Improving Renewables Financing Conditions through Deliberate Auction Design

This blog was coauthored by Ana Amazo and Martin Jakob.

Why Auction Design Matters

Renewable energy projects require high upfront investments but feature low operational costs. This makes the cost of capital (the cost under which capital providers are willing to invest and lend money to a project) a key driver of overall cost. Because the cost of capital-intensive technologies such as renewable energy is more strongly affected by a rise in capital costs than less capital-intensive technologies, de-risking investment can reduce support costs in an important way.

Policymakers often have only an indirect influence on the exogenous risk factors for renewable energy projects, such as capital market conditions or general country risk (economic, political, socioeconomic or sovereign risk). However, they can directly influence auction-specific risk factors through auction and support designs.

Policies that mitigate market exposure risk and foster learning effects in renewable energy deployments can be crucial for reducing the cost of capital. The Auctions for Renewable Energy Support II (AURES II) project found that as auctions become more established through implementing more auction rounds and auctioning large volumes, the weighted average cost of capital for renewable projects decreases.

What Are the Risks?

Auction-Specific Risks Across the Project Lifetime

(Source: Auctions for Renewable Energy Support II)

When participating in an auction, renewable energy projects may be faced with several types of risks:

• Qualification risk is the risk that a bidder prepares but does not fully meet an auction’s prequalification requirements and gets disqualified from the auction.
  
• Allocation risk describes the risk of not being awarded support after having participated in an auction. As a result, the project might not be pursued further, leading to sunk costs.
  
• Non-compliance risk refers to a bidder’s risk of not meeting the contractually agreed-upon deadlines or production obligations, resulting in having to pay a penalty or losing the awarded contract.
  
• Market exposure risk—though not strictly speaking an auction-specific risk—is the risk resulting from project revenue being exposed to price volatility in electricity markets. This leads to unsecured revenues, which affect the project’s ability to pay back investors.
  

Minimizing Unnecessary Risks through Auction Design

The AURES II project recommends four broad principles to consider when designing auctions:

1. Create long-term visibility. Auctions with long-term schedules and regular frequencies provide multiple opportunities for developers to participate, thereby reducing the possibility of sunk costs. Support design that stabilizes revenue from the electricity market increases certainty regarding future revenue streams and a project’s ability to pay back investors.
   
2. Clearly communicate procedures and rules before the auction. Auction procedures, including ceiling prices and award rules, that are fixed ahead of time and communicated clearly allow for a better assessment of a project’s chance of success. Ex post changes to rules or tariffs should be avoided.
   
3. Apply context sensitivity instead of one-size-fits-all approaches. Deadlines should respect the development stage of the auctioned projects, and penalties should be applied proportionate to delays to allow for better control of the impact on revenue. Rather than making the same rules for all, technology-specific auctions can acknowledge relevant differences between technologies and help create a more level playing field.
   
4. Help developers make better decisions instead of making decisions for them. Material and financial prequalification requirements can not only ensure the seriousness of bids but also allow bidders to gain relevant insights on site conditions, costs, and regulations. While site developers should be responsible for selection and development, in highly uncertain environments, preselecting potential project sites or areas according to grid and environmental suitability can make permit-related risks more calculable.
   

Good auction design tries to minimize unnecessary risks for developers but it does not shield developers from all risks. Instead, auction design should help developers correctly assess the risks involved and make better decisions. 

Further insights into auction design and renewable energy financing can be found in the AURES report, Auction Design and Renewable Energy Financing.