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Middle EastJuly 15 2015

MENA's energy challenge: will renewables relieve the capacity crisis?

Renewable energy is expected to play a significant role in the Middle East and north Africa's future energy mix, and the region's lenders are now paying attention to the attractive opportunities presented by this energy evolution. 
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MENA's energy challenge: will renewables relieve the capacity crisis?

The Middle East and north Africa (MENA) region is suffering from a power generation capacity crisis. Rapid population growth, increasing urbanisation and the presence of energy-intensive industries have all contributed to a growing gulf between power supply and demand. Though this situation has been years in the making, the problem is now entering a critical phase. 

With regional energy consumption expected to increase by 8.3% per year until 2019 – about three times higher than the global average – the Arab Petroleum Investments Corporation, a regional development institution, believes about $316bn-worth of investment in power generation facilities will be needed over the next five years. 

This represents both a challenge and an opportunity for energy providers and the financial institutions that support them. Meeting this challenge will require a structural shift in the region’s established energy production mix, to include a greater share of non-hydrocarbon energy sources.

Financial institutions' role 

To facilitate this transition, financial institutions and banks in particular, are expected to play a vital role in developing innovative methods of financing, while stimulating the engagement of the regional capital markets to address some of the longer term funding issues. 

Fortuitously, this problem has emerged as renewable energy providers in the region, particularly in the area of solar photovoltaic (PV), have achieved considerable technological breakthroughs. In the majority of MENA markets, solar PV is now at fossil fuel grid parity or cheaper, depending on the size of the project. To put this into context, most estimates indicate that oil would have to be priced at $20 per barrel in order for oil-fuelled generation to match the cost of the largest solar PV facilities. 

Momentum is now building behind the further development and deployment of renewable energy sources across key markets. In turn, regional banks are now paying closer attention to the opportunities offered by this nascent sector, and are examining the ways in which they can capitalise on the rollout of sovereign-backed renewable generation facilities. The scale of investment required, coupled with the attractive longer term returns on offer, make for a compelling investment case. 

“I think in the past couple of years people have realised that renewable energy sources, particularly solar, work without the need for subsidies in a number of markets across the Middle East and Africa. Grid parity has been achieved,” says Jake Cusack, co-managing director of CrossBoundary, a frontier market investment firm.

Unlocking liquidity 

For renewable energy suppliers, the next step is to unlock the abundant liquidity in the region and address a funding shortfall that has historically blighted the industry’s development. The traditional expense associated with the provision of solar PV and other renewable energies is partly to blame for this situation. It is also a product of the higher upfront costs associated with renewable energy projects. 

"In the past, the tariff that energy providers were able to offer based on renewable sources was too high. So while renewable energy has been discussed in the Middle East for some time, there has, until recently, been a relative lack of progress," says Peter Avery, partner with law firm Clifford Chance in Dubai. 

This situation changed definitively in November 2014, when Acwa Power, an independent Saudi Arabian energy provider, successfully bid $5.98 per kilowatt hour (kWh) for a 20-year 100-megawatt (MW) solar PV contract with Dubai’s state energy utility. In short, this was a record low for the provision of solar PV electricity based on a fully commercial, unsubsidised bid. The cost was so low that the Dubai Electricity and Water Authority later doubled the size of the project to 200MW. 

The Acwa power bid was the latest in a series of landmark technological breakthroughs for the renewable energy sector over the past 18 months, contributing to a growing demand for alternative power generation in the region. It comes as the installation costs of utility-scale solar PV facilities have fallen by 75% since 2009, according to the Middle East Solar Industry Association. 

“The number of solar energy projects announced in the MENA region in 2014 was six times higher than 2013,” says Imtiaz Mahtab, president of the Middle East Solar Industry Association. “Previously, small 10MW or 15MW installations in parking lots or rooftops were the regional norm. Today, we are moving towards massive developments anywhere between 50MW to 240MW.”

A question of financing 

This trend has not escaped the attention of regional lenders. In March this year, the National Bank of Abu Dhabi (NBAD) published a pioneering report entitled ‘Financing the Future of Energy’, to explore the opportunities presented by this changing energy landscape for regional banks. 

“Where NBAD has tried to add to the discussion is around the financing of these types of renewable energy investments,” says Alex Thursby, chief executive officer of NBAD. “It is banks who have the structuring capabilities, project finance teams, industry expertise, the technical know-how and the source of funds. Therefore, the banking sector will be driving this evolution of the regional energy landscape.” 

According to data from the NBAD report, more than 170 gigawatts of additional generation capacity will be required in the Gulf Co-operation Council (GCC) region alone by 2020. “It’s up to the region’s banks to find a viable way of financing these major energy projects and I think that is starting to happen,” says Mr Thursby. 

Indeed, most observers now acknowledge that regional lenders have a healthy appetite for investments in the renewables sector, marking a departure from prevailing attitudes as recently as four or five years ago. However, as a whole, it is felt that the banking sector needs to better understand the technology on offer. 

“Local banks are used to financing infrastructure. What is missing is their experience of financing solar projects as the market is in the making,” says Mr Mahtab.

Changes in attitude 

Nevertheless, a broader change in attitude is under way. This partly reflects advances in technology and a corresponding reduction in funding costs. It also relates to the MENA region’s energy architecture, which is largely state-centric. As such, demand for generation facilities stems from state-backed utilities. 

“In the utility market, financiers are seeing lower tariffs and returns in a competitive space. Once projects are fully developed, selling power to a sovereign is less risky and can be funded by relatively cheap debt and equity, often from state-backed providers,” says Mr Cusack. 

The question now facing regional banks is how this financing will be structured. “One of the key issues will be the debt equity structures that are applied to these developments. In the formative years, the debt equity structures are going to have to be conservative. If these levels can be conservative I think support for these energy projects will surge in the form of project finance and long-term lending,” says Mr Thursby. 

As such, the loan market is expected to drive the growth of regional renewable energy investments in the coming years. Backed by ample liquidity and a growing appetite for exposure to renewables projects, the banking sector is likely to emerge as a key source of initial support for some of the region’s larger projects. Moreover, this trend will largely be driven by regional lenders, with more limited participation from international players. 

"The number of international banks who do project finance has fallen considerably in recent years. But there is still going to be opportunities for both regional and global players in the Middle East's renewable energy sector moving forward," says Mr Avery.

Challenges ahead 

Nevertheless, challenges lie on the road ahead. Regulatory pressures emerging from Basel III, among other systems of oversight, may limit the banking sector’s capacity to lend. 

“Over the long term, banks will face increasing regulatory pressures on the use of their liquidity. As a result of this, we expect to see the capital markets picking up some of the slack. [Regional lenders] will have to work with debt investors to ensure that there is a capital market formation around project finance for renewable energy developments,” says Mr Thursby. 

Here, the nexus between the regional banks and capital markets will be vital to filling any potential funding gap. “Eventually, we expect the banking sector to act as a mediator between the renewable energy industry and the debt capital markets. The banks will still structure, analyse and assume some risk on these investments but they will distribute that risk through the debt capital markets,” says Mr Thursby.

Green bonds 

The successful growth of the green bond market in recent years offers a good indicator of how the MENA region’s energy financing might evolve. In 2014, the sale of new green bonds hit $36.6bn globally, which was triple the figure from the previous year, according to NBAD’s research. As the Financing the Future of Energy report notes, greater demand for ethical and environmentally sound investments from pension funds and other institutional investors could push the green bond market to new highs and ensure it becomes a substantial source of capital for the solar industry. 

Additionally, there is strong potential for the growth of a ‘green’ sukuk market to support the development of renewable generation facilities. Though this is a longer term solution, the potential remains vast. Not only would this allow energy providers to tap large pools of Islamic liquidity, particularly in the Gulf, but the various type of sukuk, from project bonds to lease-based variations, would fit well with the project lifecycle of renewable energy projects, according to research from Climate Bonds Initiative, an international not-for-profit organisation. 

“Sukuk are the perfect instrument for solar projects because they generate cashflow. New innovations are now creating so-called ‘green’ sukuk and I expect to see significant developments in this area,” says Mr Mahtab.

Joined-up thinking

More generally, greater cohesion between the financial services sector and public authorities will be required to nurture a holistically supportive environment for renewables generation facilities in the region. In this respect, support from government authorities is now gaining greater momentum, although a number of regional leaders, particularly in the GCC, have invested significant resources in this space for a number of years. 

In the United Arab Emirates, the case for renewable energy through various policy and investment initiatives including Masdar, a wholly owned subsidiary of Abu Dhabi’s Mubadala investment vehicle. Through its various business units, Masdar has advanced the prospects for renewable energy locally, regionally and globally since its founding in 2006. 

"The UAE has taken a leading position that others are now following. In particular, the government of Abu Dhabi has played a significant role in making solar energy a viable resource,” says Mr Thursby. 

Ultimately, sound policies will be required to support both the financing that is required, as well as the physical development of power generation infrastructure. “Policy and finance go hand in hand. In order to finance these types of projects, bankers and investors look for a stable policy environment, which ultimately brings down the overall cost,” says Mr Mahtab. 

Markets across the MENA region are now waking up to the possibilities offered by renewable energy sources. With the right mix of policy, finance and technology, the region’s power crisis can be averted. However, the challenge remains significant and it will take the kind of pioneering policy development, as well as financial research, that is emerging from markets such as the UAE to ensure that the MENA region is ready to address these systemic issues.

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