MORE project finance is needed to transition “hard-to-abate” sectors – such as steel and cement production, aviation and shipping – towards clean energy, said a report by banking group Citi.
Project finance is a loan structure where the project’s future cash flows are used for repayment, meaning that it is tied to the success of the project. It is often used to fund long-term infrastructure, industrial projects and public services.
“Smaller companies that do not have large balance sheets, or have high debt-to-equity ratios, or projects that require significant investment might find project finance more attractive,” Citi said in its report released July 18.
In 2021, Citi estimated that it will cost between US$900 billion and US$1.6 trillion to decarbonise several major hard-to-abate sectors.
However, a lot of financing for the energy transition presently comes from companies’ balance sheets. “Large corporates may be cash-rich and can fund the transition themselves, or they can use cash flows from other operating activities and use their creditworthiness to raise equity or borrow funds,” said the report.
The downside of this is that companies would need to absorb all the liabilities and risks of the project, which can be substantial if it does not perform well.
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In contrast, project finance typically involves non-recourse or limited-recourse debt. This means that in case of default, the lenders can only pursue the project’s collateral and nothing else.
Through project finance, companies can also attract private equity firms, family offices and other players to serve as offtakers, or parties who agree to purchase the output of the project.
Project finance could support the growing need to decarbonise hard-to-abate sectors. Companies are being pushed by legislation and carbon taxes, which will become costly over the next few years. Clients are also asking for this change, said Citi.
“This is especially noticeable for the steel industry in which some European automakers have committed to buy green steel, and in the maritime industry, in which cargo owners are tendering for green shipping to help create a market,” the report said.
The main solutions for decarbonising hard-to-abate sectors include renewable energy and hydrogen power, green transport fuels such as sustainable aviation fuel, and carbon capture utilisation and storage (CCUS) technologies.
Large project finance structures that have come to fruition include H2 Green Steel, a Sweden-based steelmaker startup that raised 6.5 billion euros (S$9.5 billion) in debt and equity to build the world’s first large-scale green steel plant. The company aims to produce five million tonnes of green steel by 2030.
Challenges
Despite the opportunities, project finance has some challenges. Non-recourse or limited-recourse debt comes with high lending rates compared with typical corporate finance. Project finance lenders also require that the cash flows being generated through the project are enough to service the company’s debt.
Another challenge is the difficulty of assessing the future cash flows for nascent technologies, such as CCUS.
“Carbon, as yet, has not been valued as a valuable resource, but its use in the production of chemicals, synthetic fuels, buildings and others will be needed in the future. This means that the demand and price are difficult to set today to support a project financing structure,” said Citi.
With these challenges, the role of multilateral development banks and development finance institutions (DFIs) is important, particularly in emerging markets. These institutions are experienced in project finance and can work together with banks and other investors to de-risk projects.
At present, a lot of project finance is centred on advanced economies, which have the fiscal capacity to help finance the decarbonisation. “However many emerging and developing economies do not (have the fiscal capacity), and have other pressing issues such as basic infrastructure, education and (addressing) poverty,” said Citi.
It highlighted the need for the World Bank and other DFIs to “step in and play an extremely important role” in financing projects in these countries, as well as help them attract and increase private finance.
“What could happen also is that there is a spillover effect from the decarbonisation of hard-to-abate sectors in advanced economies: as technology and new fuels are scaled there, these then become cheaper over time and will be easier to scale up at a global level,” said Citi.
