UK Green Investment Bank Case Study - The Hub€¦ · E4D Case Study: Part A Imperial ... UK Green Investment Bank – Case Study . Green Investment Bank Imperial College London 2

E4D Case Study: Part A Imperial College Business School

Public-Private Investment Partnerships

New models in renewable energy finance

January 2015

UK Green Investment Bank – Case Study

Green Investment Bank Imperial College London

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UK Green Investment Bank

Abstract

The UK Green Investment Bank (UKGIB) became operational in October 2012, supported by £3 billion (approximately $5 billion) of government money. As part of a multifaceted climate change strategy enacted by the United Kingdom, the bank was founded with a mission of “accelerating the UK’s transition to a more green economy, and creating an enduring institution, operating independently of government”. With an experienced, professional management team in place, the UKGIB's immediate task was to ‘crowd in’ private sector funding on new large-scale clean energy infrastructure. But while the strategic mandate for the bank was clear, a series of tactical issues remained about how to select new investments and manage its growing investment portfolio. For instance, how would the team be able to manage conflicting public and private interests? What specific type of investments would best counter market scepticism about the renewable energy projects? Most importantly, what investment evaluation framework would enable them to deliver on their vision of being both ‘green and profitable’?

This case was prepared by Christopher Corbishley and Charles Donovan. The authors acknowledge the support of the UK Green Investment Bank staff for their invaluable assistance in gathering the material for this case study. This case is for educational purposes and is not intended to illustrate either effective or ineffective management of an organisational situation. The situations and circumstances described may have been dramatized or modified for instructional purposes and may not accurately reflect actual events. This case study is provided free of charge under an Attribution-Non-commercial-No-Derivations Creative Commons licence. You may download this work free of charge and share it freely. The case studies may not, however, be changed in any way or used commercially.


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Motivations for a Green Investment Bank Following the enactment of the Climate Change Act of 2008, the United Kingdom made a legal commitment to significantly reduce its carbon emissions by 2050 and to generate up to 15% of energy from renewable sources by 2020. To meet these goals, a committee established by the UK House of Commons estimated that between £200 billion and £1 trillion of new investment would be needed over the next two decades. Traditional sources of capital for green infrastructure were thought to be able to provide no more than £80 billion over this period.

The analysis presented a serious investment shortfall, a situation exacerbated by the global financial crisis. New European guidelines would put large commercial banks under immense pressure to reduce the size of their balance sheets. The perceived risks associated with renewable technologies meant investments into green energy infrastructure were falling dramatically (Figure 1).

Figure 1: UK Renewable Energy Investment by segment (£bn)

Source: UKGIB Annual Report 2013/14

A series of influential reports subsequently observed a ‘market failure’ in the renewable energy sector, and hence advocated the creation of a state-backed infrastructure bank. Despite additional austerity measures sweeping across a number of government departments, after the 2010 general election the government budget contained the first mention of a ‘green investment bank’.

By 2011, plans were set out for the activation of a Green Investment Bank in three phases (see Appendix 1): (i) Incubation within the department of Business, Innovation & Skills and the first direct financial investments by the UK government into the green economy; (ii) Establishment of the UKGIB as a stand-alone institution by 2012, and (iii) Commitment of full borrowing powers by 2015-16 "subject to public sector's net-debt falling as a percentage of GDP".


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"This is a big advance, the first investment bank in the world dedicated to greening the economy. It's a great achievement and an example of how the Government is working together with the private sector to get big, long-term projects off the ground in a way that leaving it to the pure, free market can't do.”

UK Business Secretary Vince Cable On 27 November 2012 the UK Green Investment Bank was established pending approval from the European Union (EU) that its operations were not considered ‘anti-competitive’ under state-aid regulations. Approval was granted soon after on the basis that the GIB’s lending and investment activities be “additional to the market”, which is to say the Bank must avoid “crowding out” investors from the private sector, distorting existing markets or conferring any unfair advantage on certain market participants.

Unique from most government initiatives, the GIB was required to work on a commercial basis, to be both ‘green and profitable’. Rather than providing grants, regional assistance or one-off development loans, its purpose was to “crowd in” private capital into renewable energy investments, as opposed to “crowding them out”. This occurs when public sector spending either replaces or drives down private sector investment as a result of the government providing a good or a service (such as financing) that would otherwise be a business opportunity for the private sector. As part of this, the Bank was mandated to focus 80% of its activities on four priority sectors in which the market was perceived to have ‘failed’. These included: Offshore wind, energy efficiency, waste recycling and energy from waste.

The UK’s Green Investment Bank model differs somewhat from its European counterparts, such as Germany’s much larger KfW bank, described as ‘the largest IFI in the world’ and the European Investment Fund, which predominately provides guarantees. It differs in its remit specifically to address a market failure in the ‘green’ sector, as well as its obligation to be profitable. The GIB model has since become a beacon in other developed countries. In 2013 the New York Mayor, Andrew Cuomo announced $210 million in initial capitalization for the ‘New York Green Bank’ with the aim eventually to hit a target $1 billion capitalization.

Structured as a Public Limited Company (PLC) 100% owned by the UK Government, the GIB’s Articles of Association ensured it would maintain total operational independence, (see Appendix 2) representing a new form of public private partnership (PPP). Vested with £3 billion of taxpayer capital, and the ability to structure green energy investment products across the capital structure, (from senior debt to equity), the bank was tasked with the execution of a critical government policy, one meant to ensure the UK’s energy future needs were met.

Renewables: The ‘Ugly Duckling’ of Infrastructure Financing

As part of meeting its state aid mandate, the Bank was initially focussed on defining the ‘market failures’ it was designed to address. Most assumed the failures were an inevitable cause of negative economic externalities, specifically the lack of a clear price for carbon. This meant without intervention, the social costs of environmental impact were not borne by investors and the private sector, nor was the social benefit of more sustainable projects being captured or invested in.


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The global financial crisis had a profound impact on green infrastructure investment, as well as infrastructure financing more generally. Pressure from regulators, shareholders and governments to de-lever and de-risk made long-term financing a less attractive proposition for banks. The majority of risk came from what banks call “maturity transformation” i.e. borrowing short to lend long. However, bank appetites to hold long-term assets had diminished in favour of short-term financing due to the ‘funding mismatch’ risk of financing longer-term project debt.

Credit performance of infrastructure finance has previously been strong for the banks. Yet many commercial players were increasingly finding the cost of funding exceeded the margins on their books. This had become a particular problem in Europe, which historically relied on a number of banks committed to long-term project financing. In contrast to the ‘institutional’ structure of capital markets in North America, the global financial crisis had broken the European model of bank-led project financing, suggesting a new institutional structure was required for the UK.

Tied to this was the fact that in a global economic environment of exceedingly low long-term interest rates, investment institutions needed to identify real (inflation protected) yields to match the quantum and maturity of their pension liabilities. Hence the missing piece in this puzzle was the presence of new market infrastructure (i.e. the intermediaries and investment vehicles) that connected pools of capital with investment projects.

Risks and uncertainties around clean technologies

Information asymmetries and risk aversion have presented additional barriers to achieving higher levels of green infrastructure investment from private sector investors. As a relatively new industrial sector, there was not yet a historical track record of financial performance upon which to evaluate risk and expected return. In the case of offshore wind there are countless risks both in terms of construction and operations. Potential risks included adverse weather causing maintenance delays, the movement of foundations or array cable failures leading to construction delays, the lack of sufficient wind and technology risk associated with the corrosion of components. Such uncertainties were comparable to offshore oil and gas in the 1970s and 80s – a class of asset financing commercial banks has since become comfortable with.

Offshore wind plays a make or break role in the UK’s ability to hit its binding renewable energy targets. Forecasts of demand required to hit those targets demonstrate potential for generating sufficient electricity from renewables (Figure 2). However, supply from investor-backed developers willing to take on the construction risk suggested further encouragement was required to keep up with demand (Figure 3).


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Figure 2: Demand for Offshore Wind Infrastructure

Figure 3: Supply Status of Offshore Wind Infrastructure Projects

Political and regulatory hurdles

A number of regulatory hurdles exist in the broader European market where policy uncertainty and austerity measures have previously led to unplanned reductions in public-sector investments. For instance, retroactive changes in countries such as Greece and Spain have come close to destroying the market for green infrastructure investments. The withdrawal of support for wind energy in some countries contributed to heavy losses in the wind industry, casting doubt on the ability of suppliers to sustain themselves (Figure 4).


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Figure 4: Turbine Manufacturers’ Margins 2008 - 2012

Source: Bloomberg New Energy Finance

It was originally conceived that the Green Investment Bank find its ‘additional, non-distorting’ role through a market position in which it took “slightly too much of the risk, for slightly too little of the return” on green infrastructure projects. This was envisaged in a world in which market failures - caused by information asymmetries and risk aversion - might cause the private sector to underestimate the potential returns of green energy investments. Hence at first, it was proposed the bank should be a government-owned development bank that would own society’s “cost of capital”, thus making a real investment return, albeit a lesser return demanded by private sector investors.

A key question facing the newly established team of the Green Investment Bank was subsequently how to accelerate a shift in perception about green energy investments while earning a decent return for UK taxpayers.

UKGIB’s Mission and Business Model

Rather than acting as a “development agency”, such as the World Bank, the UKGIB team saw its role in partnering with existing long-term investors and encouraging new ones by being robustly commercial in its approach. Its mission of being “green and profitable” would ensure that investors could observe decent financial returns in the renewable energy sector. Only in this way could the Bank change existing perceptions and attract incremental capital into green infrastructure investments. The UKGIB’s ‘green impact’ is measured against five criteria:

1. Reduce green-house gas emissions 2. Improve efficiency in the use of natural resources 3. Protect or enhance the natural environment 4. Protect or enhance bio-diversity 5. Promote environmental sustainability


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Figure 5: UKGIB’s Business Model


The Bank also has a financial bottom line, which is to say that it is unashamedly and unambiguously a “for profit” bank. Financial returns are based on state aid rules, on the basis that they are always additional, but they are also based on sound finance and a commercial return. These principles are reflected in the expertise of their management team, who have been recruited from some of the world’s top banking institutions, as well as the Bank’s investment strategy and due diligence process. In its articles of association, it is even determined ‘the GIB should plan to deliver a minimum of 3.5% annual nominal return on total investments after operating costs but before tax’ (see Appendix 2).

In order not to ‘crowd out’ private investments already taking place in the green economy, UKGIB’s priority sectors were selected on the basis that they were on the cusp of being ‘mainstream investable’. Its mission was to assist in the development of private sector markets in order that the bank’s role within them becomes redundant. For a project to be investable by the UKGIB it must fit all six criteria set out by the investment managers and signed off by the Chief Risk Officer through an internal review process:

1. Fit within the state aid mandate in terms of specific ‘priority sectors’

2. Be ‘additional’ to every project. Developers must prove they cannot obtain

funding elsewhere. Often the bank starts off as a cornerstone investor and

crowds in funding by articulating the investment story.

3. Invest at market rate in order not to undercut competition. Funding must be

provided pari passu with other investors, or if the purpose is to feed stock

supply, it might involve taking equity in the project and then taking additional

revenues on the basis it is signed off as conforming to ‘market economy

investor principle’ (MEIP) rules.

4. Conforms to the five green credentials outlined in its articles of association.

5. Presents a suitable risk profile, which involves various models and forecasts,

testing the assumptions for revenues, cost of delivery and cover ratio limits.

6. Last but not least reputation is key, particularly the relationship with both the

client and the developer.


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To ensure the Bank would be profitable, it was made explicit that areas in which the UKGIB would not invest would include the provision of grants and regional assistance, subsidised debt or equity, high risk-lower reward, venture capital, development equity or lender of last resort. Instead four priority sectors to which 80% of the Bank’s investment capital would be dedicated would include offshore wind, waste/recycling, non-domestic energy efficiency and support to the Green Deal (Figure 5). The remaining 20% could then be committed to other green energy sectors, such as biomass, biofuels and transport, carbon capture, marine energy and renewable heat.

Figure 5: Investment Strategy by Green Energy Sector


Creating the Investment Framework An ongoing question for the Bank’s senior management was what level of return above 3.5% would legitimately reflect the opportunity cost of capital for investments in the renewable energy sector. The organization needed to adopt a financial framework for setting project hurdle rates (i.e. the minimum internal rate of return (RRR) required to sanction a new investment).

As a veteran in the investment banking community, Chief Risk Officer, Peter Knott was familiar with the broad range of sophisticated analytical techniques for estimating project hurdle rates (see Appendix 3 for formulae provided by professional service firms). But to deliver on all aspects of the Bank’s mission, he reasoned that the financial framework should adopt a relatively straightforward and transparent process for setting discount rates. He knew that a good discount rate for a specific project should reflect two basic assumptions: the time value of money and an appropriate compensation for risk. But categorizing and quantifying investment risk for large renewable energy projects was proving to be challenging.


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Peter and his team wondered how they could quantify the risk factors involved in green infrastructure investments when making decisions based on a risk-adjusted rate of return. On the one hand, they understood the attractiveness of infrastructure financing was in its ‘dependability’ as an asset that delivers fixed returns, particularly debt financing which offered additional security in terms of repayment and less active management. On the other hand, risks to private participants were either demand risk in the case that consumption did not match expectations or political risk.

Given that the UK government was legally committed to meeting 15% of energy demand from renewables by 2020, and that producer guarantees enjoyed cross-party support, are inflation-linked and typically run for 20 to 25 years, the investment risk for operators was low. As an instrument of policy, the UKGIB carried little political risk. However, by coming in at the early stages of project investments, the team was concerned with construction risk and the potential for cost overruns, making developer due diligence such an important part of the process.

In order to calculate the hurdle rate for each project the team had to think carefully about how these risks would be quantified before they could proceed with their investment decisions.

Example Projects

Investment 1: Refinancing of a UK Offshore Wind Project – Rhyll Flats

Rhyl Flats is a 90 MegaWatt wind farm located 8km off North Wales in which the UKGIB acquired a 24.95% direct equity stake from RWE AG for £57.7m. As one of the first investments, this represented a landmark step in supporting one of the Bank’s core sectors (offshore wind). Its main aim was to develop a secondary market for operating offshore wind assets, allowing the release of capital back to developers on the basis that this could then be reinvested into other projects.

Green Impact Financial Impact

- Expected to provide enough clean, green electricity to power around 61,000 homes

- Reduced reliance on imported gas

- Helping to meet greenhouse gas emissions and renewable energy targets

- Investment alongside Greencoat UK Wind Plc, first company to invest solely in operating UK wind farms

- GIB’s investment helped RWE meet its wish to sell a 49% holding

- Investment will allow RWE to redeploy funding from the sale in further UK offshore wind developments

Investment 2: Wakefield Waste PFI Project

Demonstrating the diversity of products it offers across the capital structure, the Bank also provided £30.4m of senior debt funding to Shanks Group PLC to support a 250-year PFI waste contract with Wakefield Council. The loan was provided alongside three commercial banks to deliver essential funding to contribute towards recycling facilities, waste treatment and generating sustainable power. In terms of green impact


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it achieves annual landfill avoidance of 200,000 tonnes, helps to increase the local authority diversion rate to 90%, increases its recycling rate to 52% and provides potential annual emissions saving of 33,300 tonnes of CO2e.


- Diversion of c.200,000 tonnes p.a. of municipal solid waste from landfill helping to increase local authority’s landfill diversion rate to 90%

- Increase local authority’s recycling rate to at least 52%, greater than UK’s 2020 target

- Provide potential annual emissions savings of approximately 34,300 tonnes of CO2e

- GIB is providing senior debt and equity bridge facilities pari passu with three commercial lenders

- GIB was invited to join banking club in mid-2012 providing necessary additional liquidity to ensure achievement of financial close

- Mobilised three times GIB investment

Investment 3: Realm Energy Centres Fund

The Bank has also committed £50m to the Aviva Investors REaLM Energy Centres Fund, which provides long-term funding for public sector energy efficiency projects. The fund made its first investment of £36m (of which GIB contributed £18m) in an energy centre project for Cambridge University Hospitals NHS Foundation Trust over a 25-year period. Technology includes a combined heat and power engine, biomass boilers, efficient dual fuel boilers and heat recovery from medical waste incineration.


- Expected CO2e savings of approximately 8000 tonnes per annum

- Reduce the Trust’s overall energy bills by £20m over the 25 year operation of the project

- Help the Trust achieve its 2020 carbon reduction goals

- GIB’s investment into the Fund has mobilised c£18m of private capital into the project from Aviva Investors REaLM Infrastructure Fund to support its first investment

- GIB’s full investment commitment of £50m will eventually mobilise a total of at least £50m private capital into the sector

The Greencoat Fund - Achieving ‘additionality’ at a fund level

With experience providing both debt and equity in offshore wind projects, the UKGIB worked with Greencoat to raise an offshore wind fund in 2013. Together, they had recognised a high level of demand amongst pension funds, sovereign wealth funds and institutional investors wishing to be exposed to the sector but lacking the confidence and closeness to the industry to make substantial investments by themselves. By helping to assess the fund's prospects for investment from the Department of Business Innovation & Skills and taking a 25% equity stake in Rhyl Flats, one of the fund's seed assets, the UKGIB helped to get the fund off the ground.


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This also involved negotiations with the EU Commission and the FCA to explore the possibility of establishing a fund management business, which would help crowd-in private investment, not by putting the Bank’s own balance sheet to work but by using its expertise in investing its own funds to manage other people’s money, channelling investment into green infrastructure projects. Based on the success of the GIB’s first fund of this kind (having achieved returns of between 8-9% in its first year), it plans to launch additional funds and financial products in future.

Taking the Next Steps

Over the last few months, Peter had been approached by a number of companies seeking equity and/or debt investments in offshore wind projects currently under development in the United Kingdom. Having carried out due diligence on each of the projects and the developers involved, he has boiled down the UKGIB’s options to three potential investments. Before proceeding, he asked his investment team to carry out the following task:

Taking into account the key risk categories for an offshore wind project, determine the weighted average cost of capital (WACC) for the three offshore wind projects.

The selection of a project-specific WACC should take into account an expected capital structure for each project, the cost of debt, and the expected return on equity. Summary data captured during the due diligence process is provided in a separate spreadsheet, providing both qualitative and quantitative insights on the relative risks associated with each project.

Generate a one page investment memorandum that justifies your WACC for each project, taking into account the Bank’s strategic mandate as well as comparable commercial returns in the sector.

Identifying the risk categories and WACC associated with each project will be helpful for Peter in future to understand the minimum acceptable rate of return, given each project’s risk profile and the opportunity cost of other investments. The weighted average cost of capital across a variety of related sectors is included in Appendix 3 as a benchmark for his investment team.


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Appendix 1: UKGIB Timeline


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Appendix 2: UKGIB’s Articles of Association


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Appendix 3: WACC Benchmarks


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Source: Access Analytics

This paper has been produced by the Rajiv Gandhi Centre for Innovation and Entrepreneurship at Imperial College Business School

Imperial College Business School Tanaka Building South Kensington Campus London SW7 2AZ United Kingdom T: +44 (0)20 7594 5485 F: +44 (0)20 7594 9184

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This case study has been produced by Imperial College Business School

This case study is provided free of charge under an Attribution-Non-commercial-No-Derivations Creative Commons licence. You may download this work free of charge and share it freely. The case studies may not, however, be changed in any way or used commercially.

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UK Green Investment Bank Case Study - The Hub€¦ · E4D Case Study: Part A Imperial ... UK Green Investment Bank – Case Study . Green Investment Bank Imperial College London 2

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