Balancing financial risk in the development of innovative energy projects
As the world moves towards a more sustainable future, the successful transition to alternative forms of energy relies heavily on innovation and new technology. However, the financial risk associated with untested technology often becomes a barrier to the implementation of these projects. The allocation and management of this risk is crucial to ensure the success of energy transition initiatives. With trillions of dollars needed to be spent on green projects, finding a solution to this challenge is imperative.
The Role of Funding in Risk Allocation
The source of funding plays a significant role in determining who bears the main risks of a project. Whether it is bank funding, government funding, private equity, or other sources, each has its own risk appetite and compensation preferences. For instance, banks providing non-recourse project funding prefer to avoid technology risk altogether and instead require all project risks, including technology risk, to be addressed in an Engineering, Procurement, and Construction (EPC) contract. On the other hand, private equity funds and investment funds may be more averse to taking on technology risks.
Compensation for Technology Risk
Compensation for technology risk can take various forms. Ownership of new technology can be valuable and a potential source of revenue beyond the individual projects. In such cases, owning the technology and having the right to deploy it elsewhere becomes crucial for managing risks. Conversely, financial backers like investment funds and pension funds are generally less willing to take on technology risks. Banks, too, are reluctant to do so. Finding the right balance of compensation becomes essential to ensure the viability of projects.
The Challenge for Contractors
Contractors often face the burden of assuming technology risks, especially when deploying new and untested technology. While they may be able to manage risks in standard projects with quantifiable and well-understood risks, it becomes more challenging when dealing with new technology. The traditional EPC model, where contractors take on all risks, may lead to higher prices for consumers as contractors demand compensation for the additional risk. Smaller contractors without the resources to bear this risk may choose not to bid on projects, causing further price increases and potential supply chain disruptions.
Aligning Interests through Equity
In situations where contractors are unable or unwilling to guarantee timely and budgeted project delivery, providing them with a stake in the equity can align their interests with the project sponsors. This approach ensures that technology risks are managed through a combination of supply agreements and shareholders’ agreements. Contractors are entitled to consideration under the supply agreement and earn a revenue stream once the project becomes profitable. The shareholders’ agreement can include remedies for breaches and keep the relevant intellectual property within the project company.
The EPCm Model
When there is no clear main contractor for an EPC role, the technology provider may act as an EPCm consultant, coordinating project contractors without underwriting the project’s timely and budgeted completion. The fees of the EPCm contractor often include a contingent element to create the right incentives and allocate risks across different contractors, reducing the likelihood of a single contractor taking on excessive or unmanageable risks.
Conclusion:
The allocation of risk in energy transition projects involving new technology is a complex challenge. The choice of funding sources, compensation structures, and contractual arrangements all play a crucial role in determining who bears the financial risk. Initiatives such as the Net Zero Technology Centre and ORE Catapult provide support for innovators, helping drive early success in innovative projects. However, more solutions are needed to bridge the gap between early-stage projects and large-scale investments. Facilitating innovation and ensuring adequate funding is essential to drive the energy transition forward.
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