The Power of Finance

Like water, the flow of financing is everything to the energy transition.

Image courtesy of Thomas Hassel (CC BY-NC-ND 2.0)

By Gregor Macdonald
November 2019

In the spring of this year, the Singapore-based Oversea-Chinese Banking Corporation
(OCBC) announced it would halt all future financing for new coal projects, save for two final newbuilds in Vietnam: Van Phong 1 at 1.3 gigawatts (GW) and Vung Ang 2 at 1.2 GW. By November, OCBC, the second largest bank in southeast Asia, announced it was dropping out of the second project, thus bringing to a sudden end its long history of coal-led project finance.

Meanwhile, in North America, Oregon-based PacifiCorp held a two-day public meeting in October to announce its plans to retire nearly 4.5 GW of coal capacity across 20 different plants by 2038, but with 60 percent of that volume under an accelerated retirement schedule by 2030. The utility, a major operator of coal in the western United States, had been warning all year that wind, solar, and storage were looking like a better value proposition to utility customers. And in particular, the utility warned that continuing to run old coal capacity would yield nothing but losses. Armed with a software model, PacifiCorp came to a surprising conclusion: it was now possible to shutter old coal, take the losses, and still return savings to customers through the buildout of new renewable assets.

“I am much more positive now about financial markets leading this transition,” says Kingsmill Bond, new energy strategist for London-based Carbon Tracker. Bond is the author of a prescient report published last year that identifies classic tipping points when old technologies are threatened, existentially, by new ones. Why You Should See the Fossil Fuel Peak Coming helpfully shows that problems for incumbents start early in any transition, not later, mostly due to growth rates falling toward zero as new entrants start to take market share. That juncture tends to send out signals to markets, equity markets to be sure, but especially debt markets, initiating predictable feedback loops. While Bond’s current work overall is quite focused on fossil fuels, his observations include a number of previous transitions, like the adoption of cars in the early 20th century.

“If I had to identify a marker, when it became clear to financial markets that a big change was inevitable, it would be the derating of General Electric,” says Bond. In 2017, the share price of GE started a long decline as a recognition took hold that the 127-year-old company had mismanaged growth expectation in the power sector—in particular, for natural gas turbines. The inflection point echoes one of Bond’s observations in his 2018 report, that the global coal sector started failing financially when global coal demand was only a few percentage points off its all-time highs. As GE’s value is down 65 percent now in just two years, the cost of equity financing has risen. “When the share price falls and the dividend yield rises, this means any new equity raises the company might propose are more expensive,” he explains.

“If I had to identify a marker, when it became clear to financial markets that a big change was inevitable, it would be the derating of General Electric.”

The end of coal financing from OCBC is part of a much larger trend. According to the Institute for Energy Economics and Financial Analysis (IEEFA), over 100 major lending institutions, from BNP Paribas and HSBC to the Asian Development Bank, have entered the divestment process from the coal sector. That financial institutions in Asia have started backing away is notable, because as recently as two years ago, Southeast Asia and India were flagged by the International Energy Agency (IEA) as the last remaining centers for global coal growth. Now, the IEA is reporting that final investment decisions (FIDs) for both coal and natural gas power generation are plunging globally. According to the IEA, coal FIDs used to run on average at 90 GW per year, but have fallen to 30 GW per year. The darkening outlook for both coal and natural gas comes as wind and solar capacity soars globally, with 49.1 GW of wind and 95.5 GW of solar capacity installed in 2018.

The mounting withdrawal of capital for coal evokes a macroeconomic phenomenon known as sudden stop, identified by economic Guillermo Calvo in the late 1990s. This describes a disruptive halt of inward investment to smaller economies, with punishing effects. This time is no different. The Indian government just canceled over 20 coal mine auctions as bids evaporated, Indian conglomerate Tata has announced it will no longer build coal plants, and the Australian government has warned that exports of coal to India are now likely to fall. The causes are many, but the cost crash for new utility-scale solar is the primary driver. Indeed, combined wind and solar provided a full 20 percent share of the total growth in India’s electricity generation last year. According to an International Renewable Energy Agency (IRENA) survey, India is now the leader in cheap solar, with costs falling 27 percent in 2018.

Courtesy of Wikimedia

Financing mechanisms and market herding are powerful precisely because they travel along multiple pathways, while arriving at common destinations. By contrast, a recent New York Times profile of Gautam Adani, “How One Billionaire Could Keep Three Countries Hooked on Coal for Decades,” mistakenly offers up a kind of great man theory of how large systems work, suggesting the powerful reach of the Adani conglomerate alone can determine global trajectories. If that were true, then an entire group of thermal power manufacturers led by Siemens, Toshiba, Westinghouse, and GE would not, as the recent IEA report on FIDs says, be facing “a painful restructuring.”

Slowing the growth of new coal, and natural gas too, is encouraging—especially in developing economies. Combined with the outright decline of coal-fired power generation in the developed economies, global coal growth has come to a halt. But more is needed. “Just doing green investments is not actually enough,” says Paul Bodnar, Managing Director of global climate finance at Rocky Mountain Institute (RMI). “To make a controversial statement, building new wind farms and solar plants does not (alone) reduce greenhouse gas (GHG) emissions. It avoids future GHG emissions from increasing. But if you want to reduce GHG you’ve got to shut off the assets that are emitting carbon.”

“If you want to reduce GHG you've got to shut off the assets that are emitting carbon.”

Bodnar works on the problem of capital stock transformation and how to retire carbon dioxide emitting assets at a faster rate. For, as important as it is to finance the new construction of low-carbon energy infrastructure, it’s equally critical to finance—or to use the specific accounting term, amortize—the losses associated with shuttering legacy assets. Indeed, 2018’s above-average growth in global electricity demand offered a sobering portrayal of the dangers of spare coal capacity—a threat that climate researchers like Glen Peters of CICERO (Center for International Climate Research) have been warning about for years. Spare coal capacity is a double-edged sword. Unused, it sends a signal that demand for coal-fired power generation is falling and that the economics of coal are deteriorating. But called upon, spare coal capacity can run roughshod over marginal growth from clean energy.

Just such a thing happened last year when combined wind and solar generation grew impressively by 273 terawatt-hours (TWh), but was overwhelmed by 294 TWh of growth from coal—almost entirely from China. That said, this was a single year’s performance and alone does not constitute a trend. Moreover, in domains where combined wind and solar are now reaching market penetrations above 20 percent, as in California, Texas, and the United Kingdom, a symbiotic effect is now coming into play—because significant volumes of renewables can actually reduce the capacity factors of existing coal and natural gas generation.

Using an analogy, Bodnar explains that current global emissions output is “like a bathtub, full of dirty water. And, of course, we want to replace the tub with clean water. But focusing only on clean investment is like only turning on the clean water tap.” In a 2018 RMI report, Reinventing Climate Finance, the analogy comes to a straightforward but not always obvious conclusion, using a stocks and flows model: only retirement of dirty capital stock will successfully drain the tub. The question remains: how might that happen?

First, let’s consider the problem in its fullest measure. Incumbent assets and incumbent fuel sources—everything from internal combustion engine (ICE) vehicles, to oil heating furnaces in municipal buildings, to oil, gas, and coal themselves, and associated infrastructure—all provide useful services even when they are no longer efficient and even when they run at a loss. A recent report from BNP Paribas, Wells, Wires, and Wheels, laid out this challenge quite specifically. If most high-emissions energy solutions were compelled to reinstall themselves anew, they’d be unable to compete with renewable technology because, as the authors explain, the return on a dollar invested is no longer in their favor. Legacy assets have one edge: they already exist.

In the case of PacifiCorp, however, the projected future losses of its legacy asset portfolio are large enough, and the cost of new wind, solar, storage, and load management is cheap enough, that we can say the retirement of the former actually begins to finance the construction of the latter. Remember, financing is an activity that primarily aggregates projections of future financial performance, and brings those realities into the present. PacifiCorp is not alone. Northern Indiana Public Service Company (NIPSCO) has announced a similar calculation, and there are indications other utilities also in the United States are looking to similarly unlock value in their portfolios. For utilities reaching this point, we might say they have crossed a kind of self-financing threshold, where liquidation of loss-making assets leads to a net gain.

Backing up from this leading edge, however, incentivizing accelerated retirement gets harder and requires more creativity. There are at least two large forces at work. On the bright side, Kingsmill Bond points out that pressure from private investors is quite real, and, “in financial markets, investors need only be more right, than wrong.” Policymakers by contrast “have many pressures on them—they have to take into consideration many constituencies. The hurdle for action is higher for a policy maker than for an investor.” This lower bar for investor action is a positive force, therefore, already playing out across the fossil fuel space, as share prices remain depressed and growth prospects are increasingly dim.

“Those who have invested in those assets have a rational incentive to intervene in the political system to maintain the viability of those assets—through non-market means.”

On the less encouraging side, as RMI’s Bodnar points out, is that fear of capital destruction is driving the opposition to climate policy. “Those who have invested in those assets (dirty capital stock) have a rational incentive to intervene in the political system to maintain the viability of those assets—through nonmarket means.” Regressive pressures like these also continue to play out, as large domains like China and even smaller domains like the State of Ohio (House Bill 6) act against public interest and continue to protect, even bail out, incumbents.

In the middle of 2014, the price of oil crashed from above $100 a barrel. While the share prices of oil producers eventually recovered, the leading-edge group that serves the industry, oil and gas services, never did. That moment was a warning about future growth. Five years later, the producers too have been pulled down so far that the entire sector now comprises just 5 percent or less of the S&P 500, a multi-decade low. The sector has been derated. In the same span of time, however, the sustainable debt sector grew from below $100 billion to over $1 trillion, according to BloombergNEF. The organization is forecasting that the next trillion will take far less than the 12 years required to reach the first.

Ultimately, financing solutions appear when innovation creates value. Whether that’s microlending for portable solar kits in Africa, or heavy state intervention to jump-start electric vehicle (EV) adoption in China, technological solutions that are verifiably better, faster, and cheaper create a kind of vacuum into which the water of financing flows. This is even true during a time of low interest rates. “If I was to try and quantify the role of interest rates versus the role of the tech learning rate, I would quantify it as 70 percent technology, maybe 10–15 percent rates, and then a small amount of policy. The fall in tech costs is far bigger than the decline of rates. I would suggest the tech learning curve is primary,” says Kingsmill Bond.

“If I was to try and quantify the role of interest rates versus the role of the tech learning rate, I would quantify it as 70 percent technology, maybe 10–15 percent rates, and then a small amount of policy.”

We are entering an era in which clean energy happens also to be cheaper energy. Without the 60–70 percent efficiency advantage that EVs have over ICE vehicles, it would be difficult, if not impossible, to attract the flows of capital required to outcompete the legacy technology. Alas, from power generation to transport, the new energy solutions on offer only require that we rationally use capital markets to bring their future savings into the present.