and fossil fuel vehicles. History clearly tells us that we chose fossil fuels. Since that time, there have been many opportunities to re-examine that choice and, as we all know, there has been a low uptake of battery electric vehicles. This remains the case very largely for smaller vehicles (cars) and almost completely for larger vehicles (trucks, trains, and planes).

That said, the main concern with battery electric vehicles, which is contrary to the general perception, is that they are not particularly green nor are the battery production and associated mineral extraction processes environmentally or socially robust. Having analysed this in 2020, Elgar Middleton’s conclusion is that the whole life CO2 production of a battery electric vehicle is sometimes, or even often, worse than the internal combustion engine equivalent. As part of our analysis, we considered the CO2 released from the power used to produce the battery as well as the CO2 released to produce the electricity to charge the battery. Clearly some use and production locations are worse than others. In countries where the electricity predominantly comes from coal (e.g., USA and China) every km driven is worse than an internal combustion engine, even if the CO2 released to produce the battery is ignored. Fuel cell vehicles which run on green hydrogen produced at the renewable energy facility are genuinely much greener although we are sure that there is room for improvement with battery electric vehicles and fuel cell vehicles alike.

Our analysis into the CO2 emissions of battery electric vehicles & hydrogen fuel cell can be found by following this link.

Trains

Trains which run on hydrogen and use fuel cells are now in regular passenger service in Austria. In other parts of the world, including the UK, fuel cell trains are in the testing phase. Hydrogen lends itself well to the decarbonisation of train services and this is particularly the case where the trainline in question is less intensively used and does not justify the capital associated with overhead electric catenary. Relevant to this discussion is that the UK is in the process of overspending badly on the electrification of the Great Western Railway.

Aviation

The decarbonisation of aviation is now within grasp. Hydrogen has of course been used for many years in space travel, both as a combustion fuel and as a fuel for fuel cells and continues to be used in the latest commercial spacecraft. As fuel cells are dramatically less heavy than batteries and dramatically more efficient than hydrogen combustion, tests are being undertaken to produce a viable passenger carrying aeroplane using this technology. The leading work on this is undertaken in the UK by ZeroAvia. In September 2020, ZeroAvia flew a 6-seater hydrogen fuel cell plane at Cranfield and is now working on a 19-passenger commercial plane. They have investment from, among others, the UK Government and funds founded by Jeff Bezos and Bill Gates.

Our predictions

Elgar Middleton’s prediction is that green hydrogen will be used to replace fossil fuels as a transport fuel in the medium term. We think this is very likely for large vehicles (e.g. lorries, trains, and buses) where the battery size would be a critical problem, and probable for smaller vehicles. Despite the current focus on battery electric vehicles, it is hydrogen fuel cell vehicles which will replace internal combustion engines. The combination of refuelling culture, convenience, battery weight, requirements to decarbonise, efficiency and the inadequacy of the electricity distribution grid are very much in green hydrogen’s favour. In the longer-term aviation will switch from fossil fuels to green hydrogen as batteries have no part to play in this due to their weight.

As for road and rail transport, it is expected that the switch to green hydrogen will happen first in northern European countries, where the cost of renewable electricity is low and where the tax on transport fossil fuels is high. We believe that the UK is particularly well placed for the adoption of green hydrogen due to its high, and increasing, production of offshore wind electricity and its recently announced intention to stop the sale of new fossil fuel cars after 2030.

Elgar Middleton completes sale of a 3.8MW anaerobic digestion facility

Elgar Middleton is delighted to have advised the shareholders of the Codford Biogas facility on their sale of 100% of their equity to JLEN Environmental Assets Group for £19.8 million.

Codford Biogas Limited is an operational anaerobic digestion facility based in Wiltshire, UK. The plant has been operational since 2014, has an electrical capacity of 3.8MWe, and processes up to 100,000 tonnes per annum of both liquid and solid food waste from the commercial and industrial sector. Revenues are secured from both the Feed-in-Tariff (FiT) and the Renewable Heat Incentive (RHI) schemes and the plant is able to supply up to 4,000 homes via the UK power grid.

The facility was successfully sold to JLEN, the listed environmental fund, for an initial upfront payment of £19.8 million. The sale has been structured to also include additional deferred payments relating to a number of post-completion expansion opportunities.

Elgar Middleton Infrastructure and Energy Finance LLP (“Elgar Middleton”) was the shareholder’s exclusive financial advisor on the transaction. This successful completion is further evidence of Elgar Middleton’s in-depth knowledge of the anaerobic digestion sector coming just a matter of days after the firm completed the £85 million refinancing of BioCapital’s anaerobic digestion portfolio.

Equitix and Helios reach financial close on £85m debt refinancing of Bio Capital Limited

Elgar Middleton is delighted to have advised Equitix Limited (“Equitix”) and Helios Energy Investments (“Helios”) on the refinancing of a portfolio of five operating anaerobic digestion plants in the UK.

Bio Capital Limited owns and operates anaerobic digestion (“AD”) assets in England, Scotland, and Northern Ireland. The completion of the £85m refinancing represents a further step in cementing the platform’s ambition to become a major player in the UK’s AD sector.

A non-recourse financing has been put in place to leverage five operating assets benefiting from strong revenue streams and a successful operational track-record. Senior debt facilities include a long-term amortizing credit facility, a debt service reserve facility, and a revolving credit facility. In addition, the financial structure allows for the platform’s growth through incremental debt features (accordion facility) which shall provide the sponsors with the dry powder they need to fuel Bio Capital’s expansion in the sector. With their sight on additional assets, the sponsors expect to continue investing in anaerobic digestion and grow the portfolio in the months and years to come.

The financing was supported by Allied Irish Banks (“AIB”), Banco de Sabadell (“Sabadell”) and NatWest Westminster Bank plc (“NatWest”). Burges Salmon LLP acted as legal advisor to the Sponsors, while Pinsent Masons supported the Lenders. Further specific transaction support was provided by Sweco, Ricardo, Baringa, Marsh, Validus, Mazars and Operis.

The Future Growth of Solar Power in the UK

The situation at present

UK solar deployment enjoyed steady growth from 2011 through to the end of March 2017 with over 13GWs connected to the UK grid. Over the past 4 years, only around 500MW have been added, with the majority of this being rooftop.

Following the abolishment of any meaningful Government support scheme, ground mounted solar deployment ground to a halt in the first quarter of 2017. While the cost of solar panels continues to plummet, power prices have also declined (exacerbated by the COVID-19 pandemic) in the UK and this has resulted in a total dearth of any meaningful deployment in the past four years. The underlying unlevered return on investment simply does not justify capital deployment given the subsidies typically represented 50% of previous revenue structures. It was the subsidy component of the revenue structure that enabled financial institutions to provide significant debt financing, on favourable terms, in order to enhance the overall equity returns. With the curtailment of subsidies, the mainstream banking sector has been unwilling to lend into ground-mounted solar in the UK.

Several studies have suggested the UK requires between 70GW and 185GW of solar as part of its energy strategy by 2050 and the UK Government’s own Energy White Paper modelling proposes between 80GW and 120GW; implying an annual deployment of 3GW per annum for the next 30 years.

So where will it come from

While there is a shortage of actual deployment of new solar on the ground, the rate of growth of planning and development is accelerating. By the end of 2018, there was approximately 3GW of solar development (at various stages) and this has expanded to over 13GW at the end of 2020 with 1GW of new developable solar being added to the pipeline each month. While over 8GW is at the screening/scoping stage, some 3GW is consented and ready to build out subject to the satisfaction of planning conditions. The vast majority of these sites are 49.9MWp thus avoiding the need to be approved by the Secretary of State for Business, Energy and Industrial Strategy (BEIS) which applies to sites over 50MWp. This is not to say seeking consent for larger sites is impossible – for example, Cleve Hill (350MWp) successful achieved statutory approval on 28 May 2020 and at least 10 further projects over 200MWp are at various stages of development. So over time it is almost certain the size of projects and the scale of investment will grow as utility scale solar deployment will become the norm.

The importance of CFDs, corporate & utility PPAs

Ground-mounted solar sites greater than 10MW will qualify for the forthcoming Contract for Difference (CFD) auction, although it is unknown how much capacity will be allocated to UK solar. At present 3GW of sites will qualify for the auction and given it may not happen for a further 12 months, in all likelihood there will be 5GW of qualifiable sites by then, most certainly far exceeding the capacity on offer in the auction. This will undoubtedly drive down the strike price to levels that potentially may even make investment unattractive.

The vast majority of new solar will almost certainly be built out without a Government support tariff and will have to rely on either a corporate or utility Power Purchase Agreement (PPA). With ever increasing demands for power and a desire for corporates to become carbon neutral more and more of the technology, power intensive orientated growth stocks (Google, Microsoft, Amazon etc.) will seek to enter into long-dated fixed-price PPAs. These contracts are the holy grail; the buyers really can dictate the terms of the contract and drive down the price of power because the quality of the counterparty and price certainty will enable any solar site with a top tier fixed price PPA to obtain significant levels of debt on extremely competitive terms from the debt market. However, these highly sought after corporate PPAs will be few and far between.

The alternative is a route-to-market utility PPA with one of the UK’s large energy suppliers (often referred to as the ‘Big Six’). These contracts have a strong credit counterparty, often have maturities of up to twenty years and can benefit from a support price floor mechanism. The combination of all of these aspects will maximise the gearing opportunity of the project; and while this will not achieve the same level of gearing as a top-tier fixed-price corporate PPA, it will ensure the project is both bankable and investable.

Technology and innovation will improve returns

Whilst previous solar sites in the UK have been static and simply orientated to the south, developers are now embracing ways to improve a site’s productivity. Innovation is therefore fundamental in improving returns with bifacial modules, trackers and east-west alignment all generating notable enhancements.

Designs and construction now include the use of bifacial panels while Cleve Hill’s design adopts an east-west design layout in order to achieve an optimum return on investment for a finite land parcel. As tracker prices continue to fall the UK may also see these adopted in the future although to date they have been far more common in southern Europe with materially higher solar irradiance.

There has also been much talk of dual solar battery sites and while a small number have been built out in the UK much work has been undertaken into the financial merits of battery supported solar projects to enhance investment returns. As battery pieces continue to fall (now 20% of the price of just 5 years ago) and the storage capacity (up to four hours) of batteries becomes more economic, solar sites coupled with a battery will be able to time shift when it deploys its power to grid (export in the evening, peak price periods) or bid for flexible imbalance grid revenue contracts. There has been significant growth in flexible Fast Frequency Response (FFR) and dynamic services being rolled out by the National Grid and this will only continue to grow to satisfy a power mix with ever increasing intermittent generation. Arbitraging power prices and sourcing flexible and dynamic revenue contracts will enhance the financial attractiveness and investment returns of debt and equity investors.

Technological and financial innovation is required

There is no doubt solar will continue to prosper, after its hiatus, simply because it will form part of an integrated UK power solution to complement growth in offshore wind and nuclear. Solar is extremely flexible, its cost to deploy on a per MW basis continues to tumble, it can be deployed on a localised basis at lower grid levels to support the local area with low carbon power. The use of attractive corporate or utility PPAs, flexible and dynamic revenue streams and time shifting price arbitrage will ensure the technology is here to stay especially given the planning process is condensed compared to nuclear or offshore wind. The challenge for the entire solar value chain will be to rise to the opportunity in hand and aspire to deploy 3GW per annum.

Elgar Middleton’s role in this deployment

Elgar Middleton has extensive debt and equity experience in arranging finance for solar projects in addition to comprehensive knowledge of structuring bankable PPAs and modelling battery solutions for both time shifting and flexible solutions. This experience is ensuring our clients not only design their sites optimally from the outset, but also achieve the lowest cost of capital from the debt markets, thereby maximising their investment returns.